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                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                            ------------------------

                                   FORM 10-K

/X/          ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
                   THE SECURITIES EXCHANGE ACT OF 1934
            FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996
                                OR

/ /        TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
                   THE SECURITIES EXCHANGE ACT OF 1934

                         COMMISSION FILE NUMBER 0-27008
                            ------------------------

                               SCHLOTZSKY'S, INC.

             (Exact name of Registrant as specified in its charter)

                TEXAS                                   74-2654208
   (State or other Jurisdiction of                   (I.R.S. Employer
    incorporation or organization)                 Identification No.)

                     200 W. 4TH STREET, AUSTIN, TEXAS 78701

              (Address of principal executive offices) (Zip Code)

       REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (512) 469-7500

          SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

                                                   Name of each exhange
         Title of each class                       on which registered

      COMMON STOCK, NO PAR VALUE                  NASDAQ NATIONAL MARKET

          SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

                                 NOT APPLICABLE
                            ------------------------

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

    Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of 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 / /

    The aggregate market value of the voting stock held by non-affiliates of the
registrant as of March 21, 1997 was approximately $35,186,832 based upon the
last sales price on March 21, 1997 on the NASDAQ National Market System for the
Company's common stock. For purposes of this computation, all officers,
directors and 10% beneficial owners of the registrant are deemed to be
affiliates. Such determination should not be deemed an admission that such
officers, directors or 10% beneficial owners are, in fact, affiliates of the
Registrant. Registrant had 5,539,922 shares of Common Stock outstanding on March
21, 1997.

                      DOCUMENTS INCORPORATED BY REFERENCE

    Portions of the registrant's definitive proxy statement to be filed with the
Securities and Exchange Commission not later than 120 days after the close of
the registrant's fiscal year are incorporated by reference into Part III of this
Form 10-K.

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<PAGE>
                               SCHLOTZSKY'S, INC.

                               INDEX TO FORM 10-K

                          YEAR ENDED DECEMBER 31, 1996

<TABLE>
<CAPTION>
                                                                                                         PAGE NO.
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<S>                                                                                                    <C>
PART I

Item 1. Business.....................................................................................            1
Item 2. Properties...................................................................................           14
Item 3. Legal Proceedings............................................................................           14
Item 4. Submission of Matters to a Vote of Security Holders..........................................           15

PART II

Item 5. Market for Registrant's Common Equity and Related Shareholder Matters........................           15
Item 6. Selected Consolidated Financial Data.........................................................           15
Item 7. Management's Discussion and Analysis of Financial Condition and Results
        of Operation.................................................................................           17
Item 8. Financial Statements and Supplementary Data..................................................           26
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial
        Disclosure...................................................................................           26

PART III

Item 10. Directors and Executive Officers of the Registrant..........................................           26
Item 11. Executive Compensation......................................................................           26
Item 12. Security Ownership of Certain Beneficial Owners and Management..............................           27
Item 13. Certain Relationships and Related Transactions..............................................           27

PART IV

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.............................           27
</TABLE>
<PAGE>
                                     PART I

ITEM 1. BUSINESS

    Schlotzsky's, Inc. (the "Company") was formed effective January 1, 1993,
when Schlotzsky's Franchising Limited Partnership, Schlotzsky's-Houston, Ltd.,
Schlotzsky's-San Antonio, Ltd., Schlotzsky's Restaurant Management Corporation,
and Schlotzsky's, Inc. (collectively, the "Predecessor Entities") were merged
into the Company and its two wholly-owned subsidiaries, Schlotzsky's
Restaurants, Inc. and Schlotzsky's Real Estate, Inc. (the "1993 Merger"). In
June 1993, the Company raised $5 million through the sale of Class A Preferred
Stock and used the proceeds to redeem the preferred stock issued in the 1993
Merger to the investors in the Predecessor Entities other than John C. Wooley
and Jeffrey J. Wooley. The Company's other subsidiaries, which are wholly-owned,
are Schlotzsky's Brands, Inc., Schlotzsky's Equipment Corporation, DFW
Restaurant Transfer Corporation, 56th and 6th, Inc., and 218 Beverage
Corporation. The Company and its subsidiaries are Texas corporations, and
references to the "Company" include its predecessors, and its and their
subsidiaries, unless the context otherwise requires.

    The Company's principal executive offices are located at 200 West Fourth
Street, Austin, Texas 78701, and its telephone number is (512) 469-7500.

GENERAL

    The Company is a franchisor of quick service restaurants that feature
made-to-order sandwiches with unique sourdough buns. At December 31, 1996, the
Schlotzsky's system included four Company-owned stores and 569 franchised stores
located in 38 states, the District of Columbia and eleven foreign countries.
System-wide sales were approximately $142.5 million for 1995 and $202.4 million
for 1996. Average unit volumes were $368,000 in 1995 and $410,000 in 1996.

STRATEGY

    John C. Wooley and Jeffrey J. Wooley acquired the Company in 1981. They were
attracted to the Company by the unique characteristics of The Schlotzsky's
Original sandwich, the only sandwich sold at Schlotzsky's restaurants at that
time, and the strong brand loyalty that had developed for this sandwich in the
Company's markets. From 1981 to 1991, management tested different strategies to
expand the Company's business, including the development of Company-owned stores
and expanded store menus.

    In 1991, the Company began implementing a strategy to achieve its objective
of becoming a leader in the specialty sandwich segment of the restaurant
industry in the United States. The key elements of this strategy are to: offer
an expanded menu of consistent, high quality foods featuring the Company's
proprietary sourdough bread recipe, complemented by excellent customer service;
utilize area developers to decentralize franchisee recruiting and support;
develop a strong network of motivated owner-operator franchisees; implement a
turnkey development program to secure superior sites and accelerate market
penetration; develop new stores in high visibility, free-standing locations; and
increase awareness of the Schlotzsky's brand through enhanced marketing and
private label products.

    MENU OF DISTINCTIVE, HIGH QUALITY PRODUCTS.  Schlotzsky's Deli restaurants
offer an expanded menu of consistent, high quality foods featuring the Company's
proprietary sourdough bread recipe, complemented by excellent customer service.
The menu features made-to-order sandwiches with sourdough buns which are baked
fresh daily from scratch. The Schlotzsky's Original sandwich, which was
introduced in 1971, is a variation of the muffaletta sandwich made with three
meats (lean ham, Genoa salami and cotto salami), three cheeses (mozzarella,
cheddar and Parmesan), garlic butter, mustard, marinated black olives, onion,
lettuce and tomato on a toasted sourdough bun. The Schlotzsky's Original
sandwich continues to be the most popular item on the Schlotzsky's menu.
Schlotzsky's Deli restaurants offer an expanded menu with 15 sandwiches on four
types of bread, ten sourdough crust pizzas, five salads, soups, chips and other
side items, fresh baked cookies and other desserts, and beverages. At most
locations, sandwiches range in price

                                       1
<PAGE>
from $2.50 to $4.75 ($7.00 for an oversized Original), and eight-inch gourmet
pizzas are priced between $3.50 and $4.50.

    AREA DEVELOPERS.  The Company utilizes area developers to decentralize
franchisee recruiting and support. The Company has recruited and trained 41 area
developers to assist it in achieving its expansion goals in the United States.
Area developers provide the following services: they recruit and qualify
franchisees; they assist in site selection, obtaining financing, construction
and store openings; they provide ongoing operational support; they monitor
product and service quality; and they coordinate local advertising. Prior to
1991, these functions were performed by Company personnel. By relying on area
developers, the Company believes that it can effectively support an increasing
number of franchised stores while controlling the Company's personnel costs and
other overhead. Area developers receive a portion of franchise fees and
royalties from each restaurant in their territories and are therefore highly
motivated to develop their markets and monitor operating performance. Area
developers must meet specific store opening schedules under their agreements
with the Company in order to maintain their development rights.

    MOTIVATED OWNER-OPERATOR FRANCHISEES.  The Company is developing a strong
network of owner-operator franchisees. The Company believes that a motivated
owner-operator is key to the success of a restaurant. Other than three locations
in Texas and one in Manhattan, the Schlotzsky's system consists exclusively of
franchised stores, owned and managed by entrepreneurial franchisees. The Company
seeks franchisees who are committed to providing on-site supervision of store
operations and prefers to limit franchisees to three locations in relatively
close proximity.

    HIGH VISIBILITY STORES.  The Company and its area developers encourage
franchisees to develop free-standing stores with high visibility and easy
access. The Company believes the location of a store is as critical to its
success as the efforts of the franchisee, and trains area developers to assist
franchisees in identifying and acquiring superior store locations. The Company
implemented its Turnkey Program as a means of accelerating the development of
high visibility stores and capitalizing on the Company's experience in
evaluating store sites.

    INCREASED BRAND AWARENESS.  The Company seeks to increase awareness of the
Schlotzsky's brand through enhanced marketing and private label products. The
Company is directing its franchising efforts to establish a sufficient number of
stores in larger markets to allow expanded cooperative advertising through
newspaper, radio and television. The Company is also developing a complete line
of private label products to increase Schlotzsky's brand awareness. Private
label products are used by franchisees in preparing foods and are displayed at
stores as part of the standard decor package. Some private label products are
sold by franchisees for home consumption.

EXPANSION

    At December 31, 1996, the Schlotzsky's system consisted of 573 stores in 38
states, the District of Columbia, and eleven foreign countries. At December 31,
1994 and 1995, the system included 353 and 463 stores, respectively.

              Schlotzsky's Store Locations as of December 31, 1996

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<CAPTION>
LOCATION                                                   NUMBER OF STORES
--------------------------------------------------------  -------------------
<S>                                                       <C>
UNITED STATES:
Texas...................................................             187
California..............................................              33
Arizona.................................................              27
Georgia.................................................              27
Florida.................................................              26
Michigan................................................              21
</TABLE>

                                       2
<PAGE>
<TABLE>
<CAPTION>
LOCATION                                                   NUMBER OF STORES
--------------------------------------------------------  -------------------
<S>                                                       <C>
Illinois................................................              17
Indiana.................................................              17
Oklahoma................................................              15
Tennessee...............................................              15
Colorado................................................              13
New Mexico..............................................              13
South Carolina..........................................              13
Alabama.................................................              11
Nebraska................................................              11
Wisconsin...............................................              11
Missouri................................................               9
North Carolina..........................................               9
Kansas..................................................               8
Louisiana...............................................               8
Arkansas................................................               7
Minnesota...............................................               7
Virginia................................................               7
Ohio....................................................               6
Utah....................................................               6
Nevada..................................................               5
Iowa....................................................               4
Oregon..................................................               3
West Virginia...........................................               3
Hawaii..................................................               2
Idaho...................................................               2
Mississippi.............................................               2
New York................................................               2
North Dakota............................................               2
Pennsylvania............................................               2
South Dakota............................................               2
Washington..............................................               2
Connecticut.............................................               1
District of Columbia....................................               1
                                                                     ---
TOTAL U.S...............................................             557
INTERNATIONAL:
Japan...................................................               4
Argentina...............................................               3
Canada..................................................               1
Germany.................................................               1
Guatemala...............................................               1
Korea...................................................               1
Lebanon.................................................               1
Mexico..................................................               1
Sweden..................................................               1
Turkey..................................................               1
U.K.....................................................               1
                                                                     ---
TOTAL INTERNATIONAL.....................................              16
                                                                     ---
TOTAL STORES............................................             573
                                                                     ---
                                                                     ---
</TABLE>

                                       3
<PAGE>
    The Company has contractual store opening commitments from area developers
which, if met (and assuming that no stores are permanently closed), would result
in over 1,000 stores by December 31, 2000, excluding international stores. While
the Company recently terminated an area developer for cause, in the past, area
developers have failed to meet store opening schedules and the Company has
agreed to extend or waive development schedules for these area developers. There
can be no assurance that the Company or its area developers will be able to
maintain their store opening schedules.

TURNKEY REAL ESTATE DEVELOPMENT PROGRAM

    The Company instituted the Turnkey Program to further assist franchisees in
obtaining superior sites and to achieve more rapid penetration in those selected
major markets where the Company believes there is strong demand by franchisees
for good locations. Under the Turnkey Program, the Company works with an area
developer to identify superior store sites within a territory. The Company will
purchase or lease a selected site, design and construct a Schlotzsky's Deli
restaurant on the site and sell, lease or sublease the completed store to a
franchisee. Where the Company does not sell the property to a franchisee, the
Company then sells the improved property, or, in the case of a leased property,
assigns the lease and any sublease, to an investor. The Company anticipates that
the total investment in each acquired free-standing location will be
approximately $500,000 to $800,000 (less for leased locations), and that it will
typically recognize fees on the sale or assignment of the site to investors
ranging from $20,000 to $60,000 per transaction. The Company believes that the
Turnkey Program enhances the ability of area developers to recruit qualified
franchisees by developing high profile store sites and achieving critical mass
more quickly in selected markets.

    The Company started and completed 13 properties under the Turnkey Program in
1996. In addition, three other properties begun in 1995 were completed and
opened. Of these, ten were sold in 1996 and the balance were generating rental
revenue pending sale of the properties to an investor. Fourteen properties were
at various stages of development at year end. Six of the ten properties sold
were acquired by two real estate investors pursuant to terms which required the
Company to pay commitment fees or deposits or to guarantee rental payments by
the lessees/franchisees for a portion of their lease terms.

MENU

    The Schlotzsky's Deli menu provides customers with popular food items which
the Company believes are fresher, more flavorful and of greater variety than
those offered by competitors. The key menu groups are made-to-order sandwiches
and pizzas, salads, soups, cookies and other desserts, and beverages. Sandwiches
and pizzas are made with delicatessen-style meats, chicken and specialty
cheeses, all of which are purchased ready for use from approved suppliers. The
Company's distinctive sandwich buns and pizza crusts are baked daily from
scratch, rather than with pre-mixed or frozen dough, to ensure the highest
quality and freshness.

FRANCHISING

    The Company has adopted a strategy of franchising, rather than owning,
stores. The Company believes that franchisees who own and operate stores are
more highly motivated and manage stores more efficiently than typical
manager-employees. Moreover, franchising allows the Company to expand the number
of stores and penetrate markets more quickly and with less capital than
developing Company-owned stores. Area developers play a key role in the
Company's franchising program by recruiting qualified franchisees and providing
a high level of support to franchised stores.

    AREA DEVELOPERS.  The Company's 41 area developers recruit and qualify
franchisees according to criteria developed by the Company. Once a franchisee is
approved by the Company, the area developer assists the franchisee in site
selection, store design and layout, construction and financing. The area
developer provides store opening assistance, monitors store performance and
compliance with product and

                                       4
<PAGE>
service quality standards established by the Company and coordinates cooperative
advertising within his territory. The Company generally pays area developers 50%
of all franchise fees paid by franchisees in their territories, although some
area developers have received up to 100% of certain franchise fees as an
inducement to develop their territories more quickly. In addition, the Company
also pays area developers approximately 42% of the royalties received under
franchise agreements providing for 6% royalties and 12.5% to 25% of royalties
received under franchise agreements providing for 4% royalties, in each case
with respect to franchisees in their territories. Area developers are not
required to own or operate stores, although some of the Company's area
developers are also franchisees under separate franchise agreements. Area
developers are granted exclusive rights to one or more television markets in the
United States, typically for a term of 50 years. Each area developer pays the
Company a nonrefundable fee for the exclusive development rights for a market.
The Company typically receives 25% to 50% of the area developer fee when the
area development agreement is signed with the balance payable with interest over
an 18 to 36-month period under a promissory note from the area developer.

    Area development agreements are nonassignable without the prior written
consent of the Company, and consents have been granted from time to time. The
Company retains rights of first refusal with respect to any proposed sale by the
area developer. Area developers are not permitted to compete with the Company.
Area developers typically commit to a store opening schedule for each territory.
If an area developer fails to meet its obligations, the Company can terminate or
repurchase its territory for resale, although the Company has agreed to extend
or waive these store opening schedules for certain area developers.

    FRANCHISEES.  The Company believes the involvement of owners in daily store
operations is critical to the success of a franchise. The Company prefers
franchisees who will operate no more than three stores, located within a single
market. Franchisees are selected on the basis of various factors, including
business background, experience and financial resources. Because the cost of
building and equipping a Schlotzsky's Deli restaurant is somewhat higher than
for some other specialty sandwich franchise operations, the Company's
franchisees must have substantial cash resources or a relatively high net worth
to obtain financing to build and equip stores. While area developers identify
and recruit potential franchisees, all franchisees must be approved by the
Company.

    FRANCHISE AGREEMENTS.  The Company enters into a unit development agreement
with each franchisee granting the franchisee the right to develop a specific
number of stores within a territory over a defined period of time. Once a site
for a store has been selected by the franchisee and accepted by the Company, a
unit franchise agreement for that store is signed. Under the Company's current
standard franchise agreement, the franchisee is required to pay a franchise fee
of $20,000 for the franchisee's first store and $10,000 for any additional
store. The franchise fee for the initial store and a partial payment on each
additional store is payable at the time of signing the unit development
agreement. The current standard franchise agreement provides for a term of 20
years (with one ten-year renewal option) and payment of a royalty of 6% of
sales. Over 135 stores governed by franchise agreements entered into prior to
1991 pay a royalty of 4% of sales.

    The Company has the right to terminate any franchise agreement for certain
specific reasons, including a franchisee's failure to make payments when due or
failure to adhere to the Company's policies and standards. Many state franchise
laws, however, limit the ability of a franchisor to terminate or refuse to renew
a franchise. See "--Government Regulation."

