**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**WASHINGTON,
      D.C. 20549**





**FORM
      10-K**




**(Mark
                One)**[X]
            **Annual
                Report Pursuant to Section 13 or 15(d) of the Securities Exchange
                Act of
                1934**For
                the fiscal year ended:**December
                31, 2006**Or[
                ]
            **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
            
            (I.R.S.
                Employerincorporation
                or organization)
            
            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
      [
      ]    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
      [
      ]    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
      [
      ]





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 the 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. [ **** ]


1


Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer or a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange
      Act.


Large
      Accelerated Filer [ ]  Accelerated
      Filer [ ]   Non-accelerated
      Filer [ **X** ]





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).          Yes
      [
      ]    No
      [ **X** ]





As
      of
      June 30, 2006 (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
      $3,357,000 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 March 27, 2007Common
                Stock, $0.01 par value per share
            
            18,613,968
                shares





**DOCUMENTS
      INCORPORATED BY REFERENCE**


Document
            
            Parts
                Into Which IncorporatedAnnual
                Report to Stockholders for the Fiscal Year Ended December 31, 2006
                (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 31, 2006(Proxy
                Statement)
            
            Part
                III





**FORWARD
      LOOKING STATEMENTS**





When
      used
      in this Annual Report on Form 10-K, the words “believes”, “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, our 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; 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; and the timing,
      costs and charges relating to restaurant openings, closings and remodelings.
      As
      a result of these and other factors, we may experience material fluctuations
      in
      future operating results on a quarterly or annual basis, which could materially
      and adversely affect our business, financial condition and stock price.
      Furthermore, this document and other documents filed by us with the Securities
      and Exchange Commission (“SEC”) contain certain forward-looking statements with
      respect to our business and the industry in which we operate. 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. We undertake no obligation to update
      these forward looking statements on a regular basis. An investment in our
      company involves various risks, including those mentioned above and those that
      are detailed from time-to-time in our 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.


2


**SHELLS
      SEAFOOD RESTAURANTS, INC.**





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


**For
      the Year Ended December 31, 2006**





**TABLE
      OF CONTENTS**


Page
                  No.PART
                  IItem
                  1. Business
              4Item
                  1A. Risk Factors
              12Item
                  1B. Unresolved Staff Comments
              19Item
                  2. Properties
              20Item
                  3. Legal Proceedings
              20Item
                  4. Submission of Matters to a Vote of Security Holders
              20PART
                  IIItem
                  5. Market for Registrant’s Common Equity, Related Stockholder Matters and
                  Issuer Purchases of Equity Securities
              21Item
                  6. Selected Financial Data
              24Item
                  7. Management’s Discussion and Analysis of Financial Condition and Results
                  of Operation
              26Item
                  7A. Quantitative and Qualitative Disclosures About Market
                  Risk
              36Item
                  8. Financial Statements and Supplementary Data
              37Item
                  9. Changes in and Disagreements With Accountants on Accounting
                  and
                  Financial Disclosure
              38Item
                  9A. Controls and Procedures
              38Item
                  9B. Other Information
              38PART
                  IIIItem
                  10. Directors, Executive Officers and Corporate Governance
              39Item
                  11. Executive Compensation
              39Item
                  12. Security Ownership of Certain Beneficial Owners and Management
                  and
                  Related Stockholder Matters
              39Item
                  13. Certain Relationships and Related Transactions, and Director
                  Independence
              39Item
                  14. Principal Accounting Fees and Services
              39PART
                  IVItem
                  15. Exhibits, Financial Statement Schedules
              40Signatures
              44




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 31, 2006, our fiscal year end, we owned 21 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 have 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 have implemented a two-tier pricing strategy that expands
      our ability to profitably build check average and sales. We have maintained
      the
      price to value relationship, which Shells is known for, primarily through our
      seafood pastas, but have also expanded the appeal of our menu at higher price
      points. 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


As
      measured by steadily increasing guest satisfaction ratings, our guests continue
      to embrace the changes we have implemented. During 2005, a steady erosion of
      sales that had been taking place for several years had reversed, and by the
      beginning of 2006 most of our company-owned restaurants had been remodeled
      with
      a brighter, more contemporary new look. Sales trends continued to improve
      through the first three quarters of 2006, but turned negative in the fourth
      quarter. Generating sales and traffic increases is critical to our future
      success. We regularly evaluate and modify our marketing strategies to better
      ensure effectiveness.





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





**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
              Coral
                  SpringsClearwater
                  Beach
              Kissimmee
              DavieHolmes
                  Beach
              New
                  Smyrna Beach
              KendallRedington
                  Shores
              Ocala
              Pembroke
                  PinesSt.
                  Pete Beach
              Orlando
              SunriseSt.
                  Petersburg
              Winter
                  ParkWinter
                  Haven
              MelbourneNorth
                  TampaSarasotaSouth
                  Tampa**West
                  Palm Beach**
              **Fort
                  Myers**Stuart
              Fort
                  MyersWest
                  Palm Beach


We
      closed
      one under-performing Florida restaurant in 2002, and an additional three Florida
      restaurants in 2004. During 2005, we closed one under-performing restaurant,
      relocated one restaurant to a more preferable site, and opened two new
      locations. Also, during 2005, we agreed with one licensee restaurant to
      terminate its management and license agreement, and took over the licensing
      rights to this strategic market within Tampa. 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 four 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.




6


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.




**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. In February 2006, focus groups were conducted in all major
      markets to determine the guests’ perception of the brand in the communities.
      Using the information gathered during the focus groups, our marketing focus
      shifted from broadcast and cable television to a strong direct mail campaign
      coupled with broadcast television in the Tampa market. Our media in the third
      quarter of 2006 focused primarily on radio endorsements in the Tampa and Orlando
      markets. The medium of radio allowed us to incorporate promotion driven events
      to the restaurants with live broadcasts, remote broadcasts and disk jockey
      appearances. We continued our local store marketing program, providing all
      of
      our restaurants with resources to take advantage of an array of sales-building
      initiatives.





In
      May
      2006, we entered into a monthly retainer with Dunn and Company, our current
      advertising agency. Dunn and Company is responsible for all creative and media
      buying services for Shells and works on various elements of the business
      including in store point-of-purchase promotions, creative services and media
      buying.




7


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





The
      Shells restaurant system currently consists of (i) 21 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. The remaining 49% interest in the Melbourne restaurant
      is indirectly owned by Wanda L. Hattaway, wife of William E. Hattaway, a former
      director and president of our company. In addition to the equity interest in
      this restaurant, we receive a management and licensing fee of 6% of the
      restaurant sales of the Melbourne restaurant.





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 restaurant’s 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 18 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 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.





**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.


8


Approximately
      13% 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.




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. 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.


9


**Employees**





As
      of
      December 31, 2006, we employed approximately 1,100 persons, of whom
      approximately 120 were management or administrative personnel employed on a
      salaried basis and 980 were employed in non-management restaurant positions
      on
      an hourly basis. Approximately 600 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
              Position
 Leslie
                        J. Christon
                    52
                    President
                        and Chief Executive Officer
 Guy
                      C. Kathman
                  50
                  Vice
                      President of Operations
 Warren
                    R. Nelson
                55
                Executive
                    Vice-President of Finance, Chief Financial Officer, Treasurer
                    and
                    Secretary


Christopher
                R. Ward, Sr.
            45
            Vice-President
                of Purchasing





**Leslie
      J. Christon** has been
      our President and Chief Executive Officer since joining Shells in July 2003.
      From 2002 to 2003, Mrs. Christon was self-employed as a management consultant
      in
      the restaurant industry. From 2000 to 2002, Mrs. Christon was employed by Sutton
      Place Gourmet, Inc. as its President and Chief Operating Officer. From 1996
      to
      2000, Mrs. Christon was employed by Brinker International, On the Border
      Restaurants, as its President.





**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 Executive Vice-President of Finance, Chief Financial
      Officer, Treasurer, and Secretary, positions he has held 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.





**Christopher
      R. Ward** has
      served as our Vice-President of Purchasing since September 2004 and as an
      executive officer since August 2005. From 2003 to 2004, Mr. Ward managed supply
      chain management for Gate Gourmet, an airline catering company. From 2001 to
      2003, Mr. Ward was Director of Purchasing for Buffets, Inc. From 1997 to 2001,
      Mr. Ward was Vice President of Purchasing for Peasant Restaurants.


10


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 10-K 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 10-K. These are statements that relate to our expectations for
      future events and time periods. Generally, the words "anticipate," "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 our recent prior years. As
      of
      December 31, 2006, our company 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. As of January 1, 2006,
      our
      company had a working capital deficiency of $4,842,000 and a cash balance of
      $1,361,000. In 2005, we incurred a net loss, before preferred stock dividend,
      of
      $1,852,000, and we invested $7,762,000 in property and equipment for our new
      remodel program. In 2004, we incurred a net loss of $1,344,000, and we invested
      $1,525,000 in property and equipment. In addition, in the fourth quarter of
      2006, we experienced declining 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.





***Operating
      expenses may increase.*** Annually, since 2005, we have incurred increases in labor costs due to the
      Florida minimum wage rate increase. Utilities and insurance expenses increased
      mostly as a result of the hurricanes in 2004 and 2005, and these expense
      categories are continuing to be elevated. Due to significantly increasing real
      estate market values throughout Florida, we also are incurring significant
      increases in real estate taxes. In addition, certain of our leases are coming
      up
      for renewal or expiring over the next several years. Increases in rent expense
      will likely 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.





***We
      may be unable to repay certain of our debts when they
      mature*** .
      Our
      investors have funded $1,440,000 on a line of credit, which matures on May
      23, 2008. There are no assurances our investors will continue to extend the
      maturity date on this note or that adequate financing options will be available
      to our company when necessary or at terms that are 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 31,
      2006, we owed $438,000 on the principal balance of this note, which matures
      in
      September 2007. We are currently negotiating with our joint venture partner
      to
      remodel this restaurant, the cost of which is intended to be included in a
      refinancing of the property with Colonial Bank. There are no assurances the
      bank
      will refinance the property under terms contemplated, or at all.




12


The
      note
      relating to the restaurant property and the $1,440,000 line of credit held
      by
      entities owned or associated with investors are secured by certain of our
      assets. Any failure to pay these debts as they mature would allow holders of
      these debts to seize and sell such assets to satisfy amounts owed.





***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 31, 2006, for federal income tax purposes, we had approximately
      $10,769,000 of net operating loss carryforwards, or NOLs, available to reduce
      taxable income in future years and approximately $3,593,000 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 27, 2007, there were outstanding 18,614,000 shares of common stock, and
      warrants, options or other convertible securities outstanding to purchase an
      additional 19,062,000 shares of common stock, including options and warrants
      representing 12,006,000 shares of common stock at an average exercise price
      of
      $1.00 per share.




Since
      fiscal 2002, we raised $11.3 million through issuing securities, including
      warrants and preferred stock convertible into 27,867,000 shares of our
      common stock. As of March 27, 2007, 13,793,000 shares of our common stock have
      been issued relating to these warrants and preferred stock, and outstanding
      warrants and preferred stock remain convertible into 14,074,000 shares of common
      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 2007. Certain forms of capital raising may
      result in substantial additional dilution to our existing
      stockholders.




***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 56.6%
      of
      our outstanding voting shares, consisting of Common Stock and Series B
      Convertible Preferred Stock, as of March 27, 2007 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.




13


***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,
      we
      relocated one restaurant in 2005 to a higher volume location and opened two
      new
      restaurants. We continually monitor the operations and financial performance
      with respect to certain of our other existing restaurants. We did not open,
      close, or relocate any restaurants in 2006.




***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.





***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.





***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 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 our
      suppliers and Performance Food Group are satisfactory and that alternative
      sources are readily available. However, the loss of some suppliers or of our
      relationship with Performance Food Group could materially adversely affect
      us.


14


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.





***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 some of these costs.
      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.




15


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 prefer-ence 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:





•
            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 con-sumer preferences, tastes and eating habits;





•
            demographic
                trends and traffic patterns;





•
            increases
                in food and labor 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
      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, has sustained significant losses during the last two
      hurricane seasons. Adequate insurance coverage is becoming 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.


16


***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.





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 and 2007, the minimum wage rate in Florida increased another $0.25
      and $0.27 per hour, respectively, with tipped employees also receiving the
      full
      wage increase. At the beginning of each year, the minimum wage will increase
      according to 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.


17


***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.





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.





***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.


18


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
      27,
      2007, we had 22,694 shares of Series A Preferred Stock outstanding.





