**UNITED
STATES**
 **SECURITIES
AND EXCHANGE COMMISSION**
 **WASHINGTON,
D.C. 20549**
 
 ____________________
 **FORM
10-K/A**
 ____________________
  **Amendment
No. 1**
 
 Annual
Report pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934
for the fiscal year (53 weeks) ended January 2, 2005.
 Or
 o Transition Report pursuant to Section 13 or 15 (d)
of the Securities Exchange Act of 1934 for the period from _______________ to
_______________.
 
 Commission
File Number 0-28258
 ____________________
 **SHELLS
SEAFOOD RESTAURANTS, INC.**
 (Exact
name of registrant as specified in its charter)
 ____________________
 **DELAWARE**
    **65-0427966**(State
      or other jurisdiction of incorporation or organization)
    (IRS
      Employer Identification Number)
 
 **16313
North Dale Mabry Highway, 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:
None.**
 **Securities
registered pursuant to Section 12 (g) of the Act:**
 **Common
Stock, $0.01 par value.**
 (Title of
Class)
 ____________________
 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 No o
 
 Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. o
 Indicate
by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Act). Yes [ ] No
  The
aggregate market value of the common stock held by non-affiliates of the
registrant (based upon the last sales price of the common stock reported on the
over-the-counter bulletin board and the assumption, for this computation only,
that all directors, executive officers, and ten-percent holders of stock are
affiliates of the registrant) at June 25, 2004 (the last business day of the
registrant's most recently completed second fiscal quarter) was
$1,469,791.
 As of
April 3, 2005, the number of shares outstanding of the registrant's common
stock, $0.01 par value, was 14,630,417.
 
 **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 our revenues and profitability, including changes in consumer
preferences, tastes and eating habits; increases in food and labor costs;
promotional timings and seasonality; the availability of qualified labor;
national, regional and local economic and weather conditions; 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; cash balances available for operating activities; 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,
operating results, and stock price. An investment in our company involves
various risks, including those which are detailed in this document and from
time-to-time in our other filings with the Securities and Exchange
Commission.
  Any
forward-looking statements included in this Annual Report speak only as of the
date of this document. We are not undertaking 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.
 
 
 
 **EXPLANATORY
NOTE**
 
 This
Amendment No. 1 to the Annual Report on Form 10-K of Shells Seafood Restaurants,
Inc. amends the Shells' Annual Report on Form 10-K for the year ended January 2,
2005, filed with the Securities and Exchange Commission on March 11, 2005.
This Amendment No. 1 is being filed to include disclosures required by Part III
of Form 10-K, to move the disclosure regarding Shells' Code of Business
Conduct and Ethics included in Part I of the original 10-K to Part III of this
report, and to add a certification with respect to changes in internal control
over financial reporting to the certifications required by Section 302 of the
Sarbanes-Oxley Act of 2002. Except as described in the preceding sentence, no
other changes have been made to the original Form 10-K. This Form 10-K/A does
not amend, update or change the financial statements in the original Form
10-K.


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, neighborhood concept, designed to appeal to a broad range of
customers by providing generous portions of high-quality seafood, warm, friendly
service, and a relaxed atmosphere at reasonable prices. Shells restaurants
feature a wide selection of seafood items, including shrimp, oysters, clams,
scallops, 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 dinner and 23 restaurant locations are also open for lunch.



As of
January 2, 2005, our fiscal year end, we owned 20 Shells restaurants, owned a
51% ownership interest in one Shells restaurant and managed four additional
Shells restaurants pursuant to contractual arrangements. In February 2005, we
acquired an additional restaurant located in Clearwater Beach, Florida. This
restaurant is scheduled to open for operation in March 2005. All of our
restaurants are located in Florida.



Fiscal
year 2004 marked a turning point in the evolution of the Shells concept.
Beginning in late 2003, our senior executive team led by new President & CEO
Leslie J. Christon began to strategically reposition the concept by leveraging
the freshness, quality and variety of Shells food as a competitive advantage.
This challenging effort to successfully improve Shells’ concept appeal and
reverse unfavorable long-term sales trends remained our focus throughout
2004.



We
revamped the menu, improved the quality of ingredients purchased, broadened
customer appeal by adding more variety, and adjusted pricing. The new menu still
maintains a very strong emphasis on value through a two-tier pricing strategy,
offering exceptionally high-quality, fresh seafood at reasonable prices
alongside lower-priced favorites. To support the brand’s quality and freshness
positioning, we worked hard to elevate levels of service and overall operational
execution, recruiting new operations talent into our company and enforcing
higher standards. We also addressed the critical need to improve Shells’
atmosphere and facilities, successfully developing a prototypical remodel
package that dramatically improves Shells’ appearance, comfort and consumer
appeal.



Our
efforts to significantly update Shells concept generally have been embraced by
customers. As a result, our comparable restaurant sales turned consistently
positive beginning in the late portion of the third quarter of 2004. Comparable
restaurant sales have remained at strong levels through the balance of 2004.



We
believe our restaurants are better positioned to capitalize on continuing
increases in seafood consumption and favorable publicity about the health
benefits associated with eating seafood. As our guests become more knowledgeable
about quality differences and positive nutritional aspects of seafood, they are
appreciating the improvements we have made. Understanding that consumer
expectations are constantly rising, we continue to work on enhancing many aspect
of the Shells experience.



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Restaurant
Locations



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



Tampa/Sarasota
    
    Orlando
    
    South
      FloridaBrandon
    
    Daytona
      Beach
    
    Coral
      SpringsClearwater Beach*
    
    Kissimmee
    
    DavieHolmes
      Beach
    
    New
      Smyrna Beach
    
    KendallRedington
      Shores
    
    Ocala
    
    Pembroke
      PinesSt.
      Pete Beach
    
    Orlando
    
    SunriseWinter
      Haven
    
    Winter
      ParkCarrollwood
    
    MelbourneNorth
      TampaSarasotaSouth
      TampaWest
      Palm Beach
    
    Fort
      MyersStuart
    
    Fort
      MyersWest
      Palm Beach
    
    Port
      Charlotte


——————

*Scheduled to open March
2005



From
1997 to 1999, in an attempt to diversify and minimize the seasonal effect of the
Florida market, we opened 18 restaurants in various Midwest markets. We
sustained operating losses in these Midwest markets and completed the
discontinuance of our Midwest operations in April 2001, closing the then
remaining nine units. We closed one under-performing Florida restaurant in 2002,
and an additional three Florida restaurants in 2004. We continuously review the
performance of each restaurant unit economics and location, and regularly
evaluate new real estate sites in Florida for potential expansion or relocation.



Restaurant
Operations



Management
and Employees.   We currently employ five 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 dinner-only restaurant consists
of one general manager, two or three assistant managers and approximately 45
other employees. The restaurants that are also open for lunch generally have 15
to 20 additional part-time employees. Restaurant management and area directors
participate in a bonus program based upon the financial results of their
particular restaurant or restaurants.



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.



Recruitment
and Training.We believe that achieving customer
satisfaction by providing knowledgeable, friendly, efficient service is critical
to a restaurants’ long-term success. We typically recruit restaurant managers
with significant experience in the restaurant industry. During a 10-week
training program, restaurant managers are taught to promote our team-oriented
atmosphere among restaurant employees with emphasis on preparing and serving
food in accordance with strict standards and providing friendly, courteous and
attentive service. The restaurant staff, through our Team Trainer program, is
trained on site by restaurant managers and other staff members. During 2002 and
2003, we reduced restaurant management turnover. In 2004, restaurant management
turnover increased as part of an effort to improve the level of quality in our
managers. Other than our recent efforts to raise manager quality levels, we
striv e to reduce turnover levels.

2



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Purchasing.Obtaining
a reliable supply of quality seafood at competitive prices is critical to our
success. We have formed long-term relationships with several seafood suppliers
and purchase both fresh and frozen seafood and certain other supplies
used in restaurant operations in bulk. 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
minimizes the effect of the shortage of any seafood products. We generally have
been able to anticipate and react to fluctuations in food costs through selected
menu price adjustments, purchasing seafood directly from numerous suppliers and
promoting certain alternative menu selections in response to availability and
price of supply.



Performance
Food Group of Florida, our primary distributor since October 2002,
distributes our food products, comprising seafood
and other commodities that make up our menu ingredients, to our
restaurants. Performance Food Group purchases and takes delivery of the products
that we recommend for purchase according to our specifications and subject to
our 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 the 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 30-day supply levels, at an interest rate
of 7.8% per annum. In addition, Performance Food Group procure s, on our behalf,
many operating supplies, other than food products, used by our restaurants
and distributes and sells these products to the individual restaurants at agreed
upon price mark-ups.



Quality
Control.We maintain a continuous inspection program for
all of our seafood purchases. Each shipment of frozen seafood 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 are also inspected on a random
basis by our quality control inspector. 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 ensuring that Shells restaurants are
operated in accordance with strict health and quality 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 a high standard of quality for 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 food-focused 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, newspaper, concentrated internet
and direct mail campaigns. The advertising messages were designed to heighten
brand awareness and drive trial through food-focused promotional offerings while
spotlighting fresh, quality and variety. Mid year, we introduced a focused local
store marketing program, providing all of our restaurants with the resources to
take advantage of an array of sales building initiatives.



In early 2004, we made significant advances in the quality and
variety of our menu offerings. For example, we introduced several new flavor
profiles and menu items to help drive new guest traffic and satisfy current
guests. The improvements to the menu and culinary supervision have enabled us to
deliver on our commitment to providing our guests with the freshest fish,
shellfish and seafood pastas at fair prices.



In December 2004, we entered into a consulting agreement with
Lawrence Wolf, principal of the Wolf Group. Mr. Wolf, as a consultant,
assists our company in providing marketing services; including guidance toward
building our creative strategy around the “Shells” brand positioning and
providing support in coordinating our media production.

3



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Disclosure Controls



Consolidated
subsidiaries are managed through a centralized executive office in Tampa,
Florida. Material information is discussed at various weekly and monthly
meetings with officers and directors. An open door policy is observed by
corporate officers to facilitate communication.



Joint Venture and
Third-Party Owned Restaurants



The
Shells restaurant system currently consists of (i) 20 restaurants that are
wholly owned by us; (ii) one restaurant in Clearwater Beach, Florida
acquired in February 2005, wholly owned by us, and scheduled to open for
operation in March 2005; (iii) one restaurant, in Melbourne, Florida, in
which we have an interest of 51%; and (iv) four 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.



Three of
the managed restaurants are managed and operated by us pursuant to management
and license agreements, originally entered into in July 1993. Pursuant to these
agreements, we provide management services and license proprietary information
required to operate these restaurants for a percentage of that restaurant’s
sales. The agreement, as amended in October 2001, provides for a 4% management
fee until such time as sales return near to 1999 levels, and then returning to a
6% fee. Of the total management fee received, 2% of sales is placed in escrow
and disbursed to a third party to satisfy each managed restaurants’ requirement
to make third party royalty payments. The management agreements grant us
authority to determine the programs and policies affecting the day-to-day
operations of each of these managed restaurants. Although the management
agreements differ slightly, they generally have a remaining term of 19 years and
pro vide that the third-party owners are responsible for funding all the
restaurant expenses, including food and beverage costs, staffing, training,
recruiting, inventory, and working capital.



We
operate the fourth 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. In accordance with the amended
management agreement for our managed restaurants, beginning in October 2001, we
receive a 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 than us.
These competitors include national, regional and local full-service casual
dining chains, many 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, quick service and fast food 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.



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

4



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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 increases in the minimum hourly wage requirements, workers
compensation insurance rates, health care insurance costs and unemployment and
other taxes.



Approximately
12% 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 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 federal minimum wage
and, accordingly, further increases in the 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 remodel a restaurant, or 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 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 effect on
us. Although there can be no assurance that we will have the financial resources
necessary to enforce or defend our service marks, we have vigorously opposed,
and intend to continue to oppose vigorously, any infringement of our service
marks.



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



Employees



As of
January 2, 2005, we employed approximately 1,200 persons, of whom approximately
110 were management or administrative personnel employed on a salaried basis and
1,090 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.

5



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Our
Executive Officers



Our
executive officers are:



Name
    
    Age
    
    PositionLeslie
      J. Christon
    
    50
    
    President
      and Chief Executive OfficerGuy
      C. Kathman
    
    48
    
    Vice
      President of OperationsWarren
      R. Nelson
    
    53
    
    Executive
      Vice President of Finance, Chief Financial Officer, Treasurer and
      Secretary




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.



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.



Our
board of directors has adopted a Code of Business Conduct and Ethics that
applies to our principal executive officer and principal financial officer, as
well as to the members of our board of directors 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.



Risk Factors Relating to
the Business of our Company



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. Additional 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 significant capital requirements and need additional financing within the
first portion of fiscal year
2005.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
many of our restaurants. As of January 2, 2005, our company had a working
capital deficiency of $4,639,000 and a cash balance of $2,350,000. In 2004, we
incurred a net loss of $1,344,000 and we invested in property and equipment of
$1,292,000. In 2003, we incurred a net loss of $1,034,000 and we invested
$755,000 in property and equipment. In addition, we have only recently
experienced some success in reversing the long-term trends in declining sales
and customer traffic. There are no assurances that these recent reversals will
continue and that the implementation of our strategies w ill result in
sales and customer traffic gains which are required to meet our contemplated
cash flow requirements.

6



---

In
December 2004, we obtained net funding of $2,010,000 through the issuance of
convertible debentures totaling $2,375,000. The convertible debentures, which
mature in April 2005, are expected to be repaid, if not converted into stock,
from the proceeds of a contemplated next round of financing anticipated to occur
during the first half of 2005.

In
March 2005, our investors provided us with a $1,600,000 revolving line of
credit, which matures on the earlier of March 31, 2006 or the closing of a
financing providing us not less than $1,600,000 of net proceeds. We expect to
use the line of credit to help repay the debentures if a cash repayment is
required, to the extent we have not then consummated the contemplated next round
of financing.

We
cannot be assured that third party financing will be available to us when we
need it or available on acceptable terms, if at all. If we cannot obtain a
contemplated next round of financing or other financing when we need it, this
could materially adversely affect our results of operations. Conversely, if we
raise additional capital, our existing stockholders could be substantially
diluted.

We may be unable to repay certain of our debts when they
mature. As noted, convertible debentures totaling $2,375,000 mature in
April 2005. In addition, in August 2004, we extended the maturity dates on notes
totaling $2,000,000 from January 31, 2005 to January 31, 2007, at which time
payment will be due in full, along with deferred interest through the due date
of $535,000. The $2,000,000 principal amount notes are held by entities owned by
or associated with various of our directors and largest shareholders. In March
2005, warrants to purchase 1,000,000 shares of common stock, which were issued
on August 4, 2004 pursuant to the extension of the $2,000,000 related-party
financing, were exercised at $0.50 per share by certain of our investors. The
proceeds of $500,000 were used to pay down the principal amount of the notes to
these investors. Additionally, in March 2005, the $1,000,000 n ote held by
Frederick R. Adler was modified to allow Shells to defer entirely the monthly
interest payment on $500,000 of principal amount of the note until the maturity
date of January 31, 2007, resulting in the deferral of $72,000 of cash payments
until the maturity date. We anticipate that prior to maturity, funds will be
available to pay off the remainder of this debt or alternative outside financing
will be available to replace these obligations. There are no assurances that
adequate financing options will be available to our company when necessary.

We
have two promissory notes outstanding through Colonial Bank, for the financing
of two restaurant locations, Melbourne and Winter Haven. As of January 2, 2005,
we owed collectively $1,099,000 on the principal balances of these notes. We are
required to meet a financial covenant relating to debt coverage. We were in
compliance in meeting this loan covenant as of January 2, 2005. However, in the
past, we were not in compliance with meeting the loan covenant for which a
covenant waiver was provided by the bank.

The
two bank notes and the remaining $1,500,000 principal amount of the notes held
by entities owned or associated with insiders are secured by various of our
assets. Our failure to pay these notes as they mature will allow the holders of
these notes to seize and sell various of our assets to satisfy amounts owed.

Our
business plan is contingent on additional future
financing.Integral to our business plan and
subject to our ability to secure a contemplated next round of financing, we
presently have plans to continue our renovation and remodeling of existing
restaurants in 2005. In addition, we will continue to explore restaurant
locations for new growth and relocations. If we do not secure the contemplated
next round of financing and achieve our operating cash flow requirements, our
plans to renovate and remodel will be adversely affected.

History
of losses.We have experienced operating and net
losses during the majority of our recent prior years. In 2004, we had losses of
$1,344,000. In 2003, we had losses of $1,034,000. Excluding non-recurring items,
our losses were $734,000 and $765,000 in 2004 and 2003, respectively.

Substantial
dilution to our stockholders is possible.During
January 2002, we completed a $2,000,000 financing transaction pursuant to which,
among other things, we issued warrants to purchase 8,908,030 shares of our
common stock, at an exercise price of $0.16 per share. As of January 31, 2005,
these warrants were exercised, some in accordance with a cashless exercise
provision; whereby 8,462,630 shares of common stock were issued to the
respective warrant holders.

In August 2004, we agreed with the holders of the $2,000,000 of
promissory notes to an extension of the term of the notes from their original
expiration date of January 31, 2005 to January 31, 2007. In connection with this
extension, we issued warrants to purchase 2,000,000 shares of common stock. In
March 2005, we issued 1,000,000 shares of common stock upon the exercise of
one-half of these warrants.

7



---

In
December 2004, we completed a $2,375,000 private placement of convertible
debentures. The debentures mature on the earliest to occur of certain events,
but in any event, not later than April 5, 2005. In conjunction with this private
placement, we issued warrants to purchase 1,971,250 shares of common stock to
the debenture holders and the placement agent. Until the maturity of these
debentures, the placement agent has the right to place up to an additional
$125,000 aggregate principal amount of debentures, which in turn would cause us
to issue up to 62,500 additional warrants.



As of
February 7, 2005, there were 13,628,417 shares of common stock outstanding, and
warrants, options or other convertible securities outstanding to purchase an
additional 5,291,125 shares of common stock at an average exercise price of
$0.58 per share. By written consent, our board of directors and the holders of a
majority of our outstanding shares of common stock have authorized an amendment
to our certificate of incorporation that will increase the total number of
authorized shares of our common stock from 20,000,000 shares to 40,000,000
shares. We are contemplating pursuing a significant round of additional equity
financing which is expected to be used, among other things, for additional
remodels and potential new locations or relocations for existing restaurants. We
anticipate using the additional authorized shares of common stock, among other
things, to finance the repayment of the debentures to the extent they are not
converted in to common stock and in other future capital raising transactions.



Control
by Management and Certain Individuals.Frederick
R. Adler, and Bruce Galloway, both significant shareholders, together with
members of our board of directors and executive management team, are beneficial
owners of record, in the aggregate, of approximately 58% of our outstanding
common stock as of February 7, 2005. In addition, as part of our $2,000,000
financing transaction in January 2002, we entered into an Investor Rights
Agreement with the investor groups and certain other stockholders. Pursuant to
the Investor Rights Agreement, our board of directors is to consist of seven
members and the investor groups are entitled to nominate six individuals to
serve on our board. These rights are presently held by three unrelated investor
groups consisting of Frederick R. Adler (3 nominees), Trinad Capital, LP and
Galloway Capital Management, LLC (collectively, 3 nominees). The investor
groups, among o thers, have agreed to vote their respective shares of our common
stock for the election to our board of the slated nominees. As a result, these
persons, acting together, currently are able to control the business and affairs
of our company, including the election of our directors and decisions regarding
any proposed dissolution, merger or sale of our assets.



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



Operating
results may require the closure of additional
restaurants.   If we experience prolonged periods of
unfavorable operating results at any existing restaurants, view the prospects
for a restaurant to be less than satisfactory or elect not to 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 and three
restaurants in 2004. We are continuing to monitor the operations and financial
performance with respect to certain of our other existing restaurants.



Our
operating results fluctuate seasonally because of our geographic
concentration.We experience significant
fluctuations in our quarter-to-quarter operating results because of factors
including:



Ÿ

the seasonal nature of our business; and

Ÿ

weather conditions in Florida, which may be severe from
time-to-time.



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

8



---

our
present geographic concentration, adverse publicity relating to our restaurants
or adverse weather conditions could have a more pronounced adverse effect 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. During the third and fourth quarters of
2004, we incurred substantial business and property losses as a result of four
hurricanes that struck Florida. 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.

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 short-term contracts with several of our
suppliers. In addition, we purchase products through Performance Food Group in
the ordinary course of business. Performance Food Group distributes and
warehouses the majority of our seafood supply and procures, distributes and
stores 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.

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 seafood. We maintain
a continuous inspection program for our seafood 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 effect on us. Our failure to obtain adequate supplies of
seafood 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 .

Our
expenses for food and other costs fluctuate.Our
profitability depends on our ability to anticipate and to react to increases in
food, labor, employee benefits, and similar costs. We have limited control over
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
effect on us. We have been able to anticipate and react to fluctuations in food
costs by:

Ÿ

adjusting selected menu prices;

Ÿ

purchasing seafood directly from numerous suppliers; and

Ÿ

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 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. This program may increase our seafood costs
because seafood suppliers’ and processors’ costs in complying with this program
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:

Ÿ

price;

Ÿ

service;

Ÿ

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

Ÿ

location.

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

9



---

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 food
restaurants, which specialize in a variety of menu offerings. In addition, the
full-service restaurant industry is characterized by the frequent introduction
of new food products, which are accompanied by substantial promotional
campaigns. In recent years, numerous companies in the full-service restaurant
industry have introduced products, including seafood, intended to capitalize on
growing consumer prefer­ence for food products that are, or are perceived to
be, healthful, nutritious, and low in calories, carbohydrates or fat content.
You can 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 you that:



Ÿ

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

Ÿ

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

Ÿ

we will be able to compete successfully.