    FRANCHISEE TRAINING AND SUPPORT.  Each franchisee is required to have a
principal operator approved by the Company who satisfactorily completes the
Company's training program and who devotes full business time and efforts to the
operation of the franchisee's restaurants. Franchisees may also enroll each
store manager in the Company's training program. The Company provides training
at operating Schlotzsky's Deli restaurants in various locations. In November
1995, the Company opened its new flagship Schlotzsky's Deli restaurant in
Austin, Texas, which includes training facilities. Most franchisee training is

                                       5
<PAGE>
being conducted at that location. Franchisees are required to pass a minimum
skills test before they can begin operating their first store. An on-site
training crew is provided by the Company or an area developer for three days
before and two days after the opening of a franchisee's first store. Company
management and area developers maintain ongoing communication with franchisees,
exchanging operating and marketing information.

    FRANCHISE OPERATIONS.  All franchisees are required to operate their stores
in compliance with the Company's policies, standards and specifications,
including matters such as menu items, ingredients, materials, supplies,
services, fixtures, furnishings, decor and signs. Food preparation is
standardized and is limited to baking bread, slicing pre-cooked meats, cheese
and produce, melting cheese and heating sandwiches. Because they usually operate
no more than three stores, franchisees are expected to be actively involved in
monitoring operations at each store. Each franchisee has full discretion to
determine the prices to be charged to its customers. Franchise stores are
periodically inspected by area developers and the Company's field service
representatives. Area developers are responsible for monitoring and enforcing
the Company's standards and specifications as set forth in the franchise
agreement and the Company's manuals on a continuous basis.

    REPORTING.  Most Schlotzsky's Deli restaurant franchisees are required to
report weekly sales and other data to the Company. Other franchisees are
required to report monthly. Generally, 6% royalties are payable weekly by
automatic bank drafts and 4% royalties are payable monthly by check. The Company
is currently developing point-of-sale software for use by franchisees to record
and report sales and other operating information and anticipates that new
franchisees will be required to use this point-of-sale software beginning in
1997. Although the Company has the right to audit franchisees, it relies
primarily on voluntary compliance by franchisees to accurately report sales and
remit royalties.

    INTERNATIONAL MASTER LICENSEES.  In addition to the Company's expansion in
the United States, the Company has granted nonassignable rights to develop
stores in international markets to master licensees. A master licensee is
typically licensed for 50 years to use the Schlotzsky's trademarks in designated
foreign territories and may grant area development rights and franchises in
those territories. Unlike area developers, master licensees contract directly
with franchisees, and the Company delegates the selection of franchisees and
approval of sites to the master licensees. When a master license is granted, the
master licensee pays the Company a negotiated, nonrefundable license fee. In
some instances, the Company will negotiate a territorial agreement pursuant to
which a foreign territory is reserved and the principal economic terms of the
master license agreement are agreed upon in return for a nonrefundable fee to be
applied toward the master license fee. The Company normally receives 15% to 35%
of the master license fee in cash when the master license or territorial
agreement is signed, with the balance payable with interest over a term of up to
48 months under a promissory note from the master licensee. Typically, the
Company also receives one-third to one-half of any sublicense and franchise fees
and one-third of any royalties received by the master licensee. All amounts
payable to the Company by the master licensees must be paid in U.S. dollars. As
of December 31, 1996, the Company had executed master licenses or territorial
agreements covering 44 foreign countries. As with area developers, if master
licensees fail to meet their obligations, the Company can terminate their rights
or repurchase their territories for resale. Master licensees are subject to
various laws and regulations regarding franchising and licensing in their
territories and are responsible for complying with these laws and regulations.

SITE SELECTION

    The Company trains area developers to assist franchisees in selecting their
sites and developing their stores. Each franchisee is responsible for selecting
store locations acceptable to the Company. Site selection criteria are based on
accessibility and visibility of the site and selected demographic factors,
including population, residential and commercial density, income, age and
traffic patterns. The Company

                                       6
<PAGE>
prefers that franchisees select sites for free-standing or end-cap stores to
maximize store visibility and sales potential.

    The Company has developed a series of prototype store designs and
specifications for free-standing and end-cap stores which its area developers
make available for use by franchisees. These specifications are designed to be
adapted to existing restaurants and other retail spaces, which should result in
more flexibility and lower rents for franchisees than restaurants with rigid
design requirements.

UNIT ECONOMICS

    The Company believes that the Schlotzsky's Deli restaurant concept offers
attractive unit economics. The cost to a franchisee of developing and opening a
Schlotzsky's Deli restaurant in leased space currently ranges from approximately
$215,000 to $300,000, including leasehold improvements, equipment, fixtures and
initial working capital. During 1996, the average store revenue for Schlotzsky's
Deli restaurants (excluding non-Deli restaurant format stores) that were open
for the entire period was approximately $398,000, although store revenue varies
significantly depending upon the type, size and location of the store. The
Company believes that food and paper costs for the Schlotzsky's Deli menu items
are relatively low as a percentage of gross store sales as compared to many
quick service restaurant concepts. With higher gross margins, franchisees should
be able to recover their cash investment and achieve profitability on relatively
lower unit sales volumes.

FINANCING

    The Company typically does not provide financing to franchisees for the
costs of developing and opening stores and is not obligated to do so. Both the
Company and area developers assist franchisees in obtaining financing by
identifying third party financing sources. Certain financial institutions have
designed equipment leasing programs specifically for Schlotzsky's franchisees
and have developed guidelines for sale and leaseback financing for Schlotzsky's
stores. The Company has also identified Small Business Administration lenders
which have made loans to Schlotzsky's franchisees. These lenders are not
committed to provide any financing to franchisees and there can be no assurance
that franchisees will be able to finance their costs of opening stores on
suitable terms.

    Although it is not obligated to do so, the Company from time to time agrees
to guarantee its franchisees' obligations to equipment and real property lessors
or subordinates all or a portion of its royalties to the obligations of
franchisees on such leases. As of December 31, 1996, the Company had guaranteed
an aggregate of approximately $10.1 million in principal amount of indebtedness
of franchisees. As of December 31, 1996, the Company had agreed to subordinate
approximately $25,000 in aggregate, average monthly royalties to liens of
lessors and other creditors of franchisees in the event of a default by the
franchisees in their lease or other obligations.

PURCHASING; PRIVATE LABELING

    Franchisees are required to purchase equipment, furniture, smallwares,
merchandising displays and food from suppliers approved by the Company.
Approximately 80% of overall purchases of goods used in daily operations by the
Company's franchised stores are from International Multifoods Corporation, which
provides volume discounts to franchisees based upon system-wide purchases. The
Company believes that comparable goods are available at competitive prices from
numerous other suppliers.

    The Company has licensed various manufacturers to produce Schlotzsky's
private label supplies including meats, cheeses, and chips, and receives
licensing fees from sales of private label foods to franchisees. While
franchisees are not required to purchase private label supplies other than the
Company's sourdough flour mixes, the Company believes that most franchisees
prefer them because they are of equal or superior quality compared to brand name
products and generally are less expensive than the supplies available from other
approved sources. In addition, some private label products can be sold
separately at stores for home consumption, enhancing brand awareness and
providing franchisees with additional sales and profit opportunities.

                                       7
<PAGE>
MARKETING

    Franchised stores contribute 1% of gross sales to Schlotzsky's N.A.M.F.,
Inc. ("NAMF"), a non-profit corporation administered by the Company. In
addition, franchisees are required by the terms of their franchise agreements to
spend at least 3% of gross sales on local advertising. To take advantage of
critical mass in certain television markets, franchisees are encouraged to form
cooperatives where local advertising funds can be pooled to maximize the
benefits of advertising for members. NAMF funds are used to develop and produce
radio and television commercials and print advertising for use in local markets,
in-store graphics and displays, and promotions. NAMF has developed advertising
campaigns for use by franchisees centered around different slogans, such as
FUNNY NAME. SERIOUS SANDWICH.--; ACCEPT NO SUBSTITUTESKY'S--; BEST BUNS IN
TOWN--; and ORIGINAL TASTE EVERY DAY--. NAMF's field marketing representatives
coordinate advertising campaigns and promotions for area developers and
franchisees.

COMPETITION

    The food service industry is intensely competitive with respect to concept,
price, location, food quality and service. There are many well established
competitors with substantially greater financial and other resources than the
Company. Such competitors include a large number of national, regional and local
food service companies, including fast food restaurants, casual full-service
restaurants, delicatessens, pizza restaurants and other convenience dining
establishments. Some of the Company's competitors have been in existence longer
than the Company and are better established in markets where Schlotzsky's stores
are or may be located. The Company also competes for franchisees with
franchisors of other restaurants and various concepts.

    Schlotzsky's stores compete primarily on the basis of distinctive, high
quality food and convenience, rather than price. The Company believes that
Schlotzsky's stores provide the quick service and convenience of fast food
restaurants while offering more distinctive, higher quality products. Pricing is
designed so that customers perceive good value (high quality food at reasonable
prices), even though Schlotzsky's menu prices are typically higher than certain
competitors' prices.

    Competition in the food service business is affected by changes in consumer
taste, economic and real estate conditions, demographic trends, traffic
patterns, the cost and availability of qualified labor, product availability and
local competitive factors. The Company's area developers attempt to assist
franchisees in managing or adapting to these factors, but no assurance can be
given that some or all of these factors will not adversely affect some or all of
the franchisees.

TRADEMARKS, SERVICE MARKS AND TRADE SECRETS

    The Company owns a number of trademarks and service marks registered with
the United States Patent and Trademark Office. The Company has also registered
or made application to register trademarks in foreign countries where master
licenses have been granted. The flour and bread making recipes and techniques
currently used in Schlotzsky's stores are based on a modification of the
Company's original recipe developed jointly by the Company and Pillsbury
Company. The recipes and techniques are protected by the Company and its
suppliers as trade secrets. The Company has not sought patent protection for
these recipes, and it is possible that competitors could develop flour recipes
and baking procedures that duplicate or closely resemble the Company's. The
Company considers its trademarks, service marks and trade secrets to be critical
to the business and actively defends and enforces them.

GOVERNMENT REGULATION

    The Company must comply with regulations adopted by the Federal Trade
Commission (the "FTC") and with several state laws that regulate the offer and
sale of franchises. The Company also must comply

                                       8
<PAGE>
with a number of state laws that regulate certain substantive aspects of the
franchisor-franchisee relationship. The FTC's Trade Regulation Rule on
Franchising (the "FTC Rule") requires that the Company furnish prospective
franchisees with a franchise offering circular containing information prescribed
by the FTC Rule.

    State laws that regulate the franchisor-franchisee relationship presently
exist in a substantial number of states. Those laws regulate the franchise
relationship, for example, by requiring the franchisor to deal with its
franchisees in good faith, by prohibiting interference with the right of free
association among franchisees, by regulating discrimination among franchisees
with regard to charges, royalties or fees, and by restricting the development of
other restaurants within certain proscribed distances from existing franchised
restaurants. Those laws also restrict a franchisor's rights with regard to the
termination of a franchise agreement (for example, by requiring "good cause" to
exist as a basis for the termination), by requiring the franchisor to give
advance notice to the franchisee of the termination and give the franchisee an
opportunity to cure any default, and by requiring the franchisor to repurchase
the franchisee's inventory or provide other compensation. To date, those laws
have not precluded the Company from seeking franchisees in any given area and
have not had a material adverse effect on the Company's operations.

    Each Schlotzsky's store must comply with regulations adopted by federal
agencies and with licensing and other regulations enforced by state and local
health, sanitation, safety, fire and other departments. Difficulties or failures
in obtaining the required licenses or approvals can delay and sometimes prevent
the opening of a new restaurant.

    Schlotzsky's stores must comply with federal and state environmental
regulations, such as those promulgated under the Federal Water Pollution Act,
Federal Clean Water Act of 1977 and the Federal Resource and Conservation
Recovery Act of 1976, but the Company believes that those regulations have not
had a material effect on their operations. More stringent and varied
requirements of local governmental bodies with respect to zoning, land use, and
environmental factors can delay and sometimes prevent development of new stores
in particular locations.

    The Company and its franchisees must comply with the Fair Labor Standards
Act and various state laws governing various matters, such as minimum wages,
overtime and other working conditions. Significant numbers of the food service
personnel in Schlotzsky's restaurants receive compensation at rates related to
the federal minimum wage and, accordingly, increases in the minimum wage
increase labor costs at those locations.

    The Company and its franchisees also must comply with the provisions of the
Americans with Disabilities Act (the "ADA"), which requires that employers
provide reasonable accommodation for employees with disabilities and that
restaurants be accessible to customers with disabilities.

EMPLOYEES

    As of December 31, 1996, the Company employed 86 persons. None of the
Company's employees is covered by a collective bargaining agreement or is
represented by any labor union. The Company believes its relationship with its
employees is good.

RISK FACTORS

    In addition to the other information contained in this report, the following
factors should be considered carefully in evaluating the Company:

    RAPID GROWTH STRATEGY.  During 1996, 135 Schlotzsky's stores were opened by
franchisees. This level of store openings continues to be greater than that
experienced by the Company in previous years. The Company will rely primarily
upon its area developers, new franchisees and new geographic markets to continue
this expansion. The opening and success of new stores will depend on various
factors, including (i) the ability of area developers to recruit qualified
franchisees, (ii) the availability of suitable sites for new

                                       9
<PAGE>
stores, (iii) the ability of franchisees to negotiate acceptable lease or
purchase terms for new locations, obtain capital required to construct,
build-out and operate new stores, meet construction schedules, and hire and
train qualified store personnel, (iv) the acceptance of the Schlotzsky's Deli
restaurant concept and the establishment of brand awareness in new markets, and
(v) the ability of the Company and its area developers to manage this
anticipated expansion. Not all of these factors are within the control of the
Company, and there can be no assurance that the Company will be able to maintain
or accelerate its growth or that the Company will be able to manage its
expanding operations effectively. See "Business-- Strategy."

    RELIANCE ON AREA DEVELOPERS.  The Company relies on its area developers to
find qualified franchisees. Area developers are independent contractors of the
Company, and are not employees. During the past two fiscal years, 60 new stores
were opened within ten territories controlled by only two area developers. As
these ten territories become more developed, system-wide growth will require
that area developers in other territories become more active. The Company
believes that the concentration of store openings among a relatively few area
developers is due primarily to the longer tenure of these area developers with
the Company and the size of the territories covered by their agreements. Most
area development agreements specify a schedule for opening stores in the
territory covered by the agreement. One area developer, which had five
territories in seven states, committed to open 121 stores within its territories
by 2000, of which only 18 were opened as of December 31, 1995. In January 1996,
the area development agreement was terminated. The territories were broken into
five separate development agreements and re-sold to new area developers. The
Company expects the level of store openings in these territories to be
unaffected by these changes. Another area development agreement was terminated
due to failure to comply with the development agreement and the development
rights were re-sold to a new area developer. In addition, the Company purchased
the development rights back from existing area developers in certain other
territories. One territory was re-sold to an existing area developer. At the end
of the year, the Company still had development rights to certain domestic
territories which it had re-purchased during 1996. After strengthening its
market position in these markets, the Company expects to sell these development
rights to qualified third parties. In the past, the Company has agreed to extend
development schedules for certain of its area developers, and there can be no
assurance that area developers will be able to meet their contractual
development schedules. These schedules form the basis for the Company's
expectations regarding the number and timing of new store openings. Delays in
store openings could adversely affect the future operations of the Company.

    As the Company relies more extensively on its area developers, many of whom
do not have experience operating restaurants, it has less direct involvement in
recruiting franchisees and in monitoring the quality of franchised stores. The
Company provides training and support to area developers, but the quality of
store operations and the ability of area developers to meet development
schedules may be diminished by their lack of experience. It may be difficult for
the Company to terminate the area development rights of area developers who fail
to meet development schedules or other standards and requirements imposed by the
Company, limiting the ability of the Company to develop the territories of such
area developers. Over the past several years, the Company has relied on
developer fees to cover the costs of new financial and information systems and
increased administrative and executive personnel. As these fees decline, the
Company will have to rely on other sources of income to cover these costs. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and "Business--Franchising."

    CREDIT RISK AND CONTINGENCIES.  The Company charges area developers and
master licensees a fee ("developer fee") for the rights to develop a defined
territory. Typically, a portion of the developer fee is paid in cash and the
balance is paid with a promissory note from the area developer or master
licensee. The Company periodically evaluates the credit risk and obtains annual
valuations of these notes from an independent financial services institution
with expertise in valuing instruments of this sort. As of December 31, 1996, the
Company held notes receivable from area developers and master licensees in an
aggregate principal amount of approximately $4.2 million before discount. At
December 31, 1996, the

                                       10
<PAGE>
principal balance of these notes had been discounted on the financial statements
of the Company by approximately $343,000, reflecting the fair market value of
such notes based upon valuations from the independent financial services
institution. The Company also holds notes receivable from certain franchisees
related to the sale of Company-owned stores. As of December 31, 1996, the
outstanding principal amount of these notes was approximately $455,000. While
the Company considers it unlikely that there will be defaults on a significant
amount of the notes, such defaults could adversely affect the Company's
financial condition. Parties controlled by or related to directors, officers and
principal shareholders of the Company have provided financing to certain area
developers and master licensees and have guaranteed obligations of certain area
developers and master licensees to the Company. See "Business--Franchising--
International Master Licensees."

    From time to time, the Company guarantees real estate and equipment leases
of its franchisees for a limited period of time, although it is not obligated to
do so. In addition, even though it is not contractually required to do so, the
Company anticipates that it will continue to enter into guarantees with respect
to most of the leases entered into between its franchisees and the buyers of the
sites developed under the Turnkey Program. See "Business--Turnkey Real Estate
Development Program." At December 31, 1996, the Company was contingently liable
for approximately $7.5 million of real estate and equipment leases of its
franchisees.