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 27, 2007, we had 322,551 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




19


**ITEM
      2. PROPERTIES**





We
      lease
      6,300 square feet of space in Tampa, Florida for our executive offices. The
      annual rent payable under the lease, which expires October 31, 2007, is
      approximately $99,000. We expect to renew this lease.





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 $18.00 per square foot.





**ITEM
      3. LEGAL PROCEEDINGS**





On
      March
      6, 2006, we received a summons in a civil case from the United States District
      Court that an employee in a South Florida Shells restaurant had filed a charge
      alleging racial discrimination in violation of the Civil Rights Act. In January
      2007, this case was fully settled through mediation.





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.
      In
      February 2007, the parties under the lease and sublease agreed to allow the
      landlord a period of six months to market the property to find a suitable
      tenant. This agreement also contained a lease buy-out provision between the
      landlord and Famous Dave’s. If a tenant is secured or the buy-out provision is
      exercised, Famous Dave’s and Shells thereafter would be released of their
      obligations under the respective leases. Otherwise, the financial implications
      to Shells are undetermined at this time. If necessary, we intend to pursue
      our
      rights against Famous Dave’s, as appropriate to protect our interest.





On
      March
      13, 2007, we received a summons from the circuit court in Kane County, Illinois,
      naming the Spring Hill Mall, L.L.C., the primary landlord, as defendant. The
      suit relates to a restaurant lease in Carpentersville, Illinois. Under this
      lease, Shells is 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. We have been negotiating with Spring Hill Mall for
      a
      buyout of our obligations under the various subleases. Under the suit, Spring
      Hill Mall is seeking payment of rent, occupancy, and related charges totaling
      $147,000 with the addition of interest and fees related to the suit. We shall
      continue to seek a financial settlement to include a full release from any
      leasehold obligations.





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





**ITEM
      4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**





None.


20


**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
                2005**
            
            **High**
            
            **Low**First
                quarter
            
            $
            1.40
            
            $
            0.71Second
                quarter
            
            $
            1.30
            
            $
            0.75Third
                quarter
            
            $
            1.25
            
            $
            0.67Fourth
                quarter
            
            $
            1.08
            
            $
            0.75**Fiscal
                2006**First
                quarter
            
            $
            1.01
            
            $
            0.86Second
                quarter
            
            $
            0.90
            
            $
            0.70Third
                quarter
            
            $
            0.82
            
            $
            0.58Fourth
                quarter
            
            $
            0.75
            
            $
            0.51




The
      number of stockholders of record of our common stock on March 27, 2007 was
      approximately 250 and as of that date, our stock price was $0.54.





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. ****


****


**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 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.




21


**Equity
      Compensation Plans**





Securities
      authorized for issuance under equity compensation plans as of December 31,
      2006
      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)
            
            
            9,228,835
            
            $
            1.09
            
            
            701,692Equity
                compensation plans not approved by security holders (2)
            
            
            2,777,278
            
            $
            0.68
            
            
            -Total
            
            
            12,006,113
            
            
            
            
            
            701,692





(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 (i) 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, President and Chief Executive Officer,
                and the
                Company, and (ii) warrants to purchase 1,873,750 shares of common
                stock,
                exercisable through December 7, 2007, issued on December 7, 2004
                in
                connection with the $2,375,000 debenture offering at an exercise
                price of
                $0.60 per share.





The
      number of securities and type of plans available for future issuance of stock
      options as of December 31, 2006 was:


Options
                for Common Shares:Plan
                Name
            
            Authorized
            
            Exercised
            
            Outstanding
            
            Expired
            
            AvailableStock
                Option Plan for Non-Employee Directors
            
            
            150,000
            
            
            0
            
            
            32,000
            
            
            0
            
            
            118,0001995
                Employee Stock Option Plan
            
            
            840,000
            
            
            11,000
            
            
            105,500
            
            
            723,500
            
            
            01996
                Employee Stock Option Plan
            
            
            101,000
            
            
            11,001
            
            
            58,007
            
            
            31,992
            
            
            02002
                Equity Incentive Plan
            
            
            4,096,472
            
            
            228,522
            
            
            3,284,258
            
            
            0
            
            
            583,692Total
                stock options
            
            
            5,187,472
            
            
            250,523
            
            
            3,479,765
            
            
            755,492
            
            
            701,692





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, President and Chief Executive Officer.





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


22


The
      1995
      Employee Stock Option Plan expired in September 2005 on its tenth anniversary
      as
      provided in the plan document. Options to purchase 105,500 shares of common
      stock remain outstanding under this plan, and expire on the tenth anniversary
      of
      their issuance, if not previously exercised; the last of which options expire
      in
      May 2011.





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.





**STOCK
      PRICE PERFORMANCE**




*The
      following Stock Price Performance Graph shall not be deemed incorporated by
      reference 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 31, 2001 (the first day of our fiscal 2002) 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**





23


**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, number of restaurants data, and percentage
      information).




Year
                  (52 Weeks) Ended
              
              Year
                      (53 Weeks) Ended
              
              Year
                  (52 Weeks) EndedDecember
                  31,
              
              January
                  1,
              
              January
                  2,
              
              December
                  28,
              
              December
                  29,2006
              
              2006
              
              2005
              
              2003
              
              2002**Statement
                  of Operations Data:**REVENUESRestaurant
                  sales
              
              $
              47,673
              
              $
              44,335
              
              $
              41,393
              
              $
              43,881
              
              $
              47,065Management
                  fees
              
              
              156
              
              
              152
              
              
              171
              
              
              165
              
              
              163Total
                  revenues
              
              
              47,829
              
              
              44,487
              
              
              41,564
              
              
              44,046
              
              
              47,228RESTAURANT
                  OPERATING COSTS:Food
                  and beverage
              
              
              15,363
              
              
              14,671
              
              
              14,051
              
              
              14,467
              
              
              15,778Labor
              
              
              14,722
              
              
              13,757
              
              
              12,935
              
              
              13,845
              
              
              14,585Other
              
              
              12,948
              
              
              11,374
              
              
              10,123
              
              
              11,117
              
              
              10,774Depreciation
                  and amortization
              
              
              2,199
              
              
              1,499
              
              
              1,058
              
              
              1,077
              
              
              1,102Pre-opening
                  expenses
              
              
              -
              
              
              758
              
              
              -
              
              
              -
              
              
              -Provision
                  for impairment of assets
              
              
              1,242
              
              
              -
              
              
              105
              
              
              360
              
              
              110Provision
                  for impairment of goodwill
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              206Total
                  restaurant operating costs
              
              
              46,474
              
              
              42,059
              
              
              38,272
              
              
              40,866
              
              
              42,555RESTAURANT
                  OPERATING INCOME
              
              
              1,355
              
              
              2,428
              
              
              3,292
              
              
              3,180
              
              
              4,673General
                  and administrative expenses
              
              
              3,821
              
              
              4,015
              
              
              3,249
              
              
              3,387
              
              
              3,565(LOSS)
                  INCOME FROM OPERATIONS
              
              
              (2,466
              )
              
              (1,587
              )
              
              43
              
              
              (207
              )
              
              1,108OTHER
                  INCOME (EXPENSE):Lease
                  buy-out
              
              
              212
              
              
              600
              
              
              -
              
              
              -
              
              
              -Provision
                  for impairment of assets due to lease buy-out
              
              
              -
              
              
              (211
              )
              
              -
              
              
              -
              
              
              -Interest
                  expense, net
              
              
              (332
              )
              
              (413
              )
              
              (1,154
              )
              
              (463
              )
              
              (534
              )Other
                  (expense) income, net
              
              
              (173
              )
              
              30
              
              
              33
              
              
              (100
              )
              
              (3
              )Total
                  other (expense) income, net
              
              
              (293
              )
              
              6
              
              
              (1,121
              )
              
              (563
              )
              
              (537
              )(LOSS)
                  INCOME BEFORE ELIMINATION OFMINORITY
                  PARTNER INTEREST AND INCOME TAXES
              
              
              (2,759
              )
              
              (1,581
              )
              
              (1,078
              )
              
              (770
              )
              
              571ELIMINATION
                  OF MINORITY PARTNER INTEREST
              
              
              (243
              )
              
              (271
              )
              
              (266
              )
              
              (264
              )
              
              (221
              )(LOSS)
                  INCOME BEFORE INCOME TAX BENEFIT
              
              
              (3,002
              )
              
              (1,852
              )
              
              (1,344
              )
              
              (1,034
              )
              
              350Income
                  tax benefit (1)
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              327NET
                  (LOSS) INCOME BEFOREPREFERRED
                  STOCK DIVIDEND
              
              
              (3,002
              )
              
              (1,852
              )
              
              (1,344
              )
              
              (1,034
              )
              
              677Deemed
                  dividend associated with warrantsand
                  beneficial conversion feature of preferred stock
              
              
              -
              
              
              (1,735
              )
              
              -
              
              
              -
              
              
              -NET
                  LOSS (INCOME) APPLICABLE TO COMMON STOCK
              
              $
              (3,002
              )
              $
              (3,587
              )
              $
              (1,344
              )
              $
              (1,034
              )
              $
              677




24


Fiscal
                  Years EndedDecember
                  31,
              
              January
                  1,
              
              January
                  2,2006
              
              2006
              
              2005**Earnings
                  per Share Data:**Basic
                  and diluted net loss per share
              
              $
              (0.18
              )
              $
              (0.24
              )
              $
              (0.26
              )**Shares
                  Outstanding Data:**Basic
                  and diluted weighted average
              
              
              16,665
              
              
              14,796
              
              
              5,262**Operating
                  Data:**Number
                  of restaurants (at end of period):Company-owned
                  restaurants (2)
              
              
              22
              
              
              22
              
              
              21Licensed
                  restaurants
              
              
              3
              
              
              3
              
              
              425
              
              
              25
              
              
              25Average
                  annual sales per Company-owned andjoint
                  venture restaurant open for full period (3)
              
              $
              2,167
              
              $
              1,998
              
              $
              1,896Increase
                  (decrease) in Company-owned and jointventure
                  restaurant same store sales (3)
              
              
              3.8
              %
              
              7.0
              %
              
              -1.6
              %
  December
                  31,
              
              January
                  1,
              
              January
                  2,
              
              December
                  28,
              
              December
                  29,2006
              
              2006
              
              2005
              
              2003
              
              2002**Balance
                  Sheet Data:**Working
                  capital (deficiency)
              
              $
              (4,446
              )
              $
              (4,842
              )
              $
              (4,639
              )
              $
              (3,606
              )
              $
              (3,116
              )Total
                  assets
              
              
              13,837
              
              
              17,438
              
              
              13,519
              
              
              11,616
              
              
              13,858Long-term
                  debt, less current portion
              
              
              172
              
              
              1,001
              
              
              2,239
              
              
              1,558
              
              
              1,760Long-term
                  debt, related party, less current portion
              
              
              1,527
              
              
              809
              
              
              1,495
              
              
              2,267
              
              
              2,123Minority
                  partner interest
              
              
              522
              
              
              472
              
              
              442
              
              
              466
              
              
              428Preferred
                  stock
              
              
              4
              
              
              5
              
              
              -
              
              
              1
              
              
              1Stockholders'
                  equity
              
              
              4,339
              
              
              7,190
              
              
              502
              
              
              1,183
              
              
              2,152







(1)
            
            The
                effective tax rates for fiscal years 2006, 2005, 2004, 2003 and 2002
                include the effects of recognizing valuation allowance adjustments
                relating to tax benefits. There was no benefit or provision for income
                taxes in 2006, 2005, 2004 or 2003. Income tax benefit of 93.3% for
                the
                fiscal year ended 2002, differ from the amounts computed by applying
                the
                effective federal income tax rate of 34% as a result of adjusting
                the
                valuation allowance, primarily related to net operating loss carryforwards
                from prior years. The valuation allowance in 2006, 2005, 2004, 2003
                and
                2002 was increased by $2,821, $252, $210, $596, and $1,403, 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 opened, one was relocated and one was closed in 2005,
                and
                three additional locations were closed in 2004.(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.





25


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





**General**




During
      fiscal year 2006, Shells experienced a more challenging operating environment
      in
      Florida, the state where all of our restaurants are located. Several cost areas,
      most notably insurance, utilities and property taxes, increased sharply,
      negatively impacting our profitability. Another increase in the state minimum
      wage also pushed labor costs higher for the second consecutive
      year.