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



Ÿ

changes in con­sumer preferences, tastes and eating
habits;

Ÿ

demographic trends and traffic patterns;

Ÿ

increases in food and labor costs;

Ÿ

inflation; and

Ÿ

national, regional and local economic conditions and the
effect of world events, in general, and the tourism industry in
particular:



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



Ÿ

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

Ÿ

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

Ÿ

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

Ÿ

regulations relating to public health; and

Ÿ

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 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 would 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:



Ÿ

the minimum hourly wage requirements;

Ÿ

workers compensation insurance rates;

10



---



Ÿ

health care insurance costs;

Ÿ

other insurance costs, including general liability and
property; and

Ÿ

unemployment and other taxes.



In May
2005, the minimum wage rate in Florida will increase by $1.00 per hour. Tipped
employees will also be receiving the $1.00 per hour wage increase under this new
law. Each year thereafter, 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 will have a significantly adverse affect to our company.
Menu price increases and other actions will be required to negate the effect of
these wage increases. There can be no assurances that such measures expected to
be taken by our company will be successful to adequately offset these additional
payroll costs, or will be accepted without adverse reaction by our
customers.



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



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



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



Ÿ

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

Ÿ

would be upheld if challenged; or

Ÿ

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.



Our
insurance coverage may not be adequate.We
maintain insurance, including insurance relating to personal injury, in amounts,
which we currently consider adequate. Nevertheless, a partially or completely
uninsured claim against us, if successful, could materially adversely affect
us.



Absence
of Dividends.We have never paid cash dividends
on our common 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.

11



---

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 d iscourage
bids for our common stock at a premium over the market price of the common stock
and may adversely affect the market price of the common stock.



On
October 24, 2001, we issued 66,862 shares of Series A 5% Convertible Preferred
Stock, par value $0.01 per share, pursuant to an exemption from registration
under Section 4(6) of the Securities Act of 1933, as amended, in consideration
for the cancellation of $669,000 of trade indebtedness by trade creditors of our
company. As of January 2, 2005, we have 35,275 shares of preferred stock
outstanding. We have no present intention to issue any additional shares of our
preferred stock. However, we cannot assure you that we will not do so in the
future.



On
February 7, 2005, we obtained written consents from our board of directors and
the holders of a majority of our outstanding shares of common stock, to increase
the number of authorized shares of common stock from 20,000,000 shares to
40,000,000 shares. One of the effects of the amendment to our certificate of
incorporation may be to enable the board to render more difficult or to
discourage an attempt to obtain control of our company, since the issuance of
these additional shares of common stock could be used to dilute the stock
ownership of persons seeking to obtain control or otherwise increase the cost of
obtaining control of our company.



ITEM
2.   PROPERTIES



We lease
4,500 square feet of space in Tampa, Florida for our executive offices. The
annual rent payable under the lease, which expires October 31, 2006, is
approximately $66,000.



All but
three 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 evaluation. 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 13 years and renewal options averaging 16 years, and
rents averaging $15.00 per square foot.



ITEM
3.   LEGAL PROCEEDINGS



On June
21, 2002 we brought legal action against The Lark Group LLC, Best Que LLC, and
Michael Sloane, II, in the United States District Court, Middle District of
Florida, Tampa Division, relating to their purchase of assets and leasehold
rights for two Midwest locations. Our complaint sought relief for breaches of
contract against each of the defendants. Defendants consented to a final
judgment in the amount of $188,201, which was filed with the Court on January
22, 2003. The parties reached a settlement which was finalized with a $100,000
lump sum payment to Shells in December 2004.



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



ITEM
4.   SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS



None.

12



---

PART II



ITEM
5.   MARKET FOR THE REGISTRANT’S COMMON STOCK AND RELATED
STOCKHOLDER MATTERS

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

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

Fiscal 2003
    
    High
    
    LowFirst
      quarter
    
    $0.75
    
    $0.35Second quarter
    
    $0.70
    
    $0.40Third quarter
    
    $0.70
    
    $0.51Fourth quarter
    
    $0.95
    
    $0.42Fiscal
      2004First
      quarter
    
    $0.75
    
    $0.34Second quarter
    
    $0.65
    
    $0.27Third quarter
    
    $0.80
    
    $0.47Fourth quarter
    
    $0.88
    
    $0.47


The
number of stockholders of record of our common stock on January 31, 2005 was
approximately 250. Our stock price as of January 31, 2005 was $0.75.

Our
authorized capital stock consists of 20,000,000 shares of common stock, par
value $0.01 per share, and 2,000,000 shares of preferred stock, par value $0.01
per share.In February 2005, our board of directors and the holders of a
majority of our outstanding shares of common stock authorized, by written
consent, an amendment to our certificate of incorporation that will increase the
total number of authorized shares of our common stock from 20,000,000 shares to
40,000,000 shares. Subsequently, an Information Statement was mailed to our
stockholders of record at that time, pursuant to Section 14(C) of the Securities
Exchange Act of 1934, regarding these actions by written consents. The
additionally authorized shares are expected to be available for issuance
commencing in March 2005.

Dividend Policy

We
have never declared or paid any cash dividends on our common stock. All future
earnings will be retained by us for the development of our business.
Accordingly, we do not anticipate paying cash dividends on the common stock in
the foreseeable future. We are subject to loan covenants containing certain
provisions prohibiting our ability to pay dividends.

Equity
Compensation Plans

Securities
authorized for issuance under equity compensation plans as of January 2, 2005
were as follows:

Plan
      category
    
    Number of securities to be issued upon exercise of
      outstanding options, warrants, and rights[a]
    
    Weighted-average exercise price of outstanding options,
      warrants and rights[b]
    
    Number of securities remaining available for future
      issuance under equity compensation plans (excluding securities reflected
      in column [a])[c]Equity
      compensation plans approved by security holders
    
    1,143,500
    
    $1.00
    
    1,583,043Equity
      compensation plans not approved by security holders
    
    9,129,280
    
    $0.30
    
    —Total
    
    10,272,780
    
    
    
    1,583,043


13




Equity
compensation plans not approved by security holders consist of (i) warrants to
purchase 5,158,030 shares of common stock, issued on January 31, 2002, in
connection with a $2,000,000 private financing transaction; warrants were
exercised at $0.16 per share on January 31, 2005, the expiration date, resulting
in the issuance of 4,712,630 shares of common stock, which provided proceeds of
$754,000 to us; warrants to purchase 445,400 shares of common stock were also
exercised by a “cashless exercise” on January 31, 2005 resulting in the issuance
of 350,381 shares of common stock; (ii) warrants to purchase 2,000,000 shares of
common stock, issued on August 4, 2004, in connection with the extension of the
maturity date of the $2,000,000 private financing transaction to January 31,
2007; warrants to purchase 1,000,000 shares were exercised in March 2005 at the
exercise price of $0.50 per share by certain o f our investors, the proceeds of
which were used to pay down the principal amount of the notes to these
investors; and (iii) warrants to purchase 1,971,250 shares of common stock,
exercisable through December 7, 2010, issued on December 7, 2004 in connection
with the $2,375,000 debenture offering; the exercise price will be determined at
a future date upon the completion of an anticipated financing transaction,
however, the exercise price will not be less than $0.45 nor greater than $0.80
per share.



The
number of securities and type of plans available for future issuance of stock
options as of January 2, 2005 was:



Options and Warrants for Common SharesPlan Name
    
    Authorized
    
    Exercised
    
    Outstanding
    
    AvailableStock
      Option Plan for Non-Employee Directors
    
    150,000
    
    0
    
    32,000
    
    118,0001995 Employee Stock
      Option Plan
    
    840,000
    
    0
    
    173,750
    
    666,2501996
      Employee Stock Option Plan
    
    101,000
    
    11,001
    
    31,992
    
    58,0072002 Equity Incentive Plan
    
    1,850,000
    
    203,456
    
    905,758
    
    740,786Total
      stock options
    
    2,941,000
    
    214,457
    
    1,143,500
    
    1,583,043




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

14



---

ITEM 6.   SELECTED CONSOLIDATED FINANCIAL
DATA



The
following table sets forth selected historical consolidated financial data for
Shells. The historical consolidated financial data is for the fiscal years (53
weeks) ended January 2, 2005 (our fiscal year 2004), and the (52 weeks) ended
December 28, 2003 (our fiscal year 2003), December 29, 2002 (our
fiscal year 2002), December 30, 2001 (our fiscal year 2001), and
December 31, 2000 (our fiscal year 2000). This consolidated financial data
should be read in conjunction with “Management’s Discussion and Analysis of
Financial Condition and Results of Operations” and the Consolidated Financial
Statements and Notes thereto included elsewhere in this Form 10-K. (The amounts
are presented in thousands, except earnings per share, shares outstanding,
number of restaurants data, and percentage information).



Year(53 Weeks)Ended
    
    Year (52 Weeks) EndedJanuary 2,2005
    
    December 28,2003
    
    December 29,2002
    
    December 30,2001
    
    December 31,2000Statement
      of Operations Data:RevenuesRestaurant
      sales
    
    $
    41,393
    
    $
    43,881
    
    $
    47,065
    
    $
    57,258
    
    $
    90,023Management
      fees
    
    
    171
    
    
    165
    
    
    163
    
    
    271
    
    
    419Total
      revenues
    
    
    41,564
    
    
    44,046
    
    
    47,228
    
    
    57,529
    
    
    90,442Costs
      and expensesCost
      of sales
    
    
    14,051
    
    
    14,467
    
    
    15,778
    
    
    21,239
    
    
    33,984Labor
      and other related expenses
    
    
    12,935
    
    
    13,845
    
    
    14,585
    
    
    17,628
    
    
    28,028Other
      restaurant operating expenses
    
    
    10,123
    
    
    11,117
    
    
    10,774
    
    
    12,047
    
    
    19,635General
      and administrative expenses
    
    
    3,249
    
    
    3,387
    
    
    3,565
    
    
    4,751
    
    
    7,212Depreciation
      and amortization
    
    
    1,058
    
    
    1,077
    
    
    1,102
    
    
    1,702
    
    
    2,703Provision
      for impairment of assets
    
    
    105
    
    
    360
    
    
    110
    
    
    2,259
    
    
    3,978Provision
      for impairment of goodwill
    
    
    —
    
    
    —
    
    
    206
    
    
    —
    
    
    —Provision
      for store closings
    
    
    —
    
    
    —
    
    
    —
    
    
    1,333
    
    
    1,027Income
      (loss) from operations
    
    
    43
    
    
    (207
    )
    
    1,108
    
    
    (3,430
    )
    
    (6,125
    )Interest
      expense, net
    
    
    (1,154
    )
    
    (463
    )
    
    (534
    )
    
    (481
    )
    
    (789
    )Other
      income (expense)Other
      income (expense), net
    
    
    33
    
    
    (100
    )
    
    (3
    )
    
    (476
    )
    
    145Gain
      on preferred stock conversion
    
    
    —
    
    
    —
    
    
    —
    
    
    588
    
    
    —(Loss)
      income before elimination of minority partner interest and income
      taxes
    
    
    (1,078
    )
    
    (770
    )
    
    571
    
    
    (3,799
    )
    
    (6,769
    )Elimination
      of minority partner interest
    
    
    (266
    )
    
    (264
    )
    
    (221
    )
    
    (221
    )
    
    (259
    )(Loss)
      income before benefit (provision) for income taxes
    
    
    (1,344
    )
    
    (1,034
    )
    
    350
    
    
    (4,020
    )
    
    (7,028
    )Income
      tax benefit (provision) (1)
    
    
    —
    
    
    —
    
    
    327
    
    
    1,001
    
    
    (2,304
    )Net
      (loss) income
    
    $
    (1,344
    )
    $
    (1,034
    )
    $
    677
    
    
    (3,019
    )
    $
    (9,332
    )




15



---



Fiscal Years EndedJanuary 2,2005
    
    December 28,2003
    
    December 29,2002Earnings
      per Share Data:Basic net (loss) income per share
    
    $
    (0.26
    )
    $
    (0.23
    )
    $
    0.15Diluted net (loss) income per share
    
    $
    (0.26
    )
    $
    (0.23
    )
    $
    0.07Shares
      Outstanding Data:Basic weighted average
    
    
    5,261,981
    
    
    4,577,470
    
    
    4,454,015Diluted weighted average
    
    
    5,261,981
    
    
    4,577,470
    
    
    10,259,188Operating
      Data:System-wide sales:Company-owned restaurants (2)(3)
    
    $
    41,393
    
    $
    43,881
    
    $
    47,065Licensed restaurants
    
    
    7,883
    
    
    7,167
    
    
    8,147$
    49,276
    
    $
    51,048
    
    $
    55,212Number
      of restaurants (at end of period):Company-owned restaurants (2)
    
    
    21
    
    
    24
    
    
    24Licensed restaurants
    
    
    4
    
    
    4
    
    
    425
    
    
    28
    
    
    28Average
      annual sales per Company-owned and joint venture restaurant open for
      full period (4)
    
    $
    1,896
    
    $
    1,828
    
    $
    1,924Decrease
      in Company-owned and joint venture restaurant same store sales
    (4)
    
    
    -1.6
    %
    
    -5.1
    %
    
    -7.2
    %




January 2,2005
    
    December 28,2003
    
    December 29,2002
    
    December 30,2001
    
    December 31,2000Balance
      Sheet Data:Working
      capital (deficiency)
    
    $
    (4,639
    )
    $
    (3,606
    )
    $
    (3,116
    )
    $
    (7,580
    )
    $
    (7,500
    )Total
      assets
    
    
    13,519
    
    
    11,616
    
    
    13,858
    
    
    14,847
    
    
    21,461Long-term debt
    
    
    3,734
    
    
    3,826
    
    
    3,883
    
    
    1,633
    
    
    5,700Minority partner interest
    
    
    442
    
    
    466
    
    
    428
    
    
    428
    
    
    449Preferred stock
    
    
    —
    
    
    1
    
    
    1
    
    
    1
    
    
    —Stockholders’ equity
    
    
    502
    
    
    1,183
    
    
    2,152
    
    
    1,475
    
    
    4,414


——————

(1)

The
effective tax rates for fiscal years 2004, 2003, 2002, 2001 and 2000 include the
effect of recognizing valuation allowance adjustments relating to tax benefits.
There was no benefit or provision for income taxes in 2004 or 2003. Income tax
benefit (provision) of 93.3%, 24.9% and (32.8)% for the fiscal years ended 2002,
2001 and 2000, respectively, 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 2004 was increased by $210,000, reserving for
all tax assets that were deemed non-realizable. The valuation allowance in 2003
was increased by $596,000, reserving for all tax assets that were deemed
non-realizable. The valuation allowance in 2002 was increased by $1,403,000,
reserving for all tax assets that were deemed non-realizable The valuation
allowance in 2001 was decreased by $706,000, reserving for all tax assets except
those subject to recovery through carrybacks resulting from the March 9, 2002
Economic Stimulus Package.

(2)

Includes
one joint venture restaurant in which we own a 51% equity interest.

(3)

Includes
three locations that were closed in 2004.

(4)

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. Same
store sales are calculated on a comparable calendar period basis.



16



---

ITEM
7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
ANDRESULTS OF OPERATIONS



General



Fiscal
year 2004 was a year of significant variability for Shells. The first half of
the year marked a continued focus on repositioning the Shells concept to
leverage the competitive strengths of freshness, quality and variety at
reasonable prices. We worked to elevate service and operations levels,
recruiting new operations talent to replace underperforming restaurant managers.
A comprehensive service program was rolled out, including certifying all
servers, bartenders, hostesses and service assistants, in the new procedures. We
also addressed improving our atmosphere and facilities, testing and completing a
remodel package to dramatically enhance the appearance and appeal of its
restaurants. Shells “new look” was unveiled at three restaurants during the year
and met with enthusiastic guest acceptance.



Just as
Shells was beginning to experience positive sales momentum from the various
changes to improve the concept, four major hurricanes struck Florida, the state
where all of our restaurants are located. The hurricanes significantly disrupted
our business, with evacuations and storm-related damage closing several
restaurants for extended periods of time. Many of the lost sales days occurred
on weekends, the period where the majority of the week’s sales are typically
generated. The impact also hampered Florida tourism for several weeks,
particularly affecting our restaurants located in coastal areas. Cash flow from
operations and same store sales are among the most significant drivers in our
business and the combined impact of the Florida hurricanes seriously diminished
our cash position and dealt us a significant financial setback.



However,
Shells regained sales momentum after the storms, and as our restaurants
reopened, sales rebounded very well. Beginning late in the third quarter, our
comparable store sales turned positive and were consistently strong for the
remainder of the year, with same store sales up 5.7% during the fourth quarter.



Management
continues to focus on its strategy to improve and strengthen the concept’s
customer appeal, striving to attract new and former Shells customers as well as
core customers. A major part of this ongoing effort is remodeling and
modernizing the restaurants. The new look introduced at three remodeled
restaurants during 2004 has been very successful in generating excellent guest
feedback and strong sales increases.



We
received funding during the fourth quarter of 2004, which we are utilizing to
remodel additional restaurants. We anticipate closing a contemplated next round
of financing in the first half of 2005 which, if completed, should allow us to
remodel most of our remaining restaurants. We may also use funds from any
contemplated financing to strategically open new restaurants or relocate
existing restaurants.



The
fourth quarter 2004 net funding of $2,010,000 was achieved by the sale of
$2,375,000 principal amount of convertible debentures, which are due in April
2005. In March 2005, our investors provided us with a $1,600,000 revolving line
of credit. We expect to use the line of credit to help repay the debentures if a
cash repayment is required, to the extent we have not then consummated the
contemplated next round of financing.



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. In addition, there are no assurances that financing options
will be available to us or that our business plan will not be significantly
hampered by cash availability.

17



---

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 EndedJanuary 2,2005
    
    December 28,2003
    
    December 29,2002RevenuesRestaurant
      sales
    
    99.6%
    
    99.6%
    
    99.7%Management
      fees
    
    0.4%
    
    0.4%
    
    0.3%100%
    
    100%
    
    100%Cost
      and expensesCost
      of sales (1)
    
    33.9%
    
    33.0%
    
    33.5%Labor
      and other related expenses (1)
    
    31.2%
    
    31.6%
    
    31.0%Other
      restaurant operating expenses (1)
    
    24.5%
    
    25.3%
    
    22.9%Total
      restaurant costs and expenses (1)
    
    89.6%
    
    89.9%
    
    87.4%General
      and administrative expenses
    
    7.8%
    
    7.7%
    
    7.5%Depreciation
      and amortization
    
    2.5%
    
    2.4%
    
    2.3%Provision
      for impairment of assets
    
    0.3%
    
    0.8%
    
    0.2%Provision
      for impairment of goodwill
    
    0.0%
    
    0.0%
    
    0.4%Income
      (loss) from operations
    
    0.1%
    
    -0.5%
    
    2.3%Interest
      expense, net
    
    -2.8%
    
    -1.1%
    
    -1.1%Other
      income (expense), net
    
    0.1%
    
    -0.2%
    
    0.0%Elimination
      of minority partner interest
    
    -0.6%
    
    -0.6%
    
    -0.5%(Loss)
      income before benefit for income taxes
    
    -3.2%
    
    -2.4%
    
    0.7%Income
      tax benefit
    
    0.0%
    
    0.0%
    
    0.7%Net
      (loss) income
    
    -3.2%
    
    -2.4%
    
    1.4%


——————

(1) As a percentage of
restaurant sales.



Results of
Operations



Fiscal Year 2004 versus Fiscal Year 2003



Total
revenues for the 53-week fiscal year 2004 were $41,564,000 as compared to
$44,046,000 for the 52-week fiscal year 2003. The $2,482,000 or 5.6% decrease in
revenues was primarily due to a reduction in the number of restaurants open for
operation in 2004. We operated 25 restaurants as of the end of 2004 compared to
28 restaurants at the end of 2003. However, revenues in 2004 contained an
additional operating week compared to 2003, as our fiscal year is the 52 or 53
weeks ending the Sunday nearest to December 31st. Our revenues consisted of
restaurant sales of our company-owned restaurants and management and licensing
fees on sales at the managed restaurants. Our food sales and liquor sales
accounted for 88% and 12% of revenues, respectively, for 2004 compared to 89%
and 11%, respectively, for 2003. Liquor sales, relative to food sales, increased
year-to-year as a result of a new beverage program initiated in the first
quarter of 20 04. Same store sales in 2004 decreased 1.6% when compared to 2003.
The decline in same store sales was the result of a 10.5% decline in customer
traffic, offset in part by a 10.0% increase in average customer check. In 2004,
we incurred estimated sales losses of $930,000 due to hurricane-related business
interruption. Adjusting for estimated hurricane-related sales losses, same store
sales would have increased by 0.2% above the prior year. Comparisons of same
store sales include only stores, which were operating during the equivalent
calendar periods being compared and, due to the time needed for a restaurant to
become established and fully operational, at least six months prior to the
beginning of that period.



The cost
of restaurant sales as a percentage of restaurant sales increased to 33.9% for
2004 from 33.0% for 2003. This increase primarily was due to a 0.6% of sales
increase in commodity costs and 0.4% increase relating to menu mix changes
including promotional items which affected customer preferences. Fiscal year
2004 and 2003 cost of sales included a non-recurring inventory write down of
$22,000 and $36,000, respectively. Exclusive of these non-recurring items, cost
of restaurant sales was 33.9% and 32.9% of restaurant sales for 2004 and 2003,
respectively. 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.

18



---

Labor
and other related expenses as a percentage of restaurant sales decreased to
31.2% in 2004 as compared to 31.6% for 2003. This decrease was mostly due to a
reduction in workers’ compensation insurance costs of 0.2% of sales and a
reduction in key hourly labor of 0.2% of sales. Fiscal year 2004 and 2003
included a non-recurring reduction in expenses of $161,000 and $196,000,
respectively, relating to a refund and corresponding reserve adjustment for
prior years workers’ compensation experience. Exclusive of
these non-recurring items, labor and other related expenses was 31.6% and 32.0%
of restaurant sales for 2004 and 2003, respectively. Labor and other related
expenses generally consist of restaurant hourly and management payroll,
benefits, taxes and workers’ compensation insurance.