    A wholly-owned subsidiary of the Company is the general partner of a limited
partnership that developed a retail shopping center in the Austin area. The
Company and its subsidiary have guaranteed the repayment of an interim
construction loan for this project with a principal balance of $1.14 million at
the end of 1996. The Company renewed the loan through April 2001 and the
partnership is making monthly payments as agreed under the new terms. The
Company does not exercise control over the partnership and does not consider its
investment in the retail shopping center to represent a separate line of
business. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Liquidity and Capital Resources."

    LIMITED OPERATING HISTORY OF DELI CONCEPT.  The Schlotzsky's Deli restaurant
concept was first implemented in late 1991. Most of the stores currently
operating have either opened as a deli restaurant or have been converted to the
deli concept. However, a majority of the Schlotzsky's Delis have operated as
such for less than three years so the long-term sales trend of this restaurant
concept is not yet established. The Deli concept requires that the Company and
franchisees implement an expanded menu requiring more employees in a larger
facility. The Company also encourages franchisees to select larger,
free-standing stores with higher visibility. This has increased the costs to
franchisees of opening and operating franchised stores. Accordingly, results
achieved to date may not be indicative of the results which will be experienced
in the future. Declining store results could decrease royalties to the Company
and make it more difficult to attract and retain qualified franchisees. There
can be no assurance that the Company will be profitable on a sustained basis.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations" and the Consolidated Financial Statements of the Company and the
Notes thereto.

    FRANCHISING.  Because royalties from franchisees' sales are a principal
component of the Company's revenue base, the Company's success is dependent upon
the ability of its franchisees to promote and capitalize upon the Schlotzsky's
concept and its reputation for quality and value. The Company believes that the
cost to a franchisee of opening a Schlotzsky's Deli restaurant is higher than
the store opening costs incurred by franchisees of many of the Company's
competitors for franchisees. This necessarily limits the number of persons who
are qualified to be franchisees of the Company. The Company has established
criteria for area developers to use in evaluating prospective franchisees, but
there can be no assurance that area developers will recruit franchisees who have
the business abilities or financial resources necessary to open Schlotzsky's
stores on schedule or that franchisees will conduct operations in a manner
consistent with the Company's concepts and standards. See
"Business--Franchising."

                                       11
<PAGE>
    The Company is subject to various state and federal laws relating to the
franchisor-franchisee relationship. The failure by the Company to comply with
these laws could subject the Company to liability to franchisees and to fines or
other penalties imposed by governmental authorities. The Company believes that
the franchising industry is experiencing an increasing trend of franchisees
filing complaints with state and federal governmental authorities and
instituting lawsuits against franchisors claiming that they have engaged in
unfair trade practices or violated express or implied agreements with
franchisees. The Company believes that it is in material compliance with these
laws and regulations and its agreements with franchisees, and that its relations
with its franchisees are generally good. See "Business--Government Regulation"
and "--Litigation."

    LIMITED EXPERIENCE IN TURNKEY PROGRAM.  The Company initiated the Turnkey
Program in 1995 and has been developing and refining the program over the last
two years. The Company will have a continuing need for capital to finance the
construction of new stores under the Turnkey Program. The Company obtained
limited interim financing for certain projects currently under development, all
of which was retired with proceeds from the Company's initial public offering.
Initial sale-leaseback commitments for certain Turnkey Program projects have
also been obtained. Additionally, the Company has secured a line of credit for
$5.0 million of financing from a financial institution. The line had not been
drawn upon as of December 31, 1996. There can be no assurance that the Company
will be able to obtain additional capital required in the future for the Turnkey
Program when needed on satisfactory terms. In addition, the Company may be
unable to sell properties acquired under the Turnkey Program at a profit or at
its cost, and the Company could be required to sell properties at a loss or hold
properties indefinitely, diminishing the capital available to reinvest in the
Turnkey Program. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Liquidity and Capital Resources" and
"Business-- Turnkey Real Estate Development Program."

    GEOGRAPHIC CONCENTRATION.  Of the 573 stores in the system at December 31,
1996, 187 were located in Texas. A downturn in the regional economy or other
significant adverse events in Texas could have a material adverse effect on the
Company's financial condition and results of operations.

    COMPETITION.  The food service industry is intensely competitive with
respect to concept, price, location, food quality and service. There are many
well-established competitors with substantially greater financial and other
resources than the Company. These competitors include a large number of
national, regional and local food service companies, including fast food and
quick service restaurants, casual full-service restaurants, delicatessens, pizza
restaurants and other convenience dining establishments. Some of the Company's
competitors have been in existence longer than the Company and may be better
established in markets where Schlotzsky's stores are or may be located. The
Company believes that it competes for franchisees against franchisors of other
restaurants and various other concepts.

    Competition in the food service industry is affected by changes in consumer
taste, economic and real estate conditions, demographic trends, traffic
patterns, the cost and availability of qualified labor, product availability and
local competitive factors. The Company's area developers assist franchisees in
managing or adapting to these factors, but no assurance can be given that some
or all of these factors will not adversely affect some or all of the
franchisees. See "Business--Competition."

    CONTROL BY PRINCIPAL SHAREHOLDERS.  As of December 31, 1996, John C. Wooley
and Jeffrey J. Wooley beneficially own an aggregate of approximately 20% of the
outstanding Common Stock and entities of which John M. Rosillo, a director of
the Company, is the managing director, beneficially own an aggregate of 22% of
the outstanding Common Stock. As a result, these shareholders, if they were to
act in concert, would have the ability to control or influence the outcome of
any issue submitted to a vote of the shareholders. There are no agreements or
understandings among these shareholders regarding the voting of their shares,
but to date they have voted consistently on matters submitted to a vote of the
shareholders.

                                       12
<PAGE>
    DEPENDENCE ON MANAGEMENT AND KEY PERSONNEL.  The Company's success is highly
dependent upon the efforts of its management and key personnel, including its
Chairman of the Board and President, John C. Wooley. The Company has employment
agreements with John C. Wooley, Jeffrey J. Wooley, Kelly R. Arnold and Karl D.
Martin, each of which includes certain noncompetition provisions that survive
the termination of employment. The Company also has obtained certain
noncompetition agreements from other members of management and key personnel who
are not subject to employment agreements. However, there can be no assurance
such noncompetition agreements will be enforceable. The loss of the services of
John Wooley or other management or key personnel could have a material adverse
effect on the Company. The Company does not carry key man life insurance on any
of its officers.

    GOVERNMENT REGULATION.  The restaurant industry is subject to numerous
federal, state and local governmental regulations, including those relating to
the preparation and sale of food and zoning and building requirements. The
Company and its area developers and franchisees are also subject to laws
governing their relationships with employees, including wage and hour laws, and
laws and regulations relating to working and safety conditions and citizenship
or immigration status. The Company's franchise operations are subject to
regulation by the United States Federal Trade Commission and the Company must
also comply with state laws relating to the offer, sale and termination of
franchises and the refusal to renew franchises. The failure to obtain or
maintain approvals to sell franchises could adversely affect the Company.
Increases in the minimum wage rate, employee benefit costs or other costs
associated with employees, could adversely affect the Company's area developers
and franchisees and, therefore, adversely affect the Company. See
"Business--Government Regulation."

    ABSENCE OF DIVIDENDS.  The Company has never paid cash dividends on its
Common Stock and does not anticipate paying any cash dividends in the
foreseeable future.

    SHARES ELIGIBLE FOR FUTURE SALE.  A substantial number of shares of Common
Stock will become available for sale in the public market at various times. No
predictions can be made as to the effect, if any, that market sales or the
availability of shares for future sale will have on the market price of the
Common Stock. The market price of the Common Stock could be adversely affected
by future sales of substantial amounts of Common Stock by existing shareholders.
The Company has 5,539,922 shares of Common Stock outstanding.

    EFFECT OF CERTAIN PROVISIONS IN ARTICLES AND BYLAWS.  The Company's Articles
of Incorporation and Bylaws include certain provisions that may have the effect
of discouraging or delaying a change in control of the Company. Directors are
elected for staggered three-year terms, which has the effect of delaying the
ability of shareholders to replace specific directors or effect a change in a
majority of the Board of Directors. All shareholder action must be effected at a
duly called annual or special meeting of shareholders and shareholders must
follow an advance notification procedure for certain shareholder proposals and
nominations of candidates for election to the Board of Directors.

    The Board of Directors has the authority, without further action by the
shareholders, to issue up to 1,000,000 shares of Preferred Stock in one or more
series and to fix the rights, preferences, privileges and restrictions thereof,
and to issue authorized unissued shares of Common Stock. The issuance of
Preferred Stock or additional shares of Common Stock could adversely affect the
voting power of the shareholders and could have the effect of delaying,
deferring or preventing a change in control of the Company. The issuance of
Preferred Stock also could adversely affect other rights of the shareholders,
including creation of a preference upon liquidation or upon the payment of
dividends in favor of the holders of Preferred Stock.

                                       13
<PAGE>
ITEM 2.  PROPERTIES

    The Company's corporate headquarters are located in approximately 11,000
square feet of office space in Austin, Texas, owned by the Company and
approximately 6,000 square feet of additional space occupied under a lease
expiring in August of 1997.

    The Company leases approximately 10,000 square feet of space for the
flagship Schlotzsky's Deli restaurant and training facility in Austin. The
Company also leases 2,500 square feet for a store in Austin, approximately 1,800
square feet for its store in Manhattan, and 3,000 square feet for the
Company-owned store in Houston.

    As of December 31, 1996, the Company owned 22 store sites under the Turnkey
Program. Construction is completed on eight of these sites and the stores are
operating and under lease. Nine of the sites are under various stages of
completion and five sites remain in the pre-development stage. It is
contemplated that stores developed under the Turnkey Program will be sold as
they are completed. See "Business-- Turnkey Real Estate Development Program."

    Schlotzsky's Real Estate, Inc., a wholly-owned subsidiary of the Company, is
the general partner and the Company is a limited partner of a limited
partnership which owns a 17,600 square foot shopping center in suburban Austin.
Schlotzsky's Real Estate, Inc. and the Company have a combined 40% interest in
the capital and profits of this limited partnership. See "Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Liquidity and Capital Resources."

ITEM 3.  LEGAL PROCEEDINGS.

    On April 25, 1995, 11 of the 37 Houston, Texas area franchisees filed suit
against the Company, the area developer for the Houston market and certain other
parties in Soonhee Ahn, et al. v. Schlotzsky's, Inc., et al., Civil Action No.
H-95-1242 in the United States District Court for the Northern District of
Texas. In September 1995, the Court granted the Company's motion to dismiss this
suit. The dismissal was without prejudice to any suit that may be filed in state
court. The suit alleged that the Company misapplied NAMF funds; that the Company
and its area developer encroached on the trade areas of existing franchisees by
granting new franchises within those trade areas; that the Company failed to
protect its trademarks by permitting their use by a non-franchisee; that the
Company failed to provide adequate operational service and support; and that the
Company committed fraud, unfair competition and other actionable conduct. The
plaintiffs sought unspecified damages, an accounting and other equitable relief.
Although the plaintiffs filed a notice of appeal of the dismissal with the
United States Court of Appeals for the Fifth Circuit, the plaintiffs did not
file their brief to perfect their appeal and their appeal was dismissed in
February 1996.

    The State of New Mexico Taxation and Revenue Department has assessed the
Company $131,000 for gross receipts taxes, penalties and interest for the years
1987 through 1993. The assessment imposes gross receipts taxes on franchise fees
and royalties received by the Company from New Mexico franchisees and NAMF
contributions by those franchisees. The Company filed a protest with the New
Mexico Taxation and Revenue Department claiming that the assessment violates the
Commerce Clause of the United States Constitution because the Company does not
have any physical presence in or substantial nexus with New Mexico. The Company
has reserved a liability for taxes and attorneys' fees in respect of this
assessment. See the Consolidated Financial Statements of the Company and related
notes included elsewhere in this Report. If other state taxing authorities
attempt to impose taxes on receipts derived by the Company from franchisees in
those states, the Company's financial condition and results of operations could
be materially adversely affected.

    The Company is subject to routine litigation in the ordinary course of
business, including contract, franchisee, area developer and employment-related
litigation. In the course of enforcing its rights under existing and former
franchise agreements and area developer agreements, the Company is subject to

                                       14
<PAGE>
complaints and letters threatening litigation concerning the interpretation and
application of these agreements, particularly in the case of a default or
termination. The Company endeavors to treat its franchisees and area developers
reasonably and fairly and in compliance with applicable contractual provisions
with due regard for the protection of the Company's trademarks, service marks
and goodwill. None of these routine matters, individually or in the aggregate,
are believed by the Company to be material to its business or financial
condition.

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

    Not applicable.

                                    PART II.

ITEM 5.  MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

    The authorized capital stock of the Company consists of 30,000,000 shares of
Common Stock, no par value, and 1,000,000 shares of Class C Preferred Stock, no
par value. The Company's Common Stock is traded on the National Market of the
National Association of Securities Dealers Automated Quotation System ("NASDAQ")
under the Symbol "BUNZ". Trading began on December 15, 1995 in connection with
the Company's initial public offering. No public market existed for the Common
Stock prior to that time. As of March 21, 1997, 5,539,922 shares of outstanding
Common Stock were owned of record by 242 Shareholders.

    The high and low bid prices as reported by NASDAQ for the period from
December 15, 1995, when trading of the Common Stock began, to December 31, 1996
are set forth below:

<TABLE>
<CAPTION>
                                                                                    HIGH        LOW
                                                                                  ---------  ---------
<S>                                                                               <C>        <C>
Fiscal 1995:
  Fourth Quarter................................................................     12 1/2     10 1/4
Fiscal 1996:
  First Quarter.................................................................         11      8 7/8
  Second Quarter................................................................     13 3/4      9 1/2
  Third Quarter.................................................................     12 3/4      9 3/4
  Fourth Quarter................................................................     11 3/4      9 1/4
</TABLE>

These quotations may reflect inter-dealer prices, without retail mark-up,
mark-down or commissions and may not necessarily represent actual transactions.
The Company has never paid and has no current plans to pay cash dividends on its
Common Stock. The Company currently intends to retain earnings for use in the
operation and expansion of the Company's business and does not anticipate paying
cash dividends in the foreseeable future. The declaration and payment of future
dividends will be at the sole discretion of the Board of Directors and will
depend on the Company's profitability, financial condition, capital needs,
future prospects and other factors deemed relevant by the Board of Directors.

    The Transfer Agent and Registrar for the Company's Common Stock is Harris
Trust and Savings Bank of Chicago, Illinois.

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

    The following table sets forth selected consolidated financial data for the
Company for the periods and the dates indicated. The statement of operations
data for the years ended December 31, 1992, 1993, 1994, 1995 and 1996 and the
balance sheet data as of December 31, 1992, 1993, 1994, 1995 and 1996 set forth
below have been derived from the financial statements of the Company and the
Predecessor Entities, which have been audited by Coopers & Lybrand L.L.P.,
independent certified public accountants, as indicated in their report included
elsewhere herein. The selected financial data should be read in

                                       15
<PAGE>
conjunction with, and are qualified in their entirety by, the Consolidated
Financial Statements of the Company and related Notes and other financial
information included elsewhere in this report.

<TABLE>
<CAPTION>
                                                                         FISCAL YEARS ENDED DECEMBER 31,
                                                              -----------------------------------------------------
                                                                1992      1993(1)     1994       1995       1996
                                                              ---------  ---------  ---------  ---------  ---------
                                                                      (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                                           <C>        <C>        <C>        <C>        <C>
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
  Revenue:
    Royalties...............................................  $   2,334  $   2,969  $   4,657  $   7,425  $  10,747
    Franchise fees..........................................        330        621      1,019      1,494      1,775
    Developer fees..........................................      1,768      2,170      2,793      2,666      1,993
    Restaurant sales........................................        780        623        428        505      3,610
    Brand contributions.....................................     --         --            150        397      1,295
    Turnkey development.....................................     --         --         --             41        726
    Other fees and revenue..................................         75        141        256        324        568
                                                              ---------  ---------  ---------  ---------  ---------
    Total Revenue...........................................      5,287      6,524      9,303     12,852     20,714
Cost and expenses:
  Service costs
    Royalty service costs...................................         72        372      1,122      2,405      3,791
    Franchise fee development costs.........................         93        338        661        767        959
  Restaurant Operations
    Restaurant cost of sales................................        255        202        188        189      1,183
    Restaurant labor costs..................................        256        214        154        408      1,424
    Restaurant operating expenses...........................        552        380        260        251      1,040
  General and administrative................................      3,555      3,679      4,199      5,751      7,028
  Depreciation and amortization.............................        371        268        372        458        779
                                                              ---------  ---------  ---------  ---------  ---------
      Total costs and expenses..............................      5,154      5,453      6,956     10,229     16,204
                                                              ---------  ---------  ---------  ---------  ---------
    Operating Income (loss).................................        133      1,071      2,347      2,623      4,510
Other:
    Interest income (expense) net...........................       (219)      (240)      (201)      (149)       455
    Other income (expense)..................................     (1,085)       232        226        138        132
                                                              ---------  ---------  ---------  ---------  ---------
      Total other income (expense)..........................     (1,304)        (8)        25        (11)       587
                                                              ---------  ---------  ---------  ---------  ---------
    Income (loss) before income taxes and extraordinary
      gain..................................................     (1,171)     1,063      2,372      2,612      5,097
    Provision for federal and state income taxes............     --             56        927      1,017      1,902
    Gain on extinguishment of debt, net of tax..............     --         --             40         38     --
                                                              ---------  ---------  ---------  ---------  ---------
    Net income (loss).......................................  $  (1,171) $   1,007  $   1,485  $   1,633  $   3,195
                                                              ---------  ---------  ---------  ---------  ---------
                                                              ---------  ---------  ---------  ---------  ---------
    Net income per share(2)(3)(4)...........................     --            .26        .44        .44        .57

CONSOLIDATED BALANCE SHEET DATA:
    Total assets............................................      5,600     12,364     16,481     36,708     40,979
    Long-term debt, less current maturities(5)..............     --          6,420     10,452      3,029      3,129
    Stockholders' equity(4).................................        284        584      1,614     28,974     32,312
</TABLE>

------------------------

(1) Effective January 1, 1993, Schlotzsky's Franchising Limited Partnership,
    Schlotzsky's San Antonio, Ltd. ("SSAL"), Schlotzsky's Houston, Ltd. ("SHL"),
    Schlotzsky's, Inc. and Schlotzsky's Restaurant Management Corporation
    ("SRMC") merged resulting in three new corporations: Schlotzsky's, Inc. (the
    parent corporation); Schlotzsky's Restaurants, Inc. (a wholly-owned
    subsidiary of Schlotzsky's, Inc.); and Schlotzsky's Real Estate, Inc. (a
    wholly-owned subsidiary of Schlotzsky's, Inc.). Prior to the merger, SRMC
    was the general partner in SSAL and SHL.