Annual
      sales were stronger during 2006, despite a soft fourth quarter, and guest
      acceptance of the revitalized Shells continued to improve, reflecting the
      changes we’ve made to enhance our menu, service and atmosphere. Guest
      satisfaction ratings have steadily improved during every quarter over the past
      two years. But the higher costs of doing business more than offset our sales
      gains.


We
      implemented several strategies aimed at improving profitability during the
      year,
      including engineering a new menu. Since its introduction last fall, the new
      menu
      has successfully increased check average and helped to reduce food costs as
      a
      percent of sales.





We
      continued to focus on controlling internal expenses despite the various cost
      hikes, and Shells operating cash flow, as adjusted for non-recurring items,
      improved during 2006. Both food and labor costs were lower as a percentage
      of
      sales compared to the prior year. An energy management program was also put
      in
      place at all restaurants to help offset the rising energy prices.





We
      experienced an improvement in sales through the first three fiscal quarters
      of
      2006. The sales trend turned negative in the fourth quarter of 2006. We believe
      this recent negative trend is partly due to the slowing growth rates of both
      tourism and the state economy, with many casual dining restaurants throughout
      Florida also experiencing a sales slowdown.





Our
      key
      challenge is to build customer traffic, attracting new and lapsed guests to
      experience the major concept enhancements that have been made over the past
      two
      years. We continue to fine-tune our marketing strategies to accomplish this,
      while regularly adding new and exciting menu items aimed at increasing frequency
      of existing guest visits.





Our
      management remains committed to our turnaround strategy launched three years
      ago. We will continue to aggressively address both our top and bottom line
      pressures. And despite the many challenges facing our company, we are encouraged
      by the guest acceptance of the work completed to update and broaden the appeal
      of the Shells concept, as well as the instilling of higher operating standards.





However,
      there are no assurances that our strategies will drive improvements in sales
      and
      customer traffic needed to meet anticipated cash flow requirements and restore
      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, or at all.


26




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
                31,
            
            January
                1,
            
            January
                2,2006
            
            2006
            
            2005REVENUESRestaurant
                sales
            
            
            99.7
            %
            
            99.7
            %
            
            99.6
            %Management
                fees
            
            
            0.3
            %
            
            0.3
            %
            
            0.4
            %Total
                revenues
            
            
            100.0
            %
            
            100.0
            %
            
            100.0
            %RESTAURANT
                OPERATING COSTSCost
                of sales (1)
            
            
            32.2
            %
            
            33.1
            %
            
            33.9
            %Labor
                and other related expenses (1)
            
            
            30.9
            %
            
            31.0
            %
            
            31.2
            %Other
                restaurant operating expenses(1)
            
            
            27.2
            %
            
            25.7
            %
            
            24.5
            %Total
                restaurant costs (1)
            
            
            90.3
            %
            
            89.8
            %
            
            89.6
            %General
                and administrative expenses
            
            
            8.0
            %
            
            9.0
            %
            
            7.8
            %Depreciation
                and amortization
            
            
            4.6
            %
            
            3.4
            %
            
            2.5
            %Pre-opening
                expenses
            
            
            0.0
            %
            
            1.7
            %
            
            0.0
            %Provision
                for impairment of assets
            
            
            2.6
            %
            
            0.0
            %
            
            0.3
            %RESTAURANT
                OPERATING (LOSS) INCOME
            
            
            -5.2
            %
            
            -3.6
            %
            
            0.1
            %Interest
                expense, net
            
            
            -0.7
            %
            
            -0.9
            %
            
            -2.8
            %Other
                (expense) income, net
            
            
            0.1
            %
            
            0.9
            %
            
            0.1
            %Elimination
                of minority partner interest
            
            
            -0.5
            %
            
            -0.6
            %
            
            -0.6
            %Net
                loss
            
            
            -6.3
            %
            
            -4.2
            %
            
            -3.2
            %Deemed
                dividend associated with warrants and beneficialconversion
                feature of preferred stock
            
            
            0.0
            %
            
            -3.9
            %
            
            0.0
            %Net
                loss applicable to common stock
            
            
            -6.3
            %
            
            -8.1
            %
            
            -3.2
            %(1)
                as a percentage of restaurant sales




**Results
      of Operations**





***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%, we believe,
      due
      in part, in 2005 due to the increased emphasis and additional menu items 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. Typically, 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.


27


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. 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 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 revenues were 31.1% and 31.8%
      for
      2006 and 2005, respectively. This improvement of 0.7% as a percentage of 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. Labor
      and
      other related expenses generally consist of restaurant hourly and management
      payroll, benefits, taxes and workers’ compensation insurance.





Other
      restaurant operating expenses were $12,948,000, or 27.2% of restaurant sales
      for
      2006, as compared with $11,375,000, or 25.7% of restaurant sales for 2005.
      This
      unfavorable variance of 1.5% as a percentage of sales was primarily due to
      increased utilities, insurance and occupancy costs, as affected by property
      taxes, partially offset by a decrease in advertising 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.




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 over 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.




Depreciation
      and amortization expense was $2,199,000 or 4.6% as a percentage of revenues,
      for
      2006 and $1,499,000, or 3.4% as a percentage of revenues, for 2005. The 1.2%
      increase 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 revenues
      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.


28


In
      2006,
      we recorded a provision in operating expenses for the impairment of assets
      totaling $1,242,000 or 2.6% of revenues 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.





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.




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-leaseback 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 $1,320,000 for
      2006 compared to $1,168,000 for 2005. Net loss 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 retained
      earnings.





***Fiscal
      Year 2005 versus Fiscal Year 2004***




29


Total
      revenues for the fiscal year 2005 were $44,487,000 as compared to $41,564,000
      for fiscal year 2004. The $2,923,000 or 7.0% increase in revenues was primarily
      due to a 7.0% increase in comparable store sales and the net addition of one
      company-owned restaurant during fiscal year 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 7.5% increase in average customer check, which was affected by
      menu
      price increases and menu mix. Customer traffic declined by 0.4% in 2005 compared
      to 2004, although this trend has improved over each of the four fiscal quarters
      of 2005. Our food sales and liquor sales accounted for 88% and 12% of revenues
      for each of 2005 and 2004, respectively. In 2005 and 2004, we incurred estimated
      sales losses of $204,000 and $930,000, respectively, due to hurricane-related
      business interruption. Adjusting for estimated hurricane-related sales losses
      in
      fiscal 2005 and 2004, same store sales would have increased by 5.5% over the
      prior year.





The
      cost
      of restaurant sales as a percentage of restaurant sales decreased to 33.1%
      for
      2005 from 33.9% for 2004. This improvement in cost of sales as a percentage
      of
      sales primarily related to improvements in operations execution and menu price
      increases implemented to compensate for the Florida minimum wage increase which
      occurred in the second quarter of 2005. Additionally, cost of revenues in 2004
      was negatively impacted by elevated commodity prices, primarily chicken and
      dairy. Fiscal year 2005 and 2004 cost of sales included a non-recurring
      inventory write down of $4,000 and $22,000, respectively.





Labor
      and
      other related expenses as a percentage of restaurant sales decreased to 31.0%
      in
      2005 as compared to 31.2% for 2004. We benefited from second quarter
      non-recurring reductions in benefits and taxes relating to workers compensation
      insurance reserve reductions, and corresponding refunds from prior years’
experience of $344,000 and $161,000 in 2005 and 2004, respectively, of which
      $330,000 and $142,000 were allocated to restaurant labor costs. Exclusive of
      the
      non-recurring items, labor and other related expenses as a percentage of
      revenues were 31.8% and 31.6% for 2005 and 2004, respectively. This increase
      over prior year primarily was related to our investment in training to elevate
      guest service levels, offset in part by the effect of an increase in revenue
      base. A second quarter menu price increase generally offset the effect of the
      increase in the Florida minimum wage rate.





Other
      restaurant operating expenses were $11,374,000, or 25.7% of restaurant sales
      for
      2005, as compared with $10,123,000, or 24.5% of restaurant sales for 2004.
      The
      increase primarily was due to increased advertising costs in the fourth quarter
      of 2005, occupancy costs related to our new restaurant and utilities expenses
      from significantly higher electricity and gas costs.




General
      and administrative expenses were $4,015,000 or 9.0% of revenues and $3,249,000
      or 7.8% of revenues in 2005 and 2004, respectively. Non-recurring expense in
      2004 included a one-time charge for severance expense of $39,000. The increase
      over the prior year is primarily related to salaries and wages relating to
      expansion and growth initiatives, including recruiting and associated salaries
      and wages.




Depreciation
      and amortization expense was $1,499,000, or 3.4% as a percentage of revenues,
      for 2005 and $1,058,000, or 2.5% as a percentage of revenues, for 2004. The
      increase over prior year related to increases in depreciation of remodeled
      restaurants and new and relocated restaurants.




Pre-opening
      expenses were $758,000, or 1.7% of revenues, in 2005. There were no pre-opening
      expenses in 2004. Pre-opening expenses relate to the costs incurred prior to
      opening a new restaurant location primarily for training, advertising, occupancy
      and legal costs. During 2005, we opened new locations in Clearwater Beach and
      St. Petersburg and relocated our Stuart restaurant to a higher volume site.


30


There
      was
      no provision recorded in operating expenses in 2005 relating to the impairment
      of assets, as compared to a provision for impaired assets of $105,000 or 0.3%
      of
      revenues for 2004. In 2004, we recorded a pre-tax charge relating to the
      write-down of impaired assets at one restaurant to their estimated fair value
      in
      accordance with Financial Accounting Standards Board Statement No. 144. The
      2004
      write-down was necessitated by the then-current period operating losses and
      the
      projected negative cash flow of the restaurant.





In
      January 2005, we entered into an agreement with our landlord in St. Pete Beach,
      Florida. On February 22, 2005 the landlord paid us $600,000 for an option to
      buy-out the lease. Commencing February 22, 2006, the landlord can provide notice
      of lease termination to Shells. Thereafter, we have 60 days to wind down
      business and vacate the premises. To date, the landlord has not exercised this
      option. We recorded a provision for asset impairment of $211,000 due to the
      St.
      Pete Beach lease buy-out. There was no corresponding provision in prior
      years.





Net
      interest expense was $413,000 in 2005 compared to $1,154,000 in 2004. In 2004,
      we recorded one-time charges of $446,000 in the third quarter, relating to
      warrants to purchase 2,000,000 shares of common stock issued in connection
      with
      the extension of the maturity dates on the then-outstanding $2,000,000
      promissory notes; and $265,000 in the fourth quarter, relating to warrants
      to
      purchase 1,187,500 shares of common stock issued to debenture holders in
      conjunction with the then-outstanding $2,375,000 financing transaction.
      Exclusive of these non-recurring charges, net interest expense was $443,000
      in
      2004. The $30,000 decrease in net interest expense in 2005 from 2004, excluding
      the non-recurring charges, was generally due to (i) a reduction in interest
      expense related to the retirement of the two $1,000,000 promissory notes in
      May
      2005, and (ii) an increase in interest income of $17,000 due to higher cash
      balances in 2005 compared to 2004, partially offset by (iii) an increase in
      interest expense, at 12% per annum, and late payment penalties on the $2,375,000
      aggregate principal amount of debentures, which we issued in December 2004
      and
      repaid on May 25, 2005.





Other
      income in 2005 was $30,000, compared to $33,000 in 2004. 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 remodelings, (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. In 2004,
      we recognized non-recurring gains for hurricane-related insurance settlements
      of
      $597,000 and the disposition of assets of $89,000. In 2004, we also recognized
      non-recurring charges for financing costs of $539,000 related to the
      then-outstanding $2,375,000 financing transaction and a loss on the disposal
      of
      assets of $41,000 related to restaurant remodelings. Exclusive of these
      non-recurring items, other expense was $13,000 in 2005 compared to $139,000
      in
      2004.





As
      a
      result of the factors discussed above, the loss from operations for 2005 was
      $1,587,000 compared to income from operations for 2004 of $43,000. Exclusive
      of
      non-recurring items, our loss from operations was $1,168,000 for 2005 compared
      to $57,000 for 2004. Net loss for 2005 was $1,852,000 compared to $1,344,000
      for
      2004. Exclusive of non-recurring items, the net loss in 2005 was $1,865,000
      compared to $733,000 for 2004.





The
      deemed dividend 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 retained earnings.


31
 **Liquidity
      and Capital Resources**





In
      2006,
      we again incurred a significant loss from operations mostly due to external
      cost
      pressures caused by significant increases in utility rates, insurance and
      property taxes. In addition, depreciation has increased significantly compared
      to 2005 as a result of investment spending relating to restaurant remodeling
      and
      the opening of new restaurants, which mostly occurred in 2005 and through the
      first quarter of 2006. We now have the new renovated look in all of the 21
      restaurants which we fully own and operate. To date, our one joint venture
      and
      three licensed restaurants have not been remodeled.