Other
restaurant operating expenses as a percentage of restaurant sales decreased to
24.5% for 2004 as compared with 25.3% for 2003. This decrease was primarily due
to a 0.9% decrease in restaurant repairs and maintenance costs, partially offset
by a loss of sales leverage caused by lower unit sales volumes. Other restaurant
operating expenses generally consist of advertising, costs associated with area
directors, supplies, repairs and maintenance, rent and other occupancy costs and
utilities.



General
and administrative expenses were $3,249,000 or 7.8% of revenues and $3,387,000
or 7.7% of revenues in 2004 and 2003, respectively. The $138,000 expense
reduction was mostly due to a general downsizing in corporate office staff,
which occurred in June 2004. Non-recurring expense in 2004 and 2003 each
included a one-time charge for severance expense of $39,000 and $70,000,
respectively. Exclusive of these non-recurring charges, general and
administrative expense was 7.7% and 7.5% of revenues in 2004 and 2003,
respectively. 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 expenses as a percentage of revenues were 2.5% for 2004 and
2.4% for 2003. The 0.1% of revenues increase was mostly due to increasing the
fixed asset basis as a result of restaurant remodeling and hurricane-related
reconstruction.



The
provision for impaired assets was $105,000 or 0.3% of revenues for 2004 as
compared to $360,000 or 0.8% of revenues for 2003. In 2004 and 2003, we recorded
a pre-tax charge relating to the write-down of impaired assets to their
estimated fair value in accordance with Financial Accounting Standards Board
Statement No. 144. The asset impairment charge in 2004 related to one restaurant
compared to three restaurants in 2003. The respective write-downs were
necessitated by the then current period operating losses and the projected cash
flows of the restaurants, many of which were negative.



Goodwill
was evaluated for impairment in each of 2004 and 2003 in accordance with FASB
Statement No. 142. As a result of the evaluation, we did not recognize goodwill
impairment in either year.



Net
interest expense was $1,154,000 in 2004 compared to $463,000 in 2003. 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 $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
$2,375,000 financing transaction. Exclusive of these non-recurring charges, net
interest expense was $443,000 in 2004. The $20,000 decrease in net interest
expense in 2004 from 2003, excluding the non-recurring charges, was generally
due to the pay down of outstanding debt, partially offset by a $9,000 reduction
in interest income resulting from lower balances of cash in 2004 compared to
2003.



Other
income in 2004 was $33,000, compared to other expense of $100,000 in 2003. 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 relating
to the $2,375,000 financing transaction and a loss on the disposal of assets of
$41,000 relating to our restaurant renovations. Exclusive of these non-recurring
items, other expense in 2004 was $139,000.



No
benefit or provision for income taxes was recognized in either 2004 or 2003.



As a
result of the factors discussed above, the income from operations for 2004 was
$43,000 compared to a loss from operations for 2003 of $207,000. Exclusive of
non-recurring items, our loss from operations was $57,000 for 2004 compared to
net income of $63,000 for 2003. Net loss for 2004 was $1,344,000 compared to
$1,034,000 for 2003. Exclusive of non-recurring items, the net loss in 2004 was
$733,000 compared to $764,000 for 2003.

19



---

Fiscal
Year 2003 versus Fiscal Year 2002

Total
revenues for 2003 were $44,046,000 as compared to $47,228,000 for 2002. The
$3,182,000 or 6.7% decrease in revenues was primarily due to a 5.1% decrease in
same store sales and, to a lesser extent, due to operating one less restaurant
during and after the third quarter of 2002. The decline in same store sales was
the result of a decline in customer traffic, offset in part by an increase in
average customer check. Our food sales and liquor sales accounted for 89% and
11% of revenues, respectively, for the fiscal year ended December 28, 2003.

The
cost of restaurant sales as a percentage of restaurant sales decreased to 33.0%
for 2003 from 33.5% for 2002. This decrease primarily was due to favorable food
costs and lower distribution costs, partially offset by a non-recurring
write-down of inventory of $36,000. Exclusive of the non-recurring item, cost of
restaurant sales was 32.9% for 2003.

Labor
and other related expenses as a percentage of restaurant sales increased to
31.6% during 2003 as compared to 31.0% for 2002. This percentage increase was
due to a loss of sales leverage caused by lower unit sales volumes, along with
increases in health insurance and workers’ compensation insurance; partially
offset by a non-recurring reduction in expenses of $196,000 relating to a
reserve adjustment for prior years workers’ compensation experience. Exclusive
of the non-recurring item, labor and other related expenses was 32.0% of
restaurant sales for 2003.

Other
restaurant operating expenses as a percentage of restaurant sales increased to
25.3% for 2003 as compared with 22.9% for 2002. This percentage increase was
primarily due to a loss of sales leverage caused by lower unit sales volumes,
along with increases in restaurant maintenance; utilities, particularly
electricity and gas; insurance and real estate taxes.

General
and administrative expenses were $3,387,000 or 7.7% of revenues and $3,565,000
or 7.5% of revenues in 2003 and 2002, respectively. Non-recurring expense in
2003 included a one-time charge for severance expense of $70,000. Exclusive of
the non-recurring charge, general and administrative expense was 7.5% in 2003.

Depreciation
and amortization expenses as a percentage of revenues were 2.4% for 2003 and
2.3% for 2002.

The
provision for impaired assets was $360,000 or 0.8% of revenues for 2003 as
compared to $110,000 or 0.2% of revenues for 2002. In 2003 and 2002, we recorded
a pre-tax charge relating to the write-down of impaired assets to their
estimated fair value in accordance with Financial Accounting Standards Board
Statement No. 144. The asset impairment charge in 2003 related to three
restaurants, two of which were previously not written down and a third that was
partially written down in 2002. The asset impairment charge in 2002 related to
three restaurants that were previously not written down.

Goodwill
was evaluated for impairment in 2003 and 2002 in accordance with FASB Statement
No. 142 which we adopted in 2002. As a result of the evaluation we did not
recognize goodwill impairment in 2003. The provision for impairment of goodwill
was $206,000 or 0.4% of revenues in 2002.

Net
interest expense was $463,000 in 2003 compared to $534,000 in 2002. We recorded
a one-time charge of $106,000 in the first quarter of 2002 relating to the
previously reported $2,000,000 financing transaction. Exclusive of this
non-recurring charge, net interest expense was $428,000 in 2002. The increase in
net interest expense in 2003 over 2002, excluding the non-recurring charge was
primarily due to a $23,000 reduction in interest income, resulting from lower
balances of cash in 2003 compared to 2002.

Other
expense in 2003 was $100,000, compared to $3,000 in 2002. The increase primarily
related to a net change in the reserve adjustment for gift certificates.

A
benefit from income taxes of $327,000 was recognized in 2002. No benefit or
provision was recognized in 2003. The benefit in 2002 related to a refund
application to recover tax payments of $1,176,000 from prior
years, resulting from the Economic Stimulus Package signed into law in
March 2002. The refund was received in July 2002.

As a
result of the factors discussed above, loss from operations for 2003 was
$207,000 compared to income from operations for 2002 of $1,108,000. Exclusive of
non-recurring items, our income from operations was $63,000 for 2003 compared to
$1,218,000 for 2002. Our net loss for 2003 was $1,034,000 compared to net income
of $677,000 for 2002. Exclusive of non-recurring items, net loss in 2003 was
$764,000 compared to net income in 2002 of $575,000.

20



---

Liquidity
and Capital Resources

We
attained a marginally positive income from operations in 2004, after incurring
significant business losses as a result of successive hurricanes in 2004.
Subsequent to the four hurricanes which occurred in the third quarter of 2004,
we began to experience a resurgence in sales growth, with a 5.7% improvement in
fourth quarter 2004 same store sales. In August 2004, the maturity dates on the
$2,000,000 principal amount promissory notes were extended from January 31, 2005
to January 31, 2007. We attained cash infusions of $600,000 in November 2004 and
$754,000 January and February 2005 from the exercise and conversion of
noteholder warrants to shares of our common stock. We also obtained a $500,000
interim line of credit from our bank to assist in the hurricane-related
reconstruction of our restaurants of which $295,000 was utilized and
subsequently repaid from insurance proceeds.

In
December 2004, we raised additional net funds of $2,010,000 for the remodeling
of many of our restaurants through an offering of $2,375,000 in convertible
debentures. The debentures mature on the earliest to occur of certain events,
but in any event, not later than April 5, 2005. In addition, we contemplate that
an additional round of financing will be sought in the first half of 2005. In
March 2005, our investors provided us a $1,600,000 revolving line of credit,
which matures on the earlier of March 31, 2006 or the closing of a financing
providing us not less than $1,600,000 of net proceeds. 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. The investors received a fee of
$80,000 for extending the credit line to Shells.

Proceeds
of $600,000 from the issuance of common stock received in November 2004 and
$295,000 obtained from an interim bank line of credit were used to remodel three
restaurants in 2004. In addition, approximately one-half of the net $2,010,000
funds received through the $2,375,000 offering of convertible debentures, is
currently being used to complete the remodeling of six additional restaurants.
We have experienced favorable sales trends as a result of our restaurant
remodeling, to-date. Subsequent to the August and September hurricanes,
aggregate sales for the three remodeled stores which were remodeled in 2004 have
increased 13.3% above the prior year period in comparison to an increase of 4.4%
for the non-remodeled restaurants over the comparable period. While we believe
that our restaurants will experience sales improvements from remodeling, there
are no assurances that future restaurant remodels will achieve similar, if any,
increases in same store sales or that the restaurants remodeled to-date or any
of these future restaurant remodels will be able to sustain continuing sales
improvements. There are also no assurances that the remodeling costs of any new
remodels will be at levels comparable to remodeling expenditures incurred
to-date.

In
addition to repaying the debentures, we anticipate that the contemplated
additional round of financing will be utilized to complete our restaurant
remodeling and position our company for growth. There can be no assurances that
such financing or any other financing will be available to us, or at terms
acceptable to us. We believe that with funds from the contemplated additional
financing or the revolving credit line, we will have sufficient capital to
satisfy the debt service requirements of the convertible debentures.

Proceeds
of $754,000 from the issuance of common stock received in January and February
2005 relating to the warrant exercise, and $600,000 for a lease termination fee
received in February 2005 on a restaurant location are being used to acquire,
renovate and prepare to open our new Clearwater Beach restaurant.

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

2004
    
    2003
    
    2002Net cash (used in) provided by operating activities
    
    $
    (128
    )
    $
    (490
    )
    $
    444Net
      cash (used in) provided by investing activities
    
    
    1,292
    
    
    (755
    )
    
    325Net
      cash provided by (used in) financing activities
    
    
    3,046
    
    
    (500
    )
    
    730Net
      increase (decrease) in cash
    
    $
    1,626
    
    $
    (1,745
    )
    $
    1,499




As of
January 2, 2005, our current liabilities of $7,992,000 exceeded our current
assets of $3,353,000, resulting in a working capital deficiency of $4,639,000.
In comparison, as of December 28, 2003, our working capital deficiency was
$3,606,000. Our operating leverage decreased mostly due to the deployment of
interim financing toward restaurant remodeling and reconstruction from
hurricane-related property losses. We may still 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 the investing of
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.

21



---

During
2004, our cash position increased by $1,626,000, from $724,000 as of
December 28, 2003 to $2,350,000 as of January 2, 2005. The increase in cash
was almost exclusively provided by financing activities of $3,046,000,
representing proceeds from the issuance of debt of $2,832,000 and common stock
of $618,000, partially offset by $404,000 in debt repayment. The net cash used
in investing activities was $1,292,000, generally reflecting capital
expenditures related to restaurant remodeling and hurricane-related
reconstruction. Net cash used in operating activities totaled $128,000.

In
connection with the $2,000,000 financing dated January 31, 2002, we issued to
each of Shells Investment Partners and Banyon (i) a $1,000,000 secured
promissory note due January 31, 2005 (extended to January 31, 2007) which bears
interest at 15% per annum, of which 8% is payable monthly in arrears and 7% is
deferred and payable when the principal is 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. On April 12, 2004, Banyon sold their interest in the $1,000,000 note to
Frederick R. Adler, a more than 10% shareholder. On June 23, 2004, Shells
Investment Partners sold their interest in the $1,000,000 note along with 90% of
their warrants to Trinad Capital, LP ($600,000) and GCM Shells Seafood Partners,
LLC ($400,000). Subsequently, on September 30, 2004, GCM Shells Seafood Partners
sold their interest in their $400,000 note to Bruce Galloway, IRA R/O. 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.
Warrants to purchase 1,000,000 shares of common stock were exercised in March
2005 by certain of our investors, and the proceeds of $500,000 were used to pay
down the principal amount of the notes to these investors. Additionally, in
March 2005, the $1,000,000 note held by Frederick R. Adler was modified to allow
Shells to defer entirely the monthly interest payment on $500,000 of principal
amount of the note until the maturity date of January 31, 2007, resul ting in
the deferral of $72,000 of cash payments until the maturity date.

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. The debentures bear interest at 12%, and
mature on the earlier of: (i) April 5, 2005, (ii) the closing of an additional
round of financing of no less than $1,500,000, or (iii) upon the occurrence of
an event of default. In the event that we, on or prior to the maturity date,
consummate the sale of shares of capital stock (other than a sale of capital
stock to our officers, directors, employees or consultants in connection with
their provision of services to us) resulting in net proceeds to us of at least
$250,000, then the outstanding principal amount of the debentures and all
accrued and unpaid interest, at the sole option of the holder of the debenture,
will convert in whole or in part, into shares of the common stock sold in such
future financing. The warrants are exercisable until December 7, 2007. The
warrants have an exercise price equal to 80% of the price per share or unit in
our contemplated next round of equity financing resulting in net proceeds to us
of at least $250,000, provided that the exercise price cannot exceed $0.80 per
share or be less than $0.45 per share. In the event that such financing is not
completed on or before September 4, 2005, the warrants will automatically be
assigned an exercise price equal to 65% of the closing price of our common stock
on September 4, 2005, but in no event greater than $0.80 or less than $0.45 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 in
vestors.

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. The loans, which bear interest at the bank’s base rate, are for
terms of five years with required monthly principal payments based on a 15 year
amortization schedule, and a balloon payment at the end of the five years. The
principal balances owed on these two notes as of January 2, 2005 were $532,000
and $567,000, respectively. Relative to these two promissory notes, we are
required to meet a financial covenant relating to debt coverage. We were in
compliance in meeting this loan covenant as of January 2, 2005. However, in the
past, we were not in compliance with meeting the loan covenant for which a
covenant waiver was provided by the bank.

We
believe that our cash balance, coupled with the $1,600,000 revolving credit line
provided to Shells in March 2005, along with our operating cash flow will be
sufficient to satisfy our contemplated cash requirements through the end of
2005. 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.

22



---

We
have, from time-to-time utilized, and to the extent applicable may utilize
sale-leaseback transactions, real estate mortgage and restaurant equipment
financing with various banks or financing institutions as necessary. In the
event that our plans change, assumptions prove to be inaccurate, or due to
unanticipated expenses, and in the event projected cash flow or third party
financing otherwise prove to be insufficient to fund operations, we could be
required to seek additional financing from sources not currently anticipated.
There can be no assurance that third party financing will be available to us
when needed, on acceptable terms, or at all.



Contractual
Obligations



As of January 2, 2005, our
contractual obligations were:



Payments due by periodTotal
    
    < 1 yr
    
    1 - 3 yrs
    
    3 - 5 yrs
    
    > 5 yrsLong-term
      debt (1)
    
    $
    2,010,609
    
    $
    515,761
    
    $
    1,254,504
    
    $
    240,344
    
    $
    —Capital
      lease obligations
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    —Operating
      lease obligations (2)
    
    
    15,086,000
    
    
    1,968,000
    
    
    3,475,000
    
    
    3,112,000
    
    
    6,531,000Purchase
      obligations
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    —Other
      debt obligations reflected on the company’s balance sheet under GAAP
      (3)
    
    
    4,634,242
    
    
    2,395,301
    
    
    2,238,941
    
    
    —
    
    
    —Total
    
    $
    21,730,851
    
    $
    4,879,062
    
    $
    6,968,445
    
    $
    3,352,344
    
    $
    6,531,000


——————

Note 1 –
consists of long-term debt as reported in footnote 6 of the financial
statements.

Note 2 –
consists of operating leases primarily for real estate.

Note 3 –
consists of convertible debentures due in 2005 and 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 full
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. and 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 effect on sales or expenses. As expenses
increase, we expect to recover increased costs by increasing prices, to the
extent permitted by competition, or by 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 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. Due to the fact that our business is somewhat
dependent on tourism in Florida, any significant decrease in tourism due to
inflation would likely have a material adverse effect on revenues and
profitability.



In May
2005, the minimum wage rate in Florida will increase by $1.00 per hour. Tipped
employees will also be receiving the $1.00 per hour wage increase under this new
law. Each year thereafter, 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 could have a significant adverse affect to our company.
Menu price increases and other actions will be

23



---

required
to negate the effect 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.



New Accounting
Pronouncements



In April
2003, the FASB issued Statement No. 149, “Amendment of Statement 133 on
Derivative Instruments and Hedging Activities,” This Statement amends and
clarifies financial accounting and reporting for derivative instruments,
including certain derivative instruments embedded in other contracts
(collectively referred to as derivatives) and for hedging activities under FASB
Statement No. 133, Accounting for Derivative Instruments and Hedging Activities.
This Statement is effective for contracts entered into or modified after June
30, 2003, and for hedging relationships designated after June 30, 2003. In
addition, all provisions of this Statement should be applied prospectively.
Adoption of FASB Statement 149 did not materially impact our consolidated
financial statements.



In May
2003, the FASB issued Statement No. 150, “Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity.” This Statement
establishes standards for how an issuer classifies and measures certain
financial instruments with characteristics of both liabilities and equity. Many
of those instruments were previously classified as equity. This Statement is
effective for financial instruments entered into or modified after May 31, 2003,
and otherwise is effective at the beginning of the first interim period
beginning after June 15, 2003. Adoption of FASB Statement No. 150 did not
materially impact our consolidated financial statements.



In
December 2003, the FASB issued a pronouncement, Financial Interpretation
Number 46R (“FIN 46R”), “Consolidation of Variable Interest Entities.” This FIN
deals with Off-Balance Sheet Assets, Liabilities, and Obligations and gives
guidance for determining which entities should consolidate the respective assets
and liabilities associated with the obligations. We must fully consolidate
assets and liabilities covered by FIN 46R in our financial statements in the
first fiscal year or interim period beginning after March 15, 2004. Full
disclosure, as well as consolidation, if applicable, of any newly created
agreements after January 31, 2003 must begin immediately. Adoption of FIN 46R
did not materially impact our consolidated financial statements.



In
December 2003, the FASB revised Statement No. 132, “Employers’ Disclosures
about Pensions and Other Postretirement Benefits” which amended FASB Statements
No. 87, 88, and 106. Statement No. 132 requires additional disclosures about the
assets, obligations, cash flows, and net periodic benefit cost of defined
benefit pension plans and other defined benefit post-retirement plans. The
required information is to be provided separately for pension plans and for
other post-retirement benefit plans. Adoption of revised FASB Statement No. 132
did not materially impact our consolidated financial statements.



In
November 2004, the FASB issued FASB Statement No. 151, “Inventory Costs” which
amended ARB No. 43, Chapter 4. The amendments made by FASB Statement No. 151
will improve financial reporting by clarifying that abnormal amounts of idle
facility expense, freight, handling costs, and wasted materials (spoilage)
should be recognized as current-period charges and by requiring the allocation
of fixed production overheads to inventory based on the normal capacity of the
production facilities. The guidance is effective for inventory costs incurred
during fiscal years beginning after June 15, 2005. Earlier application is
permitted for inventory costs incurred during fiscal years beginning after
November 23, 2004. The provisions of FASB Statement No. 151 are to be applied
prospectively. Adoption of FASB Statement No. 151 is not expected to materially
impact our consolidated financial statements.



In
December 2004, the FASB revised Statement No. 123, “Accounting for
Stock-Based Compensation.” This Statement supersedes APB Opinion No. 25,
“Accounting for Stock Issued to Employees,” and its related implementation
guidance. This Statement establishes standards for the accounting for
transactions in which an entity exchanges its equity instruments for goods or
services. It also addresses transactions in which an entity incurs liabilities
in exchange for goods or services that are based on the fair value of the
entity’s equity instruments or that may be settled by the issuance of those
equity instruments. Revised Statement No. 123 focuses primarily on accounting
for transactions in which an entity obtains employee services in share-based
payment transactions. This Statement does not change the accounting guidance for
share-based payment transactions with parties other than employees provided in
Statement 123 as originally issued and 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,” nor address the accounting for
employee share ownership plans, which are subject to AICPA Statement

24



---

of
Position 93-6, “Employers’ Accounting for Employee Stock Ownership Plans.”
Revised Statement No. 123 is effective for Shells as of the beginning of the
first interim or annual reporting period that begins after June 15, 2005.
Adoption of revised FASB Statement No. 123 is not expected to materially impact
our consolidated financial statements.



In
December 2004, the FASB issued Statement No. 153, “Exchanges of
Non-monetary Assets” which amended APB Opinion No. 29, “Accounting for
Non-monetary Transactions.” The amendments made by FASB Statement No. 153 are
based on the principle that exchanges of non-monetary assets should be measured
based on the fair value of the assets exchanged. Further, the amendments
eliminate the narrow exception for non-monetary exchanges of similar productive
assets and replace it with a broader exception for exchanges of non-monetary
assets that do not have commercial substance. Previously, Opinion 29 required
that the accounting for an exchange of a productive asset for a similar
productive asset or an equivalent interest in the same or similar productive
asset should be based on the recorded amount of the asset relinquished. The
Statement is effective for non-monetary asset exchanges occurring in fiscal
periods beginning after June 15, 2005. Earlier application is permitted for
non-monetary asset exchanges occurring in fiscal periods beginning after the
date of issuance. The provisions of this Statement are to be applied
prospectively. Adoption of FASB Statement No. 153 is not expected to materially
impact our consolidated financial statements.



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 the $1,099,000
in outstanding debt with banks that is based on variable rates. Borrowings under
the loan agreements bear interest at the rate equal to the applicable bank’s
base rate.