(2) The Company was organized as a limited partnership in 1992. Accordingly, net
    income (loss) per common share is not applicable for that year.

                                       16
<PAGE>
(3) As a result of the issuance of Class B Preferred Stock in July 1994,
    Preferred Stock dividends increased $235,000 for the year ended December 31,
    1995 compared to the same period in 1994, thereby reducing net income
    available to Common Stock by $.05 per share in the 1995 period.

(4) For 1992, stockholders' equity reflects partners' capital in the Predecessor
    Entities. Stockholders' equity for 1995 has been adjusted to give effect to
    the conversion of the Preferred Stock, including accrued dividends, into
    Common Stock. Working capital has been adjusted only for the year ended
    December 31, 1995.

(5) For 1993 and 1994, long-term debt includes $5,000,000 and $8,000,000,
    respectively for redeemable preferred stock.

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

    When used in this discussion, the words "believes," "anticipates," "expects"
and similar expressions are intended to identify forward-looking statements.
Such statements are subject to certain risks and uncertainties which could cause
actual results to differ materially from those projected. See "Risk Factors"
above. Readers are cautioned not to place undue reliance on these
forward-looking statements which speak only as of the date hereof. The Company
undertakes no obligation to publicly release the results of any revisions to
these forward-looking statements which may reflect events or circumstances which
occur after the date hereof or the occurrence of unanticipated events.

OVERVIEW

    John C. Wooley and Jeffrey J. Wooley acquired the Company in 1981 and for
the next six years concentrated their efforts on improving the existing
franchise system. Between 1987 and 1990, management focused on expanding the
Company's business by developing Company-owned stores, as well as franchising.
During this period, 16 Company-owned and 67 franchised stores were opened. In
1990 and 1991, the Company closed or sold 20 of its Company-owned stores due to
difficulties with operations, and beginning in the fourth quarter of 1991,
management adopted the strategy of developing only franchised stores and relying
on area developers to recruit and support franchisees. In late 1991 and 1992,
the Company concentrated on building its network of area developers throughout
the United States. The addition of area developers has resulted in an increasing
rate of store openings during the last three years.

    The Company derives its revenue from several sources: royalties, franchise
fees, developer fees (consisting of area developer and master licensee fees),
Company-owned restaurant sales, and other franchise-related activities. Between
1991 and 1994, developer fees and franchise fees grew to represent a significant
portion of total revenue as the Company sold development rights for most of the
television markets in the United States and certain international territories.
Franchise fees increased during this period as the rate at which stores opened
increased. Management believes that as it completes the repositioning of the
Company which began in 1991, developer fees derived from these non-recurring
transactions will decline as a percentage of total revenue, while franchise fees
and royalties based on franchise store sales will continue to increase. As of
December 31, 1996, there were 393 stores committed to be opened by franchisees
within the two years ending December 31, 1998. There can be no assurance that
franchisees will open the stores committed to be opened within this time period.

    Royalties are based on a percentage of franchisees' net sales and are
recognized by the Company in the same period that the franchise store sales
occur. Generally, royalties are earned at the rate of 6% of sales for stores
opened after the 1991 year end, and 4% of sales for stores opened before that
time. Royalties are paid by means of weekly automatic drafts by the Company on
franchisee bank accounts for 6% royalty stores. Currently, approximately 135
franchised stores pay royalties on a monthly basis at the rate of 4%. This
number of stores will decline as older franchise agreements expire (the majority
of which will expire after 1998). A portion of the royalties received by the
Company are paid to its area developers as royalty service costs for providing
on-going services to franchisees in their territories. As more stores open under
6% franchise agreements, the Company expects that royalty service costs will
approach 40% of

                                       17
<PAGE>
royalties. See "Business--Franchising--Area Developers." Royalties have
increased since 1992 due not only to the growth in the number of stores, but
also to increases in average weekly sales. The increase in average weekly sales
is due primarily to the conversion of older franchise stores to the Schlotzsky's
Deli restaurant concept, as well as the selection of more free-standing
locations for newer stores, which have better visibility and generally
experience higher sales than the smaller "in-line" stores located in strip
shopping centers which are characteristic of stores opened prior to 1992.

    Franchise fees are nonrefundable payments received by the Company from
franchisees and are typically recognized into revenue as stores open. The
franchise fee for a franchisee's initial store increased from $15,000 in 1990 to
$20,000 as of July 1, 1995. The franchise fee for each additional store
committed to and opened by a franchisee is $10,000. Expenses associated with
franchise fees are shown as franchise fee development costs and include the
portion of the franchise fee paid to area developers. The Company generally pays
area developers approximately one-half of the franchise fees collected from
franchisees in their development areas, although the Company agreed to pay some
area developers up to 100% of certain franchise fees as an inducement to develop
their territories more quickly. As the number of stores covered by these
enhanced arrangements begins to diminish, the Company expects that franchise fee
development costs will decrease as a percentage of franchise fees to
approximately 50%.

    The Company charges developers a nonrefundable fee for the exclusive rights
to develop a defined territory for a specified term. Typically, a portion of the
developer fee is paid in cash and the balance is paid with a promissory note.
See "Business--Franchising--Area Developers" and "--International Master
Licensees." When the Company has fulfilled substantially all of its contractual
responsibilities and obligations, such as training, providing manuals, and, in
the case of master licensees, reasonable efforts to obtain trademark
registration, the Company recognizes as revenue the cash portion of the fee and
the value of the promissory note, as determined by an independent third party
valuation.

    Restaurant sales are reported from Company-owned stores, and declined from
1991 to 1994 as a result of the Company's strategy adopted in 1991 to develop
only franchised stores. The number of Company-owned stores declined from 22 at
December 31, 1990 to only two stores at December 31, 1995. However, restaurant
sales increased significantly in 1996 because the Company's flagship restaurant
in Austin, Texas was in operation the entire year, having opened in late 1995,
and because two additional stores were acquired from franchisees during 1996.
Currently, Company stores are operated primarily for product development,
concept refinement and provision of training to franchisees. Accordingly,
management does not believe that the operating costs of sales for Company-owned
stores is indicative of costs for franchised stores on a system-wide basis.
Restaurant sales were not a significant component of revenue from 1992 through
1995, but contribute more significantly to revenue now that the flagship
restaurant is fully operational.

    Other fees and revenue are generated from private label license fees and the
Turnkey Program. The Company has licensed manufacturers to produce Schlotzsky's
private label supplies and began receiving licensing fees from sales of private
label foods to franchisees in late 1994. The Company believes that private label
license fees will increase as system-wide sales grow. See "Business--Purchasing;
Private Labeling." Turnkey Program revenue consists of fees earned upon the sale
of real estate developed by the Company. The Company expects to receive fees
ranging from approximately $20,000 to $60,000 per Turnkey Program transaction in
addition to rental revenue where operations begin at completed sites prior to
the completion of the sales to third parties. Turnkey Program revenue was not
significant prior to December 31, 1995.

    General and administrative overhead expenses consist of salaries, benefits
and other overhead expenses. These expenses also include commissions, such as
those previously paid to Deli Marketing, Inc. and certain officers of the
Company. In 1993 and 1994, the Company invested cash flow from developer fees in
new financial and information systems and new administrative and executive
personnel to establish the operating systems and management infrastructure that
management believes is necessary to service the growing Schlotzsky's system.

                                       18
<PAGE>
    The following table sets forth (i) the percentage relationship to total
revenue of the listed items included in the Company's consolidated statements of
operations, except as otherwise indicated, and (ii) selected store data.

<TABLE>
<CAPTION>
                                                                                 FISCAL YEAR ENDED DECEMBER 31,
                                                                               ----------------------------------
                                                                                  1994        1995        1996
                                                                               ----------  ----------  ----------
<S>                                                                            <C>         <C>         <C>
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Revenue:
    Royalties................................................................        50.1%       57.8%       51.9%
    Franchise fees...........................................................        11.0        11.6         8.6
    Developer fees...........................................................        30.0        20.7         9.6
    Restaurant sales.........................................................         4.6         4.0        17.4
    Brand contribution.......................................................         1.6         3.1         6.3
    Turnkey development......................................................      --              .3         3.5
    Other fees and revenues..................................................         2.7         2.5         2.7
                                                                               ----------  ----------  ----------
      Total revenue..........................................................       100.0       100.0       100.0
Cost and expenses:
  Service Cost
    Royalty service costs(1).................................................        24.1        32.4        35.3
    Franchise fee development costs(2).......................................        64.9        51.3        54.0
  Restaurant operations
    Cost of sales(3).........................................................        43.9        37.3        32.8
    Labor costs(3)...........................................................        35.9        80.8        39.5
    Operating expenses(3)....................................................        60.7        49.7        28.8
  General and administrative.................................................        45.1        44.8        33.9
  Depreciation and amortization..............................................         4.0         3.6         3.8
      Total costs and expenses...............................................        74.7        79.6        78.2
                                                                               ----------  ----------  ----------
    Income (loss) from operations............................................        25.3        20.4        21.8
                                                                               ----------  ----------  ----------
Other:
    Interest income (expense), net...........................................       (2.2)       (1.2)         2.2
    Other income (expense)...................................................         2.4         1.1         0.6
                                                                               ----------  ----------  ----------
      Total other income (expense)...........................................         0.2       (0.1)         2.8
                                                                               ----------  ----------  ----------
    Income before income taxes and extraordinary gain........................        25.5        20.3        24.6
    Provision for federal and state income taxes.............................        10.0         7.9         9.2
    Gain on extinguishment of debt, net of tax...............................         0.5          .3      --
    Net income (loss)........................................................        16.0%       12.7%       15.4%
                                                                               ----------  ----------  ----------
                                                                               ----------  ----------  ----------
STORE DATA:
System-wide sales(4).........................................................  $   97,685  $  142,500  $  202,400
Change in same store sales(5)................................................         6.5%        1.7%        3.3%
Average annual store sales(6)................................................  $  317,000  $  368,000  $  410,000
Weighted average weekly store sales(7).......................................  $    6,276  $    7,086  $    7,867
Change in average weekly store sales(8)......................................        13.9%       12.9%       11.0%
Number of stores open during period..........................................          85         120         135
Number of stores closed during period........................................           9          10          25
Number of stores in operation at end of period...............................         353         463         573
</TABLE>

------------------------

(1) Expressed as a percentage of royalties.

(2) Expressed as a percentage of franchise fees.

(3) Expressed as a percentage of restaurant sales.

                                       19
<PAGE>
(4) In thousands. Includes sales for all stores, as reported by franchisees or
    derived by the Company from other data reported by franchisees, expressed in
    thousands of dollars.

(5) Same store sales are based upon stores which were open for the entire period
    indicated and for at least 18 months as of the end of the corresponding
    prior period.

(6) In actual dollars (rounded in the case of average annual store sales).

(7) Percentage change in weighted average weekly store sales from previous
    fiscal year.

RESULTS OF OPERATIONS

FISCAL YEAR 1996 COMPARED TO 1995

    REVENUE.  Total revenue increased 61.2% from $12,852,000 to $20,714,000.
Royalties and franchise fees increased 44.7% and 18.8% respectively, from
$7,425,000 to $10,747,000 and $1,494,000 to $1,775,000. These increases were
primarily due to the increased number of stores opened during the period as well
as the stronger sales volume of the newer stores. There were 135 store openings
in 1996 compared to 120 openings in 1995. Also, average annualized volumes for
stores opened in 1995 was $480,000 compared to $591,000 for stores opened in
1996.

    Developer income decreased by 25.2% from $2,666,000 to $1,993,000 and
decreased as a percentage of revenue from 20.7% to 9.6%. This trend reflects the
Company's transition from one-time nonrecurring transactions to a revenue stream
driven principally by royalties and franchise fees.

    During 1996, four territorial agreements were executed for 12 foreign
territories. In addition, six area developer agreements were executed for
domestic territories where the prior area development agreement had been
terminated due to failure to comply with the terms of the agreement or where the
Company bought back the development rights and subsequently resold the rights to
new area developers.

    Restaurant sales increased from $506,000 to $3,610,000. Fiscal year 1996 was
the first full year of operations for the Company's flagship store in Austin,
Texas which opened in late 1995, and the Company operated two stores purchased
from franchisees during the second quarter of 1996. It is the Company's
intention to re-market the units acquired from franchisees, probably after 1997,
once operations and profitability are improved at those stores.

    Private label licensing fees increased 226.1% from $397,000 to $1,295,000
because of an increase in the volume of these products purchased by franchisees
and the re-negotiated terms of two contracts from major suppliers.

    Turnkey development fees rose from $41,000 to $726,000 in 1996 (of which
$364,000 was rental revenue for periods of operations prior to the sales of the
sites). The completion of sixteen Turnkey sites and the sale of ten of these
sites accounted for the increase in the current year.

    Other fees and revenues increased 75.3% from $324,000 to $568,000 due
primarily to an increase in the overhead recovery from the Company's national
advertising fund and other nonrecurring miscellaneous fees.

    COSTS AND EXPENSES.  Royalty service costs increased 57.6% from $2,405,000
to $3,791,000. This increase was a result of the growth in royalty revenue and
the increasing percentage of Schlotzsky's restaurants under the area developer
program for the twelve months ended December 31, 1996, as compared to the same
period in the prior year. Likewise, royalty service costs as a percentage of
royalties increased from 32.4% to 35.3%.

    Franchise fee development costs increased 25.0% from $767,000 to $959,000.
This increase was a result of the number of stores opened during the period.

                                       20
<PAGE>
    Restaurant cost of sales, which consists of food, beverage and paper costs,
increased 526.9% from $189,000 to $1,183,000. This increase reflects the impact
of full-year operations at the Company's flagship store which opened in Austin,
Texas in November 1995, and the operation of two stores acquired from
franchisees in the second quarter of 1996. The Company expects these costs to
increase only slightly in 1997 as expenses level off at the flagship store,
subject to opportunities to acquire, operate and improve other franchisee stores
that are not performing well. It is contemplated that the Company would
re-market such stores after improvements are made.

    Restaurant labor cost and operating expenses also reflect the impact of
full-year operations at the Company's flagship store and the addition of the two
former franchisee restaurants now being operated by the Company. Labor costs
increased 248.6% from $409,000 to $1,424,000. Additionally, restaurant operating
expenses grew 314.2% from $251,000 to $1,040,000 for the twelve months ended
December 31, 1996. Due to the training and product development performed at the
flagship store, the Company does not anticipate these costs to be indicative of
those of a franchised restaurant.

    General and administrative expenses increased 22.2% from $5,751,000 to
$7,027,000. This increase was primarily due to the addition of staff at the
corporate office, the strengthening of reserves for certain receivables, and
other administrative costs. In addition, a one-time expense related to the
exercise of certain stock options by a former employee was incurred in the
second quarter of 1996.

    Depreciation and amortization increased 70.2% from $458,000 to $779,000. The
increase was primarily due to first time depreciation of improvements and
equipment at the Company's flagship store and the two additional stores acquired
from franchisees during the second quarter of 1996. Amortization of pre-opening
costs for the flagship store and the royalty value related to remarketing the
two newly acquired stores were the primary factors contributing to an increase
in amortization expense.

    OTHER.  A portion of the proceeds from the Company's initial public offering
was used to retire debt, with a portion invested in short-term liquid
securities. As a result, net interest income was $455,000 for 1996, a $604,000
improvement from the net interest expense incurred during 1995.

    INCOME TAX EXPENSES.  Income tax expense for the year reflects a combined
federal and state effective tax rate of 37.3% in 1996 compared to the prior
year's rate of 38.9%. Current year expense is down slightly as a percentage due
to an expense amount in 1995 from prior years. Based on projections of taxable
income, the Company anticipates that its effective combined tax rate will be
approximately 37% to 38%.

FISCAL YEAR 1995 COMPARED TO 1994

    The comparison of fiscal 1995 to 1994 has been revised to reflect the more
detailed revenue line items now separately disclosed on the Company's income
statements. Total revenue and net income remain unchanged, but more specific
types of revenue are compared for consistency with the comparison of fiscal 1996
to 1995.

    REVENUE.  Total revenue increased 38.1% from $9,303,000 to $12,852,000.
Royalties and franchise fees increased 59.4% and 46.5% respectively, from
$4,657,000 and $1,019,000 to $7,425,000 and $1,494,000 largely due to an
increase in stores open at period end from 353 to 463. In addition, royalties
increased because of higher volumes experienced at new stores.