Capital
      expenditures in 2006 totaled $1,774,000, of which $1,029,000 related to
      restaurant remodels. In 2006, we received proceeds from the sale of assets
      totaling $1,495,000, which mostly related to the sale-leaseback of the New
      Smyrna Beach property in the third quarter of 2006 and the sale of a lease
      option on the Ocala property in the second quarter of 2006.





We
      recorded a provision of $1,242,000 for an impairment of assets in the fourth
      quarter of 2006. In 2005, we incurred $758,000 in pre-opening expenses relating
      to new restaurants. Although we experienced a 3.0% same store sales decline
      in
      the fourth quarter of 2006, we attained an annual 2006 same store sales increase
      of 3.8%.





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
      financing in May 2005 described below, 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. It is not expected
      that we will be able to borrow the remaining $160,000 under the credit line.
      On
      March 30, 2007, the maturity date was further extended to May 23, 2008, and
      we
      paid an extension fee of $101,000 with shares of our common stock.




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 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. We anticipate refinancing our Melbourne, Florida
      joint venture restaurant property to fund its remodel and provide a source
      of
      additional working capital.




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




2006
              
              2005
              
              2004Net
                  cash provided by (used in) operating activities
              
              $
              38
              
              $
              1,477
              
              $
              162Net
                  cash used in investing activities
              
              
              (278
              )
              
              (5,518
              )
              
              (1,292
              )Net
                  cash provided by (used in) financing activities
              
              
              (387
              )
              
              3,052
              
              
              2,756Net
                  (decrease) increase in cash
              
              $
              (627
              )
              $
              (989
              )
              $
              1,626


32


As
      of
      December 31, 2006, our current liabilities of $6,141,000 exceeded our current
      assets of $1,695,000, resulting in a working capital deficiency of $4,446,000.
      In comparison, as of January 1, 2006, our working capital deficiency was
      $4,842,000. Our operating leverage marginally improved, primarily due to a
      decreases in accounts payable of $734,000, and accrued expenses of $132,000,
      and
      the current portion of long term debt of $154,000, partially offset by a
      decrease in cash of $627,000 from the prior year. We may encounter operating
      pressures from declining sales, increasing food, labor or other operating costs
      or additional restaurant restoration or disposition costs. 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 by $627,000, from $1,361,000 as of January
      1,
      2006 to $734,000 as of December 31, 2006. The decrease in cash related to cash
      used in investing activities of $278,000, representing purchases of property
      and
      equipment of $1,774,000, partially offset by proceeds from the sale of assets
      of
      $1,495,000. Cash used in financing activities of $387,000 reflected $2,107,000
      in debt repayment and $193,000 in minority partner distributions, partially
      offset by proceeds from the issuance of debt of $1,887,000 and proceeds from
      the
      issuance of stock of $27,000. Net cash provided by operating activities was
      $38,000 compared to $1,477,000 in 2005, generally reflecting decreases in
      accounts payable and accrued expenses.





In
      connection with the $2,000,000 financing dated January 31, 2002, we issued
      to
      each of Shells Investment Partners (subsequently Trinad Capital, LP and Bruce
      Galloway, IRA R/O) and Banyon (subsequently Frederick R. Adler) (i) a $1,000,000
      secured promissory note due January 31, 2005 (extended to January 31, 2007)
      which accrued interest at 15% per annum, of which 8% was payable monthly in
      arrears and 7% was deferred and paid when the principal was paid in full, and
      (ii) a warrant to purchase 4,454,015 shares of our common stock, at an exercise
      price of $0.16 per share. These warrants to purchase an aggregate of 8,908,030
      shares of our common stock were exercised from November 2004 through January
      31,
      2005, resulting in net proceeds to us of $600,000 in 2004 and $754,000 in 2005.





On
      August
      4, 2004, the $2,000,000 aggregate principal amount of secured promissory notes
      set to mature on January 31, 2005 were extended to be due on January 31, 2007,
      under the same terms as the original notes. As an inducement to extend the
      maturity date of the notes, warrants to purchase 2,000,000 shares of common
      stock at an exercise price of $0.50 per share were issued to the note holders
      in
      proportion to the value of their respective notes. In March and May of 2005,
      the
      warrants were exercised and the $1,000,000 in aggregate proceeds was used to
      pay
      down the principal balance of the promissory notes. On May 23, 2005, the
      remaining $1,000,000 principal amount of debt plus $281,666 of deferred
      interest, were converted into our Series B Convertible Preferred Stock. Deferred
      interest of $7,574 was paid in cash to one investor.





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 are exercisable until December 7, 2007 at an exercise
      price of $0.60 per share. The exercise price of the warrants and the number
      of
      underlying shares of common stock is 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.


33


In
      May
      2005, we completed an aggregate financing of $6.9 million through a private
      placement of securities to accredited investors. Under the terms of the
      transaction, we issued 461,954 units, with each unit consisting of (i) one
      share
      of Series B Convertible Preferred Stock, initially convertible into 20 shares
      of
      common stock, and (ii) a warrant to purchase 10 shares of common stock at an
      exercise price of $1.30 per share. The purchase price was $15.00 per unit.
      We
      realized net proceeds of approximately $5.8 million from this financing. Of
      the
      total proceeds from securities issued, $1,282,000 represented cancellation
      or
      conversion of related party debt and $348,000 represented the conversion of
      existing convertible debentures, all of which converted into the securities
      issued in the transaction. We used a portion of the net proceeds from the May
      2005 private placement to retire the remaining $2,232,000 of loans and accrued
      interest from debenture holders from the December 2004 financing, as well as
      $8,000 of related party accrued interest. Additionally, in conjunction with
      the
      private placement, $500,000 principal amount of related party debt was used
      to
      exercise warrants to purchase 1,000,000 shares of our common stock.





In
      September 2005, we completed a sale of our restaurant in Winter Haven, Florida
      at a sale price of $1,667,000. The net proceeds of $981,000 from this sale
      were
      used to fund our restaurant remodels, as well as new and relocated restaurants.
      In addition, during the first quarter of 2005, we received $600,000 relating
      to
      a landlord option to buy out a restaurant.





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. 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. The Melbourne
      loan, which bears interest at the bank's base rate, 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 2007. The principal balance owed
      on
      this note as of December 31, 2006 was $438,000. We anticipate the refinancing
      of
      this note to fund this restaurant’s remodel and to provide additional working
      capital.





We
      believe based on our current outlook, that our cash balance along with our
      operating forecast, coupled with the extension of the maturity date for the
      revolving line of credit and a portion of the proceeds from the contemplated
      refinancing of the Melbourne property, will be sufficient to satisfy our
      contemplated cash requirements through the end of 2007. There are no assurances
      that the implementation of our strategies will result in sales and customer
      traffic gains, which are required to meet our contemplated cash flow
      requirements. 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, or at all.


34


**Contractual
      Obligations**





As
      of
      December 31, 2006, our contractual obligations were:


Payments
                due by periodTotal
            
            <
                1 yr
            
            1
                -
                3 yrs
            
            4
                -
                5 yrs
            
            >
                5yrsLong-term
                debt (1)
            
            $
            795,373
            
            $
            623,526
            
            $
            171,847
            
            $
            -
            
            $
            -Capital
                lease obligations
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Operating
                lease obligations (2)
            
            
            25,302,067
            
            
            2,683,025
            
            
            7,552,906
            
            
            6,073,797
            
            
            8,992,339Purchase
                obligations
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Other
                debt obligations reflected on the company's balance sheet under GAAP
                (3)
            
            
            1,527,453
            
            
            1,527,453
            
            
            -
            
            
            -
            
            
            -Total
            
            $
            27,624,893
            
            $
            4,834,004
            
            $
            7,724,753
            
            $
            6,073,797
            
            $
            8,992,339





(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 2007.




**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 or openings or remodelings. Because of the seasonality
      of
      our business and the impact of restaurant closings, openings or 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.





**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. As expenses
      increase, such as annual increases in the minimum wage rate in Florida and
      other
      expense categories, including recent significant increases in 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.


35


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





We
      are
      exposed to market risk from changes in interest rates on debt and changes in
      commodity prices. Our exposure to interest rate risk relates to $438,000 in
      outstanding debt at December 31, 2006 owed to our bank based on a variable
      rate.
      Borrowings under the loan agreement bears interest at the rate equal to the
      applicable bank’s base rate.


36


**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




37


**REPORT
      OF INDEPENDENT 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 31, 2006
      and
      January 1, 2006 and the related consolidated statements of operations,
      stockholders' equity and cash flows for the fiscal years ended December 31,
      2006
      (52 weeks), January 1, 2006 (52 weeks) and January 2, 2005 (53 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 audit 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
      31, 2006 and January 1, 2006 and the results of its operations and cash flows
      for the fiscal years ended December 31, 2006 (52 weeks), January 1, 2006 (52
      weeks) and January 2, 2005 (53 weeks) in conformity with accounting principles
      generally accepted in the United States of America.








Kirkland,
      Russ, Murphy & Tapp P.A.


Clearwater,
      Florida


March
      30,
      2007




F-1




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


**CONSOLIDATED
      BALANCE SHEETS**


**CONSOLIDATED
                  BALANCE SHEETS**December
                  31,
              
              January
                  1,2006
              
              2006**ASSETS**Cash
              
              $
              734,122
              
              $
              1,360,740Inventories
              
              
              543,183
              
              
              498,975Other
                  current assets
              
              
              383,598
              
              
              365,227Receivables
                  from related parties, net
              
              
              34,305
              
              
              114,485Total
                  current assets
              
              
              1,695,208
              
              
              2,339,427Property
                  and equipment, net
              
              
              9,170,821
              
              
              11,733,861Goodwill
              
              
              2,474,407
              
              
              2,474,407Other
                  assets
              
              
              481,641
              
              
              547,395Prepaid
                  rent
              
              
              14,629
              
              
              343,242TOTAL
                  ASSETS
              
              $
              13,836,706
              
              $
              17,438,332**LIABILITIES
                  AND STOCKHOLDERS’ EQUITY**Accounts
                  payable
              
              $
              3,248,031
              
              $
              3,982,153Accrued
                  expenses
              
              
              2,043,678
              
              
              2,175,380Sales
                  tax payable
              
              
              225,639
              
              
              245,673Current
                  portion of long-term debt
              
              
              623,526
              
              
              777,823Total
                  current liabilities
              
              
              6,140,874
              
              
              7,181,029Notes
                  and deferred interest payable to related parties
              
              
              1,527,453
              
              
              808,702Long-term
                  debt, less current portion
              
              
              171,847
              
              
              1,001,081Deferred
                  rent
              
              
              1,135,873
              
              
              784,976Total
                  liabilities
              
              
              8,976,047
              
              
              9,775,788Minority
                  partner interest
              
              
              521,876
              
              
              472,131STOCKHOLDERS’
                  EQUITY:Preferred
                  stock, $0.01 par value; authorized 2,000,000 shares;Series
                  A - 22,694 and 23,731 shares issued and outstanding
              
              
              227
              
              
              237Series
                  B - 373,849 and 443,850 shares issued and outstanding
              
              
              3,738
              
              
              4,439Common
                  stock, $0.01 par value; authorized 58,000,000 shares;17,586,988
                  and 16,134,817 shares issued and outstanding, respectively
              
              
              175,870
              
              
              161,348Additional
                  paid-in-capital
              
              
              25,259,714
              
              
              25,122,312Accumulated
                  deficit
              
              
              (21,100,766
              )
              
              (18,097,923
              )Total
                  stockholders’ equity
              
              
              4,338,783
              
              
              7,190,413TOTAL
                  LIABILITIES AND STOCKHOLDERS’ EQUITY
              
              $
              13,836,706
              
              $
              17,438,332





**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
                  31,
              
              January
                  1,
              
              January
                  2,2006
              
              2006
              
              2005REVENUES
              
              $
              47,829,608
              
              $
              44,487,348
              
              $
              41,564,138RESTAURANT
                  OPERATING COSTS:Food
                  and beverage
              