25



---

ITEM
8.   FINANCIAL STATEMENTS







INDEX TO
CONSOLIDATED FINANCIAL STATEMENTS



Independent
      Auditors’ Report
    F-2Consolidated
      Balance Sheets
    F-3Consolidated
      Statements of Operations
    F-4Consolidated
      Statements of Stockholders’ Equity
    F-5Consolidated
      Statements of Cash Flows
    F-6Notes
      to Consolidated Financial Statements
    F-8




F-1



---

INDEPENDENT AUDITORS’ REPORT



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 January 2, 2005 and
December 28, 2003 and the related consolidated statements of operations,
stockholders’ equity and cash flows for the fiscal years ended January 2, 2005
(53 weeks), December 28, 2003 (52 weeks) and December 29, 2002 (52
weeks). These consolidated financial statements are the responsibility of the
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 auditing 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 financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.



In our
opinion, such consolidated financial statements referred to above present
fairly, in all material respects, the financial position of the company at
January 2, 2005 and December 28, 2003 and the results of its operations and
cash flows for the fiscal years ended January 2, 2005 (53 weeks),
December 28, 2003 (52 weeks) and December 29, 2002 (52 weeks) in
conformity with accounting principles generally accepted in the United States of
America.





KIRKLAND,
RUSS, MURPHY& TAPPP.A.



Clearwater, Florida

February 4, 2005, except as
to Note 19,

which date is March 10,
2005



F-2



---

SHELLS SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS





January 2, 2005
    
    
    December 28, 2003ASSETSCash
    
    $
    2,349,519
    
    
    $
    723,939Inventories
    
    
    396,823
    
    
    
    382,549Other
      current assets
    
    
    497,178
    
    
    
    265,891Receivables
      from related parties
    
    
    109,477
    
    
    
    110,147Total
      current assets
    
    
    3,352,997
    
    
    
    1,482,526Property
      and equipment, net
    
    
    7,095,922
    
    
    
    6,996,095Goodwill
    
    
    2,474,407
    
    
    
    2,474,407Other
      assets
    
    
    595,332
    
    
    
    663,189TOTAL
      ASSETS
    
    $
    13,518,658
    
    
    $
    11,616,217LIABILITIES
      AND STOCKHOLDERS’  EQUITYAccounts
      payable
    
    $
    2,311,584
    
    
    $
    2,390,685Accrued
      expenses
    
    
    2,567,026
    
    
    
    2,295,290Sales
      tax payable
    
    
    202,666
    
    
    
    168,385Convertible
      debentures and interest payable
    
    
    2,395,301
    
    
    
    —Current
      portion of long-term debt
    
    
    515,764
    
    
    
    234,247Total
      current liabilities
    
    
    7,992,341
    
    
    
    5,088,607Notes
      and deferred interest payable to related parties
    
    
    2,238,941
    
    
    
    2,267,416Long-term
      debt, less current portion
    
    
    1,494,845
    
    
    
    1,558,245Deferred
      rent
    
    
    849,287
    
    
    
    1,053,531Total
      liabilities
    
    
    12,575,414
    
    
    
    9,967,799Minority
      partner interest
    
    
    441,618
    
    
    
    465,836STOCKHOLDERS’
      EQUITY:Preferred
      stock, $0.01 par value; authorized 2,000,000 shares; 35,275 and 63,548
      shares issued and outstanding
    
    
    353
    
    
    
    635Common
      stock, $0.01 par value; authorized 20,000,000 shares; 8,565,406 and
      4,631,375 shares issued and outstanding
    
    
    85,654
    
    
    
    46,314Additional
      paid-in-capital
    
    
    14,926,627
    
    
    
    14,303,151Accumulated
      deficit
    
    
    (14,511,008
    )
    
    
    (13,167,518
    )Total
      stockholders’ equity
    
    
    501,626
    
    
    
    1,182,582TOTAL
      LIABILITIES AND STOCKHOLDERS’ EQUITY
    
    $
    13,518,658
    
    
    $
    11,616,217


See notes to consolidated financial statements and independent
auditors' report.

F-3



---

SHELLS SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS





Fiscal Years EndedJanuary 2,2005
    
    
    December 28,2003
    
    
    December 29,2002REVENUES
    
    $
    41,564,138
    
    
    $
    44,046,055
    
    
    $
    47,227,747COST
      AND EXPENSES:Cost
      of sales
    
    
    14,050,690
    
    
    
    14,466,578
    
    
    
    15,777,572Labor
      and other related expenses
    
    
    12,935,204
    
    
    
    13,845,271
    
    
    
    14,585,378Other
      restaurant operating expenses
    
    
    10,123,584
    
    
    
    11,117,396
    
    
    
    10,773,494General
      and administrative expenses
    
    
    3,248,657
    
    
    
    3,387,470
    
    
    
    3,564,828Depreciation
      and amortization
    
    
    1,057,841
    
    
    
    1,076,511
    
    
    
    1,102,221Provision
      for impairment of assets
    
    
    105,000
    
    
    
    360,000
    
    
    
    110,000Provision
      for impairment of goodwill
    
    
    —
    
    
    
    —
    
    
    
    206,19641,520,976
    
    
    
    44,253,226
    
    
    
    46,119,689INCOME
      (LOSS) FROM OPERATIONS
    
    
    43,162
    
    
    
    (207,171
    )
    
    
    1,108,058INTEREST
      EXPENSE, net
    
    
    (1,153,340
    )
    
    
    (462,246
    )
    
    
    (533,870
    )OTHER
      INCOME (EXPENSE), net
    
    
    32,641
    
    
    
    (100,352
    )
    
    
    (2,743
    )(LOSS)
      INCOME BEFORE ELIMINATION OF MINORITY PARTNER INTEREST AND INCOME
      TAXES
    
    
    (1,077,537
    )
    
    
    (769,769
    )
    
    
    571,445ELIMINATION
      OF MINORITY PARTNER INTEREST
    
    
    (265,953
    )
    
    
    (263,964
    )
    
    
    (221,319
    )(LOSS)
      INCOME BEFORE BENEFIT FOR INCOME TAXES
    
    
    (1,343,490
    )
    
    
    (1,033,733
    )
    
    
    350,126BENEFIT
      FOR INCOME TAXES
    
    
    —
    
    
    
    —
    
    
    
    326,715NET
      (LOSS) INCOME
    
    $
    (1,343,490
    )
    
    $
    (1,033,733
    )
    
    $
    676,841NET
      (LOSS) INCOME PER SHARE OF COMMON STOCK:Basic
    
    $
    (0.26
    )
    
    $
    (0.23
    )
    
    $
    0.15Diluted
    
    $
    (0.26
    )
    
    $
    (0.23
    )
    
    $
    0.07WEIGHTED
      AVERAGE NUMBER OF SHARES OF COMMON STOCKOUTSTANDING:Basic
    
    
    5,261,981
    
    
    
    4,577,470
    
    
    
    4,454,015Diluted
    
    
    5,261,981
    
    
    
    4,577,470
    
    
    
    10,259,188




See notes to consolidated financial statements and independent
auditors' report.

F-4



---

SHELLS SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY





Preferred Stock
    
    
    
    Common Stock
    
    
    Additional
      Paid-In Capital
    
    
    AccumulatedDeficit
    
    
    TotalShares
    
    
    Amount
    Shares
    
    
    AmountBalance
      at December 30, 2001
    
    
    66,862
    
    
    $
    669
    
    
    
    4,454,015
    
    
    $
    44,540
    
    
    $
    14,240,576
    
    
    $
    (12,810,626
    )
    
    $
    1,475,159Net
      income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    < /TD>
    
    
    
    676,841
    
    
    
    676,841Balance
      at December 29, 2002
    
    
    66,862
    
    
    
    669
    
    
    
    4,454,015
    
    
    
    44,540
    
    
    
    14,240,576
    
    
    
    (12,133,785
    )
    
    
    2,152,000Net
      loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,033,733
    )
    
    
    (1,033,733
    )Conversion
      of preferred to common
    
    
    (3,314
    )
    
    
    (34
    )
    
    
    16,570
    
    
    
    166
    
    
    
    (132
    )
    
    
    
    
    
    
    —Issuance
      of common stock
    
    
    
    
    
    
    
    
    
    
    160,790
    
    
    
    1,608
    
    
    
    62,707
    
    
    
    
    
    
    
    64,315Balance
      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
    )Conversion
      of preferred to common
    
    
    (28,273
    )
    
    
    (282
    )
    
    
    141,365
    
    
    
    1,413
    
    
    
    (1,131
    )
    
    
    
    
    
    
    —Issuance
      of common stock
    
    
    
    
    
    
    
    
    
    
    3,792,666
    
    
    
    37,927
    
    
    
    624,607
    
    
    
    
    
    
    
    662,534Balance
      at January 2, 2005
    
    
    35,275
    
    
    $
    353
    
    
    
    8,565,406
    
    
    $
    85,654
    
    
    $
    14,926,627
    
    
    $
    (14,511,008
    )
    
    $
    501,626




See notes to consolidated financial statements and independent
auditors' report.

F-5



---

SHELLS SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS





Fiscal Years EndedJanuary 2,2005
    
    
    December 28,2003
    
    
    December 29,2002OPERATING
      ACTIVITIES:Net
      (loss) income
    
    $
    (1,343,490
    )
    
    $
    (1,033,733
    )
    
    $
    676,841Adjustments
      to reconcile net (loss) income to net cash (used in) provided by
      operating activities:Depreciation
      and amortization
    
    
    1,057,841
    
    
    
    1,076,511
    
    
    
    1,102,765Interest
      expense on warrants issued
    
    
    711,000
    
    
    
    —
    
    
    
    —Financing
      costs on warrants issued
    
    
    175,000
    
    
    
    —
    
    
    
    —Provision
      for impairment of goodwill
    
    
    —
    
    
    
    —
    
    
    
    206,196Provision
      for impairment of assets
    
    
    201,000
    
    
    
    360,000
    
    
    
    110,000Gain
      from hurricane-related insurance recoveries
    
    
    (499,795
    )
    
    
    —
    
    
    
    —(Gain)
      loss on sale of assets
    
    
    (48,204
    )
    
    
    2,874
    
    
    
    6,956Loss
      on sale of assets applied against reserves
    
    
    63,554
    
    
    
    49,356
    
    
    
    144,153Minority
      partner interest
    
    
    (24,218
    )
    
    
    37,984
    
    
    
    210Changes
      in operating assets and liabilities:Increase
      in current assets and liabilities
    
    
    (483,201
    )
    
    
    (891,690
    )
    
    
    (1,759,505
    )Changes
      in other assets and liabilities:Decrease
      (increase) in other assets
    
    
    20,691
    
    
    
    (205,826
    )
    
    
    (6,577
    )Increase
      in accrued interest to related parties
    
    
    136,840
    
    
    
    144,081
    
    
    
    123,335Decrease
      in deferred rent
    
    
    (95,356
    )
    
    
    (29,230
    )
    
    
    (160,296
    )Total
      adjustments
    
    
    1,215,152
    
    
    
    544,060
    
    
    
    (232,763
    )Net
      cash (used in) provided by operating activities
    
    
    (128,338
    )
    
    
    (489,673
    )
    
    
    444,078INVESTING
      ACTIVITIES:Proceed
      from hurricane-related insurance recoveries
    
    
    139,935
    
    
    
    —
    
    
    
    —Proceeds
      from sale of assets
    
    
    92,776
    
    
    
    500
    
    
    
    1,091,324Purchase
      of property and equipment
    
    
    (1,524,515
    )
    
    
    (755,278
    )
    
    
    (766,772
    )Net
      cash (used in) provided by investing activities
    
    
    (1,291,804
    )
    
    
    (754,778
    )
    
    
    324,552FINANCING
      ACTIVITIES:Proceeds
      from debt financing
    
    
    2,832,298
    
    
    
    578,585
    
    
    
    3,043,817Repayment
      of debt
    
    
    (404,496
    )
    
    
    (1,079,004
    )
    
    
    (2,313,318
    )Proceeds
      from the issuance of common stock
    
    
    617,920
    
    
    
    —
    
    
    
    —Net
      cash provided by (used in) financing activities
    
    
    3,045,722
    
    
    
    (500,419
    )
    
    
    730,499Net
      increase (decrease) in cash
    
    
    1,625,580
    
    
    
    (1,744,870
    )
    
    
    1,499,129CASH
      AT BEGINNING OF PERIOD
    
    
    723,939
    
    
    
    2,468,809
    
    
    
    969,680CASH
      AT END OF PERIOD
    
    $
    2,349,519
    
    
    $
    723,939
    
    
    $
    2,468,809




See notes to consolidated financial statements and independent
auditors' report.

F-6



---

SHELLS SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)





Fiscal Years EndedJanuary 2,2005
    
    
    December 28,2003
    
    
    December 29,2002Cash
      (outflows) flows from changes in current assets and
liabilities:Inventories
    
    $
    (14,274
    )
    
    $
    (26,115
    )
    
    $
    101,176Receivables
      from related parties
    
    
    670
    
    
    
    (4,794
    )
    
    
    (27,216
    )Tax
      refunds receivable
    
    
    —
    
    
    
    —
    
    
    
    898,338Other
      current assets
    
    
    128,573
    
    
    
    337
    
    
    
    (81,763
    )Accounts
      payable
    
    
    (79,101
    )
    
    
    (164,169
    )
    
    
    (1,524,542
    )Accrued
      expenses
    
    
    (553,350
    )
    
    
    (673,481
    )
    
    
    (1,109,438
    )Sales
      tax payable
    
    
    34,281
    
    
    
    (23,468
    )
    
    
    (16,060
    )Change
      in current assets and liabilities
    
    $
    (483,201
    )
    
    $
    (891,690
    )
    
    $
    (1,759,505
    )Supplemental
      disclosure of cash flow information:Cash
      paid for interest
    
    $
    309,006
    
    
    $
    338,883
    
    
    $
    445,793Cash
      paid (received) for income taxes, net
    
    $
    634
    
    
    $
    3,300
    
    
    $
    (1,216,438
    )Cash
      received from the 2002 sales of assets
    
    $
    100,000
    
    
    $
    —
    
    
    $
    —


Non-cash
operating and investing activities:

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 reduced net book value of property and equipment by $19,062 and deferred
rent by $5,714 in June 2004; and (ii) $38,778 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, Shells 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.

Bonuses
of $64,315 were paid in common stock during 2003.

Losses
on disposals of assets of $49,356 were applied against reserves in 2003.

During
2002, Shells relieved $3,789,595 of the FAS 144 Allowance relating to disposed
restaurants.

Gains,
net of losses, on disposals of assets of $144,153 were applied against reserves
for store closings in 2002.

Notes
receivable of $100,000 were received on the sale of assets during 2002.

Shells
transferred $43,794 from other assets into property and equipment for assets
placed in service during 2002.

Property
held for sale of $1,022,060 on December 30, 2001 was sold during 2002.



See notes to consolidated financial statements and independent
auditors' report.

F-7



---

SHELLS SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements



NOTE
1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis
of Presentation – At January 2, 2005, 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
consolidated 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 January 2, 2005 (“fiscal year
2004”) was 53 weeks, and each of the fiscal years ended December 28, 2003
(“fiscal year 2003”) and December 29, 2002 (“fiscal year 2002”) were 52
weeks.

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

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. Shells utilizes a third party to hold and
distribute certain products. The inventory is not recorded by Shells nor is the
risk of ownership transferred to Shells until its individual restaurants receive
the 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. Leasehold improvements and buildings are
depreciated over the shorter of the lease term or the estimated useful life and
range from five to 30 years. Useful lives for equipment, furniture and fixtures,
and signs range from three to 10 years.

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. Prior to 2002,
goodwill was amortized on the straight-line basis over 20 years; the use of a
20-year estimated life was based on the upper and lower limits considering among
other factors the lease terms of restaurants acquired and the cash flow
projections of the restaurants. 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
estimated future undiscounted cash flows. The impairment write-down is the
difference between the carrying amounts and the fair value of those assets. If
the total of future undiscounted cash flows is less than the carrying amount of
goodwill or property and equipment, the carrying amount is written down to the
fair value, and a loss resulting from value impairment is recognized by a charge
to earnings. The undiscounted cash flow for each restaurant is calculated
through the end of the real estate rental period, plus extensions, if
applicable, by estimating future cash flows based on actual historical results
of operations and the 2005 budget for each restaurant.

Income
Taxes – Shells uses 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.
On March 9, 2002, the Economic Stimulus Package was signed into law. This
program allows for, among other initiatives, the lengthening of the carry back
period allowed for net operating losses from two years to five years. Shells
recognized

F-8



---

SHELLS SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements (continued)



an
estimate of the income tax benefit and receivable in 2001 and an additional
income tax benefit was recognized in 2002 when the refund was received, relating
to the recovery of taxes paid in 1996 and 1997.

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.
The 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. The diluted net loss per common share is computed by dividing net
loss by the weighted average common shares outstanding excluding common stock
equivalents, which are anti-dilutive.

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.

In
April 2002, the FASB issued Statement No. 145, “Rescission of FASB Statements
No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections.” The Statement updates, clarifies and simplifies existing
accounting pronouncements. Statement No. 145 rescinds Statement No. 4, which
required all gains and losses from extinguishment of debt to be aggregated and,
if material, classified as an extraordinary item, net of related income tax
effect. As a result, the criteria in Opinion 30 will now be used to classify
those gains and losses. Statement No. 64 amended Statement No. 4, and is no
longer necessary because Statement No. 4 has been rescinded. Statement No. 44
was issued to establish accounting requirements for the effects of transition to
the provisions of the Motor Carrier Act of 1980. Because the transition has been
completed, Statement No. 44 is no longer necessary. Statement No.145 al so
amends Statement No. 13 to require that certain lease modifications that have
economic effects similar to sale-leaseback transactions be accounted for in the
same manner as sale-leaseback transactions. This amendment is consistent with
the FASB’s goal of requiring similar accounting treatment for transactions that
have similar economic effects. Statement No. 145 also makes technical
corrections to existing pronouncements. The adoption of Statement No. 145 did
not have a material affect our consolidated financial statements.

In
June 2002, the FASB issued Statement No. 146, “Accounting for Costs Associated
with Exit or Disposal Activities.” The Statement addresses costs that are a
result of exiting an activity, such as termination benefits, costs to terminate
a contract that is not a capital lease, and costs to consolidate facilities or
relocate employees. Under the Statement, a company may recognize costs related
to a restructuring only when the liability is incurred. Under previous
accounting principles generally accepted in the United States of America, a
liability for such costs was recognized on the date when a company committed to
an exit plan. The provisions of this statement are effective for exits and
disposal activities that are initiated after December 31, 2002. Based on
our actual results for 2004 and our business plan for 2005, the adoption of
Statement No. 146 did not have a material affect on our consolidat ed financial
statements during 2004 and is not expected to have a material affect on our
consolidated financial statements in 2005.

In
November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting
and Disclosure Requirements for Guarantees, including Indirect Guarantees of
Indebtedness of Others.” Interpretation No. 45 supersedes Interpretation No. 34,
“Disclosure of Indirect Guarantees of Indebtedness of Others,” and provides
guidance on the recognition and disclosures to be made by a guarantor in its
interim and annual financial statements about its obligations under certain
guarantees. The initial recognition and measurement provisions of Interpretation
No. 45 are effective for guarantees issued or modified after December 31,
2002, and are to be applied prospectively. The disclosure requirements are
effective for financial statements for interim or annual periods ending after
December 15, 2002. The adoption of Interpretation No. 45 did not have a
material affect on our consolidated financial statements.

F-9



---

SHELLS SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements (continued)



In
November 2002, the FASB’s Emerging Issues Task Force (EITF) discussed Issue No.
02-16, “Accounting by a Reseller for Cash Consideration Received from a Vendor.”
Issue No. 02-16 provides guidance on the recognition of cash consideration
received by a customer from a vendor. The consensus reached by the EITF in
November 2002 is effective for fiscal periods beginning after December 15,
2002. Income statements for prior periods are required to be reclassified to
comply with the consensus. Adoption of the consensus reached in November 2002
related to Issue No. 02-16 did not have a material affect on our consolidated
financial statements.

In
December 2002, we adopted FASB Statement No. 148, “Accounting for
Stock-Based Compensation-Transition and Disclosure.” Statement No. 148 amends
Statement No. 123, “Accounting for Stock-Based Compensation,” and provides
alternative methods of transition for a voluntary change to the fair value based
method of accounting for stock-based employee compensation. Statement No. 148
also amends the disclosure requirements of Statement No. 123 to require more
prominent and frequent disclosures in financial statements about the effects of
stock-based compensation. The transition guidance and annual disclosure
provisions of Statement No. 148 are effective for financial statements issued
for fiscal years ending after December 15, 2002. The interim disclosure
provisions are effective for financial reports containing financial statements
for interim periods beginning after December 15, 2002. See Note 14 for
required disclosures under Statement No. 148.

In
April 2003, the FASB issued Statement No. 149, “Amendment of Statement 133 on
Derivative Instruments and Hedging Activities,” This Statement amends and
clarifies financial accounting and reporting for derivative instruments,
including certain derivative instruments embedded in other contracts
(collectively referred to as derivatives) and for hedging activities under FASB
Statement No. 133, Accounting for Derivative Instruments and Hedging Activities.
This Statement is effective for contracts entered into or modified after June
30, 2003, and for hedging relationships designated after June 30, 2003. In
addition, all provisions of this Statement should be applied prospectively.
Adoption of FASB Statement No. 149 did not have a material affect on our
consolidated financial statements.

In
May 2003, the FASB issued Statement No. 150, “Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity.” This Statement
establishes standards for how an issuer classifies and measures certain
financial instruments with characteristics of both liabilities and equity. Many
of those instruments were previously classified as equity. This Statement is
effective for financial instruments entered into or modified after May 31, 2003,
and otherwise is effective at the beginning of the first interim period
beginning after June 15, 2003. Adoption of FASB Statement No. 150 did not have a
material affect on our consolidated financial statements.