    Developer income decreased from $2,793,000 to $2,666,000 and decreased as a
percentage of revenue from 30% to 21%, reflecting the decreasing contribution of
transactional revenue, primarily as the result of growing royalty revenue.

    During 1995, 11 master license agreements were executed for 25 foreign
territories and two area development agreements were executed. The developer
receivables were discounted by an aggregate of approximately $190,000 reflecting
a third party's valuation of certain notes and obligations not yet

                                       21
<PAGE>
performed by the Company. As the Company's duties and obligations were completed
during 1996, the Company recognized these developer fees.

    Restaurant sales increased 18.0% from $428,000 to $506,000. The change was
due to the opening of the Company's flagship store in Austin, Texas in November
of 1995.

    Private label licensing fees increased 164.7% from $150,000 to $397,000. The
private label licensing program was initiated at the end of 1994 and this change
is reflective of the effect of the program for a full year in 1995.

    Turnkey development fees of $41,000 were generated in 1995 as this program
began. No such fees were generated in 1994. Other fees and revenue increased
26.6% from $256,000 to $324,000 primarily from an increase in the overhead
recovery from the Company's national advertising fund.

    COSTS AND EXPENSES.  Royalty service costs increased $1,283,000 during 1995
compared to 1994 because of the increased royalty base. This represented an
increase as a percentage of royalties from 24.1% to 32.4%, reflecting an
increasing proportion of new store openings in area developer territories.
Franchise fee development costs increased 16.4% from $661,000 to $767,000
because of fees paid to area developers for stores opened in their territories,
but declined from 64.8% to 51.3% as a percentage of franchise fees. This
reduction reflected a return to more typical arrangements with area developers
compared to the 1994 period when several stores were opened in territories where
area developers received 100% of a limited number of the initial franchise fees
paid in their territories.

    Restaurant cost of sales increased only 0.5% from $188,000 to $189,000. This
increase reflects the operational impact of the Company's flagship store in
Austin, Texas, which opened in November 1995, but was offset somewhat by the
disposition of a Company-owned restaurant in Houston, Texas that was operated
during most of 1994.

    Restaurant labor cost and operating expenses also reflect the impact of
operations at the Company's flagship store. Labor costs increased 165.8% from
$154,000 to $409,000 primarily because of operations at the flagship store where
much of the staff was added several months prior to opening. Restaurant
operating expenses decreased 3.6% from $260,000 to $251,000 for 1995.

    General and administrative expenses increased 37.0% from $4,199,000 to
$5,751,000, reflecting increased executive and managerial staff expense and
increased costs associated with new financial and information systems and
franchisee and area developer manuals, as well as opening costs for the
Company's flagship store in Austin, Texas. Because costs associated with
developer fees are substantially lower than costs associated with royalties and
franchise fees and because there were significantly more developer fees in 1994
compared to 1995, operating income margins were lower for 1995.

    OTHER.  Interest expense decreased because outstanding indebtedness in 1994
was repaid with the proceeds of the private placement of Class B Preferred
Stock. Other income was not material for either period. The Company expects
interest expense to continue to be a small percentage of revenue as the proceeds
of the Company's initial public offering were used to repay $6,027,000 of
outstanding indebtedness.

    INCOME TAXES.  Federal income tax expense together with the Texas franchise
tax increased from $927,000 to $1,017,000 due to higher earnings. The effective
tax rate was 39% for both years.

    EXTRAORDINARY ITEMS.  In 1995 and 1994, the Company retired certain debt
before it became due resulting in recognition of income.

                                       22
<PAGE>
LIQUIDITY AND CAPITAL RESOURCES

    The Company's financial position remained strong in 1996 as a continuing
result of its initial public offering in December 1995. Proceeds from the
offering funded the operations of the Turnkey Program and allowed proceeds from
those operations to be invested in money market accounts.

    The Company's financial position improved significantly as the result of its
initial public offering of Common Stock on December 15, 1995. The Company sold
1,850,000 shares of the total 2,250,000 shares offered to the public at a per
share price of $11. After expenses associated with the offering, the Company
generated cash proceeds of $17,594,000. The Company applied $6,027,000 of the
cash proceeds to retire outstanding obligations and $6,500,000 has been used to
fund operations of the Turnkey Program. The remaining proceeds have been
invested in money market accounts and will be used to fund operations, including
the Turnkey Program.

    As a result of the Company's initial public offering, its working capital
ratio has improved from 1.57 at December 31, 1994 to 6.98 at December 31, 1995
and 4.56 at December 31, 1996 while its debt to equity ratio has fallen from 9.3
at December 31, 1994 to .13 at December 31, 1995 and .11 at December 31, 1996.

    Prior to the initial public offering, the Company financed its business
activities primarily with the proceeds of long-term debt, the sale of preferred
stock and funds generated from operating activities.

    Net cash provided by operating activities increased from $2,012,000 in 1995
to $3,216,000 in 1996. Net cash provided by operating activities in 1994 was
$6,200. The net cash used in investing activities increased from $8,136,000 to
$9,630,000 in 1996, due primarily to the re-acquisition of several domestic
development territories. The acquisition of these intangibles, along with the
purchase of two restaurants from franchisees, was a cash use of approximately
$1,912,000. Additionally, the Company invested $300,000 to acquire a preferred
equity interest in a Master Licensee. Investing activities attributable to notes
receivable and the collection of payments did not change significantly from 1995
to 1996.

    In 1996, financing activities used net cash of $292,000. The Company retired
debt of approximately $915,000 during the period. In connection with the
purchases of two restaurants and the development rights to several territories,
the Company issued $584,000 of notes payable and long-term debt.

    During 1995, financing activities provided net cash of $17,416,000. In
addition to the initial public offering discussed above, financing activities
related primarily to the issuance of debt in connection with the Turnkey Program
and a $500,000 mortgage loan secured by the Company's headquarters. The proceeds
of the mortgage loan were used primarily for working capital. The primary source
of cash during 1994 was the private placement of Class B Preferred Stock in July
1994 in the amount of $3,000,000.

    In November and December 1994, the Company borrowed $663,000 from an
unaffiliated corporation to fund the development of two properties for the
Turnkey Program. This loan bore interest at 9% per annum, was secured by the
properties developed with the proceeds of the loan, was due on demand and was
repaid in December 1995. In April 1995, the Company borrowed $2,000,000 from a
bank to finance the development of eight properties under the Turnkey Program at
the bank's base rate plus 2%. This loan, which was secured by the assignment of
royalties from certain franchisees and by the negative pledge of the Turnkey
Program properties being developed, was repaid in December 1995. During 1995,
the Company violated a covenant under this loan concerning the timely payment of
the 1995 first and second quarterly federal income tax installments. The Company
borrowed $400,000 from an unaffiliated corporation and paid these taxes in
September 1995. This note bore interest at the NationsBank, N.A. prime rate plus
2%, was secured by certain notes receivable, was personally guaranteed by John
Wooley and Jeffrey Wooley and was repaid in December 1995. In July 1995, the
Company borrowed $750,000 from BeneVent-Noro Venture B.V. to fund the
development of three sites for the Turnkey Program at 13% per annum until
December 31, 1995 and at 16% thereafter, until maturity in December 1996. The
borrowing was secured by the properties under development, and was repaid in
December 1995. In October 1995, the Company borrowed $576,000 from a bank to
finance two property acquisitions under the Turnkey Program. This loan

                                       23
<PAGE>
bore interest at the bank's base lending rate plus 2% (12.5% at September 30,
1995), was secured by specific royalties from franchisees and was repaid in
December 1995. Also in October 1995, the Company borrowed $500,000 from a bank
to fund working capital. This loan, which was secured by notes receivable from
developers, bore interest at 9.75% per annum and was repaid in December 1995. In
November 1995, the Company borrowed $245,000 from a bank to finance a property
acquisition under the Turnkey Program. This loan bore interest at 9.75% per
annum, was secured by certain notes receivable and was repaid in December 1995.
The Company used the proceeds of its offering for each of the loans which was
repaid in December 1995.

    The Company expects to have 20 to 30 sites at various stages of development
at any given time when the Turnkey Program is fully implemented. As stores are
completed, the Company intends to sell the properties to third party lessors and
invest the sales proceeds into the next location. However, there can be no
assurance that the Company will be able to sell properties acquired under the
Turnkey Program at a profit or at its cost. See "Business--Turnkey Real Estate
Development Program." Based upon its estimates of the costs associated with
developing Turnkey Program properties, the Company believes that resources
currently available will be adequate to finance the ongoing Turnkey Program in
the near term. During 1996, the Company used net proceeds from its offering to
finance a majority of the development activity under the Turnkey Program. The
Company has also obtained a commitment from a financial institution for a line
of credit of up to $5 million to provide financing for the Program. The Company
believes that proceeds from the sales of the properties as they are developed
over time should be adequate to finance the Turnkey Program at the contemplated
level of development thereafter, although there can be no assurance that this
will be the case.

    In November 1995, the Company obtained permanent financing from a financial
institution for $1,100,000 to finance the Company-owned store in Austin. This
loan is payable monthly, is secured by fixtures and equipment at the store,
bears interest at 9.47% per annum and is due in November 2002.

    Bee Cave/Westbank, Ltd., a limited partnership in which the Company and its
subsidiary, Schlotzsky's Real Estate, Inc., own a combined 40% interest in
capital and profits, obtained an interim loan of $1,150,000 from a bank in
December 1994 to finance the construction of a retail shopping center. The
Company is liable for the full amount of this loan. The loan, which had an
outstanding balance of $1,138,744 on December 31, 1996, was renewed in April
1996 at a rate of prime plus 1.25% and matures April 2001. Monthly payments are
being made by the partnership.

    The Company believes that cash flow from operations, together with the
proceeds of the Turnkey Program, collections from notes receivable and
borrowings under existing credit facilities described above, will be sufficient
to meet the Company's anticipated cash needs through the end of 1997.
Thereafter, the Company believes that new store openings will result in
increasing cash flow from operations which, together with the proceeds of the
Turnkey Program and borrowings under credit facilities, should be sufficient to
meet the Company's anticipated cash needs, although there can be no assurance in
this regard. Substantially all of the Company's royalties have been pledged to
secure Company debt in the past. However, the proceeds of its offering were used
to repay most of these obligations. Accordingly, these assets are available to
secure future financings. The Company guarantees certain leases of its
franchisees for limited periods of time, which may affect its ability to obtain
financing in the future. To the extent that the net proceeds from the Turnkey
Program, credit facilities, and cash flow from operations are insufficient to
finance the Company's future expansion plans, the Company intends to seek
additional funds for this purpose from future debt financings or additional
offerings of equity securities, although there can be no assurance of the
availability of such funds on acceptable terms in the future.

    REAL ESTATE DEVELOPMENT.  The Company has completed 16 properties under the
Turnkey Program during 1996, ten of which were sold during the year, and the
remaining stores are under lease with the franchisees generating rental income.
Twenty-two properties were under various stages of development as of the end of
the period.

                                       24
<PAGE>
    A summary of site development during 1996 is as follows:

<TABLE>
<CAPTION>
                                                               NUMBER OF       INVESTED AT     ESTIMATED TO
                                                                 UNITS      DECEMBER 31, 1996    COMPLETE
                                                             -------------  -----------------  -------------
<S>                                                          <C>            <C>                <C>
Opened and sold............................................           10      $    --          $    --
Opened (receiving rent and royalties)......................            7          4,778,000         --
Under construction.........................................            9          3,432,000        2,421,000
Pre-acquisition............................................           13            160,000        9,840,000
Other......................................................            5          1,573,000         --
                                                                      --
                                                                            -----------------  -------------
    Total..................................................           44      $   9,943,000    $  12,261,000
                                                                      --
                                                                      --
                                                                            -----------------  -------------
                                                                            -----------------  -------------
</TABLE>

    Included in the table above are six properties under option purchase
agreements in which the Company invested $3,976,000 at the end of 1996.
Estimates above are based upon information from third parties and management's
assessment of conditions in existence at the time of this filing. There can be
no assurance that conditions (such as general or regional economic conditions)
will not change significantly, requiring greater investment of resources or a
longer period of time to satisfactorily complete construction or marketing the
properties.

    NEW ACCOUNTING STANDARDS.  In February 1997, the Financial Accounting
Standards Board (FASB) issued SFAS No. 128 "Earnings per Share" and No. 129
"Disclosure of Information About Capital Structure." SFAS No. 128 specifies the
computation, presentation and disclosure requirements for earnings per share and
is designed to improve earnings per share information by simplifying the
existing computational guidelines and revising the previous disclosure
requirements. SFAS No. 129 consolidates the existing disclosure requirements to
disclose certain information about an entity's capital structure. Both
statements are effective for periods ending after December 15, 1997. Management
has not yet determined the impact that SFAS No. 128 will have on earnings per
share, and there are no changes in disclosures associated with adoption of SFAS
No. 129.

QUARTERLY COMPARISONS

    Since the adoption of the Schlotzsky's Deli restaurant concept in 1991, the
Company has experienced growth in royalties and franchise fees. The growth in
franchise fees has been realized sporadically, as store openings have tended to
occur in groups followed by periods of only isolated openings. Store openings
typically mark the recognition of franchise fees and the beginning of the
royalty stream to the Company. Accordingly, a large increase in store openings
has a significant impact on the amount and timing of revenue. The timing of
store openings can also affect the same store sales and other period-to-period
comparisons. Store openings increased from 85 in 1994 to 120 in 1995 and 135 in
1996. At January 1, 1995, the initial franchise fee was increased from $15,000
to $17,500 and was further increased to $20,000 effective July 1, 1995. The net
profitability from developer fees is substantially higher than that derived from
royalties and franchise fees because of the relatively lower costs associated
with developer fees. Therefore, quarters in which the Company derived a high
percentage of total revenue from developer fees reflect substantially higher
margins. While developer fees have been a significant portion of revenue in
various quarters, it is not anticipated that they will continue to be material
after 1996 because most of the attractive developer territories have been sold.
Moreover, the Company anticipates that royalty and other revenue will increase
above historic levels so that developer fees will decline as a percentage of
total revenue, resulting in more normalized margins. Also, the Company believes
turnkey and licensing fees will continue to increase as a percentage of revenue.

    Management believes that the Company experiences only moderate seasonality.
The Company attempts to make store sales less seasonal by offering a variety of
products which tend to sell better during various seasons.

                                       25
<PAGE>
    The following table presents unaudited quarterly results of operations for
the 1994, 1995 and 1996 fiscal years.
<TABLE>
<CAPTION>
FISCAL YEARS                                     1994                                        1995                       1996
                              ------------------------------------------  ------------------------------------------  ---------
QUARTERS                         1ST        2ND        3RD        4TH        1ST        2ND        3RD        4TH        1ST
                              ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
                                                   (DOLLARS IN THOUSANDS EXCEPT PER SHARE AND STORE DATA)
<S>                           <C>        <C>        <C>        <C>        <C>        <C>        <C>        <C>        <C>
Revenues:
Royalties...................  $     998  $   1,167  $   1,221  $   1,271  $   1,476  $   1,858  $   1,961  $   2,130  $   2,245
Franchise fees..............        191        197         75        556        368        390        228        508        348
Developer fees..............        285        806        330      1,372        287        324        260      1,795        595
Restaurant sales............        160        143        108         17         76         80         77        273        566
Brands Contribution.........     --         --            150     --              7        145         65        180        121
Turnkey Development.........     --         --         --         --         --             12         18         12         39
Other fees and revenues.....         39        115         63         39         90        154         38         40        168
                              ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
    Total revenues..........      1,673      2,428      1,947      3,255      2,304      2,963      2,647      4,938      4,082
COSTS AND EXPENSES..........      1,592      1,829      1,651      1,883      2,063      2,567      2,533      3,066      3,261
                              ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
OPERATING INCOME (LOSS).....         81        599        296      1,372        241        396        114      1,872        821
NET INCOME (LOSS)...........  $      32  $     342  $     191  $     920  $     178  $     244  $      58  $   1,152  $     629
                              ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
                              ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
EARNINGS (LOSS) PER
  SHARE(1)..................  $     .01  $     .09  $     .05  $    0.24  $    0.02  $    0.04  $   (0.03) $    0.39  $    0.11
                              ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
                              ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
STORE OPENINGS..............         15         23          6         41         29         27         25         39         28

<CAPTION>
FISCAL YEARS

QUARTERS                         2ND        3RD        4TH
                              ---------  ---------  ---------

<S>                           <C>        <C>        <C>
Revenues:
Royalties...................  $   2,675  $   2,875  $   2,953
Franchise fees..............        475        400        553
Developer fees..............        416        325        657
Restaurant sales............        810      1,061      1,173
Brands Contribution.........        238        511        424
Turnkey Development.........         80        143        463
Other fees and revenues.....        214        123         63
                              ---------  ---------  ---------
    Total revenues..........      4,908      5,438      6,286
COSTS AND EXPENSES..........      3,945      4,240      4,758
                              ---------  ---------  ---------
OPERATING INCOME (LOSS).....        963      1,198      1,528
NET INCOME (LOSS)...........  $     714  $     798  $   1,053
                              ---------  ---------  ---------
                              ---------  ---------  ---------
EARNINGS (LOSS) PER
  SHARE(1)..................  $    0.13  $    0.14  $    0.19
                              ---------  ---------  ---------
                              ---------  ---------  ---------
STORE OPENINGS..............         33         21         43
</TABLE>

------------------------------
(1) Earnings per share in 1994 reflect the per share computation based on the
    weighted average number of shares outstanding in the respective period
    retroactively restated to give effect to the conversion of the Preferred
    Stock, including accrued dividends, into Common Stock.