              
              15,363,255
              
              
              14,670,554
              
              
              14,050,690Labor
              
              
              14,722,437
              
              
              13,756,895
              
              
              12,935,204Other
              
              
              12,948,385
              
              
              11,374,609
              
              
              10,123,584Depreciation
                  and amortization
              
              
              2,199,499
              
              
              1,498,656
              
              
              1,057,841Pre-opening
                  expenses
              
              
              -
              
              
              758,168
              
              
              -Provision
                  for impairment of assets
              
              
              1,242,000
              
              
              -
              
              
              105,000Total
                  restaurant operating costs
              
              
              46,475,576
              
              
              42,058,882
              
              
              38,272,319RESTAURANT
                  OPERATING INCOME
              
              
              1,354,032
              
              
              2,428,466
              
              
              3,291,819General
                  and administrative expenses
              
              
              3,821,155
              
              
              4,014,675
              
              
              3,248,657(LOSS)
                  INCOME FROM OPERATIONS
              
              
              (2,467,123
              )
              
              (1,586,209
              )
              
              43,162OTHER
                  (EXPENSE) INCOME:Lease
                  buy-out
              
              
              212,198
              
              
              600,000
              
              
              -Provision
                  for impairment of assets due to lease buy-out
              
              
              -
              
              
              (211,000
              )
              
              -Interest
                  expense, net
              
              
              (331,814
              )
              
              (413,012
              )
              
              (1,153,340
              )Other
                  (expense) income, net
              
              
              (173,114
              )
              
              29,587
              
              
              32,641Total
                  other (expense) income, net
              
              
              (292,730
              )
              
              5,575
              
              
              (1,120,699
              )LOSS
                  BEFORE ELIMINATION OF MINORITYPARTNER
                  INTEREST
              
              
              (2,759,853
              )
              
              (1,580,634
              )
              
              (1,077,537
              )ELIMINATION
                  OF MINORITY PARTNER INTEREST
              
              
              (242,990
              )
              
              (271,112
              )
              
              (265,953
              )NET
                  LOSS BEFORE PREFERRED STOCK DIVIDEND
              
              
              (3,002,843
              )
              
              (1,851,746
              )
              
              (1,343,490
              )Deemed
                  dividend associated with warrants andbeneficial
                  conversion feature of preferred stock(See
                  Note 12, Series B Convertible Preferred Stock)
              
              
              -
              
              
              (1,735,169
              )
              
              -NET
                  LOSS APPLICABLE TO COMMON STOCK
              
              $
              (3,002,843
              )
              $
              (3,586,915
              )
              $
              (1,343,490
              )NET
                  LOSS PER SHARE OF COMMON STOCK:Basic
                  and diluted
              
              $
              (0.18
              )
              $
              (0.24
              )
              $
              (0.26
              )WEIGHTED
                  AVERAGE NUMBER OF SHARES OFCOMMON
                  STOCK OUTSTANDING:Basic
                  and diluted
              
              
              16,665,209
              
              
              14,796,278
              
              
              5,261,981


**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 December 28, 2003
              
              
              63,548
              
              $
              635
              
              
              -
              
              
              -
              
              
              4,631,375
              
              $
              46,314
              
              $
              14,303,151
              
              $
              (13,167,518
              )
              $
              1,182,582Net
                  loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (1,343,490
              )
              
              (1,343,490
              )Preferred
                  stock converted
              
              
              (28,273
              )
              
              (282
              )
              
              
              
              
              
              
              
              141,365
              
              
              1,413
              
              
              (1,131
              )
              
              
              
              
              -Warrants
                  exercised
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              3,750,000
              
              
              37,500
              
              
              562,500
              
              
              
              
              
              600,000Warrant
                  valuation reserve(See
                  Note 6)
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              44,613
              
              
              
              
              
              44,613Stock
                  options exercised
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              42,666
              
              
              427
              
              
              17,494
              
              
              
              
              
              17,921Balance
                  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 privateplacement financing, net ofissuance costs
                    of $1,137,672
              
              
              
              
              
              
              
              
              461,954
              
              
              4,620
              
              
              
              
              
              
              
              
              5,787,018
              
              
              
              
              
              5,791,638Issuance
                  costs, private placement financing
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (123,872
              )
              
              
              
              
              (123,872
              )Series
                      B Preferred Stock warrantissued to placement agent forprivate
                      placement financing
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              123,872
              
              
              
              
              
              123,872Deemed
                      dividend for warrants andbeneficial conversion featureof 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
              )
              $
              4,338,783





**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
                  31,
              
              January
                  1,
              
              January
                  2,OPERATING
                  ACTIVITIES:
              
              
              
              2006
              
              2006
              
              2005Net
                  loss
              
              
              
              
              $
              (3,002,843
              )
              $
              (1,851,746
              )
              $
              (1,343,490
              )Adjustments
                  to reconcile net loss to net cash provided by operating
                  activities:Depreciation
                  and amortization
              
              
              
              
              
              2,199,499
              
              
              1,498,656
              
              
              1,057,841Stock
                  option expense
              
              
              
              
              
              124,677
              
              
              -
              
              
              -Interest
                  expense on warrants issued
              
              
              
              
              
              -
              
              
              -
              
              
              711,000Financing
                  costs on warrants issued
              
              
              
              
              
              -
              
              
              -
              
              
              175,000Lease
                  buy-out option
              
              
              
              
              
              (212,198
              )
              
              (600,000
              )
              
              -Provision
                  for impairment of assets
              
              
              
              
              
              1,242,000
              
              
              211,000
              
              
              201,000Gain
                  from hurricane-related insurance recoveries
              
              
              
              
              
              -
              
              
              -
              
              
              (499,795
              )Gain
                  on sale of restaurant
              
              
              
              
              
              -
              
              
              (792,969
              )
              
              -Loss
                  (gain) on disposal of fixed assets
              
              
              
              
              
              10,359
              
              
              472,318
              
              
              (48,204
              )Loss
                  on sale of assets applied against reserves
              
              
              
              
              
              -
              
              
              -
              
              
              63,554Minority
                  partner interest
              
              
              
              
              
              242,990
              
              
              271,112
              
              
              265,962Changes
                  in operating assets and liabilities:Change
                  in current assets and liabilities
              
              
              
              
              
              (860,524
              )
              
              2,767,808
              
              
              (483,201
              )Changes
                  in other assets and liabilities:Decrease
                  (increase) in prepaid rent
              
              
              
              
              
              28,161
              
              
              (306,286
              )
              
              15,621Decrease
                  (increase) in other assets
              
              
              
              
              
              55,710
              
              
              (16,869
              )
              
              5,070Increase
                  (decrease) in accrued interest to related parties
              
              
              
              
              
              78,751
              
              
              (230,239
              )
              
              136,840Increase
                  (decrease) in deferred rent
              
              
              
              
              
              131,913
              
              
              54,964
              
              
              (95,356
              )Total
                  adjustments
              
              
              
              
              
              3,041,338
              
              
              3,329,495
              
              
              1,505,332Net
                  cash provided by operating activities
              
              
              
              
              
              38,495
              
              
              1,477,749
              
              
              161,842INVESTING
                  ACTIVITIES:Proceeds
                  from sale of assets
              
              
              
              
              
              1,494,987
              
              
              2,243,859
              
              
              92,776Proceeds
                  from hurricane-related insurance recoveries
              
              
              
              
              
              -
              
              
              -
              
              
              139,935Purchase
                  of property and equipment
              
              
              
              
              
              (1,773,547
              )
              
              (7,762,226
              )
              
              (1,524,515
              )Net
                  cash used in investing activities
              
              
              
              
              
              (278,560
              )
              
              (5,518,367
              )
              
              (1,291,804
              )FINANCING
                  ACTIVITIES:Proceeds
                  from the issuance of stock
              
              
              
              
              
              26,536
              
              
              4,963,916
              
              
              617,920Proceeds
                  from debt financing
              
              
              
              
              
              1,886,742
              
              
              1,951,750
              
              
              2,832,298Repayment
                  of debt
              
              
              
              
              
              (2,106,586
              )
              
              (3,623,227
              )
              
              (404,496
              )Minority
                  partner distributions
              
              
              
              
              
              (193,245
              )
              
              (240,600
              )
              
              (290,180
              )Net
                  cash (used in) provided by financing activities
              
              
              
              
              
              (386,553
              )
              
              3,051,839
              
              
              2,755,542Net
                  (decrease) increase in cash
              
              
              
              
              
              (626,618
              )
              
              (988,779
              )
              
              1,625,580CASH
                  AT BEGINNING OF PERIOD
              
              
              
              
              
              1,360,740
              
              
              2,349,519
              
              
              723,939CASH
                  AT END OF PERIOD
              
              
              
              
              $
              734,122
              
              $
              1,360,740
              
              $
              2,349,519


**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
                  31,
              
              January
                  1,
              
              January
                  2,2006
              
              2006
              
              2005Cash
                  (outflows) flows from changes in current assets and
                  liabilities:Inventories
              
              
              
              
              $
              (44,208
              )
              $
              (102,152
              )
              $
              (14,274
              )Receivables
                  from related parties
              
              
              
              
              
              80,180
              
              
              (5,008
              )
              
              670Other
                  current assets
              
              
              
              
              
              (18,371
              )
              
              131,951
              
              
              128,573Accounts
                  payable
              
              
              
              
              
              (734,122
              )
              
              1,670,569
              
              
              (79,101
              )Accrued
                  expenses
              
              
              
              
              
              (123,969
              )
              
              1,029,441
              
              
              (553,350
              )Sales
                  tax payable
              
              
              
              
              
              (20,034
              )
              
              43,007
              
              
              34,281Change
                  in current assets and liabilities
              
              
              
              
              $
              (860,524
              )
              $
              2,767,808
              
              $
              (483,201
              )Supplemental
                  disclosure of cash flow information:Cash
                  paid for interest
              
              
              
              
              $
              258,165
              
              $
              399,916
              
              $
              309,006Hurricane-related
                  insurance recoveries
              
              
              
              
              $
              49,336
              
              $
              375,283
              
              $
              -Financing
                  costs, line of credit
              
              
              
              
              $
              -
              
              $
              80,000
              
              $
              -Cash
                  paid for income taxes
              
              
              
              
              $
              -
              
              $
              -
              
              $
              634Cash
                  received from the 2002 sales of assets
              
              
              
              
              $
              -
              
              $
              -
              
              $
              100,000





Non-cash
      operating, investing and financing activities:




·
            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.




·
            Accrued
                expense of $7,733 was reduced with a corresponding reduction in operating
                expense during 2006.




·
            Deferred
                rent of $119,275 was reduced to offset the loss on disposal of two
                restaurants in November 2005.




·
            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.




·
            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.




**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)**





Non-cash
      operating, investing and financing activities (continued):




·
            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.




·
            Accrued
                interest to related parties of $165,315 was refinanced through a
                second
                mortgage in June 2004 and classified as long-term
                debt.




·
            Provision
                for impairment of assets of $201,000 consists of a $96,000 charge,
                which
                was applied to accrued expenses in June 2004, and $105,000 which
                was
                expensed in fiscal year 2004.




·
            Loss
                on sale of assets applied against reserves totaled $63,554 consisting
                of
                (i) $24,776, which reduced net book value of property and equipment
                by
                $19,062 and deferred rent by $5,714 in June 2004; and (ii) $38,778,
                which
                reduced net book value of property and equipment in December
                2004.




·
            Asset
                impairment charges of $158,335 were applied to reduce the basis of
                fixed
                assets damaged by a fire in September
                2004.




·
            During
                2004, we relieved $383,695 of the FAS 144 allowance for impaired
                assets
                relating to disposed restaurants.




·
            Deferred
                rent of $114,602 was applied to gain on sale of restaurant in April
                2004.




·
            Asset
                impairment charges of $110,000 were applied against gain on sale
                of
                restaurant in April 2004.




·
            Warrant
                valuation reserves of $44,613 relating to warrants exercised in November
                2004 was applied to paid in
                capital.






**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 31, 2006, Shells Seafood Restaurants, Inc. and subsidiaries managed
      and
      operated 25 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.





**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 Shells is 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.
      Our
      fiscal year ended December 31, 2006 (“fiscal year 2006”) was 52 weeks, January
      1, 2006 (“fiscal year 2005”) was 52 weeks and fiscal year ended January 2, 2005
      (“fiscal year 2004”) was 53 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.





**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 its 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, and signs range from three to 10
      years.