In
December 2003, the FASB issued a pronouncement, Financial Interpretation
No. 46R (“FIN 46R”), “Consolidation of Variable Interest Entities.” FIN 46R
deals with Off-Balance Sheet Assets, Liabilities, and Obligations and gives
guidance for determining which entities should consolidate the respective assets
and liabilities associated with the obligations. Corporations must fully
consolidate assets and liabilities covered by FIN 46R in their financial
statements in the first fiscal year or interim period beginning after March 15,
2004. Full disclosure, as well as consolidation, if applicable, of any newly
created entities after January 31, 2003 must begin immediately. Adoption of
FIN 46R did not have a material affect on our consolidated financial
statements.

In
December 2003, the FASB revised Statement No. 132 Employers’ Disclosures
about Pensions and Other Postretirement Benefits which amended FASB Statements
No. 87, 88, and 106. Statement No. 132 requires additional disclosures about the
assets, obligations, cash flows, and net periodic benefit cost of defined
benefit pension plans and other defined benefit postretirement plans. The
required information is to be provided separately for pension plans and for
other postretirement benefit plans. Adoption of revised FASB Statement No. 132
did not have a material affect on our consolidated financial statements.

In
November 2004, the FASB issued FASB Statement No. 151, “Inventory Costs” which
amended ARB No. 43, Chapter 4. The amendments made by FASB Statement No. 151
will improve financial reporting by clarifying that abnormal amounts of idle
facility expense, freight, handling costs, and wasted materials (spoilage)
should be recognized as current-period charges and by requiring the allocation
of fixed production overheads to inventory based on the normal capacity of the
production facilities. The guidance is effective for inventory costs incurred
during fiscal years beginning after June 15, 2005. Earlier application is
permitted for inventory costs incurred during fiscal years beginning after
November 23, 2004. The provisions of FASB Statement No. 151

F-10



---

SHELLS SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements (continued)



are
to be applied prospectively. Adoption of FASB Statement No. 151 is not expected
to materially impact our consolidated financial statements.

In
December 2004, the FASB revised Statement No. 123, “Accounting for
Stock-Based Compensation.” This Statement supersedes APB Opinion No. 25,
“Accounting for Stock Issued to Employees,” and its related implementation
guidance. This Statement establishes standards for the accounting for
transactions in which an entity exchanges its equity instruments for goods or
services. It also addresses transactions in which an entity incurs liabilities
in exchange for goods or services that are based on the fair value of the
entity’s equity instruments or that may be settled by the issuance of those
equity instruments. This Statement focuses primarily on accounting for
transactions in which an entity obtains employee services in share-based payment
transactions. This Statement does not change the accounting guidance for
share-based payment transactions with parties other than employees provided in
Statement 123 as originally issued and 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.” This Statement does not address
the accounting for employee share ownership plans, which are subject to AICPA
Statement of Position 93-6, “Employers’ Accounting for Employee Stock Ownership
Plans.” This Statement is effective for Shells as of the beginning of the first
interim or annual reporting period that begins after June 15, 2005. Adoption of
revised FASB Statement No. 123 is not expected to materially impact our
consolidated financial statements.

In
December 2004, the FASB issued Statement No. 153, “Exchanges of
Non-monetary Assets” which amended APB Opinion No. 29, “Accounting for
Non-monetary Transactions.” The amendments made by FASB Statement No. 153 are
based on the principle that exchanges of non-monetary assets should be measured
based on the fair value of the assets exchanged. Further, the amendments
eliminate the narrow exception for non-monetary exchanges of similar productive
assets and replace it with a broader exception for exchanges of non-monetary
assets that do not have commercial substance. Previously, Opinion 29 required
that the accounting for an exchange of a productive asset for a similar
productive asset or an equivalent interest in the same or similar productive
asset should be based on the recorded amount of the asset relinquished. The
Statement is effective for non-monetary asset exchanges occurring in fisca l
periods beginning after June 15, 2005. Earlier application is permitted for
non-monetary asset exchanges occurring in fiscal periods beginning after the
date of issuance. The provisions of this Statement are to be applied
prospectively. Adoption of FASB Statement No. 153 is not expected to materially
impact our 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 increased from $3,606,000 in 2003 to
$4,639,000 in 2004, however, our cash position at January 2, 2005 improved to
$2,349,000 from $724,000 at December 28, 2003. In August 2004, the maturity
dates on the $2,000,000 principal amount promissory notes were extended from
January 31, 2005 to January 31, 2007. Shells obtained cash infusions
of $600,000 in November 2004 from the exercise and conversion of noteholder
warrants to shares of our common stock. Shells also obtained a $500,000 interim
line of credit from our bank to assist in the hurricane-related reconstruction
of our restaurants of which $295,000 was utilized and subsequently repaid from
insurance proceeds.

In
December 2004, Shells raised additional funds, which are being utilized for
the remodeling of several restaurants, through an offering of $2,375,000 in
convertible debentures. The debentures mature on the earliest to occur of
certain events, but in any event, not later than April 5, 2005.



Additional
information about our liquidity is discussed in Note 19, Subsequent
Events.

F-11



---

SHELLS SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements (continued)



NOTE 3. OTHER CURRENT
ASSETS



Other
current assets consist of the following:



January 2, 2005
    
    
    December 28, 2003Prepaid
      expenses
    
    $
    97,176
    
    
    $
    139,893Insurance
      proceeds receivable
    
    
    359,860
    
    
    
    —Note
      receivable
    
    
    —
    
    
    
    100,000Other
      current assets
    
    
    40,142
    
    
    
    25,998$
    497,178
    
    
    $
    265,891




NOTE
4.  PROPERTY AND EQUIPMENT



Property
and equipment consist of the following:



January 2, 2005
    
    
    December 28, 2003Leasehold
      improvements
    
    $
    5,694,911
    
    
    $
    4,632,847Equipment
    
    
    3,321,306
    
    
    
    5,292,188Furniture
      and fixtures
    
    
    3,150,959
    
    
    
    2,995,371Land
      and buildings
    
    
    2,541,397
    
    
    
    2,291,546Signage
    
    
    451,832
    
    
    
    488,71515,160,405
    
    
    
    15,700,667Less
      accumulated depreciation and amortization
    
    
    (8,064,483
    )
    
    
    (8,704,572
    )$
    7,095,922
    
    
    $
    6,996,095




NOTE
5.  ACCRUED EXPENSES



Accrued
expenses consist of the following:



January 2, 2005
    
    
    December 28, 2003Accrued
      payroll
    
    $
    776,652
    
    
    $
    801,548Accrued
    insurance
    
    
    26,382
    
    
    
    237,098Restaurant closing
      expenses
    
    
    216,677
    
    
    
    396,537Warrant valuation
      reserve
    
    
    947,364
    
    
    
    105,977Other
    
    
    348,453
    
    
    
    473,982Unearned gift card
      revenue
    
    
    251,498
    
    
    
    280,148$
    2,567,026
    
    
    $
    2,295,290


F-12



---

SHELLS SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements (continued)



NOTE
6.  LONG-TERM DEBT



Long-term
debt consists of the following:



January 2, 2005
    
    
    December 28, 2003$667,500
      promissory note with a bank collateralized by real property owned by
      Shells. Interest is payable monthly based on the Colonial Bank Base
      Rate. Principal is payable $3,709 monthly with all unpaid principal
      due in September 2007. The interest rate was 5.25% at January 2,
      2005.
    
    $
    567,357
    
    
    $
    611,865$635,000
      promissory note with a bank collateralized by real property owned by
      the 51% owned joint venture. Interest is payable monthly based on the
      Colonial Bank Base Rate. Principal is payable $3,900 monthly with all
      unpaid principal due in September 2007. The interest rate was 5.25% at
      January 2, 2005.
    
    
    531,871
    
    
    
    578,671$655,000
      promissory note collateralized by real property owned by Shells.
      Payments are $8,000 monthly with unpaid principal due June 2009. The
      interest rate is fixed at 10.0%.
    
    
    425,518
    
    
    
    483,934Line
      of credit with bank to finance construction from fire loss, interest
      payable monthly at bank base rate plus 1%; interest rate was 6.25% at
      January 2, 2005; principal payable by April 18, 2005.
    
    
    295,000
    
    
    
    —$165,315
      promissory note collateralized by real estate owned by Shells. Payable
      at $6,888 monthly starting June 2005 through June 2007.
    
    
    165,315
    
    
    
    —Capitalized
      lease agreement, collateralized by equipment, payable monthly at
      $2,132 through November 2005.
    
    
    21,083
    
    
    
    40,850Finance
      agreement, collateralized by insurance policy, principal and interest
      due monthly through January 2005, at 5.0% fixed interest
    rate.
    
    
    4,465
    
    
    
    8,137$540,000
      non-interest bearing note, principal was payable in variable monthly
      installments through December 2004. The balance was net of
      imputed  interest of $3,927 at December 28, 2003 at 11%. The
      note was collateralized by a leasehold interest in certain property
      and fixed assets of Shells.
    
    
    —
    
    
    
    57,436Finance
      agreements were collateralized by equipment, principal and interest
      was paid monthly through January 2004, interest rates ranged from
      6.8% - 8.0%
    
    
    —
    
    
    
    11,5992,010,609
    
    
    
    1,792,492Less
      current portion
    
    
    (515,764
    )
    
    
    (234,247
    )$
    1,494,845
    
    
    $
    1,558,245


F-13



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SHELLS SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements (continued)



The
annual maturities of debt as of January 2, 2005 are as follows:

2005
    
    $
    515,7642006
    
    
    235,4852007
    
    
    1,019,0192008
    
    
    75,0802009
    
    
    165,261Thereafter
    
    
    —$
    2,010,609




Relative
to the two promissory notes provided by Colonial Bank, we are required to meet a
financial covenant relating to debt coverage. We were in compliance in meeting
this loan covenant as of January 2, 2005. However, in the past, we were not
in compliance with meeting the loan covenant for which a covenant waiver was
provided by the bank.

NOTE
7.  RELATED PARTY DEBT

On
January 31, 2002, we raised $2,000,000 in a private financing transaction,
consisting of secured promissory notes and warrants to purchase shares of our
common stock. The two investors in this financing were Shells Investment
Partners, LLC (“SIP”) and Banyon Investment, LLC, each for $1,000,000 principal
amount. Shells Investment Partners is an entity comprised of members previously
unaffiliated with our company. Banyon is an entity associated with Philip R.
Chapman, Chairman of the Board, and certain family members of Frederick R.
Adler, a greater than 10% stockholder. The proceeds of the financing were used
for working capital.

In
April 2004, Banyon Investment, LLC sold its interest in the $1,000,000
promissory note to Frederick R. Adler. In June 2004, SIP sold to GCM Shells
Seafood Partners, LLC (“GCM”) and Trinad Capital, L.P. (“Trinad”) the $1,000,000
promissory note issued to SIP. GCM and Trinad purchased the note in the amount
of $400,000 and $600,000, respectively. We refinanced deferred interest of
$165,315 on the $1,000,000 note, previously scheduled to be payable to SIP in
full on January 31, 2005, through a note which calls for 24 equal monthly
payments beginning June 1, 2005. This deferred interest note is secured by a
second mortgage on certain real estate owned by us. In September 2004, GCM sold
its interest in the $400,000 note to Bruce Galloway, IRA R/O.

Notes
and deferred interest payable to these related parties were:

January 2, 2005
    
    
    December 28, 2003Secured
      promissory notes due January 31, 2007 bearing interest at 15%, of
      which 8% is payable monthly in arrears and 7% is deferred and payable
      when the principal is paid in full, owned by:Frederick
      R. Adler
    
    $
    1,000,000
    
    
    $
    —Bruce
      Galloway, IRA R/O
    
    
    400,000
    
    
    
    —Trinad
      Capital, L.P.
    
    
    600,000
    
    
    
    —Banyon
      Investment, LLC
    
    
    —
    
    
    
    1,000,000Shells
      Investment Partners, LLC
    
    
    —
    
    
    
    1,000,000Aggregate
      deferred interest due on January 31, 2007
    
    
    238,941
    
    
    
    267,416$
    2,238,941
    
    
    $
    2,267,416




The
deferred interest due at maturity, January 31, 2007, will be $535,000.

See
Note 19, Subsequent Events, for discussion of pay down of the principal amount
of the loans and deferral of cash payments for interest now due at maturity.

NOTE
8.   COMMITMENTS AND CONTINGENCIES

Prior to
January 1, 1995, Shells agreed to pay $540,000 over a 10 year period as
inducement to obtain a lease for a certain restaurant site. This amount, net of
interest imputed at 11% was recorded as prepaid rent and was amortized over the
term of the lease. The $540,000 note expired in December 2004.

F-14



---

SHELLS SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements (continued)



With the
exception of three operating restaurants, Shells conducts all of its operations
and maintains its administrative offices in leased facilities. Certain leases
provide for Shells to pay for common area maintenance charges, insurance, and
its 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 $2,712,000, $2,571,000 and $2,568,000, for 2004, 2003 and 2002,
respectively, which included contingent rent of $108,000, $143,000 and $100,000,
respectively. The approximate future minimum aggregate rental payments under
such operating leases as of January 2, 2005 are as follows:



2005
    
    $
    1,968,0002006
    
    
    1,842,0002007
    
    
    1,633,0002008
    
    
    1,566,0002009
    
    
    1,546,000Thereafter
    
    
    6,531,000$
    15,086,000




These
leases expire at various dates through the year 2016 and generally have renewal
options for additional periods.

During
2003, Shells entered into an employment agreement with Leslie J. Christon,
President and Chief Executive Officer, that included a salary of $275,000 per
year. The term of the employment agreement is two years, and thereafter renews
automatically for successive one-year periods unless either party provides
notice of intent not to renew. The agreement also provided for the grant of
employee options to purchase 297,374 shares of common stock, which vest over a
two year period on an annual basis.

Warren
R. Nelson, our Chief Financial Officer, holds a letter agreement from the board
of directors clarifying his severance arrangement, if applicable.

During
1996, Shells entered into an agreement to purchase the leasehold interest in six
sites, as well as the leasehold improvements, fixtures and equipment, from
Islands Florida, LP, a Delaware limited partnership, in exchange for $500,000
plus, in general, an aggregate amount equal to 1% of the gross sales, as defined
(“royalty”), of each of the restaurants opened and continuing to be operated by
Shells at each of the six sites through the end of the initial terms of the
respective leases. Of the six sites originally leased, four sites continue to be
leased. The base terms expire at various dates through 2015 one of which expired
in 2003. The royalty expense related to these restaurants was $56,000, $95,000
and $99,000 for 2004, 2003 and 2002, respectively. During 2004, this agreement
was terminated through a $100,000 settlement, paid in installment payments
throughout the year.

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

NOTE
9.  MINORITY PARTNER INTEREST

Shells
has a 51% equity interest in a joint venture partnership that owns and operates
the Shells restaurant located in Melbourne, Florida. Shells 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. We have a 51% equity interest and WLH Investments
has the remaining 49%. As a condition of the joint venture partnership, WLH
Investments contributed $400,000 in capital on March 1, 1994. The profits, as
defined in the joint venture agreement, of the joint venture 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 Shells, if available,
and (iii) any excess over the $120,000 is allocated 51% to Shells and 49% to WLH
Investments. All losses are allocated in accordance with the owners hip
percentages.

Our
share of the joint venture partnership profits was $296,000 (inclusive of a
$10,000 prior period adjustment), $272,000 and $235,000 during 2004, 2003 and
2002, respectively. In addition, the joint venture partnership paid us $181,000,
$177,000 and $180,000 in 2004, 2003 and 2002, respectively, for management
and

F-15



---

SHELLS SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements (continued)



license
fees. The WLH Investments’ share of the joint venture partnership profits was
$266,000, $264,000 and $221,000 in 2004, 2003 and 2002, respectively. The joint
venture agreement 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 ventures cash balance was $130,000 as of January 2, 2005.

The
joint venture agreement, which was effective March 1994, as amended March 1995,
contains a purchase option for Shells to purchase the WLH Investments interest
in the joint venture partnership, or conversely, for WLH Investments to put
their interest in the joint venture partnership to Shells, 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 January 2, 2005.

NOTE
10.  STOCKHOLDERS’ EQUITY AND CONVERTIBLE DEBENTURES

In
connection with the $2,000,000 financing dated January 31, 2002, we issued
to each of Shells Investment Partners and Banyon (i) a $1,000,000 secured
promissory note due January 31, 2005 (extended to January 31, 2007)
which bears interest at 15% per annum, of which 8% is payable monthly in arrears
and 7% is deferred and payable when the principal is 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. The warrants were exercisable through
January 31, 2005.

On
April 12, 2004, Banyon sold their interest in the $1,000,000 note to Frederick
R. Adler, a more than 10% shareholder. On June 23, 2004, Shells Investment
Partners sold their interest in the $1,000,000 secured promissory note along
with 90% of their warrants to Trinad Capital, LP ($600,000) and GCM Shells
Seafood Partners, LLC ($400,000). Subsequently, on September 30, 2004, GCM
Shells Seafood Partners sold their interest in their $400,000 note to Bruce
Galloway, IRA R/O.

On
August 4, 2004, our $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 our 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. These newly issued warrants are exercisable from January 31, 2005
through January 31, 2007. We recognized a one-time, non-cash charge of
$446,000 relating to this transaction.

In
November 2004, a portion of the warrants issued as part of the $2,000,000
January 2002 financing were exercised, resulting in the issuance of
3,750,000 shares of common stock.

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. The debentures bear interest at 12%, and
mature on the earlier of: (i) April 5, 2005, (ii) the closing of an additional
round of financing of no less than $1,500,000, or (iii) upon the occurrence of
an event of default. In the event that we, on or prior to the maturity date,
consummate the sale of shares of capital stock (other than a sale of capital
stock to our officers, directors, employees or consultants in connection with
their provision of services to us) resulting in net proceeds to us of at least
$250,000, then the outstanding principal amount of the debentures and all
accrued and unpaid interest, at the sole option of the holder of the debenture,
will convert in whole or in part, into shares of the common stock sold in such
future financing. The warrants are exercisable until December 7, 2007. The
warrants have an exercise price equal to 80% of the price per share or unit in
our next round of equity financing resulting in net proceeds to us of at least
$250,000, provided that the exercise price cannot exceed $0.80 per share or be
less than $0.45 per share. In the event that such financing is not completed on
or before September 4, 2005, the warrants will automatically be assigned an
exercise price equal to 65% of the closing price of our common stock on
September 4, 2005, but in no event greater than $0.80 or less than $0.45 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.

F-16



---

SHELLS SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements (continued)



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
11.  CONVERTIBLE PREFERRED STOCK

On
October 24, 2001, Shells 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 by trade creditors of Shells. The shares were
issued exclusively to “accredited investors” as defined in Rule 501(a) under the
Securities Act. Shells 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 the board of directors of Shells 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
May 2004, investors converted 28,273 shares of Series A Preferred Stock into
141,365 shares of our common stock. During January 2003, investors
converted 3,314 shares of Series A Preferred Stock into 16,570 shares of our
common stock.

NOTE 12.  INCOME TAXES

The
components of the provision (benefit) for income taxes for the years ended
January 2, 2005, December 28, 2003 and December 29, 2002 are as
follows:

Fiscal Years EndedJanuary 2, 2005
    
    
    December 28, 2003
    
    
    December 29, 2002FederalCurrent
    
    $
    —
    
    
    $
    —
    
    
    $
    (326,715
    )Deferred
    
    
    —
    
    
    
    —
    
    
    
    ——
    
    
    
    —
    
    
    
    (326,715
    )StateCurrent
    
    
    —
    
    
    
    —
    
    
    
    —Deferred
    
    
    —
    
    
    
    —
    
    
    
    ——
    
    
    
    —
    
    
    
    —Tax
      asset valuation allowance
    
    
    —
    
    
    
    —
    
    
    
    —Income
      tax benefit
    
    $
    —
    
    
    $
    —
    
    
    $
    (326,715
    )


Our
effective tax rate is composed of the following for the years ended
January 2, 2005, December 28, 2003 and December 29, 2002,
respectively:

Fiscal Years EndedJanuary 2,2005
    
    
    December 28, 2003
    
    
    December 29, 2002Federal
      statutory rate
    
    (34.0
    )%
    
    (34.0
    )%
    
    34.0
    %State
      income tax, net of federal benefit
    
    (0.4
    )
    
    (3.5
    )
    
    3.5FICA
      tip credits
    
    (15.8
    )
    
    (19.3
    )
    
    (64.3
    )Warrant
      grants
    
    22.4
    
    
    —
    
    
    —Valuation
      allowance and other adjustment
    
    15.6
    
    
    56.8
    
    
    (125.4
    )Revalue
      certain deferred tax assets
    
    8.4
    
    
    —
    
    
    —Other
    
    3.8
    
    
    —
    
    
    —Goodwill
      impairment write-down
    
    —
    
    
    —
    
    
    58.9Effective
      income tax benefit
    
    —
    %
    
    —
    %
    
    (93.3
    )%


F-17



---

SHELLS SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements (continued)



As
of January 2, 2005, we have net operating loss carryforwards for federal
income tax purposes of approximately $8,500,000 which expire between 2006 and
2023. We also have approximately $2,800,000 of general business credits to carry
forward, which expire by 2023. We had an ownership change in 2002 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
to approximately $75,000 per year. Any portion of the $75,000 amount not
utilized in any year will carry forward to the following year subject to a 15 to
20 year limitation on carryforward of net operating losses and credits.
Approximately $5,900,000 of our net operating loss carryforwards and
approximately $2,000,000 of credits are subject to the annual limitation.
Assuming maximum utilization in future years, we expect that approximately $4,50
0,000 in net operating loss carryforwards and $2,000,000 in credits will expire
without benefit to us.