IMPACT OF INFLATION

    The Company believes that inflation did not have a material impact on its
operations for the periods reported. Significant increases in labor, employee
benefits, food costs and other operating expenses could have a material adverse
effect on franchisees' store operations.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

    Reference is made to the financial statements referred to in the index on
page F-1 setting forth the Consolidated Statements of Schlotzsky's, Inc. and
Subsidiaries, together with the report of Coopers & Lybrand L.L.P. dated
February 28, 1997.

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

    None.

                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

    Information with regard to directors and executive officers and their
business experience is set forth under "Election of Directors" in the
Registrant's definitive Proxy Statement for the Annual Meeting of Shareholders
to be held on May 30, 1997, and is incorporated herein by reference.

ITEM 11. EXECUTIVE COMPENSATION

    Information with regard to executive compensation and pension or similar
plans is set forth under "Compensation of Directors" and "Compensation of
Executive Officers" in the Registrant's definitive Proxy Statement for the
Annual Meeting of Shareholders to be held on May 30 , 1997, and is incorporated
herein by reference.

                                       26
<PAGE>
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

    Information with regard to security ownership of certain beneficial owners
and management is set forth under "Security Ownership of Certain Beneficial
Owners and Management" in the Registrant's definitive Proxy Statement for the
Annual Meeting of Shareholders to be held on May 30, 1997, and is incorporated
herein by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

    Information with regard to certain relationships and related transactions is
set forth under "Election of Directors; Certain Relationships and Related
Transactions," in the Registrant's definitive Proxy Statement for the Annual
Meeting of Shareholders to be held on May 30, 1997, and is incorporated herein
by reference.

                                    PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a)(1) FINANCIAL STATEMENTS. Reference is made to the index on page F-1 for a
       list of all financial statements filed as part of this Report.

(a)(2) FINANCIAL STATEMENTS SCHEDULES. Reference is made to the index on page
       F-1 for a list of all financial statement schedules filed as part of this
       Report.

(a)(3) EXHIBITS

<TABLE>
<S>        <C>        <C>
 3.1*      --         Articles of Incorporation of the Registrant, as amended.

 3.2*      --         Bylaws of the Registrant, as amended.

 4.1*      --         Specimen stock certificate evidencing the Common Stock.

10.1*      --         Form of Unit Franchise Agreement entered into by the Registrant and franchisees.

10.2*      --         Form of Unit Development Agreement entered into by the Registrant and
                        franchisees.

10.3*      --         Form of Area Developer Agreement entered into by the Registrant and area
                        developers.

10.4*      --         Form of Master License Agreement entered into by the Registrant and area
                        developers.

10.5(a)*   --         Form of Territorial Agreement entered into by the Registrant and master
                        licensees.

10.5(b)*   --         Form of Master Development Agreement entered into by the Registrant and master
                        licensees.

10.6*      --         Preferred Stock Repurchase Agreement, dated October 1993, among the Company, John
                        C. Wooley, Jeffrey J. Wooley, and the purchasers of Class A Preferred Stock.

10.7*      --         Preferred Stock Purchase Agreement, dated July 20, 1994, among the Registrant and
                        the purchasers named therein.

10.8*      --         Registration Rights Agreement, dated July 20, 1994, by and between the Registrant
                        and the shareholders named therein.

10.9*      --         Second Amended Agreement among Shareholders, dated July 20, 1994, by and among
                        the Registrant and the Shareholders described therein.

10.10*     --         Loan/Compromise and Settlement Agreement, dated April 7, 1994, between the
                        Federal Deposit Insurance Corporation, as Receiver of Bank of the Hills,
                        Austin, Texas, and the Registrant.

10.11*     --         Promissory Note, dated May 18, 1993, of the Registrant to First State Bank,
                        Austin, Texas in the original principal amount of $381,249.99.
</TABLE>

                                       27
<PAGE>
<TABLE>
<S>        <C>        <C>
10.12(a)*  --         Promissory Note, dated April 15, 1993, of the Registrant to Janet P. Newberger
                        and Lester Baum, as trustees of the 1992 Newberger Family Trust, in the
                        original principal amount of $750,000.

10.12(b)*  --         Promissory Note, dated March 31, 1994, by and between the Registrant and Janet P.
                        Newberger and Lester Baum, co-trustees of the 1992 Newberger Family Trust in
                        the original principal amount of $750,000.00.

10.12(c)*  --         Second Modification Agreement, dated effective December 31, 1994, by and between
                        the Registrant and Janet P. Newberger and Lester Baum, as trustees of the 1992
                        Newberger Family Trust.

10.12(d)*  --         Promissory Note, dated September 6, 1995, of the Registrant to JanMor
                        Corporation, in the original principal amount of $400,000.

10.13*     --         Promissory Note, dated February 1, 1995, of the Registrant to Liberty National
                        Bank, Austin, Texas in the original principal amount $220,000, Security
                        Agreement, dated February 1, 1995 and Guarantee, dated February 1, 1995, by and
                        between John C. Wooley and Liberty National Bank.

10.14*     --         Real Estate Lien Note and Deed of Trust, Security Agreement and Financing
                        Statement, dated March 31, 1995, of the Registrant to Texas Bank, N.A. in the
                        original principal amount of $500,000.

10.15*     --         Promissory Note, dated April 14, 1995, between the Registrant and First State
                        Bank in the original principal amount of $2,000,000.

10.16*     --         Promissory Note and Security Agreement, dated July 15, 1993, of the Registrant to
                        R. M. Wilkin, Inc. in the original principal amount of $450,000.

10.17*     --         Commitment Letter, dated July 7, 1995, by and between AT&T Commercial Finance
                        Corporation and the Registrant in an amount not to exceed $1,100,000.

10.18*     --         Term Sheet, dated July 19, 1995 by and between BeneVent-Noro and the Registrant.

10.19*     --         Promissory Note, dated December 1, 1994, by and between Bee Cave/Westbank, Ltd.
                        and Liberty National Bank in the original principal amount of $1,150,000.

10.20*     --         Loan Commitment, dated July 18, 1995, by and between Manns Capital Corporation
                        and Bee Cave/Westbank, Ltd., and Letter Amendment to Permanent Loan Commitment,
                        dated July 28, 1995.

10.21*     --         Promissory Note, dated August 18, 1995, by and between the Registrant and First
                        State Bank in the original principal amount of $850,000.

10.22*     --         Operating Lease for 218 South Lamar, dated May 27, 1994, by and between William
                        C. Pfluger, et al. and Schlotzsky's Restaurants, Inc.

10.23*     --         Lease Agreement, September 8, 1995, by and between the Registrant and Austin CBD
                        29, Inc.

10.24*     --         Deed of Trust and Real Estate Lien Note, dated December 31, 1993, by and between
                        Schlotzsky's Real Estate, Inc. and Austin CBD Block 29, Ltd.

10.25(a)*  --         Franchise Financing Program Procedures for Qualified Franchisees, dated April 15,
                        1994, by and between Captec Financial Group, Inc. and the Registrant.

10.25(b)*  --         Ultimate Net Loss Agreement, dated April 15, 1994, by and between the Registrant
                        and Captec Financial Group, Inc.

10.25(c)*  --         Amendment to Ultimate Net Loss Agreement, dated March 30, 1995.

10.26(a)*  --         Franchise finance letter of understanding, dated February 21, 1994, by and
                        between Stephens Franchisee Finance and the Registrant.
</TABLE>

                                       28
<PAGE>
<TABLE>
<S>        <C>        <C>
10.26(b)*  --         Franchisee Financing Agreement, dated September 1, 1994, between the Registrant
                        and Stephens Diversified Leasing, Inc.

10.27*     --         Agreement, dated July 1, 1994, by and among Thomas Development Corporation,
                        Micardo, Inc. and the Registrant.

10.28*     --         Earnest Money Contract, dated May 20, 1994, among Schlotzsky's Real Estate, Inc.,
                        William C. Pfluger, et al., Schlotzsky's Restaurants, Inc., the Registrant and
                        John C. Wooley.

10.29*     --         Unsecured Promissory Note, dated June 29, 1993, from John C. Wooley payable to
                        the Registrant in the original principal amount of $280,000.

10.30*     --         Unsecured Promissory Note, dated June 29, 1993, from Jeffrey J. Wooley payable to
                        the Registrant in the original principal amount of $150,000.

10.31*     --         Unsecured Promissory Note, dated January 1, 1993, from John C. Wooley payable to
                        the Registrant in the original principal amount of $319,712.45.

10.32*     --         Unsecured Promissory Note, dated January 1, 1993, from Jeffrey J. Wooley payable
                        to the Registrant in the original principal amount of $76,540.93.

10.33*     --         Unsecured Promissory Note, dated February 6, 1995, from John C. Wooley payable to
                        the Registrant in the original principal amount of $131,000.

10.34*     --         Unsecured Promissory Note, dated February 6, 1995, from Jeffrey J. Wooley payable
                        to the Registrant in the original principal amount of $6,000.

10.35      --         Schlotzsky's, Inc. 1993 Third Amended and Restated Stock Option Plan of the
                        Registrant (filed herewith).

10.36(a)*  --         Employment Agreement, dated January 1, 1994, by and between the Registrant and
                        John C. Wooley.

10.36(b)*  --         Employment Agreement, dated January 1, 1994, by and between the Registrant and
                        Jeffrey J. Wooley.

10.36(c)*  --         Employment Agreement, dated January 1, 1994, by and between the Registrant and
                        Kelly R. Arnold.

10.36(d)*  --         Employment Agreement, dated January 1, 1994, by and between the Registrant and
                        Karl D. Martin.

10.37(a)*  --         Indemnity Agreement, dated June 30, 1993, by and between the Registrant and John
                        C. Wooley.

10.37(b)*  --         Indemnity Agreement, dated June 30, 1993, by and between the Registrant and
                        Jeffrey J. Wooley.

10.38*     --         Form of Indemnification Agreement for Directors and Officers of the Registrant.

10.39*     --         Schlotzsky's 1995 Nonemployee Directors Stock Option Plan, and form of Stock
                        Option Agreement.

10.40*     --         Warrant Certificate, dated March 31, 1994, of the Registrant to William C.
                        Pfluger for 75,000 warrants.

10.41*     --         Confidentiality Agreement, dated December 8, 1989, by and between Bunge Foods
                        Corporation and Schlotzsky's Franchising Limited Partnership.

10.42*     --         Real Estate Lien Note, dated December 31, 1993, from CBD Block 29, Ltd. to
                        Schlotzsky's Real Estate, Inc. in the original principal amount of $302,209.12.

10.43*     --         Promissory Note, dated October 4, 1995, from the Registrant to First State Bank,
                        Austin, Texas in the original principal amount of $576,000.
</TABLE>

                                       29
<PAGE>
<TABLE>
<S>        <C>        <C>
10.44*     --         Promissory Note, dated October 25, 1995, from the Registrant to United Bank &
                        Trust in the original principal amount of $500,000.

10.45*     --         Promissory Note, dated November 1995, from Registrant and Schlotzsky's
                        Restaurants, Inc. to AT&T Commercial Finance Corporation in the original
                        principal amount of $1,100,000.

10.46*     --         Promissory Note, dated November 17, 1995, from Registrant to Comerica Bank--Texas
                        in the original principal amount of $245,000.

11.1       --         Statement Regarding Computation of Per Share Earnings.

21.1*      --         List of subsidiaries of the Registrant.

23.1       --         Consent of Independent Accountants.

25.1*      --         Power of Attorney (contained on the signature page of this Registration
                        Statement).

27         --         Financial Data Schedule
</TABLE>

------------------------

*   An asterisk indicates an exhibit previously filed with the Securities and
    Exchange Commission as an exhibit to the Registrant's Registration Statement
    on Form S-1, Registration No. 33-98004 (the "IPO Registration Statement"),
    such exhibit being incorporated from the exhibits to the IPO Registration
    Statement by reference. Unless otherwise indicated, the number of the
    exhibit is also the number of such exhibit in the IPO Registration
    Statement.

(b) REPORTS ON FORM 8-K

    The following is the date and description of the events reported on Form 8-K
covering events in the fourth quarter of fiscal year 1996: None

                                       30
<PAGE>
                                   SIGNATURES

    Pursuant to the requirements of Section 13 of the Securities Exchange Act of
1934 as amended, the Registrant has duly caused this Report to be signed on its
behalf by the undersigned, thereunto duly authorized.

<TABLE>
<S>                             <C>  <C>
                                SCHLOTZSKY'S, INC.

                                By:              /s/ JOHN C. WOOLEY
                                     -----------------------------------------
                                                  John C. Wooley,
                                        CHAIRMAN OF THE BOARD AND PRESIDENT

                                Date: March 27, 1997
</TABLE>

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

<TABLE>
<CAPTION>
          SIGNATURE                      CAPACITY                  DATE
------------------------------  --------------------------  -------------------

<C>                             <S>                         <C>
      /s/ JOHN C. WOOLEY        Chairman of the Board and
------------------------------    President (Principal        March 27, 1997
        John C. Wooley            Executive Officer)

                                Executive Vice President
  /s/ CHARLES E. HARVEY, JR.      and Chief Financial
------------------------------    Officer (Principal          March 27, 1997
    Charles E. Harvey, Jr.        Financial Officer)

                                Executive Vice President
    /s/ JEFFREY J. WOOLEY         and Chief Financial
------------------------------    Officer (Principal          March 27, 1997
      Jeffrey J. Wooley           Financial Officer)

       /s/ MONICA GILL          Controller, Treasurer
------------------------------    (Principal Accounting       March 27, 1997
         Monica Gill              Officer)

    /s/ JOHN L. HILL, JR.
------------------------------  Director                      March 27, 1997
      John L. Hill, Jr.

    /s/ AZIE TAYLOR MORTON
------------------------------  Director                      March 27, 1997
      Azie Taylor Morton

------------------------------  Director                      March   , 1997
       John M. Rosillo

   /s/ RAYMOND A. RODRIGUEZ
------------------------------  Director                      March 27, 1997
     Raymond A. Rodriguez

------------------------------  Director                      March   , 1997
        Floor Mouthaan
</TABLE>

                                       31
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES
                       CONSOLIDATED FINANCIAL STATEMENTS
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES
                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                                                               PAGE
                                                                                                             ---------
<S>                                                                                                          <C>
Report of Independent Accountants..........................................................................        F-2

Consolidated Financial Statements:

  Consolidated Balance Sheets at December 31, 1995 and 1996................................................        F-3

  Consolidated Statements of Income for the years ended December 31, 1994, 1995 and 1996...................        F-4

  Consolidated Statements of Stockholders' Equity for the years ended December 31, 1994, 1995 and 1996.....        F-5

  Consolidated Statements of Cash Flows for the years ended December 31, 1994, 1995 and 1996...............        F-6

  Notes to Consolidated Financial Statements...............................................................        F-7

Financial Statement Schedule:

  Schedule II--Valuation and Qualifying Accounts...........................................................        S-1
</TABLE>

    All other schedules are omitted as the required information is not
applicable or the information is presented in the consolidated financial
statements, related notes or other schedules.

                                      F-1
<PAGE>
                       REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors

Schlotzsky's, Inc. and Subsidiaries

    We have audited the consolidated financial statements and the financial
statement schedule of Schlotzsky's, Inc. and Subsidiaries listed in the index on
page F-1 of this Form 10-K. These consolidated financial statements and the
financial statement schedule are the responsibility of the Company's management.
Our responsibility is to express an opinion on these consolidated financial
statements and the financial statement schedule based on our audits.

    We conducted our audits in accordance with generally accepted auditing
standards. 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, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Schlotzsky's, Inc. and Subsidiaries as of December 31, 1995 and 1996, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 1996, in conformity with generally
accepted accounting principles. In addition, in our opinion, the financial
statement schedule referred to above, when considered in relation to the basic
consolidated financial statements taken as a whole, presents fairly, in all
material respects, the information required to be included therein.

                                                      [SIGNATURE]

                                          COOPERS & LYBRAND L.L.P.

Austin, Texas
February 28, 1997

                                      F-2
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES
                          CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                                             DECEMBER 31,
                                                                                     ----------------------------
                                                                                         1995           1996
                                                                                     -------------  -------------
<S>                                                                                  <C>            <C>
                                                     ASSETS
Cash and cash equivalents..........................................................  $  12,344,682  $   5,638,958
Restricted certificates of deposit.................................................         78,983         18,000
Royalties receivable...............................................................        304,649        580,470
Other receivables..................................................................        597,536      1,573,483
Prepaid expenses and other assets..................................................        292,880        247,762
Real estate development, current portion...........................................      5,717,049      8,458,301
Notes receivable, current portion..................................................      2,325,965        557,332
Notes receivable from related parties, current portion.............................        221,402        595,000
                                                                                     -------------  -------------
        Total current assets.......................................................     21,883,146     17,669,306

Property, equipment and leasehold improvements, net................................      4,139,619      5,440,882
Real estate development, less current portion......................................       --            2,642,773
Notes receivable, less current portion.............................................      1,474,311      2,656,502
Notes receivable from related parties, less current portion........................        867,687      2,180,456
Investments and advances...........................................................        882,715      1,265,862
Deferred federal income tax asset..................................................        531,870        607,448
Intangible assets, net.............................................................      6,929,019      8,515,883
                                                                                     -------------  -------------
        Total assets...............................................................  $  36,708,367  $  40,979,112
                                                                                     -------------  -------------
                                                                                     -------------  -------------
                                      LIABILITIES AND STOCKHOLDERS' EQUITY

Current maturities of long-term debt...............................................  $     913,915  $     482,205
Accounts payable...................................................................        589,532      1,540,527
Accrued liabilities................................................................      1,010,331      1,851,257
Federal income taxes payable.......................................................        619,382       --
                                                                                     -------------  -------------
        Total current liabilities..................................................      3,133,160      3,873,989

Deferred revenue, net..............................................................      1,572,325      1,663,765
Long-term debt, less current maturities............................................      3,028,517      3,129,337
                                                                                     -------------  -------------
        Total liabilities..........................................................      7,734,002      8,667,091
                                                                                     -------------  -------------
Commitments and contingencies

Stockholders' equity:
  Preferred stock:
    Class C--no par value
      Authorized--1,000,000 shares; issued--none...................................       --             --
  Common stock, no par value, 30,000,000 shares authorized, 5,509,998 and 5,539,922
    issued and outstanding at December 31, 1995 and 1996, respectively.............         43,958         44,257
  Additional paid-in capital.......................................................     26,238,964     26,493,165
  Retained earnings................................................................      2,691,443      5,774,599
                                                                                     -------------  -------------
        Total stockholders' equity.................................................     28,974,365     32,312,021
                                                                                     -------------  -------------
        Total liabilities and stockholders' equity.................................  $  36,708,367  $  40,979,112
                                                                                     -------------  -------------
                                                                                     -------------  -------------
</TABLE>

   The accompanying notes are an integral part of the consolidated financial
                                  statements.