F-8
 SHELLS
          SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES
 **Notes
          to Consolidated Financial Statements**




**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.





**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.





**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-9
 SHELLS
          SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES
 **Notes
          to Consolidated Financial Statements**


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




Fiscal
                Years EndedJanuary
                1,
            
            January
                2,2006
            
            2005Net
                loss applicable to common stock, as reported
            
            $
            (3,586,915
            )
            $
            (1,343,490
            )Add:
                Stock-based employee compensation expenseincluded
                in reported net loss applicable to commonstock,
                net of related tax effects
            
            
            -
            
            
            -Deduct:
                Total stock-based employee compensationexpense
                determined under fair value based methodfor
                all awards, net of related tax effects
            
            
            (502,948
            )
            
            (95,580
            )Pro
                forma net loss applicable to common stock
            
            
            (4,089,863
            )
            
            (1,439,070
            )Net
                loss per share of common stock:Basic
                and diluted—as reported
            
            $
            (0.24
            )
            $
            (0.26
            )Basic
                and diluted—pro forma
            
            $
            (0.28
            )
            $
            (0.27
            )








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
      Income (Loss) per Share of Common Stock** -- Net
      income (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 income (loss) per share of
      common stock is computed by dividing net income (loss) applicable to common
      stock by the weighted average number of shares of common stock outstanding.
      Diluted net income per share of common stock is computed by dividing net income
      applicable to common stock by the weighted average number of shares of common
      stock and common stock equivalents outstanding. Diluted net loss per common
      share is computed by dividing net loss by the weighted average common shares
      outstanding excluding common stock equivalents, as they would be anti-dilutive.


F-10
 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
      March 2005, the Financial Accounting Standards Board’s (FASB) issued
      Interpretation 47, “Accounting for Conditional Asset Retirement Obligations—an
      interpretation of FASB Statement No. 143” clarifying that the term conditional
      asset retirement obligation as used in FASB Statement No. 143, “Accounting for
      Asset Retirement Obligations”, refers to a legal obligation to perform an asset
      retirement activity in which the timing and (or) method of settlement are
      conditional on a future event that may or may not be within the control of
      the
      entity. Clarifications found in Interpretation 47 had no material impact on
      our
      consolidated financial statements.





In
      May
      2005, the FASB issued Statement No. 154, “Accounting Changes and Error
      Corrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3.” This
      Statement replaces APB Opinion No. 20, “Accounting Changes,” and FASB Statement
      No. 3, “Reporting Accounting Changes in Interim Financial Statements,” and
      changes the requirements for the accounting for and reporting of a change in
      accounting principle. This Statement applies to all voluntary changes in
      accounting principle. FASB Statement No. 154 became effective for accounting
      changes and corrections of errors made in fiscal years beginning after December
      15, 2005. Adoption of FASB Statement No. 154 had no material impact on our
      consolidated financial statements.





In
      February 2006, the FASB issued Statement No. 155, “Accounting for Certain Hybrid
      Financial Instruments − an amendment of FASB Statements No. 133 and 140.” The
      purpose of SFAS 155 is to simplify the accounting for certain hybrid financial
      instruments by permitting fair value re−measurement for any hybrid financial
      instrument that contains an embedded derivative that otherwise would require
      bifurcation. SFAS 155 is effective for all financial instruments acquired or
      issued after the beginning of an entity’s first fiscal year that begins after
      September 15, 2006. Adoption of SFAS 155 on January 1, 2007 is not expected
      to
      have a material impact on our consolidated financial statements.





In
      March
      2006, the FASB issued SFAS 156, “Accounting for Servicing Financial Assets - an
      amendment of FASB Statement No. 140.” SFAS 156 requires separate recognition of
      a servicing asset and a servicing liability each time an entity undertakes
      an
      obligation to service a financial asset by entering into a servicing contract.
      This statement also requires that servicing assets and liabilities be initially
      recorded at fair value and subsequently be adjusted to the fair value at the
      end
      of each reporting period. SFAS 156 is effective for an entity’s first fiscal
      year that begins after September 15, 2006. Adoption of SFAS 156 on January
      1,
      2007 is not expected to have a material impact on our consolidated financial
      statements.


F-11
 SHELLS
          SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES
 **Notes
          to Consolidated Financial Statements**




In
      March
      2006, the FASB’s Emerging Issues Task Force (EITF) issued Issue 06−3, “How Sales
      Taxes Collected From Customers and Remitted to Governmental Authorities Should
      Be Presented in the Income Statement “ (EITF 06−3). A consensus was reached that
      entities may adopt a policy of presenting sales taxes in the income statement
      on
      either a gross or net basis. If taxes are significant, an entity should disclose
      its policy of presenting taxes and the amounts of taxes. The guidance is
      effective for periods beginning after December 15, 2006. We present Company
      sales net of sales taxes. We believe we currently satisfy the requirements
      of
      EITF 06−3 for recording these sales taxes in our consolidated financial
      statements.





In
      June
      2006, the FASB issued Interpretation 48, “Accounting for Uncertainty in Income
      Taxes.” FIN 48 clarifies the accounting for uncertainty in income taxes
      recognized in accordance with FASB Statement No. 109, “Accounting for Income
      Taxes.” This Interpretation prescribes a recognition threshold and measurement
      attribute for the financial statement recognition and measurement of a tax
      position taken or expected to be taken in a tax return. This Interpretation
      also
      provides guidance on derecognition, classification, interest and penalties,
      accounting in interim periods, disclosure, and transition. This Interpretation
      is effective for fiscal years beginning after December 15, 2006. Clarifications
      found in FIN 48 are not expected to have a material impact on our consolidated
      financial statements.





In
      September 2006, the FASB issued SFAS 157, “Fair Value Measurements.” SFAS 157
      defines fair value, establishes a framework for measuring fair value in
      generally accepted accounting principles (GAAP), and expands disclosures about
      fair value measurements. This Statement applies under other accounting
      pronouncements that require or permit fair value measurements, the FASB having
      previously concluded in those accounting pronouncements that fair value is
      the
      relevant measurement attribute. Accordingly, this Statement does not require
      any
      new fair value measurements. However, for some entities, the application of
      this
      Statement will change current practice. This Statement is effective for fiscal
      years beginning after November 15, 2007. Definitions found in SFAS 157 are
      not
      expected to have a material impact on our consolidated financial statements.





In
      June
      2006, the EITF reached a consensus on EITF Issue No. 06-4, “Accounting for
      Deferred Compensation and Postretirement Benefit Aspects of Endorsement
      Split-Dollar Life Insurance Arrangements” (“EITF 06-4”), which requires the
      application of the provisions of SFAS No. 106, “Employers’ Accounting for
      Postretirement Benefits Other Than Pensions” to endorsement split-dollar life
      insurance arrangements. This would require recognition of a liability for the
      discounted future benefit obligation owed to an insured employee by the
      insurance carrier. EITF 06-4 is effective for fiscal years beginning after
      December 15, 2007. Adoption of EITF 06-4 is not expected to have a material
      impact on our consolidated financial statements.





In
      September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering
      the Effects of Prior Year Misstatements when Quantifying Misstatements in
      Current Year Financial Statements” (“SAB 108”). SAB 108 requires companies to
      evaluate the materiality of identified unadjusted errors on each financial
      statement and related financial statement disclosure using both the rollover
      approach and the iron curtain approach, as those terms are defined in SAB 108.
      The rollover approach quantifies misstatements based on the impact of the
      misstatement, whereas the iron curtain approach quantifies misstatements based
      on the effects of correcting the misstatement existing in the balance sheet
      at
      the end of the current year, irrespective of the reversing effect of prior
      year
      misstatements on the income statement. Financial statements would require
      adjustment when either approach results in quantifying a misstatement that
      is
      material. Correcting prior year financial statements for immaterial errors
      would
      not require previously filed reports to be amended. If a company determines
      that
      an adjustment to prior year financial statements is required upon adoption
      of
      SAB 108 and does not elect to restate its previous financial statements, then
      it
      must recognize the cumulative effect of applying SAB 108 in fiscal 2006
      beginning balances of the affected assets and liabilities with a corresponding
      adjustment to the fiscal 2006 opening balance in retained earnings. SAB 108
      is
      effective for the first fiscal year ending after November 15, 2006. The adoption
      of SAB 108 did not have a material impact on our consolidated financial
      statements.


F-12
 SHELLS
          SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES
 **Notes
          to Consolidated Financial Statements**




**Reclassifications** --
      Certain reclassifications of prior year balances have been made to conform
      to
      the current presentation.





**NOTE
      2. LIQUIDITY**





Our
      company’s working capital deficit decreased to $4,446,000 in 2006 from
      $4,842,000 in 2005 and our cash position at December 31, 2006 decreased to
      $734,000 from $1,361,000 on January 1, 2006. Capital expenditures in 2006
      totaled $1,774,000, of which $1,029,000 related to restaurant remodels. In
      2006,
      we received proceeds from the sale of assets totaling $1,495,000, which mostly
      related to the sale-leaseback of the New Smyrna Beach property in the third
      quarter of 2006 and the sale of an option on the Ocala property in the second
      quarter of 2006.





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. It is not expected
      that we will be able to borrow the remaining $160,000 under the credit line.
      On
      March 30, 2007, the maturity date was further extended to May 23, 2008, and
      we paid an extension fee of $101,000 with shares of our common
      stock.





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
      October 2002, we refinanced through Colonial Bank our Melbourne restaurant
      location with a note of $635,000. The loan, which bears interest at the bank's
      base rate, 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
      2007. The principal balance owed on this note as of December 31, 2006 was
      $438,000. We anticipate the refinancing of this note prior to its
      maturity.





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


F-13
 SHELLS
          SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES
 **Notes
          to Consolidated Financial Statements**




**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
                fiscal years ended December 31, 2006, January 1, 2006 and January
                2, 2005,
                approximately 43%, 42% and 36%, 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
                31,
            
            January
                1,2006
            
            2006Prepaid
                expenses
            
            $
            359,103
            
            $
            271,486Insurance
                proceeds receivable
            
            
            -
            
            
            40,000Other
                current assets
            
            
            24,495
            
            
            53,741$
            383,598
            
            $
            365,227





**NOTE
      4. PROPERTY AND EQUIPMENT**





Property
      and equipment consist of the following:




December
                31,
            
            January
                1,2006
            
            2006Leasehold
                improvements
            
            $
            7,818,971
            
            $
            7,855,516Equipment
            
            
            3,884,837
            
            
            3,904,680Furniture
                and fixtures
            
            
            4,797,285
            
            
            4,692,974Land
                and buildings
            
            
            826,338
            
            
            1,750,114Signage
            
            
            640,143
            
            
            582,759Automobiles
            
            
            257,775
            
            
            214,28818,225,349
            
            
            19,000,331Less
                accumulated depreciationand
                amortization
            
            
            (9,054,528
            )
            
            (7,266,470
            )$
            9,170,821
            
            $
            11,733,861





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





F-14
 SHELLS
          SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES
 **Notes
          to Consolidated Financial Statements**


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. The 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 forecasted future cash flow of those
      restaurant locations acquired in the merger with the carrying value of the
      asset. As a result of the evaluation, there was no reduction to the carrying
      value of goodwill in 2006 or 2005; 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:







December
                31,
            
            January
                1,2006
            
            2006Accrued
                payroll
            
            $
            837,085
            
            $
            922,964Unearned
                gift card revenue
            
            
            333,558
            
            
            261,151Other
            
            
            276,362
            
            
            339,354Public
                reporting costs
            
            
            234,013
            
            
            199,345Workers
                compensation
            
            
            167,989
            
            
            -Restaurant
                closing expenses
            
            
            107,933
            
            
            168,671Property
                taxes
            
            
            86,739
            
            
            184,556Construction
            
            
            -
            
            
            99,339$
            2,043,679
            
            $
            2,175,380


F-15
 SHELLS
            SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES
 **Notes
            to Consolidated Financial Statements**
  **NOTE
      7. LONG-TERM DEBT**





Long-term
      debt consists of the following:




December
                  31,
              
              January
                  1,2006
              
              2006Line
                      of credit with Colonial Bank to finance remodeling construction
                      costs,
                      interest was payable monthly at bank base rate plus 1%;
                      interest rate
                      was 9.25%at October 1, 2006; principal paid in full October
                      2006.
              
              
              
              
              $
              -
              
              $
              500,000$635,000
                        promissory note with Colonial Bank collateralized by real
                        property owned
                        by the 51% owned joint venture. Interest is payable
                        monthly based on
                        the bank's base rate. Principal is payable $3,900 monthly,
                        with all
                        unpaid principal due in September 2007. The interest rate was 8.25%
                        at
                        January 1, 2006.
              
              
              
              
              
              438,271
              
              
              485,071$655,000
                      promissory note collateralized by real property owned byShells.
                      Payments were $8,000 monthly with unpaid principal originally
                      due
                      onJune 2009. The interest rate was fixed at
                      10.0%.
              