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:

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
    )$
    —




December 28, 2003Current
    
    
    Non-current
    
    
    TotalBasis
      difference in fixed assets and other assets
    
    $
    —
    
    
    $
    617,000
    
    
    $
    617,000Accrued
      liabilities
    
    
    481,000
    
    
    
    400,000
    
    
    
    881,000Net operating loss
      carryforwards
    
    
    —
    
    
    
    2,871,000
    
    
    
    2,871,000General business
      credits
    
    
    —
    
    
    
    2,534,000
    
    
    
    2,534,000481,000
    
    
    
    6,422,000
    
    
    
    6,903,000Valuation
      allowance
    
    
    
    
    
    
    
    
    
    
    (6,903,000
    )$
    —




December 29, 2002Current
    
    
    Non-current
    
    
    TotalBasis
      difference in fixed assets and other assets
    
    $
    —
    
    
    $
    728,000
    
    
    $
    728,000Accrued
      liabilities
    
    
    690,000
    
    
    
    411,000
    
    
    
    1,101,000Net operating loss
      carryforwards
    
    
    —
    
    
    
    2,460,000
    
    
    
    2,460,000General business
      credits
    
    
    —
    
    
    
    2,018,000
    
    
    
    2,018,000690,000
    
    
    
    5,617,000
    
    
    
    6,307,000Valuation
      allowance
    
    
    
    
    
    
    
    
    
    
    (6,307,000
    )$
    —




NOTE
13.  RELATED PARTY TRANSACTIONS

Shells
manages three restaurants pursuant to a management and license agreement, which
became effective July 1993. These entities are deemed to be related parties
based on our ability to influence the management and operating policies of the
managed restaurants. Shells provides management services and licenses 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
restaurants

F-18



---

SHELLS SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements (continued)



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 fourth restaurant is
operated by Shells, 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 was originally set
at 4% of the restaurant’s sales, and later was modified to 2% in October
2001. The aggregate management fees earned under these agreements was
approximately $172,000, $165,000 and $163,000 for 2004, 2003 and
2002, respectively.

Shells
also has entered into option agreements with three of the licensees, effective
July 1993, which were amended in August 1995 and October 2001, documenting the
terms by which, Shells 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
January 2, 2005.

Effective
January 31, 2002, Shells raised $2,000,000 in a private financing
transaction, consisting of secured promissory notes and warrants to purchase
shares of our common stock. The two investors in the financing were Shells
Investment Partners, LLC and Banyon Investment, LLC. Shells Investment Partners
is an entity comprised of members previously unaffiliated with Shells. Banyon is
an entity associated with Philip R. Chapman, Chairman of our board of directors,
and certain family members of Frederick R. Adler. The proceeds of the financing
were used for working capital requirements. During 2004, Banyon sold their
interest in the note to Frederick R. Adler and Shells Investment Partners sold
their interest in their note along with 90% of their warrants to Trinad Capital,
LP ($600,000) and GCM Shells Seafood Partners, LLC ($400,000). GCM has sold
their interest in the note to the Bruce Galloway, IRA R/O. See Note 7 – Related
Party Debt.

In
connection with this financing, we issued to each of Shells Investment Partners
and Banyon a $1,000,000 secured promissory note due January 31, 2005
(extended to January 31, 2007) which bears interest at 15% per annum, of
which 8% is payable monthly in arrears and 7% is deferred and payable when the
principal is paid in full, and a warrant to purchase 4,454,015 shares of our
common stock, at an exercise price of $0.16 per share. The warrants were
exercisable through January 31, 2005. During November 2004, warrant holders
exercised warrants and acquired 3,750,000 shares of common stock for $600,000 in
proceeds to Shells.

Furthermore,
as part of this financing, we entered into an Investor Rights Agreement, with
the two investor groups and certain other stockholders. Pursuant to this
agreement, the composition of our board of directors is fixed at seven members
and each of Banyon and Shells Investment Partners (now Trinad Capital and GCM
Shells Seafood Partners) are entitled to nominate three individuals to serve on
our board. This right will terminate with respect to each of Banyon and Shells
Investment Partners (now Trinad Capital and GCM Shells Seafood Partners) on the
earlier of the date that such entity, or any legal successors thereto, ceases to
own at least 13% of our issued and outstanding stock on a fully diluted basis,
or the date that all amounts due and payable under such entity’s $1,000,000
promissory note have been paid in full. Additionally, each of these investor
groups and Frederick R. Adler and Philip R. Chapma n, among others, have agreed
to vote their shares, to cause these slated nominees to be elected to our board
of directors.

Banyon
initially appointed Philip R. Chapman, Richard A. Mandell and Christopher D.
Illick, all of whom were then serving as directors of our company, as Banyon’s
nominees for election to the board. Shells Investment Partners initially
nominated Thomas R. Newkirk, J. Stephen Gardner and John N. Giordano as its
nominees for election to the board. Messrs. Newkirk, Gardner and Giordano were
appointed directors of our company, to fill the vacancies existing on the board.
Mr. Mandell resigned from the board on March 12, 2002. Effective April 2,
2002, Michael R. Golding filled the vacancy on the board as Banyon’s nominee. On
June 23, 2004, the three members from Shells Investment Partners resigned from
the board when their interests were acquired by Trinad Capital

F-19



---

SHELLS SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements (continued)



and
GCM Shells Seafood Partners. Trinad and GCM appointed Jay A. Wolf, Robert Ellin
and Gary Herman as its nominees, all of whom were appointed directors to fill
the vacancies on the board.

On
December 28, 2004, we entered into a consulting agreement with Lawrence
Wolf, the father of Jay Wolf who is a member of our board of directors. The
consulting agreement has a one year term, where Mr. Lawrence Wolf is to
assist Shells 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, pursuant to 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 fully vest on the first
anniversary of the grant date.

NOTE
14.  STOCK COMPENSATION PLAN

At
January 2, 2005, we have four stock-based employee compensation plans,
which are described more fully below. We account for these plans under the
recognition and measurement principles of Accounting Principles Board Opinion
25, “Accounting for Stock Issued to Employees,” and related interpretations.
Stock-based compensation costs are not reflected in net income, as all options
granted under these plans had an exercise price equal to the market value of the
underlying common stock on the date of grant. Had compensation cost for our
stock option plans been determined based on the fair value at the grant dates
consistent with recognition provisions of FASB Statement No. 123, “Accounting
for Stock-Based Compensation,” the effect on net income (loss) and earnings per
share on a pro forma basis would have been immaterial.

On
September 11, 1995, our board of directors approved two employee stock option
plans. The options generally vest over three years, one third annually on the
anniversary date of the grant and, under both plans, have a maximum term of 10
years. The 1995 Employee Stock Option Plan, as amended, provides for the
issuance of options to purchase up to a total of 840,000 shares. The 1996
Employee Stock Option Plan provides for the issuance of options to purchase a
total of 101,000 shares. As of January 2, 2005, options to purchase an
aggregate of 205,742 shares were outstanding under the plans of which all were
exercisable.There were 11,001 shares purchased through the exercise of
these options through 2004. The exercise prices of the outstanding options range
from $0.45 to $5.75. The weighted average remaining contractual life for the
options outstanding at January 2, 2005 for both plans is approximate ly
five years.

On
May 20, 1997, the 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 this director’s compensation plan. Shells did not
grant any options under this plan during 2004, 2003 or 2002. Shells granted
options to purchase 20,000 shares during each of 2001 and 2000, at the market
price on the date of grant. As of January 2, 2005, options to purchase
32,000 shares were outstanding and exercisable.

On May
21, 2002, the stockholders approved the 2002 Equity Incentive Plan allowing for
grants of options to purchase up to 1,850,000 shares of common stock. 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. As of January 2,
2005, options to purchase 905,758 shares were outstanding, 620,286 of which were
exercisable. The weighted average remaining contractual life for the options
outstanding at January 2, 2005 is approximately seven years. During 2004,
201,900 options were granted at prices ranging between $0.36 and $0.83 per
share, the fair market value on the date of the grant. During April 2003,
officers and corporate management were issued 160,790 shares of common stock at
$0.40 per share, pursuant to a 2002 management bonus plan.

F-20



---

SHELLS SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements (continued)



Option
activity is summarized below:

Number of Shares
    
    
    Option Price
    
    
    Weighted Average PriceOutstanding
      at December 30, 2001
    
    864,025
    
    
    $0.20 -
      $11.00
    
    
    $
    1.36Granted
    
    1,332,484
    
    
    0.35 -
      0.65
    
    
    
    0.42Cancelled
    
    (163,300
    )
    
    0.22 -
      9.50
    
    
    
    1.53Outstanding
      at December 29, 2002
    
    2,033,209
    
    
    0.20 -
      9.50
    
    
    
    0.73Granted
    
    571,704
    
    
    0.37 -
      0.90
    
    
    
    0.55Exercised
    
    (160,790
    )
    
    0.40
    
    
    
    0.40Cancelled
    
    (1,235,056
    )
    
    0.37 -
      5.75
    
    
    
    0.48Outstanding
      at December 28, 2003
    
    1,209,067
    
    
    0.20 -
      9.50
    
    
    
    0.95Granted
    
    201,900
    
    
    0.36 -
      0.83
    
    
    
    0.77Exercised
    
    (42,666
    )
    
    0.42
    
    
    
    0.42Cancelled
    
    (224,801
    )
    
    0.20 -
      5.75
    
    
    
    0.61Outstanding
      at January 2, 2005
    
    1,143,500
    
    
    $0.24 -
      $9.50
    
    
    $
    1.00




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 EndedJanuary 2, 2005
    
    
    December 28, 2003
    
    
    December 29, 2002Net
      (loss) income
    
    $
    (1,343,490
    )
    
    $
    (1,033,733
    )
    
    $
    676,841Weighted
      common shares outstanding
    
    
    5,261,981
    
    
    
    4,577,470
    
    
    
    4,454,015Basic
      net (loss) income per share of common stock
    
    $
    (0.26
    )
    
    $
    (0.23
    )
    
    $
    0.15Effect
      of dilutive securities:Warrants
    
    
    —
    
    
    
    —
    
    
    
    5,575,916Stock
      options
    
    
    —
    
    
    
    —
    
    
    
    229,257Diluted
      weighted common shares outstanding
    
    
    5,261,981
    
    
    
    4,577,470
    
    
    
    10,259,188Diluted
      net (loss) income per share of common stock
    
    $
    (0.26
    )
    
    $
    (0.23
    )
    
    $
    0.07




Diluted net loss per common share excludes anti-dilutive stock
options and warrants of 6,305,000 and 6,909,000 during 2004 and 2003,
respectively.

See Note 19, Subsequent Events, for information about common stock
issued in 2005.

NOTE
16.  PROVISION FOR IMPAIRMENT OF ASSETS

In
accordance with FASB Statement No. 144, which superseded FASB Statement No. 121,
Shells identified certain long-lived assets as impaired. The 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 making whatever estimates, judgments and projections
were deemed necessary.

Shells
recognized write-downs of $201,000 (of which $96,000 was applied against
reserves), $360,000 and $110,000 during 2004, 2003 and 2002, respectively. We
have seven restaurants that are deemed to be impaired as of January 2,
2005. The write-down in 2004 related to one Florida restaurant which had not
previously been written

F-21



---

SHELLS SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements (continued)



down.
The write-down in 2003 related to three Florida restaurants, two of which have
not previously been written down. The write-down in 2002 related to three
Florida restaurants, which were not previously written down. The write-downs
were necessitated by the current period operating losses as well as the
projected cash flows of the restaurants.

NOTE
17.  DEFINED CONTRIBUTION PLAN

Shells
has a defined contribution plan which meets the requirements of Section 401(k)
of the Internal Revenue Code. All salaried employees of Shells 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 Shells. Shells, which pays the plan
expenses, has contributed $12,000 in discretionary contributions to date.

NOTE
18.  ADVERTISING AND MARKETING

Shells
has incurred the following costs for television, radio, billboards and local
store marketing:

Fiscal Years EndedJanuary 2, 2005
    
    
    December 28, 2003
    
    
    December 29, 2002Advertising
      and marketing expenses
    
    $
    1,467,000
    
    
    $
    1,501,000
    
    
    $
    1,545,000As
      a percentage of revenues
    
    
    3.5%
    
    
    
    3.4%
    
    
    
    3.3%




NOTE
19.  SUBSEQUENT EVENTS

In
January and February 2005, the remaining warrants issued as part of the
$2,000,000 financing in January 2002 were exercised, whereby warrant
holders acquired 4,712,630 shares of common stock for $754,000 in proceeds to
Shells. Additionally, Shells Investment Partners converted their retained
warrants into common stock under the cashless exercise provisions of the warrant
agreement, resulting in the issuance of 350,381 shares of common stock.

In
January 2005, we entered into an agreement with our landlord in St. Pete
Beach, Florida, whereby on February 22, 2005, the landlord paid $600,000 to
Shells for an option to buy-out the lease. Any time after 12 months beyond the
payment date, the landlord can provide notice of lease termination to Shells.
Thereafter, we have 60 days to wind down business and vacate the premises.

In
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. We
expect the restaurant to reopen as a “Shells” in March 2005, once remodeling and
staff training are completed.

In
February 2005, we mailed notice to stockholders of record on February 7, 2005 an
Information Statement advising that our board of directors and the holders of a
majority of our outstanding shares of common stock have delivered written
consents authorizing an amendment to our certificate of incorporation that will
increase the number of authorized shares of our common stock, $0.01 par value
per share, from 20,000,000 shares to 40,000,000 shares. This increase to our
capitalization is expected to become effective in March 2005.

In March 2005, our investors provided us with a $1,600,000
revolving line of credit, which matures on the earlier of March 31, 2006 or the
closing of a financing providing us not less than $1,600,000 of net proceeds.
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.
The investors received a fee of $80,000 for extending the credit line to
Shells.

In March
2005, warrants to purchase a total of 1,000,000 shares of common stock, which
were issued on August 4, 2004 pursuant to the extension of the $2,000,000
related-party financing, were exercised at $0.50 per share by Trinad Capital,
L.P. and Bruce Galloway, IRA R/O. The proceeds of $500,000 were used to pay down
the principal amount of the notes to these investors. Additionally, in March
2005, the $1,000,000 note held by Frederick R. Adler was modified to allow
Shells to defer entirely the monthly interest payment on $500,000 of principal
amount of the note until the maturity date of January 31, 2007, resulting in the
deferral of $72,000 of cash payments until the maturity date. The remaining
principal balance of $1,500,000 matures on January 31, 2007 along with deferred
interest payable at maturity of $535,000.

F-22



---

SHELLS SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES

Notes to
Consolidated Financial Statements (continued)



We
contemplate that an additional round of financing will be sought by us in the
first half of 2005. In addition to repaying the debentures (as discussed in Note
10, Stockholders' Equity and Convertible Debentures), we anticipate that the
contemplated additional round of financing will be utilized to complete our
restaurant remodeling and position our company for growth. There can be no
assurance that this contemplated financing will be available to us when needed,
on acceptable terms, or at all.

F-23



---

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 possible controls
and pro cedures. 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.

26



---

**PART
III**





**ITEM
10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT**





**Board
Structure**





The Board
of Directors of Shells is comprised of seven members. Directors are elected for
a term of one year which expires at the next annual meeting of stockholders or
at such other time as his or her successor is duly elected and qualified.




As part
of our financing transaction in January 2002 (described in Item 7 "Management's
Discussion and Analysis of Financial Condition Results of Operation - Liquidity
and Capital Resources"), we entered into an Investor Rights Agreement with SIP,
Banyon and certain other stockholders. SIP's rights under the Investor Rights
Agreement were transferred to GCM and Trinad in connection with the purchase by
GCM Shells Seafood Partners, LLC, a Delaware limited liability company ("GCM")
and Trinad Capital, L.P., a Delaware limited partnership ("Trinad") of the
$1,000,000 promissory note on June 23, 2004. The Investor Rights Agreement,
among other things, fixed the composition of our board of directors at seven
members, subject to certain requirements, and provided each of SIP and Banyon
with the right to nominate three individuals to serve on the board. Banyon, SIP
(now GCM and Trinad) and certain other stockholders that are parties to the
Investor Rights Agreement agreed to vote their respective shares for the
election as directors of the other's nominees. As part of the transfer by SIP of
the $1,000,000 promissory note to GCM and Trinad in June 2004, we accepted the
resignation of J. Stephen Gardner, John N. Giordano and Thomas R. Newkirk (who
were SIP's designees) as members of our board of directors and elected Robert S.
Ellin, Jay A. Wolf and Gary Herman (the board nominees of GCM and Trinad) to our
board to fill these three vacancies. In accordance with the terms of the
Investors Rights Agreement, the right to nominate individuals for election to
our Board terminated upon the repayment in full of the $2,000,000 promissory
notes.





In April
2005, the Nominating Committee, consisting of Messrs. Herman and Illick and Dr.
Golding was formed. The Nominating Committee nominated Philip R. Chapman, Leslie
J. Christon, Robert S. Ellin, Michael R. Golding, Gary Herman, Christopher D.
Illick and Jay A. Wolf to stand for re-election as members of our Board of
Directors at the 2005 Annual Meeting of Stockholders.





**Directors**





The
members of our Board of Directors (each of whom has been nominated for
re-election at the 2005 Annual Meeting of Stockholders), their ages, the year in
which each first became a director and their principal occupations or employment
during the past five years are summarized below:







**Director**
    **Age**
    **Year First**
      **Became**
      **Director**
    
    **Principal
      Occupation During the Past Five Years**Philip
      R. Chapman
    44
    1997
    
    Mr.
      Chapman has served on our Board of Directors since May 1977 and as
      Chairman since April 2002. Since 1993, Mr. Chapman has been President of
      Adler & Company, a corporation which provides administrative services
      for financial and venture capital investing, including certain entities
      controlled by Frederick R. Adler, a greater than 10% stockholder. Mr.
      Chapman is a director of Regeneration Technologies, Inc., a company which
      produces allografts for surgical use, and various private companies. He is
      also a General Partner in Euro-America II, L.P., a private venture capital
      fund, and a managing partner of Alpha Beta Capital Management, a private
      hedge fund. Mr. Chapman is the son-in-law of Fredrick R.
      Adler.Leslie
      J. Christon
    50
    2004
    
    Mrs.
      Christon has served as the President and Chief Executive Officer of Shells
      since joining our company 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.Robert
      S. Ellin
    40
    2004
    
    Mr.
      Ellin has served on our Board of Directors since June 2004. In 2003, Mr.
      Ellin founded Trinad Capital, LP and has served as a managing member of
      Trinad Advisors GP, LLC which is the general partner of Trinad Capital,
      LP, since inception. In 1990, Mr. Ellin founded and served as President of
      Atlantis Equities Inc., a private investment company. From 1996 to 1998,
      he served as President of S&S Industries, Inc. Prior to founding
      Atlantis Equities, Mr. Ellin worked in Institutional Sales at LF
      Rothschild and was the Manager of Retail Operations at Lombard
      Securities.Michael
      R. Golding
    71
    2002
    
    Dr.
      Golding has been a professor of surgery at the State University of New
      York Health Science Center in Brooklyn, New York since 1963, where he is
      currently an Emeritus Clinical Professor of Surgery. From 1977 to 1989,
      Dr. Golding served as Director of Surgery at Lutheran Medical Center in
      Brooklyn, New York. From 1984 to 1989, Dr. Golding was President of the
      Tri-Boro Association of Directors of Surgery. Dr. Golding is a Fellow of
      the American College of Surgeons, a Fellow of the American College of
      Chest Physicians, and a Fellow of the American College of Angiology. Dr.
      Golding is a Member of the Board of Directors of the United Hospital Fund.
      Dr. Golding also serves on the boards of numerous professional entities
      and private companies.


Gary
      Herman
    
    
    40
    
    2004
    
    Mr.
      Herman has been the Chairman and Secretary of Digital Creative Development
      Corporation, an investment holding company, since 2001. He has been a
      member of the Board of Directors of DataMetrics Corporation, a military
      defense company, since 2000. In addition, Mr. Herman has been a member of
      Galloway Capital Management, LLC, an affiliate of a greater than 10%
      stockholder, since 2002. Mr. Herman has also been a member of the Board of
      Directors of NYC Industrial Development Agency since
      1997.Christopher
      D. Illick
    
    
    66
    
    1998
    
    Mr.
      Illick has been the President of iQ Venture Partners, Inc., an investment
      bank, since 2001 and a General Partner of Illick Brothers, a real estate
      and management concern, since 1965. From 1997 to 2001, Mr. Illick was a
      senior officer of the investment bank of Brean Murray & Co., Inc. Mr.
      Illick is a Member of the Board of Directors of Analytical Surveys,
      Inc.Jay
      A. Wolf
    
    
    32
    
    2004
    
    Mr.
      Wolf has served on our Board of Directors since June 2004 and as Audit
      Committee Chairman since 2004. Since February 2004, Mr. Wolf has served as
      a Managing Director of Trinad Capital, LP. From 1999 to 2003, Mr. Wolf
      served as Vice President of Corporate Development for Wolf Group
      Integrated Communications Ltd. where he was responsible for the company's
      acquisition program. From 1996 to 1999, Mr. Wolf was employed by Canadian
      Corporate Funding, Ltd., a Toronto-based merchant bank in the senior debt
      department and, subsequently by Trillium Growth Capital, the firm's
      venture capital Fund. Mr. Wolf currently sits on the board of Amalgamated
      Technologies Inc.


During
fiscal year 2004, our Board of Directors held 17 meetings, acted by unanimous
written consent 3 times and acted by committee action 6 times. During fiscal
2004, each director currently nominated for re-election to the Board at the 2005
Annual Meeting attended at least 75% of the aggregate number of meetings of the
Board of Directors and all committees of the Board on which he or she served,
during the time period in which he or she served.




We have a
general policy of expecting our directors to attend our annual meetings of
stockholders. All of our directors were in attendance at last year's annual
meeting of stockholders.





**Board
Committees**




The Board
of Directors has standing Executive, Audit, and Stock Option and Compensation
Committees and, since April 2005, a Nominating Committee.




The
Executive Committee possesses all the powers and authority of the Board in the
management of the business and affairs of our company, except for certain powers
which are specifically reserved by Delaware law to the entire Board or the
stockholders. Messrs. Chapman and Herman are the current members of the
Executive Committee. The Executive Committee did not meet in fiscal
2004.