                                      F-3
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES
                       CONSOLIDATED STATEMENTS OF INCOME

<TABLE>
<CAPTION>
                                                                                YEAR ENDED DECEMBER 31,
                                                                       ------------------------------------------
                                                                           1994          1995           1996
                                                                       ------------  -------------  -------------
<S>                                                                    <C>           <C>            <C>
Revenue:
  Royalties..........................................................  $  4,657,010  $   7,424,810  $  10,747,238
  Franchise fees.....................................................     1,019,000      1,493,750      1,775,000
  Developer fees.....................................................     2,792,524      2,665,562      1,992,750
  Restaurant sales...................................................       428,484        505,765      3,610,199
  Brand contribution.................................................       150,000        397,064      1,294,982
  Turn-key development...............................................       --              41,006        725,913
  Other fees and revenue.............................................       255,905        323,708        568,250
                                                                       ------------  -------------  -------------
    Total revenues...................................................     9,302,923     12,851,665     20,714,332
Expenses:
  Service costs:
    Royalties........................................................     1,121,934      2,405,299      3,791,384
    Franchise fees...................................................       660,875        766,625        958,500
  Restaurant operations:
    Cost of sales....................................................       188,341        188,751      1,183,361
    Labor costs......................................................       153,705        408,575      1,424,434
    Operating expenses...............................................       260,213        250,962      1,039,591
  General and administrative.........................................     4,199,023      5,751,154      7,027,258
  Depreciation and amortization......................................       371,702        457,938        779,284
                                                                       ------------  -------------  -------------
    Total expenses...................................................     6,955,793     10,229,304     16,203,812
                                                                       ------------  -------------  -------------
Income from operations...............................................     2,347,130      2,622,361      4,510,520
Other:
  Interest income (expense), net.....................................      (201,097)      (149,151)       454,670
  Other income.......................................................       225,664        137,976        132,075
                                                                       ------------  -------------  -------------
Income before income taxes and extraordinary gain....................     2,371,697      2,611,186      5,097,265
Provision for Federal and state income taxes.........................       927,160      1,016,596      1,902,290
                                                                       ------------  -------------  -------------
Income before extraordinary item.....................................     1,444,537      1,594,590      3,194,975
Gain on extinguishment of debt, net of applicable income taxes of
  $20,676 at December 31, 1994 and $18,271 at December 31, 1995......        40,137         38,307       --
                                                                       ------------  -------------  -------------
    Net income.......................................................     1,484,674      1,632,897      3,194,975
Redeemable preferred stock dividends.................................      (455,000)      (544,274)      --
                                                                       ------------  -------------  -------------
    Net income available to common stockholders......................  $  1,029,674  $   1,088,623  $   3,194,975
                                                                       ------------  -------------  -------------
                                                                       ------------  -------------  -------------
Income per common share--primary:
  Income before extraordinary item...................................  $       0.42  $        0.42  $        0.57
  Extraordinary item.................................................          0.02           0.02       --
                                                                       ------------  -------------  -------------
  Income per common share............................................  $       0.44  $        0.44  $        0.57
                                                                       ------------  -------------  -------------
                                                                       ------------  -------------  -------------
  Weighted average shares outstanding................................     2,341,218      2,451,898      5,639,225
                                                                       ------------  -------------  -------------
                                                                       ------------  -------------  -------------
Income per common share--fully diluted:
  Income before extraordinary item...................................  $       0.41  $        0.41  $        0.57
  Extraordinary item.................................................          0.01           0.01       --
                                                                       ------------  -------------  -------------
  Income per common share............................................  $       0.42  $        0.42  $        0.57
                                                                       ------------  -------------  -------------
                                                                       ------------  -------------  -------------
  Weighted average shares outstanding................................     3,290,410      3,440,643      5,639,225
                                                                       ------------  -------------  -------------
                                                                       ------------  -------------  -------------
</TABLE>

   The accompanying notes are an integral part of the consolidated financial
                                  statements.

                                      F-4
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>
                                                   COMMON STOCK
                                              ----------------------   ADDITIONAL                      TOTAL
                                                SHARES                   PAID-IN       RETAINED    STOCKHOLDERS'
                                              OUTSTANDING   AMOUNT       CAPITAL       EARNINGS       EQUITY
                                              -----------  ---------  -------------  ------------  -------------
<S>                                           <C>          <C>        <C>            <C>           <C>
Balance, January 1, 1994....................   2,187,500   $  10,733  $    --        $    573,146  $     583,879
Redeemable preferred stock dividends........      --          --           --            (455,000)      (455,000)
Net income..................................      --          --           --           1,484,674      1,484,674
                                              -----------  ---------  -------------  ------------  -------------
Balance, December 31, 1994..................   2,187,500      10,733       --           1,602,820      1,613,553
Redeemable preferred stock dividends........      --          --           --            (544,274)      (544,274)
Public sale of stock........................   1,850,000      18,500     17,575,264       --          17,593,764
Conversion of redeemable preferred stock....   1,354,167      13,542      7,964,883       --           7,978,425
Conversion of redeemable preferred stock
  dividends.................................     118,331       1,183        698,817       --             700,000
Net income..................................      --          --           --           1,632,897      1,632,897
                                              -----------  ---------  -------------  ------------  -------------
Balance, December 31, 1995..................   5,509,998      43,958     26,238,964     2,691,443     28,974,365
Options exercised...........................      29,924         299        254,201      (111,819)       142,681
Net income..................................      --          --           --           3,194,975      3,194,975
                                              -----------  ---------  -------------  ------------  -------------
Balance, December 31, 1996..................   5,539,922   $  44,257  $  26,493,165  $  5,774,599  $  32,312,021
                                              -----------  ---------  -------------  ------------  -------------
                                              -----------  ---------  -------------  ------------  -------------
</TABLE>

   The accompanying notes are an integral part of the consolidated financial
                                  statements.

                                      F-5
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                                YEAR ENDED DECEMBER 31,
                                                                      -------------------------------------------
                                                                          1994           1995           1996
                                                                      -------------  -------------  -------------
<S>                                                                   <C>            <C>            <C>
Cash flows from operating activities:
  Net income........................................................  $   1,484,674  $   1,632,897  $   3,194,975
  Adjustments to reconcile net income to net cash provided by (used
    in) operating activities:
    Depreciation and amortization...................................        371,702        454,107        703,533
    Bad debt expense................................................       --             --              187,774
    Gain on extinguishment of debt, net of tax......................        (40,137)       (38,307)      --
    Financed fees...................................................     (1,790,823)    (1,799,750)    (1,785,045)
    Payments received on financed fees..............................        500,373        670,002        829,590
    Non-recurring expense relating to the issuance of stock to a
      non-employee..................................................       --             --              103,791
    Changes in assets and liabilities:
      Accounts receivable...........................................       (386,305)       (32,830)    (1,251,768)
      Prepaid expenses and other assets.............................       (187,468)        70,711         45,118
      Deferred revenue..............................................        113,970        491,270         91,440
      Deferred federal income tax asset.............................        (49,039)      (183,694)       (75,578)
      Accounts payable..............................................       (161,622)       205,723        950,995
      Accrued liabilities...........................................        138,503        541,654        221,544
                                                                      -------------  -------------  -------------
        Net cash provided by (used in) operating activities.........         (6,172)     2,011,783      3,216,369
                                                                      -------------  -------------  -------------
Cash flows from investing activities:
  Expenditures for property and equipment...........................       (270,022)    (1,905,795)    (1,664,363)
  Acquisition of minority interest and intangible assets............       (412,983)    (1,181,369)    (2,227,297)
  Redemption of restricted certificates of deposit..................        277,435         13,582         60,983
  Purchase of restricted certificates of deposit....................       (170,000)      --             --
  Issuance of notes receivable......................................       (169,228)      (590,790)      (603,121)
  Collections on notes receivable...................................        340,432        158,361        235,933
  Acquisition of investments........................................       --              (66,788)       (83,147)
  Advances to limited partnership, stockholders and affiliates......       (794,527)      (258,818)       (45,014)
  Distributions and collections from limited partnership,
    stockholders and affiliates.....................................        530,034        469,748         79,958
  Acquisition of real estate for development and resale.............     (1,088,474)    (4,773,648)    (5,384,025)
                                                                      -------------  -------------  -------------
        Net cash used in investing activities.......................     (1,757,333)    (8,135,517)    (9,630,093)
                                                                      -------------  -------------  -------------
Cash flows from financing activities:
  Sale of stock.....................................................       --           18,925,500       --
  Stock issue costs.................................................       --           (1,331,736)       (51,180)
  Options exercised.................................................       --             --               90,070
  Proceeds from issuance of notes payable and long-term debt........      2,251,197      7,012,174        583,774
  Principal payments on notes payable and long-term debt............     (2,406,823)    (7,065,992)      (914,664)
  Proceeds from issuance of redeemable preferred stock..............      3,000,000       --             --
  Cash dividends on redeemable preferred stock......................       (262,500)      (124,274)      --
                                                                      -------------  -------------  -------------
        Net cash provided by (used in) financing activities.........      2,581,874     17,415,672       (292,000)
                                                                      -------------  -------------  -------------
Net increasee (decrease) in cash and cash equivalents...............        818,369     11,291,938     (6,705,724)
Cash and cash equivalents at beginning of year......................        234,375      1,052,744     12,344,682
                                                                      -------------  -------------  -------------
Cash and cash equivalents at end of year............................  $   1,052,744  $  12,344,682  $   5,638,958
                                                                      -------------  -------------  -------------
                                                                      -------------  -------------  -------------
</TABLE>

   The accompanying notes are an integral part of the consolidated financial
                                  statements.

                                      F-6
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

    BUSINESS

    Schlotzsky's, Inc. and Subsidiaries (the "Company") is a franchisor of quick
service restaurants ("Schlotzsky's" or "Schlotzsky's Deli") that feature
made-to-order sandwiches, which had 573 franchised stores located in 38 states,
the District of Columbia, Argentina, Canada, Germany, Guatemala, Korea, Japan,
Lebanon, Mexico, Sweden, Turkey and the United Kingdom. Approximately 33% of
franchised stores are located in Texas. In addition, the Company has granted
territorial rights to Area Developers located in 49 states and to Master
Licensees in 44 foreign countries for a fee which is typically payable in cash
and notes receivable generally collateralized by the related territorial rights.

    The Company also operates a Turnkey Real Estate Development Program (the
"Turnkey Program") to further assist franchisees in obtaining store sites.

    ORGANIZATION

    The Company's organization includes Schlotzsky's, Inc. (the parent
corporation) and its wholly-owned subsidiaries Schlotzsky's Restaurant, Inc.,
Schlotzsky's Real Estate, Inc., Schlotzsky's Equipment Corporation, Schlotzsky's
Brands, Inc. and DFW Restaurant Transfer Corp.

    During 1996, an additional corporation, 56th and 6th, Inc. was formed in
connection with the purchase of a restaurant located in New York. This
corporation is wholly-owned by Schlotzsky's Restaurant, Inc. Also in 1996,
Schlotzsky's Restaurant, Inc. purchased the remaining interest in 218 Beverage
Corporation and is now the sole shareholder. The purpose of this entity is to
allow for the sale of adult beverages in the Company-owned restaurants.

    PRINCIPLES OF CONSOLIDATION

    The accompanying consolidated financial statements include the accounts of
Schlotzsky's, Inc., a Texas corporation, and its wholly-owned subsidiaries. All
significant intercompany balances and transactions are eliminated in
consolidation.

    USE OF ESTIMATES

    The preparation of financial statements in conformity with generally
accepted accounting principles 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 financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.

    CASH EQUIVALENTS

    Cash equivalents include unrestricted highly liquid investments purchased
with an original maturity date of three months or less. At December 31, 1995 and
1996 cash equivalents totaling approximately $11,553,000 and $1,962,000,
respectively, consisted primarily of money market accounts and overnight
repurchase agreements.

                                      F-7
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
(CONTINUED)
    NOTES RECEIVABLE

    The Company obtains annual valuations of all Area Developer and Master
Licensee promissory notes receivable from an independent financial services
institution. For the year ended December 31, 1995, no valuation allowance was
necessary as the cost basis of each instrument approximated fair value. For the
year ended December 31, 1996, a valuation allowance of approximately $188,000
was established to adjust the cost basis to estimated fair value.

    PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS

    Property, equipment and leasehold improvements are stated at cost, net of
accumulated depreciation and amortization. Expenditures for normal maintenance
of property and equipment are charged against income as incurred. Expenditures
which significantly extend the useful lives of the assets are capitalized. The
costs of assets retired or otherwise disposed of and the related accumulated
depreciation and amortization balances are removed from the accounts and any
resulting gain or loss is included in income. Depreciation and amortization is
calculated using straight-line and accelerated methods over the estimated useful
lives of the assets, or lease term for leasehold improvements if less.

    INVESTMENTS AND ADVANCES

    Investments are stated at the lower of cost or market. Limited partnership
investments are accounted for under the equity method, and accordingly, the
Company's investment is adjusted for allocated profits, losses and
distributions.

    REAL ESTATE DEVELOPMENT

    Under the Turnkey Program, following the identification of a site by the
Company and an area developer, the Company typically purchases or leases the
site, designs and constructs a Schlotzsky's Deli Restaurant on the site which is
then leased or subleased to a franchisee. The Company will typically sell the
improved property and assign its lease to a third-party investor, or in the case
of a leased property, assign the lease and sublease to an investor.

    Real estate development in process is stated at the lower of cost or
estimated net realizable value. Land, site development, building and equipment
costs, including capitalized carrying costs (primarily interest incurred and
property taxes) are accumulated by specific development. Construction costs
incurred in connection with the development of properties are capitalized to
individual projects. Generally, interest incurred and property taxes are
capitalized until the related properties are ready for sale; thereafter, such
costs are charged to expense as incurred.

    During 1995, the Company completed six stores under the Turnkey Program,
five of which were sold and one under contract to be sold as of December 31,
1995.

    During 1996, the Company started and completed 13 stores under its Turnkey
Development Program. In addition, it completed and opened three other stores
started in 1995. Ten of these sites were sold in 1996, and the remainder were
under lease with the franchisees and generating rental income. Another 14
projects were in various stages of development at December 31, 1996.

    Turnkey Development Program properties which management expects to complete
and sell within the next year are classified as current assets.

                                      F-8
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
(CONTINUED)
    INTANGIBLE ASSETS

    Intangible assets consist primarily of the Company's original franchise
rights, royalty values, developer and franchise rights related to the Company's
reacquiring of franchises and developer rights. These assets are amortized over
their estimated useful lives ranging from 4 to 40 years.

    At each balance sheet date, the Company evaluates the propriety of the
carrying amount of its intangible assets, as well as the amortization period for
each intangible. If an indicator of impairment is present, the Company compares
the projected undiscounted operating income for the related business with the
unamortized balance of the related intangible asset. If an imminent loss exists,
management estimates the fair value of the intangible asset based on future
operating cash flows for the next 10 years, discounted at the Company's primary
borrowing rate. The excess of the unamortized balance of the intangible asset
over the fair value, as determined, is charged to impairment loss. At this time,
the Company believes that no impairment of its intangibles has occurred and that
no reduction of the carrying amounts or estimated useful lives is warranted.

    REVENUE RECOGNITION

    Royalties:

    Royalties are paid to the Company by franchisees at 4% to 6% of gross
franchise sales. Royalties are recognized in the period the related gross
franchise sales are earned.

    Franchise Fees:

    Nonrefundable proceeds from the awarding of a franchise are recognized as
revenue when the Company has performed substantially all services for the
franchisee as stipulated in the franchise agreement, typically at store opening.
Franchise fees collected but not yet recognized are recorded, net of deferred
direct incremental expenses, as deferred revenue in the accompanying
consolidated financial statements.

    Developer Fees:

    The Company will convey rights to certain persons, under agreements ("Area
Developer Agreements") to act as an area developer within a specific development
area for a specified term. Developers within the United States ("Area
Developers") locate prospective new franchisees, perform site selection duties
and service the franchisees subsequent to the store opening. The Company charges
the Area Developers a nonrefundable fee for the rights conveyed. The Company
typically collects a portion of the fee in cash at closing of the Area Developer
Agreements, and extends terms on the remainder typically not exceeding three
years.