              
              
              
              
              -
              
              
              371,518Finance
                  agreement, collateralized by automobiles, principal and interest
                  duemonthly
                  at $3,538 through August 2010, at 6.75% fixed interest
                  rate.
              
              
              
              
              
              138,117
              
              
              169,147Finance
                    agreement, collateralized by insurance policy, principal and
                    interest
                    duemonthly thru February 2007, at 5.45% fixed interest
                    rate.
              
              
              
              
              
              113,181
              
              
              5,207Finance
                    agreement, collateralized by computer equipment principal and
                    interestdue
                    monthly at $2,569 through June 2009, at 9.3% fixed interest
                    rate.
              
              
              
              
              
              65,954
              
              
              -Finance
                  agreement, collateralized by automobile, principal and interest
                  duemonthly
                  at $818 through February 2010, at 8% fixed interest rate.
              
              
              
              
              
              27,322
              
              
              -Tenant
                    improvement allowance, collateralized by leasehold improvements
                    and
                    equipment, was payable monthly at $2,988 through July 2010.
                    Interest
                    imputed at 10.5%.
              
              
              
              
              
              -
              
              
              130,938Promissory
                    note for early termination of lease, was payable monthly at $10,370
                    principal and interest through October 2006, at 8.0% fixed
                    interest
                    rate.
              
              
              
              
              
              -
              
              
              100,000Capitalized
                    lease agreement, collateralized by equipment, payable monthly
                    at
                    $517principal and interest through March 2009.
              
              
              
              
              
              12,528
              
              
              17,023795,373
              
              
              1,778,904Less
                  current portion
              
              
              
              
              
              (623,526
              )
              
              (777,823
              )$
              171,847
              
              $
              1,001,081





The
      annual maturities of debt as of December 31, 2006 are as follows:





2007
            
            $
            623,5262008
            
            
            78,5172009
            
            
            62,5252010
            
            
            30,805$
            795,373





The
      promissory note provided by Colonial Bank no longer requires us to meet a
      financial covenant, relating to debt coverage as the mortgage note that
      contained this provision was paid in September 2005.





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





**Related
      Party Debt**


F-16
 SHELLS
          SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES
 **Notes
          to Consolidated Financial Statements**


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. 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. As of December 31,
      2006,
      we have drawn $1,440,000 of the $1,600,000 line of credit availability, 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.
      It
      is not expected that we will be able to borrow the remaining $160,000 under
      the
      credit line. On March 30, 2007, the maturity date was further extended to May
      23, 2008 and we paid an extension fee of $101,000 wtih shares of our common
      stock.




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
                31,
            
            January
                1,2006
            
            2006Line
                of credit due May 23, 2007 bearing interest at 15%, of which
                8%is
                payable monthly in arrears and 7% is deferred and payable when
                theprincipal
                is paid in full, owned by:Frederick
                R. Adler
            
            $
            800,000
            
            $
            400,000Bruce
                Galloway, IRA R/O
            
            
            160,000
            
            
            160,000Trinad
                Capital, L.P.
            
            
            480,000
            
            
            240,000Aggregate
                deferred interest to be payable on May 23, 2007
            
            
            87,453
            
            
            8,702$
            1,527,453
            
            $
            808,702





The
      deferred interest due at maturity, May 23, 2007, will be $125,000 on the
      $1,440,000 borrowing.





**Related
      Party Transactions**


F-17
 SHELLS
          SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES
 **Notes
          to Consolidated Financial Statements**


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
      $156,000, $152,000 and $172,000 for fiscal 2006, 2005 and 2004,
      respectively.





On
      August
      9, 2005, we entered into an agreement with Deborah Christen Corporation.
      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, Deborah Christen Corporation (“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 Deborah Christen Corporation 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 $24,000 for fiscal 2006.





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 31, 2006.


F-18
 SHELLS
          SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES
 **Notes
          to Consolidated Financial Statements**


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, owns 1,333,340 shares of our common
      stock along with warrants to purchase 666,670 shares of our common stock.
      Drawbridge is 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
      $3,925,000, $3,257,000 and $2,712,000 for fiscal 2006, 2005 and 2004,
      respectively, which included contingent rent of $71,000, $97,000 and $108,000,
      respectively. The approximate future minimum aggregate rental payments under
      such operating leases as of December 31, 2006 are as follows:




2007
            
            $
            2,683,0252008
            
            
            2,539,7782009
            
            
            2,530,1032010
            
            
            2,483,0252011
            
            
            2,199,419Thereafter
            
            
            12,866,717$
            25,302,066




F-19
 SHELLS
          SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES
 **Notes
          to Consolidated Financial Statements**




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





During
      November 2005, we entered into an amended and restated employment agreement
      with
      Leslie J. Christon, President and Chief Executive Officer. The amended and
      restated employment agreement extended the term of her employment with us
      through June 30, 2007, subject to automatic successive one year extensions
      thereof, unless either party delivers prior written notice of non-extension.
      Pursuant to the amended and restated employment agreement, Mrs. Christon is
      entitled to receive an annual base salary of $300,000 and a target bonus
      potential up to 100% of her base salary. Mrs. Christon also received options
      to
      purchase an additional 1,061,535 shares of the our common stock (which vest
      in
      one-third installments on December 31, 2005, July 1, 2007 and July 1, 2008,
      subject to her continued employment with Shells), inclusive of a grant of
      903,528 options under a Stock Option Agreement dated November 14, 2005 by and
      between Mrs. Christon and us. The remaining options to purchase 158,007 shares
      of our common stock were granted under our existing stock option plans. Based
      on
      the vesting schedule of the options, we expect to recognize compensation expense
      of approximately $105,000 in each of 2007 and 2008 as a result of the adoption
      of FASB Statement No. 123-R, “Share-Based Payment.” In addition, pursuant to her
      employment agreement, Mrs. Christon is entitled to (i) severance pay equal
      to
      one year’s then effective base salary and (ii) other immediate vesting of any of
      the unvested 1,061,535 stock options, if she is terminated without cause or
      she
      terminates her employment due to a significant diminution in her job
      responsibilities or title within 6 months following a Change in Control (as
      defined in the Amended and Restated Employment Agreement) of our Company.





Effective
      March 13, 2006, we entered into an agreement with each of Guy C. Kathman, our
      Vice-President of Operations, Warren R. Nelson, our Chief Financial Officer,
      and
      Christopher R. Ward, Sr., our Vice-President of Purchasing, 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.





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-20
 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 $251,000, $280,000 and $296,000 during fiscal
      2006, 2005 and 2004, respectively. In addition, the partnership paid us
      $180,000, $190,000 and $181,000 in fiscal 2006, 2005 and 2004, 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 $94,000, $176,000, and $130,000 for 2006, 2005, and 2004,
      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 31,
      2006.





**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 warrants are exercisable until December
      7, 2007 at an exercise price of $0.60 per share. The exercise price of the
      warrants and the number of underlying shares of common stock are 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. As of December 31, 2006, there
      were 1,873,750 warrants outstanding to purchase shares of our common
      stock.





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 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 31, 2006, none of these warrants have
      been exercised.


F-21
 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 2006, 2005 and 2004, investors converted an aggregate of 1,037, 11,544
      and 28,273 shares, respectively, of Series A Preferred Stock into 5,185, 57,720
      and 141,365 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-22
 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, based on the conversion price then
      in
      effect.




During
      fiscal 2006 and 2005, investors converted 70,001 and 18,104 shares,
      respectively, of Series B Preferred Stock into 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 years ended December 31, 2006,
      January 1, 2006 and January 2, 2005.





Our
      effective tax rate is composed of the following for the years ended December
      31,
      2006, January 1, 2006 and January 2, 2005, respectively:




Fiscal
                  Years EndedDecember
                  31,
              
              January
                  1,
              
              January
                  2,2006
              
              2006
              
              2005Federal
                  statutory rate
              
              
              (35.0
              )%
              
              (34.0
              )%
              
              (34.0
              )%State
                  income tax, net of federal benefit
              
              
              (3.6
              )
              
              (2.8
              )
              
              (0.4
              )FICA
                  tip credits
              
              
              (4.7
              )
              
              (6.6
              )
              
              (15.8
              )Warrant
                  grants
              
              
              -
              
              
              -
              
              
              22.4Valuation
                  allowance and other adjustment
              
              
              43.3
              
              
              43.4
              
              
              15.6Revalue
                  certain deferred tax assets
              
              
              -
              
              
              -
              
              
              8.4Other
              
              
              0.0
              
              
              -
              
              
              3.8Effective
                  income tax benefit
              
              
              -
              %
              
              -
              %
              
              -
              %




As
      of
      December 31, 2006, we had net operating loss carryforwards for federal income
      tax purposes of approximately $10,769,000 which expire between 2007 and 2021.
      We
      also had approximately $3,593,000 of general business credits to carry forward,
      which expire by 2026. 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 $7,200,000
      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 $3,300,000 in net operating loss
      carryforwards and approximately $2,700,000 in credits will expire without
      benefit to us.


F-23
 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
                  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
              )$
              -January
                  2, 2005Current
              
              
              Non-current
              
              
              TotalBasis
                  difference in fixed assets and other assets
              
              $
              -
              
              $
              544,000
              
              $
              544,000Accrued
                  liabilities
              
              
              411,000
              
              
              323,000
              
              
              734,000Net
                  operating loss carryforwards
              
              
              -
              
              
              3,214,000
              
              
              3,214,000General
                  business credits
              
              
              -
              
              
              2,848,000
              
              
              2,848,000411,000
              
              
              6,929,000
              
              
              7,340,000Valuation
                  allowance
              
              
              
              
              
              
              
              
              (7,113,000
              )Net
                  deferred tax assets
              
              
              
              
              
              
              
              
              227,000Involuntary
                  conversion proceeds and service marks
              
              
              
              
              
              
              
              
              (227,000
              )$
              -





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





**Stock
      Option Plans** --
      At
      December 31, 2006, we had two stock-based employee compensation plans that
      are
      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. The 1996 Employee Stock Option Plan provided for the
      issuance of options to purchase a total of 101,000 shares. There were no options
      awarded under these plans during 2006. As of December 31, 2006, options to
      purchase an aggregate of 163,507 shares were outstanding under the plans of
      which 105,500 were fully exercisable and 58,007 shares vest in future
      years. ****


F-24
 SHELLS
          SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES
 **Notes
          to Consolidated Financial Statements**


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 to be
      reserved for issuance under the plan. There was no activity in this Plan during
      2006. As of December 31, 2006, options to purchase 32,000 shares were
      outstanding and exercisable. The plan will expire 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 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 2006,
      options for 197,000 shares of common stock were granted under this plan at
      prices ranging between $0.55 and $0.93 per share, the fair market value on
      the
      date of the grant, of which 150,000 options were granted to directors and
      officers. As of December 31, 2006, options to purchase 3,284,258 shares were
      outstanding of which 1,820,235 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 its employees, including its executive officers, and
      its
      directors under the 2002 Plan 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.





During
      November 2005, we entered into a Stock Option Agreement with Leslie J. Christon,
      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 vest as to 274,842 on each of July 1, 2007
      and
      July 1, 2008. 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 with vesting ratably in July 2007 and
      July 2008.




F-25
 SHELLS
          SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES
 **Notes
          to Consolidated Financial Statements**


Transactions
      during 2006 were as follows:


WeightedWeighted
              
              AverageAverage
              
              Remaining
              
              AggregateNumber
                  of
              
              Exercise
              
              Contractual
              
              IntrinsicOptions
              
              Price
              
              Life
                  (Years)
              
              ValueOutstanding
                  at January 1, 2006
              
              
              4,356,876
              
              $
              0.88Granted
              
              
              197,000
              
              
              0.75Exercised
              
              
              (9,466
              )
              
              0.43Forfeited
              
              
              (161,117
              )
              
              1.34Outstanding
                  at December 31, 2006
              
              
              4,383,293
              
              $
              0.86
              
              
              5.4
              
              $
              120,975Exercisable
                  at December 31, 2006
              
              
              2,311,579
              
              $
              0.84
              
              
              5.3
              
              $
              117,211


The
      total
      intrinsic value (market value on date of exercise less exercise price) of
      options exercised during the fiscal years 2006, 2005 and 2004 was approximately
      $3,000, $16,000 and $6,000, respectively. The aggregate intrinsic value of
      options outstanding as of December 31, 2006, 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 31, 2006.