The Audit
Committee's responsibilities, which include reviewing our internal accounting
procedures and consulting with and reviewing the services provided by the
independent auditors, are described in the Audit Committee Charter. Messrs.
Illick and Wolf and Dr. Golding are the current members of the Audit Committee.
Mr. Illick and Dr. Golding are independent directors as that term is defined by
Rule 4200(a)(15) of the Nasdaq Listing Standards. Mr. Wolf may not be an
independent director pursuant to that definition. Messrs. Illick and Wolf are
audit committee financial experts, as that term is defined in Item 401(h)(2) of
Regulation S-K. The Audit Committee met 4 times in fiscal 2004.





The Stock
Option and Compensation Committee is charged with reviewing compensation
policies and practices, recommending compensation for executives and key
employees and administering our stock option plans. The Stock Option and
Compensation Committee Report appears under Item 11 of this annual report and is
titled "Executive Compensation - Stock Option and Compensation Committee Report
to Stockholders Regarding Executive Compensation." Messrs. Chapman and Ellin are
the current members of the Stock Option and Compensation Committee. During
fiscal 2004, the Stock Option and Compensation Committee met 2
times.





In April
2005, the Board of Directors established a Nominating Committee to assist the
Board in its selection of individuals (i) as nominees for election to the Board
of Directors and (ii) to fill any vacancies or newly created directorships on
the Board. The members of the Nominating Committee are Messrs. Herman and Illick
and Dr. Golding.





30


It is the
policy of the Nominating Committee to consider candidates for Board membership
suggested by Nominating Committee members and other Board members, management,
our stockholders, third-party search firms and any other appropriate sources. As
a stockholder, you may recommend any person for consideration as a nominee for
director by writing to the Nominating Committee of the Board of Directors, 16313
N. Dale Mabry Highway, Suite 100, Tampa, Florida 33618. Recommendations must be
received by January 18, 2006 to be considered for the 2006 Annual Meeting of
Stockholders. Recommendations must include the name and address of the
stockholder making the recommendation, a representation setting forth the number
of shares of Common Stock beneficially owned by the recommending stockholder, a
statement that the recommended nominee has expressed his or her intent to serve
on the Board if elected, biographical information about the recommended nominee,
any other information the stockholder believes would be helpful to the
Nominating Committee in evaluating the recommended nominee and a description of
all arrangements or understandings between the recommending stockholder and each
nominee and any other person concerning the nomination.




In
evaluating candidates, the Nominating Committee will consider the following
criteria: personal integrity, sound business judgment, business and professional
skills and experience, independence, potential conflicts of interest, the extent
to which a candidate would fill a present need, and concern for the long term
interests of stockholders. In any particular situation, the Nominating Committee
may focus on persons possessing a particular background, experience or
qualifications which the Committee believes would be important to enhance the
effectiveness of the Board. The evaluation process for stockholder
recommendations is the same as for candidates recommended from any other
source.





**AUDIT
COMMITTEE REPORT**




*This
report of the Audit Committee shall not be deemed incorporated by reference by
any general statement incorporating by reference this annual report into any
filing under the Securities Act of 1933 or the Securities Exchange Act of 1934,
except to the extent that Shells specifically incorporates the information by
reference, and shall not otherwise be deemed filed under such
Acts.*




Management
has the primary responsibility for the financial statements and the reporting
process, including the systems of internal control. On behalf of the Board, the
Audit Committee, among other things, reviews and monitors the financial
reporting process, the systems of internal control, the audit process, the
independence and performance of the independent accountants and the process for
monitoring compliance with laws and regulations. The members of the Audit
Committee are Dr. Michael R. Golding and Messrs. Christopher Illick and Jay A.
Wolf.





The Audit
Committee reviewed our financial statements with management and the Board of
Directors and discussed with Kirkland Russ Murphy & Tapp P.A., or Kirkland
Russ, our independent auditors for fiscal 2004, the matters required to be
discussed by Statement of Auditing Standard No. 61. The Audit Committee received
from Kirkland Russ the written disclosures and the letter required by
Independence Standards Board Standard No. 1 and discussed with Kirkland Russ its
independence. The Audit Committee has reviewed the audit fees of Kirkland Russ
and any non-audit services and fees, to assure compliance with Shells' and the
Committee's policies restricting the independent accountants from performing
services that might impair their independence.







After
reviewing and discussing the financial statements, and in reliance on the
matters reviewed and discussed above, and without other independent
verification, the Audit Committee recommended that the audited consolidated
financial statements of Shells be included in our Annual Report on Form 10-K for
our fiscal 2004.




Audit
Committee


Jay A.
Wolf, Chairman


Christopher
D. Illick


Michael
R. Golding















**ITEM
11. EXECUTIVE COMPENSATION**





The
following table shows all the cash compensation, as well as other compensation,
we paid during the fiscal years indicated to (i) our Chief Executive Officer and
(ii) each other executive officer whose total annual salary and bonus exceeded
$100,000 for our fiscal year 2004.




**SUMMARY
COMPENSATION TABLE**


**Annual
      Compensation**
    **Long-Term
      Compensation****Name
      and Principal Position**
    
    **Fiscal**
      **Year**
    
    **Salary**
    
    **Bonus**
    
    **Other**
    **Awards**
    **Options**Leslie
      J. Christon,
      Chief
      Executive Officer and President (1)
    
    2004

      2003
    
    $$
    285,577

      121,635
    
    
    
    1,164-
    
    $$
    8,120

      31,403
    
    -
      -
    
    -297,374Warren
      R. Nelson,
      Executive
      Vice President of Finance,
      Chief
      Financial Officer, Secretary and
      Treasurer
      (2)
    
    2004
      2003
      2002
    
    $$$
    
    162,000
      155,769
      142,225
    
    $$
    
    1,164
      36,334
      -
    
    $
    530
      605
      -
    
    ---
    
    -  
      -
      157,984Guy
      C. Kathman,
      Vice
      President of Operations (3)
    
    20042003
    
    $$
    
    124,615
      27,692
    
    $
    1,164
      -
    
    $
    12,768
      -
    
    --
    
    -  
      50,000


(1)
    
    Mrs.
      Christon joined Shells in July 2003. Compensation for 2003 reflects
      payments made pursuant to her employment agreement for the portion of 2003
      during which she was employed by us. The amount of other compensation for
      2004 includes: (i) $7,500 paid by Shells for Mrs. Christon's automobile
      allowance, and (ii) $620 paid by Shells for life insurance premiums. The
      amount of other compensation for 2003 includes: (i) $1,403 paid by Shells
      for Mrs. Christon's automobile allowance, and (ii) $30,000 paid by Shells
      for relocation costs of Mrs. Christon.(2)
    
    Mr.
      Nelson's other compensation consists of $530 and $605 for 2004 and 2003,
      respectively, paid by Shells for life insurance premiums. The fiscal 2003
      bonus consisted of $18,167 in cash and $18,167 in Common Stock grants,
      which after adjusting for payroll tax withholdings, comprised 28,318
      shares of unrestricted Common Stock at $0.40 per share, issued and paid
      pursuant to the 2002 management incentive plan relating to 2002 results.(3)
    
    Mr.
      Kathman joined Shells in September 2003. Compensation for 2003 reflects
      payments made for the portion of 2003 during which he was employed by us.
      The amount of other compensation for 2004 includes: (i) $12,451 paid by
      Shells for relocation costs of Mr. Kathman, and (ii) $317 paid by Shells
      for life insurance premiums.





**AGGREGATED
OPTION EXERCISES IN LAST FISCAL**


**YEAR
AND FISCAL YEAR END OPTION VALUES**




The
following table sets forth information with respect to (i) options exercised
during fiscal 2004 by the persons named in the Summary Compensation Table and
(ii) unexercised options held by these individuals at January 2, 2005 (our
fiscal year end).









**Shares**
      **Acquired**
      **on**
      **Exercise**
      **(#)**
    
    **Value**
      **Realized**
    
    **Number
      of Securities**
      **Underlying
      Unexercised**
      **Option
      Held**
      **at
      Fiscal Year End**
    
    **Value
      of Unexercised,**
      **In-the-Money
      Option at**
      **Fiscal
      Year End****(1)****Name**
    
    
    
    
    
    **Exercisable**
    
    **Unexercisable**
    
    **Exercisable**
    
    **Unexercisable**Leslie
      J. Christon
    
    
    -
    
    
    -
    
    
    148,687
    
    
    148,687
    
    $
    29,737
    
    $
    29,737Warren
      R. Nelson
    
    
    -
    
    
    -
    
    
    173,783
    
    
    63,193
    
    
    45,316
    
    
    25,277Guy
      C. Kathman
    
    
    -
    
    
    -
    
    
    16,667
    
    
    33,333
    
    
    3,000
    
    
    6,000




(1)
    
    Based
      on the closing market price of the Common Stock of $0.82 on Thursday,
      December 30, 2004, the last day of fiscal 2004 on which our Common Stock
      was traded.




**Employment
Agreements**




On July
1, 2003, we entered into a two-year employment agreement with Leslie J.
Christon, pursuant to which she serves as our President and Chief Executive
Officer. The employment agreement provided for an annual base salary of $275,000
during fiscal 2004, along with discretionary bonuses, as determined by the Stock
Option and Compensation Committee of the Board. Mrs.
Christon's employment agreement automatically renews for consecutive one-year
terms unless either she or Shells gives notice to the other of an intention not
to renew.





We
currently do not have employment agreements with Messrs. Nelson and Kathman.
However, Mr. Nelson has a letter agreement with the Board stating that in the
event Mr. Nelson's employment is terminated without cause, Mr. Nelson will be
entitled to receive severance payments for a period of 12 months following the
termination in an amount equal to his then current salary as of such date.





**STOCK
OPTION AND COMPENSATION COMMITTEE REPORT TO STOCKHOLDERS**


**REGARDING
EXECUTIVE COMPENSATION**




*The
report of the Stock Option and Compensation Committee shall not be deemed
incorporated by reference by any general statement incorporating by reference
this annual report into any filing under the Securities Act of 1933, as amended,
or under the Securities Exchange Act of 1934, as amended, except to the extent
Shells specifically incorporates this information by reference, and shall not
otherwise be deemed filed under such Acts.*




**Executive
Compensation Philosophy**




Shells
manages and operates full service, mid-priced, casual dining seafood
restaurants. One of our central goals is to ensure that our remuneration policy
enables us to attract, retain and reward capable employees who can contribute,
both short and longer-term, to the success of Shells. Equity participation and a
strong alignment to stockholders' interests are key elements of our compensation
philosophy.







Our
executive compensation program consists of three parts: base salary, bonus and
stock options. In awarding salary increases and bonuses, we considered whether
the compensation package as a whole adequately compensated each executive for
Shells' performance during fiscal 2004 and that executive's contribution to this
performance.





**Base
Salaries of Executive Officers**




Base
salary represents the fixed component of the executive compensation program. Our
practice generally is to maintain base salaries at approximately competitive
industry averages. Determinations of base salary levels are established on an
annual review of marketplace competitiveness with similar restaurant companies.
Periodic increases in base salary relate to individual contributions to Shells'
overall performance and relative marketplace competitiveness.




**Bonus**




Bonuses
represent the variable component of the executive compensation program that is
tied to our performance and individual achievement. To the extent deemed
appropriate, our policy is to grant bonuses as a portion of the compensation
paid to Shells' management personnel. In determining bonuses, we consider
factors such as the performance of Shells during the year and the individual's
contribution to that performance. During fiscal 2002, we adopted an executive
and management bonus program specifying criteria relating to our financial
performance as well as individual contributions to Shells.





**Stock
Options**




We
believe that an important goal of the executive compensation program should be
to provide executives and key employees who have significant responsibility for
the management, growth and future success of Shells with an opportunity to
increase their ownership in Shells and the potential for financial gain from
increases in our stock price. This approach ensures that the interests of the
stockholders, executives and employees will be closely aligned. Therefore,
executive officers and other key employees of Shells are granted stock options
which give them a right to purchase shares of Common Stock at a specified price
in the future. The grant of options is based primarily on an employee's
potential contribution to Shells' growth and financial results. In determining
the size of option grants, we also consider the number of options owned by such
officer, the number and exercise price of options previously granted and
currently outstanding, and the aggregate size of the current option grants.
Options generally are granted at the prevailing market value of the Common Stock
and will only have value if our stock price increases. Generally, grants of
options vest over time, and the individual must be employed by Shells for the
options to vest.







**Compensation
of Shells' President**




On July
1, 2003, Shells entered into a two-year employment agreement with Leslie J.
Christon, pursuant to which she serves as President and Chief Executive Officer.
The employment agreement provided for an annual base compensation of $275,000
during fiscal 2004 and supplemental discretionary bonuses, as determined by the
Stock Option Committee. In determining Mrs. Christon's compensation, we
considered the pay practices of other companies in the restaurant industry as
well as her potential contribution to our future performance. A more complete
description of Mrs. Christon's employment agreement is set out earlier in the
annual report statement under the heading "Executive Compensation - Employment
Agreements."




Stock
Option and Compensation Committee


Philip R.
Chapman, Chairman


Robert
Ellin








**OUR
STOCK PRICE PERFORMANCE**




*The
following Stock Price Performance Graph shall not be deemed incorporated by
reference by any general statement incorporating by reference this annual report
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 January 3, 2000 (the first day of our fiscal 2000) 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**

















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





INFORMATION
ABOUT OWNERSHIP OF OUR COMMON STOCK




The
following table sets forth certain information as of April 3, 2005 regarding the
beneficial ownership of our Common Stock by (i) each person known by us to own
beneficially more than 5% of the outstanding Common Stock; (ii) each current
director (all of whom are standing for re-election); (iii) each executive
officer named in the Summary Compensation Table appearing in Item 11 "Executive
Compensation - Summary Compensation Table" in this annual report; and (iv) all
of our directors and executive officers as a group. Except as otherwise
specified, the named beneficial owner has the sole voting and investment power
over the shares listed, and has an address c/o Shells Seafood Restaurants, Inc.,
16313 N. Dale Mabry Highway, Suite 100, Tampa, FL 33618. For purposes of this
table, beneficial ownership is determined according to the rules of the
Securities and Exchange Commission, which generally attributes beneficial
ownership of securities to persons who possess sole or shared voting power
and/or investment power with respect to those securities. Common stock options
and warrants which are presently exercisable or which become exercisable within
60 days of April 3, 2005 are considered beneficially owned shares of Common
Stock.




**Name
      and Address of Beneficial Owner**
    
    **Beneficial**
      **Ownership**
      **Amount**
    
    **Percent of Class**Philip
      R. Chapman
      750
      Lexington Avenue, 18th Floor
      New
      York, NY 10022 (1)
    
    
    4,526,682
    
    
    30.8
    %Leslie
      J. Christon (2)
    
    
    163,687
    
    
    1.1
    %Robert
      Ellin
      c/o
      Trinad Capital, L.P.
      2121
      Avenue of the Stars, Suite 1650
      Los
      Angeles, CA 90067 (3)
    
    
    2,878,215
    
    
    19.7
    %Michael
      R. Golding
      439
      Newman Springs Road
      Lincroft,
      NJ 07738 (4)
    
    
    16,667
    
    
    *Gary
      Herman
      Galloway
      Capital Management, LLC
      1325
      Avenue of Americas, 26th floor
      New
      York, NY 10019 (5)
    
    
    492,607
    
    
    3.4
    %
  
 Christopher
      D. Illick
      154
      Mercer Street
      Princeton,
      NJ 08540 (6)
    
    
    40,667
    
    
    *Jay
      Wolf
      c/o
      Trinad Capital, L.P.
      2121
      Avenue of the Stars, Suite 1650
      Los
      Angeles, CA 90067 (7)
    
    
    6,667
    
    
    *Guy
      C. Kathman (8)
    
    
    16,667
    
    
    *Warren
      R. Nelson (9)
    
    
    241,684
    
    
    1.6
    %Catherine
      R. Adler
      1520
      South Ocean Blvd.
      Palm
      Beach, FL 33480 (10)
    
    
    4,454,015
    
    
    30.4
    %Frederick
      R. Adler
      1520
      South Ocean Blvd.
      Palm
      Beach, FL 33480 (11)
    
    
    2,204,426
    
    
    14.1
    %Bruce
      Galloway
      Galloway
      Capital Management LLC
      1325
      Avenue of Americas, 26th floor
      New
      York, NY 10019 (12)
    
    
    2,294,566
    
    
    15.7
    %Banyon
      Investment, LLC
      750
      Lexington Avenue, 18th Floor
      New
      York, NY 10022
    
    
    4,454,015
    
    
    30.4
    %Galloway
      Capital Management, LLC
      1325
      Avenue of Americans, 26th floor
      New
      York, NY 10019
    
    
    387,502
    
    
    2.7
    %Trinad
      Advisors GP, LLC
      153
      East 53rd Street, 48th floor
      New
      York, NY 10022 (13)
    
    
    2,871,548
    
    
    19.6
    %Trinad
      Capital, L.P.
      153
      East 53rd Street, 48th floor
      New
      York, NY 10022
    
    
    2,871,548
    
    
    19.6
    %All
      directors and executive officers as a group (9
persons)(14)
    
    
    8,383,541
    
    
    55.5
    %




*
    less
      than 1%




(1)
    Includes
      (i) 4,454,015 shares of Common Stock owned by Banyon Investment, LLC, and
      (ii) 42,667 shares of Common Stock which may be acquired through the
      exercise of options held by Mr. Chapman. Does not include options to
      purchase 13,333 shares of Common Stock which are not exercisable within 60
      days of April 3, 2005. Mr. Chapman and Catherine R. Adler are co-managing
      members of Banyon Investment, LLC and share voting and investment powers.







(2)
    Includes
      148,687 shares of Common Stock which may be acquired through the exercise
      of options. Does not include options to purchase 148,687 shares of Common
      Stock which are not exercisable within 60 days of April 3, 2005.




(3)
    Consists
      of: (i) 2,871,548 shares of Common Stock owned by Trinad Capital, LP, and
      (ii) 6,667 shares of Common Stock which may be acquired through the
      exercise of options. Does not include options to purchase 13,333 shares of
      Common Stock which are not exercisable within 60 days of April 3, 2005.
      Mr. Ellin is a managing member of Trinad Advisors GP, LLC which is the
      general partner of Trinad Capital, LP.




(4)
    Consists
      of 16,667 shares of Common Stock which may be acquired through the
      exercise of options. Does not include options to purchase 13,333 shares of
      Common Stock which are not exercisable within 60 days of April 3,
      2005.




(5)
    Includes:
      (i) 387,502 shares of Common Stock owned by Galloway Capital Management,
      LLC; (ii) 6,667 shares of Common Stock which may be acquired through the
      exercise of options; and (iii) 4,688 shares of Common Stock owned by a
      trust for the benefit of Mr. Herman's children. Does not include options
      to purchase 13,333 shares of Common Stock which are not exercisable within
      60 days of April 3, 2005. Mr. Herman is a managing member of Galloway
      Capital Management, LLC and GCM Shells Seafood Partners, LLC, and the
      trustee of the aforementioned trust.




(6)
    Consists
      of 40,667 shares of Common Stock which may be acquired through the
      exercise of options. Does not include options to purchase 13,333 shares of
      Common Stock which are not exercisable within 60 days of April 3,
      2005.




(7)
    Consists
      of 6,667 shares of Common Stock which may be acquired through the exercise
      of options. Does not include options to purchase 13,333 shares of Common
      Stock which are not exercisable within 60 days of April 3,
      2005.(8)
    Consists
      of 16,667 shares of Common Stock which may be acquired through the
      exercise of options. Does not include options to purchase 158,333 shares
      of Common Stock which are not exercisable within 60 days of April 3, 2005.




(9)
    Includes
      176,416 shares of Common Stock which may be acquired through the exercise
      of options. Does not include options to purchase 185,560 shares of Common
      Stock which are not exercisable within 60 days of April 3,
      2005.




(10)
    Consists
      of 4,454,015 shares of Common Stock owned by Banyon Investment, LLC. Mrs.
      Adler and Mr. Chapman are co-managing members of Banyon Investment, LLC
      and share voting and investment powers. Does not include any shares held
      by Mr. Adler.




(11)
    Includes
      a warrant to purchase 1,000,000 shares of Common Stock and 10,100 shares
      of Common Stock held by 1520 Partners LP. Mr. Adler is the General Partner
      of 1520 Partners LP. Does not include 4,454,015 shares of Common Stock
      owned by Banyon Investment, LLC. Mr. Adler's wife is a co-managing member
      of Banyon Investment, LLC.




(12)
    Includes:
      (i) 387,502 shares of Common Stock owned by Galloway Capital Management,
      LLC; (ii) 1,749,964 shares of Common Stock owned by the Bruce Galloway,
      IRA R/O; (iii) 93,100 shares of Common Stock owned by Jacombs Trading,
      Inc.; and (iv) 64,000 shares of Common Stock owned by trusts for the
      benefit of Mr. Galloway's children. Mr. Galloway is a managing member of
      Galloway Capital Management, LLC and GCM Shells Seafood Partners, LLC, the
      beneficiary and manager of the Bruce Galloway, IRA R/O, a majority
      shareholder of Jacombs Trading, Inc., and trustee of the aforementioned
      trust.







(13)
    Consists
      of 2,871,548 shares of Common Stock owned by Trinad Capital, LP. Trinad
      Advisors GP, LLC is the general partner of Trinad Capital, LP.





(14)
    Includes
      461,770 shares of Common Stock which may be acquired through the exercise
      of options. Does not include options to purchase an aggregate of 1,022,580
      shares of Common Stock which are not exercisable within 60 days of April
      3, 2005.




*Certain
information in the table and its footnotes is derived from filings made with the
Securities and Exchange Commission or supplemental information received from
various of the entities named in this table.*





**The
2002 Financing Transaction**




In
January 2002, we raised $2,000,000 in a private financing transaction,
consisting of secured promissory notes and warrants to purchase Common Stock.
The two investors in the financing transaction were Shells Investment Partners,
L.L.C. ("SIP") and Banyon Investment, LLC ("Banyon"). SIP is an entity comprised
of Messrs. J. Stephen Gardner, John N. Giordano and Thomas R. Newkirk, each of
whom served as a member of our board of directors until his resignation in June
2004. At the time of the transactions, none of Messrs. Gardner, Giordano or
Newkirk were affiliated with us. Banyon is an entity associated with Philip R.
Chapman, Chairman of our Board of Directors, and certain family members of
Frederick R. Adler, who was at the time a greater than 10% stockholder. The
proceeds of the financing transaction were used for working capital
requirements.




In the
financing, we issued to each of SIP and Banyon (i) a $1,000,000 secured
promissory note initially due January 31, 2005 (subsequently extended to January
31, 2007) which bears interest at 15% per annum, of which initially 8% was
payable monthly in arrears and 7% was deferred and payable when the principal
was payable in full (subsequently amended to provide for the deferral of the
entire 15% per annum interest until maturity) and (ii) a warrant to purchase
4,454,015 shares of Common Stock at an exercise price of $0.16 per share. The
warrants automatically converted into shares of Common Stock on January 31, 2005
(unless the warrants were exercised prior to that date) pursuant to a mandatory
cashless exercise provision in the warrant agreements.




**Change
of Control**





On June
23, 2004, SIP sold to GCM Shells Seafood Partners, LLC, a Delaware limited
liability company ("GCM"), and Trinad Capital, L.P., a Delaware limited
partnership ("Trinad"), the $1,000,000 promissory note issued by us to SIP on
January 31, 2002 as part of our $2,000,000 private financing transaction. GCM
and Trinad purchased the note with working capital in the amount of $400,000 and
$600,000, respectively.




As part
of the June 23, 2004 sale of the $1,000,000 promissory note by SIP to GCM and
Trinad, warrants to purchase an aggregate of 4,008,615 shares of our Common
Stock were transferred to Galloway Capital Management, LLC (668,103 shares), GCM
(1,068,964 shares), Trinad (1,603,445 shares) and Atlantis Equities, Inc.
(668,103 shares)(collectively, the "GCM Entities"). Galloway Capital Management,
LLC and Atlantis Equities, Inc. are affiliates of GCM. The remaining warrants to
purchase 445,400 shares of our Common Stock were retained by SIP. Banyon
exercised its warrant to purchase 4,454,015 shares of Common Stock, and the GCM
Entities exercised their warrants to purchase an aggregate of 4,008,615 shares
of Common Stock, all by the payment in cash of the exercise price. The warrants
retained by SIP were automatically exercised pursuant to the mandatory cashless
exercise provision, whereby an aggregate of 350,381 shares of Common Stock were
issued to the individual members of SIP.







In August
2004, we agreed with the holders of the $2,000,000 of promissory notes to an
extension of the term of the notes from their original expiration date of
January 31, 2005 to January 31, 2007. In connection with this extension, we
issued warrants to purchase 400,000, 600,000 and 1,000,000 shares of Common
Stock, respectively, to GCM, Trinad and Frederick R. Adler, at the time a
greater than 10% stockholder, who is not affiliated with GCM or
Trinad.





In March
2005, GCM and Trinad exercised these warrants in full. We used a portion of the
proceeds from this exercise to repay an aggregate of $500,000 principal amount
of promissory notes held by GCM and Trinad. At the same time, the $1,000,000
note held by Frederick R. Adler was modified to allow Shells to defer entirely
the monthly interest payment on $500,000 of principal amount of the note until
the maturity date of January 31, 2007, resulting in the deferral of $72,000 of
cash payments until the maturity date.




In May
2005, we anticipate completing an offering of our securities (Common Stock and
warrants to purchase Common Stock), which would provide us with net proceeds of
approximately $10,000,000. We contemplate using a portion of these proceeds to
repay in full the remaining $1,500,000 principal amount of the promissory notes
from the 2002 financing and all accrued but unpaid interest on these
notes.




For
information regarding the approximate number of shares and percentage of Common
Stock beneficially owned by Frederick R. Adler, GCM, Trinad and other persons
and entities affiliated with them, we refer you to the information set forth in
the beneficial ownership table in this Item 12 under the heading "Information
About Ownership of Our Common Stock". Certain information contained in this
annual report regarding these beneficial owners has been obtained from the
filings made by such entities with the Securities and Exchange
Commission.





**ITEM
13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**




The
information set forth below briefly describes certain transactions between our
Company and certain parties who or which may be deemed to be affiliated with
us.




On March
1, 1994, our wholly-owned subsidiary, Shells of Melbourne, Inc. entered into a
joint venture agreement with WLH Investments, Inc., a corporation wholly-owned
by Wanda L. Hattaway, wife of William E. Hattaway, our then president. The joint
venture owns and operates the Shells restaurant located in Melbourne, Florida.
The Joint Venture Agreement provides that WLH Investments receives a cumulative
annual preferred return of 15% on the $400,000 of capital contributed to the
joint venture by WLH Investments. Shells of Melbourne will then be allocated an
equal amount to this preferred return. The remaining net income of the joint
venture will be allocated 51% to Shells of Melbourne and 49% to WLH Investments.
Based upon these allocations, we paid $60,000 to WLH Investments for its fiscal
2004 preferred return, and $268,737 in net income allocations to WLH Investments
during 2004. Capital contributions in 2004 by WLH Investments were $104,393.
Distributions in 2004 exceeded life-to-date income allocations resulting in a
net capital increase in 2004 of $62,775.




41


In
January 2002, we raised $2,000,000 in the financing transaction described more
fully in Item 12 "Security Ownership of Certain Beneficial Owners and Management
- Information about Ownership of Our Common Stock - The 2002 Financing
Transaction." Both of the investment entities which participated in the
financing transaction, SIP and Banyon, had members who were nominated for
election to the Board of Directors. On June 23, 2004, SIP sold to GCM and Trinad
the $1,000,000 promissory note issued to SIP, and GCM and Trinad acquired the
rights to nominate individuals to serve as Board members under the Investor
Rights Agreement. Robert S. Ellin, Jay A. Wolf and Gary Herman, the individuals
nominated by GCM and Trinad to serve as Board members, are members of GCM and
Trinad. Philip R. Chapman, our Chairman of the Board, and Catherine Adler, the
spouse of Frederick R. Adler, one of our principal stockholders, are co-managing
members of Banyon. Certain other family members of Frederick R. Adler also are
members of Banyon. The financing transaction was approved by a special committee
of the Board, comprised of the then disinterested members of the Board. Although
we believe that the transaction was on terms no less favorable than would have
been available from unaffiliated third parties in arm's length transactions,
there can be no assurance that this is the case. Pursuant to the Investor Rights
Agreement described in Item 10 "Directors and Executive Officers of the
Registrant - Board Composition" in this annual report, each of GCM, Trinad and
Banyon have nominated individuals (Messrs. Ellin, Herman and Wolf in the case of
GCM and Trinad, and Messrs. Chapman and Illick and Dr. Golding in the case of
Banyon) to serve as members of our Board of Directors.





In August
2004, we agreed with the holders of the $2,000,000 of promissory notes to an
extension of the term of the notes from their original expiration date of
January 31, 2005 to January 31, 2007. In connection with this extension, we
issued warrants to purchase 400,000, 600,000 and 1,000,000 shares of Common
Stock, respectively, to GCM, Trinad and Frederick R. Adler, at the time a
greater than 10% stockholder, who is not affiliated with GCM or
Trinad.




During
October 2002, we refinanced through Colonial Bank two of our restaurant
properties, Melbourne and Winter Haven, with notes of $635,000 and $667,000,
respectively. The loans, which bear interest at the bank's then base rate, are
for terms of five years with required annual principal payments based on a 15
year amortization schedule, and a balloon payment of all then outstanding
amounts due at the end of the five years. The principal balances owed on these
two notes as of January 2, 2005, were $532,000 and $567,000,
respectively.





On
December 28, 2004, we entered into a consulting agreement with Lawrence Wolf,
the father of Jay A. Wolf, a member of our Board of Directors. The consulting
agreement has a one year term, and under it, Mr. Lawrence Wolf is to assist
Shells 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, pursuant to our 2002 Equity Incentive Plan, to purchase 130,000 shares
of Common Stock at an exercise price of $0.83, the market price of the Common
Stock on the date of grant. The options fully vest on the first anniversary of
the grant date.







**Section
16(a) Beneficial Ownership Reporting Compliance**




Section
16(a) of the Securities Exchange Act of 1934, as amended, requires our executive
officers and directors, and persons who beneficially own more than 10% of our
Common Stock, to file initial reports of ownership and reports of changes in
ownership with the SEC. Executive officers, directors and greater than 10%
stockholders are required by the SEC to furnish us with copies of all Section
16(a) forms they file.





Based
upon a review of the copies of the forms furnished to us and written
representations from our executive officers and directors, we believe that
during fiscal 2004, all Section 16(a) filing requirements applicable to our
executive officers, directors and greater than 10% beneficial owners were
complied with on a timely basis, except for (i) Philip Chapman, Catherine Adler
and Banyon Investment, LLC each failed to timely file a Form 4 reporting the
exercise of a warrant by Banyon, (ii) Galloway Capital Management, LLC and GCM
Shells Seafood Partners, LLC each failed to timely file a Form 3 with respect to
their becoming greater than 10% stockholders, and (iii) Warren R. Nelson failed
to timely file a Form 4 to report a stock bonus awarded in 2003. Each of the
forms listed above was subsequently filed with the Securities and Exchange
Commission.




**Code
of Ethics**





Our board
of directors has adopted a Code of Business Conduct and Ethics that applies to
our principal executive officer and principal financial officer, as well as to
the members of our board of directors 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.





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





**Independent
Auditors**





The firm
of Kirkland, Russ, Murphy & Tapp, P.A. audited and issued a report on our
financial statements for fiscal 2004 and has been selected by the Audit
Committee to issue a report on our financial statements for the fiscal year
ending January 1, 2006.





**Audit
fees for fiscal 2004 and 2003.**





For
fiscal 2004 and 2003, fees for professional services performed by Kirkland Russ
were as follows:









**Fiscal 2004**
    
    **Fiscal 2003**Audit
      Fees
    
    $
    62,321
    
    $
    51,550Audit
      Related Fees
    
    
    0
    
    
    0Tax
      Fees
    
    
    23,000
    
    
    22,800All
      Other Fees - tax planning
    
    
    5,250
    
    
    0Total
    
    $
    90,571
    
    $
    74,350




The Audit
Committee of the Board of Directors has considered whether the performance and
services related to "Tax Fees" is compatible with maintaining the independence
of Kirkland Russ.




We have a
policy that discourages the retention of our independent auditors for non-audit
services. We will not retain our independent auditors for non-audit work unless:
(a) the approvals of the Chair of the Audit Committee and the Chief Financial
Officer are obtained prior to the retention; and (b) the retention will not
affect the status of the auditors as "independent accountants" under applicable
rules of the Securities and Exchange Commission and the Independence Standards
Board.




The
details regarding any engagement of the independent auditors for non-audit
services are provided promptly to the full Audit Committee. During fiscal 2004
and 2003, all of the services provided by Kirkland Russ for the services
described above under Tax Fees were pre-approved using the above
procedures.










PART IV



ITEM
15.  EXHIBITS AND 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, 10.30, 10.31, 10.53, 10.54, 10.55 and
10.57 are management contracts, compensatory plans or arrangements.

Exhibits

Description
(everything filed which is currently active)

3.1

Certificate
of Incorporation*

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. *

3.3

By-laws.
*

3.4

Certificate
of Designation. **

4.1

Specimen
common stock certificate. *

10.1

1996
Employee Stock Option Plan. *

10.2

1995
Employee Stock Option Plan. *

10.3

Agreement
for Purchase and Sale of Assets, dated May 14, 1993, between Shells Seafood
Restaurants, Inc. and Shells, Inc.*

10.4

1996
Stock Option Plan for Non-Employee Directors **

10.5

2002
Equity Incentive Plan **

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. *

10.7

Joint
Venture Agreement, dated March 1, 1994, between Shells of Melbourne, Inc. and
WLH Investments, Inc. *

10.8

First
Amendment to Joint Venture Agreement, effective as of March 31, 1995 between
Shells of Melbourne, Inc. and WLH Investments, Inc. *

10.9

Management
and License Agreement, dated March 1, 1994, between Shells of Melbourne Joint
Venture and Shells Seafood Restaurants, Inc. *

10.10

Management
and License Agreement dated July 29, 1993, between Shells of Carrollwood
Village, Inc. and Shells Seafood Restaurants, Inc., as amended. *

10.11

Management
and License Agreement, dated July 28, 1993, between Shells of North Tampa, Inc.
and Shells Seafood Restaurants, Inc., as amended. *

10.12

Management
and License Agreement, dated July 29, 1993, between Shells of Sarasota South,
Inc. and Shells Seafood Restaurants, Inc., as amended. *

10.13

Amended
Option Agreement dated August 10, 1995 between Shells Seafood Restaurants, Inc.
and Shells of Carrollwood Village, Inc.*

10.14

Amended
Option Agreement, dated August 11, 1995 between Shells Seafood Restaurants, Inc.
and Shells of North Tampa, Inc. *

10.15

Amended
Option Agreement, dated August 16, 1995 by and between Shells Seafood
Restaurants, Inc. and Shells of Sarasota South, Inc. *

10.16

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. *

10.17

Asset
Purchase Agreement, dated September 30, 1994 between Shells of St. Petersburg
Beach, Inc. and the Bleckley Corporation. *

10.18

Assignment
Agreement, dated September 30, 1994 between Shells of St. Pete Beach, Inc. and
the Bleckley Corporation. *

10.19

Promissory
Note in the initial principal amount of $540,000, dated September 30, 1994 by
Shells of St. Pete Beach, Inc. for the benefit of the Bleckley Corporation
(retired in 2004 with satisfaction of debt). *

10.20

Continuing
and Unconditional Guaranty by Shells Seafood Restaurants, Inc. for the benefit
of the Bleckley Corporation. *

10.21

Security
Agreement, dated September 30, 1995 between Shells of St. Pete Beach, Inc. and
the Bleckley Corporation. *

45



---

Exhibits

Description
(everything filed which is currently active)



10.24

Form of
Directors Indemnification Agreement. *

10.26

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 **

10.28

Loan
agreement, dated January 15, 1998, between Shells Seafood Restaurants, Inc. and
Manufacturers Bank of Florida, in the initial principal amount of $850,000.
**

10.30

Letter
from board of directors, dated January 19, 2000, clarifying severance
arrangement for Warren R. Nelson **

10.31

Employment
Agreement, dated April 2, 2001, between David W. Head and Shells Seafood
Restaurants, Inc. (employment terminated June 6, 2003) **

10.33

Secured
Promissory Note, dated January 18, 2002, between Shells Seafood Restaurants,
Inc., and Best Que, LLC (funded in 2004) **

10.36

Assignment
and Assumption of Lease, dated January 21, 2002 between Shells Seafood
Restaurants, Inc. and Famous Dave’s Ribs, Inc. with landlord consent **

10.39

Second
Amendment to Management and License Agreement, dated October 4, 2001, between
Shells Seafood Restaurants, Inc. and Shells of Sarasota South, Inc. **

10.40

Second
Amendment to Management and License Agreement, dated October 4, 2001, between
Shells Seafood Restaurants, Inc. and Shells of North Tampa, Inc. **

10.41

Second
Amendment to Management and License Agreement, dated October 4, 2001, between
Shells Seafood Restaurants, Inc. and Shells of Carrollwood Village, Inc. **

10.42

Securities
Purchase Agreement, dated as of January 31, 2002, by and among Shells Seafood
Restaurants, Inc., its subsidiaries listed on the signature pages thereto,
Shells Investment Partners, LLC and Banyon Investment, LLC ***

10.43

Security
Agreement, dated as of January 31, 2002, by and among Shells Seafood
Restaurants, Inc., its subsidiaries listed in the signature pages thereto,
Shells Investment Partners, LLC and Banyon Investment, LLC ***

10.44

Investor
Rights Agreement, dated as of January 31, 2002, among Shells Seafood
Restaurants, Inc., Shells Investment Partners. LLC, Banyon Investment, LLC and
the shareholders listed on Schedule I thereto; *** amended June 23, 2004,
whereby Shells Investment Partners assigned their rights collectively to Trinad
Capital, LP and Galloway Capital Management, LLC

10.45

Secured
Senior Note in the aggregate principal amount of $1,000,000 issued to Banyon
Investment, LLC, and sold to Frederick R. Adler on April 12, 2004 ***

10.46

Secured
Senior Note in the aggregate principal amount of $1,000,000 issued to Shells
Investment Partners, LLC, and sold to Trinad Capital, LP ($600,000) and GCM
Shells Seafood Partners, LLC ($400,000) on June 23, 2004; GCM sold their
$400,000 note to Bruce Galloway, IRA R/O on October 1, 2004. *** (and 2004
transactions *****)

10.47

Warrant
to purchase 4,454,015 shares of Common Stock of Shells Seafood Restaurants,
Inc., issued to Banyon Investment, LLC ***

10.48

Warrant
to purchase 4,454,015 shares of Common Stock of Shells Seafood Restaurants,
Inc., issued to Shells Investment Partners, LLC; transferred to Trinad Capital,
LP and GCM Shells Seafood Partners, LLC on June 23, 2004 except for 445,400
warrants which were retained. *** (and 2004 transactions *****)

10.49

Loan
agreement, dated October 8, 2002, between Shells Seafood Restaurants, Inc. and
Colonial Bank (previously known as Manufacturers Bank of Florida), in the
initial principal amount of $667,500. **

10.50

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. **

10.51

Settlement
Agreement and Release, dated February 27, 2003, between Shells Seafood
Restaurants, Inc. and The Lark Group, L.L.C., Best Que, L.L.C, and Michael L
Sloane, II in the amount of $188,201 (fully settled in 2004) **

10.52

Distribution
Agreement, dated August 28, 2002, between Shells Seafood Restaurants, Inc. and
Performance Food Group, LLC. **

10.53

Consulting
Agreement, dated March 21, 2003, between Shells Seafood Restaurants, Inc. and
George Heaton; terminated August 28, 2003.**

10.54

Amendment
to the Non-Employee Director Stock Option Plan, as approved October 23, 2001
**

10.55

Amendment
to the 1995 Employee Stock Option Plan, as approved October 23, 2001
**

46



---

Exhibits

Description
(everything filed which is currently active)



10.56

Equipment
lease agreement between Colonial Pacific Leasing Corporate dba GE Capital
Colonial Pacific Leasing and Shells Seafood Restaurants, Inc. dated November 8,
2002 and funded in 2003. **

10.57

Employment
Agreement, dated July 1, 2003, between Leslie J. Christon and Shells Seafood
Restaurants, Inc. ****

10.58

Code of
Ethics. **

10.59

Form of
Securities and Debenture Purchase Agreement, dated December 7, 2004. *****

10.60

Form of
Stock Purchase Warrant, dated December 7, 2004, in the aggregate of
1,971,250 warrants to purchase shares of common stock. *****

10.61

Form of
12% Convertible Debenture, dated December 7, 2004, in the aggregate amount
of $2,375,000. *****

10.62

Promissory
Note in the aggregate principal amount of $165,315.07 issued to Shells
Investment Partners, L.L.C. +

10.63

Mortgage
and Security Agreement in the aggregate principal amount of $165,315.07 issued
to Shells Investment Partners, L.L.C. +

21

Subsidiaries
of the Registrant. *

31.1
    Certification
      of Chief Executive Officer under Rule 13a-14(a) (filed March 11, 2005 on
      Form 10-K)
 31.1.1
    Amended
      Certification of Chief Executive Officer under Rule
13a-14(a)
 31.2
    Certification
      of Chief Financial Officer under Rule 13a-14(a) (filed March 11, 2005 on
      Form 10-K)
 31.2.1
    Amended
      Certification of Chief Financial Officer under Rule
13a-14(a)
 32
    Certification
      of Chief Executive Officer and Chief Financial Officer under Section 906
      (filed March 11, 2005 on Form 10-K)
 32.1
    Amended
      Certification of Chief Executive Officer and Chief Financial Officer under
      Section 906


——————

*

Previously
filed with the Securities and Exchange Commission as Exhibits to, and
incorporated herein by reference from our Registration Statement on Form S-1
(File No. 333-1600).

**

Previously
filed with the Securities and Exchange Commission as Exhibits to, and
incorporated herein by reference from our Form 10-K or 10-KA for the fiscal year
ended December 28, 2003.

***

Previously
filed with the Securities and Exchange Commission as Exhibits to, and
incorporated herein by reference from our Form 8-K dated February 11, 2002.

****

Previously
filed with the Securities and Exchange Commission as an Exhibit to, and
incorporated herein by reference from our Form 10-Q for the quarter ended June
29, 2003.

*****

Previously
filed with the Securities and Exchange Commission as Exhibits to, and
incorporated herein by reference from our Form 8-K dated December 9,
2004.

+

Previously
filed with the Securities and Exchange Commission as Exhibits to, and
incorporated herein by reference from our Form 8-K dated June 25, 2004.

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





31.1
    Certification
      of Chief Executive Officer under Rule 13a-14(a) (filed March 11, 2005 on
      Form 10-K)


31.1.1
    Amended
      Certification of Chief Executive Officer under Rule
13a-14(a)


31.2
    Certification
      of Chief Financial Officer under Rule 13a-14(a) (filed March 11, 2005 on
      Form 10-K)


31.2.1
    Amended
      Certification of Chief Financial Officer under Rule
13a-14(a)


32
    Certification
      of Chief Executive Officer and Chief Financial Officer under Section 906
      (filed March 11, 2005 on Form 10-K)


32.1
    Amended
      Certification of Chief Executive Officer and Chief Financial Officer under
      Section 906




(c)

Financial
statement schedules



None

47



---

SIGNATURES



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



SHELLS SEAFOOD RESTAURANTS, INC.Dated: May 2,
    2005
    By:/s/WARRENR.
      NELSONWarren
      R. NelsonExecutive Vice President of Finance,Chief
      Financial Officer, Treasurer and Secretary




---