**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
                31, 2006
            
            October
                1, 2006
            
            July
                2, 2006
            
            April
                2, 2006Volatility
            
            30.0%
            
            24.2%
            
            20.3%
            
            25.9%Weighted-average
                estimated life
            
            3.5
                years
            
            3.5
                years
            
            3.5
                years
            
            3.5
                yearsWeighted-average
                risk-free interest rate
            
            4.68%
            
            5.00%
            
            4.87%
            
            4.46%Dividend
                yield
            
            0
            
            0
            
            0
            
            0





At
      December 31, 2006, there was $614,000 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 2006, 2005 and 2004 was $0.75, $0.89 and $0.77 per share,
      respectively. See Note 20, Subsequent Events for additional information on
      option grants.




F-26
 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 earnings (loss)
      per share of common stock as required by FASB Statement No. 128:


Fiscal
                Years EndedDecember
                31,
            
            January
                1,
            
            January
                2,2006
            
            2006
            
            2005Net
                loss attributable to common shareholders
            
            $
            (3,002,843
            )
            $
            (3,586,915
            )
            $
            (1,343,490
            )Weighted
                common shares outstanding
            
            
            16,665,209
            
            
            14,796,278
            
            
            5,261,981Basic
                net loss per share of common stock
            
            $
            (0.18
            )
            $
            (0.24
            )
            $
            (0.26
            )Effect
                of dilutive securities:Preferred
                stock
            
            
            -
            
            
            -
            
            
            -Warrants
            
            
            -
            
            
            -
            
            
            -Stock
                options
            
            
            -
            
            
            -
            
            
            -Diluted
                weighted common shares outstanding
            
            
            16,665,209
            
            
            14,796,278
            
            
            5,261,981Diluted
                net loss per share of common stock
            
            $
            (0.18
            )
            $
            (0.24
            )
            $
            (0.26
            )


Diluted
      net loss per common share excludes anti-dilutive stock options and warrants
      of
      12,034,000, 7,831,000 and 6,352,000 for fiscal 2006, 2005 and 2004,
      respectively; additionally, the anti-dilutive effect of preferred stock of
      8,491,000, 5,884,000 and 233,150 has been excluded for fiscal 2006, 2005 and
      2004, 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 based on the best information
      available.





We
      recognized write-downs of $1,242,000 (of which $300,000 reduced prepaid rent),
      $211,000 and $201,000 (of which $96,000 was applied against reserves) during
      fiscal 2006, 2005 and 2004, respectively. We have seven operating restaurants
      that have been previously written-down for impairment through December 31,
      2006.
      The write-down in 2006 related to one Florida restaurant with operating losses
      that had not previously been written down. The write-down in 2005 related to
      one
      Florida 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 write-down in 2004 related
      to
      restaurant level operating losses at one Florida restaurant that had not
      previously been written down. The fiscal 2006 and 2004 write-downs were
      necessitated by the then current period operating losses, as well as the
      projected undiscounted cash flows of the restaurants.




F-27
 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
                31,
            
            January
                1,
            
            January
                2,2006
            
            2006
            
            2005Advertising
                and marketing expenses
            
            $
            1,351,000
            
            $
            1,770,000
            
            $
            1,467,000As
                a percentage of revenues
            
            
            2.8
            %
            
            4.0
            %
            
            3.5
            %





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





The
      following tables present selected quarterly financial data for fiscal
      2006 and 2005 ,
      (in
      thousands, except per share data):


Fiscal
                Year 2006FirstQuarter
            
            SecondQuarter
            
            ThirdQuarter
            
            FourthQuarterRevenues
            
            $
            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 (1)
            
            
            284
            
            
            (334
            )
            
            (962
            )
            
            (1,049
            )Diluted
                earnings (loss) per share excluding non-recurring items
            
            $
            0.01
            
            $
            (0.02
            )
            $
            (0.06
            )
            $
            (0.06
            )Fiscal
                Year 2005FirstQuarter
            
            
            SecondQuarter
            
            
            ThirdQuarter
            
            
            FourthQuarterRevenues
            
            $
            12,526
            
            $
            11,919
            
            $
            10,241
            
            $
            9,801Income
                (loss) from operations
            
            
            528
            
            
            416
            
            
            (907
            )
            
            (1,623
            )Net
                income (loss) attributable to common stock
            
            
            410
            
            
            (1,576
            )
            
            (152
            )
            
            (2,269
            )Basic
                earnings (loss) per share
            
            $
            0.03
            
            $
            (0.10
            )
            $
            (0.01
            )
            $
            (0.14
            )Diluted
                earnings (loss) per share
            
            $
            0.03
            
            $
            (0.10
            )
            $
            (0.01
            )
            $
            (0.14
            )Net
                income (loss) excluding non-recurring items (2)
            
            
            563
            
            
            (182
            )
            
            (1,010
            )
            
            (1,237
            )Diluted
                earnings (loss) per share excluding non-recurring items
            
            $
            0.04
            
            $
            (0.01
            )
            $
            (0.06
            )
            $
            (0.08
            )





(1)
            
            One-time
                non-recurring charges (income) were $23,000, ($325,000) and $1,242,000
                in
                the first, second and fourth quarters, respectively.(2)
            
            One-time
                non-recurring charges (income) were $153,000, $1,394,000, ($858,000)
                and
                $1,032,000 in the first, second, third and fourth quarters,
                respectively.


F-28
 SHELLS
            SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES
 **Notes
            to Consolidated Financial Statements**




**NOTE
      20. SUBSEQUENT EVENTS**




In
      January 2007, we granted options to purchase 490,817 shares of our common stock
      to key employees, including 308,992 options issued to executive officers, with
      an exercise price of $0.70 per share. The options vest ratably over three years
      and have a term of seven years. The estimated cost of these stock option awards
      to be recognized in our consolidated financial statements is $126,000. The
      cost
      will be expensed $42,000 annually in each of fiscal years 2008, 2009 and
      2010.




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. Upon completion
      of our financing in May 2005, the maturity date was extended to May
      23, 2007. 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




F-29
 SHELLS
            SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES
 **Notes
            to Consolidated Financial Statements**




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





None.





**ITEM
      9A. CONTROLS AND PROCEDURES**





We
      maintain "disclosure controls and procedures," as such term is defined under
      Securities Exchange Act Rule 13a-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 Chief Executive Officer 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 Chief
      Executive Officer and Chief Financial Officer, of the effectiveness of the
      design and operation of our disclosure controls and procedures. Based upon
      their
      evaluation and subject to the foregoing, the Chief Executive Officer 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 Chief Executive Officer and Chief Financial Officer by others within
      our
      company during the period in which this report was being prepared.





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.


38
 SHELLS
          SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES
 **Notes
          to Consolidated Financial Statements**


**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 headings “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 2007 Annual Meeting of Stockholders
      to be filed with the SEC within 120 days after the end of the fiscal year ended
      December 31, 2006.




**ITEM
      11. EXECUTIVE COMPENSATION**




The
        information required by this item is incorporated by reference to the Proxy
        Statement for our 2007 Annual Meeting of Stockholders to be filed with the
        SEC
        within 120 days after the end of the fiscal year ended December 31,
        2006.





**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 2007 Annual Meeting of Stockholders to be filed with the
        SEC
        within 120 days after the end of the fiscal year ended December 31,
        2006.


**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 2007 Annual Meeting of Stockholders to be filed with the
        SEC
        within 120 days after the end of the fiscal year ended December 31,
        2006.





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


The
        information required by this item is incorporated by reference to the Proxy
        Statement for our 2007 Annual Meeting of Stockholders to be filed with the
        SEC
        within 120 days after the end of the fiscal year ended December 31,
        2006.


39
 SHELLS
          SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES
 **Notes
          to Consolidated Financial Statements**


**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, 10.17, 10.22, 10.23,
                    10.24, 10.30,
                    10.31, 10.34, 10.35, 10.36, 10.37, 10.38 and 10.39 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)


40
 SHELLS
          SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES
 **Notes
          to Consolidated Financial Statements**




**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
              
              Employment
                  Agreement, dated July 1, 2003, between Leslie J. Christon and Shells
                  Seafood Restaurants, Inc. (4)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
              
              Amended
                  and Restated Employment Agreement, effective as of July 1, 2005,
                  by and
                  between Shells Seafood Restaurants, Inc. and Leslie J. Christon.
                  (10)10.35
              
              Stock
                  Option Agreement, dated November 14, 2005, by and between Shells
                  Seafood
                  Restaurants, Inc. and Leslie J. Christon. (10)10.36
              
              Amendment
                  to the 2002 Equity Incentive Plan, dated November 14, 2005.
                  (10)10.37
              
              Agreement,
                  dated March 13, 2006, by and between Shells Seafood Restaurants
                  and
                  Warrant Nelson. (11)10.38
              
              Agreement,
                  dated March 13, 2006, by and between Shells Seafood Restaurants
                  and Guy
                  Kathman. (11)
  41
 SHELLS
              SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES
 **Notes
              to Consolidated Financial Statements**
 **Number**
              
              **Description**
 10.39
              
              Agreement,
                  dated March 13, 2006, by and between Shells Seafood Restaurants
                  and Chris
                  Ward. (11)10.40
              
              Purchase
                  and Sale Agreement, dated April 17, 2006, between the Shells Seafood
                  Restaurants and FRI Fish, LLC for the Ocala, Florida location.
                  (12)10.41
              
              Land
                  and Building Lease, dated April 17, 2006, between the Shells Seafood
                  Restaurants and FRI Fish, LLC for the Ocala, Florida location.
                  (12)10.42
              
              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)10.43
              
              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)10.45
              
              Renewal Letter
                  on Credit Facility, dated September 28, 2006.
                  (15)10.46
              
              Promissory
                  Note, dated December 28, 2005, between Shells Seafood Restaurants,
                  Inc.
                  and Colonial Bank, N.A (16)10.47
              
              Business
                  Loan Agreement, dated December 28, 2005, between Shells Seafood
Restaurants,
                  Inc. and Colonial Bank, N.A (16)10.48
              
              Commercial
                  Security Agreement,
                  dated December 28, 2005, between Shells Seafood Restaurants, Inc.
                  and
                  Colonial Bank, N.A (16)10.49
              
              Extension
                    Letter, dated July 7, 2006, between Shells Seafood Restaurants, Inc.
                    and Colonial Bank, N.A (16)10.50
              
              Amendment
                  No. 2 to the Loan and Security Agreement, dated March 30, 2007.
                  (17)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.(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 September
                  28, 2006
                  and incorporated herein by reference.(16)
              Included
                  as an exhibit to our Current Report on Form 8-K dated July 7, 2006
                  and
                  incorporated herein by reference.(17)
              Included
                  as an exhibit to our Current Report on Form 8-K dated April 2,
                  2007 and
                  incorporated herein by
                  reference.




42
 SHELLS
            SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES
 **Notes
            to Consolidated Financial Statements**




(b)
              Exhibits
                (currently being filed or not previously
                filed)
  31.1
              Certification of Chief Executive Officer
                under Rule 13a-14(a)31.2
              Certification of Chief Financial Officer
                under Rule 13a-14(a)32
              Certification of Chief Executive Officer
                and
                Chief Financial Officer under
                Section 90699.1
              Insider Trading Compliance Policy,
                adopted
                February 5, 200799.2
              Audit Committee Charter, adopted December
                22,
                2006
  (c)
                        Financial
                          Statements


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.




43
 SHELLS
          SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES
 **Notes
          to Consolidated Financial Statements**


**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 30, 2007
            SHELLS
                SEAFOOD RESTAURANTS, INC.By:
                /s/ Warren R. NelsonWarren
                R. Nelson
              Executive
                Vice President of Finance,
              Chief
                Financial Officer, Treasurer and Secretary
              (Principal
                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/Leslie
                J. Christon
            
            President,
                Chief Executive Officer and Director
              (Principal
                Executive Officer)
            April
                2, 2007Leslie
                J. Christon/s/Warren
                R. Nelson
            
            Executive
                Vice President of Finance,
              Chief
                Financial Officer, Treasurer and Secretary (Principal Financial
                Officer)
            April
                2, 2007Warren
                R. Nelson/s/Philip
                R. Chapman
            
            Chairman
                of the Board
            April
                2, 2007Philip
                R. Chapman/s/Michael
                R. Golding
            
            Director
            April
                2, 2007Michael
                R. Golding/s/Gary
                L. Herman
            
            Director
            April
                2, 2007Gary
                L. Herman/s/Christopher
                D. Illick
            
            Director
            April
                2, 2007Christopher
                D. Illick/s/Jay
                A. Wolf
            
            Director
            April
                2, 2007Jay
                A. Wolf


44