    International developers ("Master Licensees") have the exclusive right to
develop and license the development and operation of Schlotzsky's Restaurants
using the Company's system and trademarks within the development area. The
rights to develop, operate and sublicense the development and operation of
Schlotzsky's restaurants in the foreign territory are granted pursuant to the
terms and conditions of a Master License Agreement.

    The Company has also entered into Master Development Agreements or
Territorial Agreements (collectively the "Territorial Agreements") which, for a
nonrefundable reservation fee, grants the right to

                                      F-9
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
(CONTINUED)
negotiate exclusive territorial rights to develop Schlotzsky's Restaurants in
the territory, subject to and in accordance with terms and conditions of a
Master License Agreement; however, the right to develop, operate and sublicense
the development and operation of Schlotzsky's Restaurants in the territory is
not granted until the execution of the Master License Agreement. The Territorial
Agreement specifies the desired economic terms and basic form of the Master
License Agreement. The Company requires the Master Licensee to obtain clauses,
covenants and agreements to comply and confirm with the business practices or
laws of the respective territory. The cost of conforming the contract of the
Master License Agreement is the responsibility of Master Licensee. If the
Company cannot reasonably satisfy itself of the enforceability of such clauses,
covenants and agreements within the territory, the Company will not be obligated
to grant a Master License Agreement and any rights granted under the Territorial
Agreements will terminate immediately upon notice by the Company. The Company
ordinarily collects approximately 15% to 35% of cash at closing of either a
Master Development, Territorial Agreement or Master License Agreement, with the
remainder financed typically over a term not exceeding four years, depending on
the credit worthiness of the Maker and Guarantor of the note.

    With respect to Area Developers and Master Licensees, the Company recognizes
as revenue the nonrefundable fees received in cash and the fair value of the
financed portion as established by an independent third party, net of an
appropriate discount for any interest free financed portion, and any incentive
fees due, upon fulfillment of substantially all of its contractual
responsibilities and obligations to the Area Developers and Master Licensees.
For Area Developers, this includes providing manuals and sales offering
materials, which typically coincides with the execution of the Area Developer
Agreement and the receipt of cash and a promissory note. With respect to Master
Licensees, the Company's duties to the Master Licensees include providing
manuals, initial training if requested, and reasonable efforts to obtain
registration of the Company's trademarks in the applicable foreign territories.
Completion of the Company's duties typically coincides with the execution of a
Master Development, Territorial Agreement of Master License Agreement and the
receipt of cash and a promissory note.

    Area Developers and Master Licensees are required to meet certain
performance requirements under their agreements which include minimum store
opening schedules, performance standards and compliance with the terms of their
notes to the Company, if any. Failure to meet these requirements could result in
the Company terminating their agreements.

    In general, the Area Developers and Master Licensees then receive a fee for
recruitment and development, including advertising, soliciting, qualifying and
closing sales as well as consultation and advice in establishment, construction,
financing and opening of restaurants in their territory. Area Developers, in
general, receive a fee equal to one-half of franchise fee paid by franchisees to
the Company. Master Licensees collect the initial sublicense and developer fees
and then remit a portion of these fees back to the Company. The Company expects
to receive approximately one-third to one-half of these fees from the Master
Licensee.

    In addition, Area Developers and Master Licensees receive a portion of the
ongoing royalties from the franchised restaurants for providing service and
support to the franchisees in their development area. Area Developers typically
receive 2.5% out of the 6% ongoing royalties and Master Licensees typically
retain two-thirds of ongoing royalties, remitting one-third to the Company.

                                      F-10
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(CONTINUED)

    Revenue from developer fees represented approximately 30%, 21% and 10% of
the Company's total revenue in 1994, 1995 and 1996, respectively. During these
years, due to the relatively lower costs associated with developer fee revenue,
the Company has relied heavily on such revenue for its operating profits. The
Company anticipates that revenue from developer fees will continue to decline as
almost all of the attractive developer territories have been sold. As such, the
Company will rely on other sources of revenue to cover such costs.

    ROYALTY SERVICE COSTS

    In accordance with the Area Development Agreements, the Company typically
pays Area Developers 2.5% out of the 6% royalties received from franchisees.
Royalty service costs are recognized in the period the related royalties are
recognized.

    FRANCHISE FEE DEVELOPMENT COSTS

    In accordance with the Area Development Agreements, the Company pays Area
Developers approximately one-half of the initial franchise fees collected from
franchise sales in a specified development area. These costs are recognized as
expenses when the Company has performed substantially all services for the
franchisee as stipulated in the franchise agreement, typically at store opening.
Franchise fee development costs paid, but not yet recognized, are recorded as a
reduction of gross deferred revenue in the accompanying financial statements.

    INCOME TAXES

    The Company accounts for its income taxes in accordance with Statement of
Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes,"
under which deferred tax assets or liabilities are computed based on the
difference between the financial statement and income tax bases of assets and
liabilities using the enacted marginal tax rate. Deferred income tax expenses or
credits are based on the changes in the asset or liability from period to
period.

    FAIR VALUE OF FINANCIAL INSTRUMENTS

    The Company's financial instruments as defined by SFAS No. 107, "Disclosures
about Fair Value of Financial Instruments," include cash and cash equivalents,
restricted certificates of deposit, receivables, notes receivable, accounts
payable, accrued liabilities and debt. All financial instruments are accounted
for on a historical cost basis which approximates fair value at December 31,
1995 and 1996, except for notes receivable from Area Developers and Master
Licensees which are valued at the lower of appraised value or cost.

    EARNINGS PER SHARE

    The computation of primary earnings per common share is based upon the
weighted average number of common shares outstanding during the period plus the
effect of common shares contingently issuable, primarily from stock options and
warrants, in periods in which they have a dilutive effect.

    The fully diluted earnings per share computation reflects the effect of
common shares contingently issuable upon the exercise of stock options and
warrants in periods in which such exercise would cause

                                      F-11
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(CONTINUED)
dilution, and for convertible securities assumed converted to common stock in
periods which such conversion would cause dilution.

    In computing income per common share--fully diluted, earnings available to
common stockholders was net of redeemable preferred dividends totaling $105,000
and $340,261 at December 31, 1994 and 1995, respectively. No redeemable
preferred dividends were distributed for the year ended December 31, 1996. See
note on "Stockholders' Equity."

    NEW ACCOUNTING STANDARDS

    In February 1997, the Financial Accounting Standards Board (FASB) issued
SFAS No. 128 "Earnings per Share" and No. 129 "Disclosure of Information About
Capital Structure." SFAS No. 128 specifies the computation, presentation and
disclosure requirements for earnings per share and is designed to improve
earnings per share information by simplifying the existing computational
guidelines and revising the previous disclosure requirements. SFAS No. 129
consolidates the existing disclosure requirements to disclose certain
information about an entity's capital structure. Both statements are effective
for periods ending after December 15, 1997. Management has not yet determined
the impact that SFAS No. 128 will have on earnings per share, and there are no
changes in disclosures associated with adoption of SFAS No. 129.

    RECLASSIFICATIONS

    Certain reclassifications were made to previously reported amounts in the
accompanying consolidated financial statements and notes to make them consistent
with the current presentation format.

    Additionally, the presentation of revenues in the accompanying consolidated
statements of income has been changed to a more detailed format than in previous
years. Due to the increasing levels of revenue being generated by brands
contribution and Turnkey Program activities, these categories have been expanded
to separate line items.

                                      F-12
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

2.  NOTES RECEIVABLE:

    Notes receivable consist of the following:

<TABLE>
<CAPTION>
                                                                           DECEMBER 31,
                                                                    --------------------------
                                                                        1995          1996
                                                                    ------------  ------------
<S>                                                                 <C>           <C>
Notes receivable from Area Developers (under Area Development
 Agreements) and Master Licensees (under Master License and
 Territorial Agreements) bearing interest ranging from 7.5% to 10%
 per annum and where no interest is stated, imputed interest at 9%
 per annum, due through 1998, net of $190,235 and $187,774
 discount for 1995 and 1996, respectively.........................  $  3,279,748  $  2,313,918

Notes receivable from franchisees related to the sale of Company
 owned stores, bearing interest at 8% per annum, collateralized by
 the stores with monthly principal and interest installments
 ranging from $1,723 to $2,428 due through December 2000..........       273,716       257,106

Notes receivable from franchisees bearing interest ranging from
 8.75% to 9.5% per annum, collateralized by franchisees' property
 and equipment with payments due through August 1999..............       --            454,772

Note receivable under private label development program due in
 monthly installments based on franchisee product purchase
 volume...........................................................       103,769         9,763

Notes receivable from others bearing interest ranging from 8% to
 10% per annum, collateralized by an interest in a limited
 partnership and certain other equity instruments with payments
 due through June 2000............................................       143,043       178,275
                                                                    ------------  ------------

                                                                       3,800,276     3,213,834

Current portion...................................................    (2,325,965)     (557,332)
                                                                    ------------  ------------

Notes receivable, less current portion............................  $  1,474,311  $  2,656,502
                                                                    ------------  ------------
                                                                    ------------  ------------
</TABLE>

    During 1995, notes receivable from Area Developer and Master Licensees
totaling approximately $1,122,000 were extended beyond their original terms,
including approximately $462,000 which was due in 1995 and was extended beyond
December 31, 1995.

    During 1996, notes receivable from Area Developers and Master Licensees
totaling approximately $255,000 were extended beyond their original terms,
including approximately $230,000 which was due in 1996 and was extended beyond
December 31, 1996.

                                      F-13
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

3.  NOTES RECEIVABLE FROM RELATED PARTIES:

    Notes receivable from related parties consist of the following:

<TABLE>
<CAPTION>
                                                                           DECEMBER 31,
                                                                    --------------------------
                                                                        1995          1996
                                                                    ------------  ------------
<S>                                                                 <C>           <C>
Note receivable from Master Licensee, an organization of which a
  member of the Company's Board of Directors is Managing Director,
  bearing interest at 9% per annum due through December 1998......  $    350,000  $    275,000

Notes receivable from certain stockholders of the Company, bearing
  interest at 7.5% per annum, principal and accrued interest due
  quarterly through 2001..........................................       242,577       237,618

Notes receivable from related entities controlled by stockholders
  of the Company, bearing interest at 9% per annum, principal and
  accrued interest due annually through 2001 collateralized by
  real estate.....................................................       496,512       541,527

Note receivable from Master Licensee, an organization of which a
  member of the Company's management is a shareholder, bearing
  interest at 8% per annum due through December 2006..............       --            875,000

Notes receivable from Master Licensee, an organization of which
  the Company is a preferred shareholder, bearing interest at 9%
  per annum, principal due ratably beginning December 31, 1998
  through December 31, 2007. (see note on "Related Party
  Transactions")..................................................       --            846,311
                                                                    ------------  ------------

                                                                       1,089,089     2,775,456

Current portion...................................................      (221,402)     (595,000)
                                                                    ------------  ------------

Notes receivable, less current portion............................  $    867,687  $  2,180,456
                                                                    ------------  ------------
                                                                    ------------  ------------
</TABLE>

    During 1996, notes receivable from Master Licensees, certain stockholders
and entities controlled by certain stockholders totaling approximately
$1,625,000 were extended beyond their original terms, including approximately
$540,000, which was due in 1996 and was extended beyond December 31, 1996.

    From time to time, the Company makes advances to certain stockholders,
related partnerships and affiliates (see notes on "Investments and Advances" and
"Related Party Transactions").

                                      F-14
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

4.  PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS:

    Property, equipment and leasehold improvements consist of the following:

<TABLE>
<CAPTION>
                                                      DEPRECIABLE         DECEMBER 31,
                                      DEPRECIATION       LIFE      --------------------------
                                         METHOD         (YEARS)        1995          1996
                                     ---------------  -----------  ------------  ------------
<S>                                  <C>              <C>          <C>           <C>
Building...........................    Straight Line      32       $    720,741  $    720,741
Furniture, fixtures
  and equipment....................    Straight Line    5 to 7        1,036,628     1,684,840
Leasehold
  improvements.....................    Straight Line   25 to 32       2,677,839     3,452,202
                                                                   ------------  ------------
                                                                      4,435,208     5,857,783
Accumulated depreciation and amortization........................      (445,589)     (808,612)
                                                                   ------------  ------------
                                                                      3,989,619     5,049,171
Land.............................................................       150,000       391,711
                                                                   ------------  ------------
Property, equipment and leasehold improvements, net..............  $  4,139,619  $  5,440,882
                                                                   ------------  ------------
                                                                   ------------  ------------
</TABLE>

    Depreciation and amortization of property, equipment and leasehold
improvements totaled approximately $154,000, $169,000 and $363,100 in 1994, 1995
and 1996, respectively.

5.  INVESTMENTS AND ADVANCES:

    Investments and advances consist of the following:

<TABLE>
<CAPTION>
                                                                            DECEMBER 31,
                                                                      ------------------------
                                                                         1995         1996
                                                                      ----------  ------------
<S>                                                                   <C>         <C>
Limited partnership:
  Investment........................................................  $  180,598  $    191,744
  Advances..........................................................     439,046       511,047
                                                                      ----------  ------------
                                                                         619,644       702,791
Building art........................................................     263,071       263,071
Investment in Master Licensee.......................................      --           300,000
                                                                      ----------  ------------
Investments and advances............................................  $  882,715  $  1,265,862
                                                                      ----------  ------------
                                                                      ----------  ------------
</TABLE>

    LIMITED PARTNERSHIP

    The Company owns a 40% general and limited partnership interest in an entity
engaged in the acquisition, development and construction of certain commercial
real estate. The partnership has the following assets, liabilities and partners'
capital:

<TABLE>
<CAPTION>
                                                                           DECEMBER 31,
                                                                    --------------------------
                                                                        1995          1996
                                                                    ------------  ------------
<S>                                                                 <C>           <C>
Assets............................................................  $  2,280,697  $  2,359,498
Liabilities.......................................................     1,648,515     1,699,445
Partners' Capital.................................................       632,182       660,053
</TABLE>

                                      F-15
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

5.  INVESTMENTS AND ADVANCES: (CONTINUED)
    The partnership's net profits, losses and distributions are allocated based
upon methods set forth in the partnership agreement. The Company is allocated
25% of distributions and like amount of net profits until the other limited
partner has received an aggregate amount equal to its aggregate contribution.
Thereafter, remaining net profits and all losses are allocated 40% to the
Company.

    The Company is the guarantor of all partnership indebtedness which consist
of borrowings under a $1,150,000 bank line of credit with an original maturity
date of December 31, 1995 with approximately $1,146,000 and $1,139,000
outstanding at December 31, 1995 and 1996, respectively. Principal and interest
of $10,665 is due monthly until April 2001 whereupon all outstanding principal
and interest is due. The line of credit bears interest at 1.25% above the bank's
prime rate until maturity and after. The indebtedness is collateralized by
project real estate, and related leases and rents. The partnership has entered
into leases for substantially all of the approximately 17,600 square feet of its
retail shopping center for a term of 10 years at approximately $15.00 per square
foot per annum which began in September 1995. The partnership completed the
development of this project in February 1996 and is fully leased and occupied.

    INVESTMENT IN MASTER LICENSEE

    In November 1996, the Company paid $300,000 to a Master Licensee and also
agreed to serve as guarantor of additional financing not to exceed $400,000. At
December 31, 1996, the outstanding balance on the additional financing
guaranteed by the Company was $300,000. See note on "Related Party
Transactions."

6. INTANGIBLE ASSETS:

    Intangible assets consist of the following:

<TABLE>
<CAPTION>
                                                    AMORTIZATION          DECEMBER 31,
                                                       PERIOD     ----------------------------
                                                      (YEARS)         1995           1996
                                                    ------------  -------------  -------------
<S>                                                 <C>           <C>            <C>
Original franchise rights.........................       40       $   5,688,892  $   5,688,892
Royalty value.....................................       20           1,359,576      1,359,576
Developer and franchise rights acquired...........    20 to 40          505,420      1,915,630
Goodwill..........................................       20             254,950        635,082
Debt issue costs..................................    5 to 25           107,328        107,328
Organization costs................................    4 to 10            29,021         29,021
Other intangible assets...........................    up to 5           124,029        260,980
                                                                  -------------  -------------
                                                                      8,069,216      9,996,509
  Less accumulated amortization...................                   (1,140,197)    (1,480,626)
                                                                  -------------  -------------
    Intangible assets, net........................                $   6,929,019  $   8,515,883
                                                                  -------------  -------------
                                                                  -------------  -------------
</TABLE>

    In 1995, the Company reacquired franchises and franchise rights in Omaha,
Nebraska, Albuquerque, New Mexico and Houston, Texas. The franchises acquired in
Albuquerque and two of the four franchises acquired in Omaha, were upgraded to
specification then resold with noncompete areas reduced from a three mile to 3/4
mile radius and royalties increased from 4% to 6% of gross revenues. The excess
of reacquisition and upgrade costs over franchise sale proceeds are reported as
royalty value, amortized into

                                      F-16
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

6. INTANGIBLE ASSETS: (CONTINUED)
income over the 20 year term of the related franchises. The franchise acquired
in Houston was resold in December 1995.

    In 1996, the Company reacquired franchises and developer and franchise
rights in New York and Texas. The purchase price of the New York franchise of
$250,000 exceeded the fair value of the identifiable assets acquired by
approximately $150,000. The purchase price of the Texas franchise of $350,000
exceeded the fair value of the identifiable assets acquired by approximately
$230,000. The franchise acquisitions were accounted for using the purchase
method of accounting and the resulting goodwill is being amortized on a
straight-line basis over 20 years. The developer rights acquired under these
transactions totaled approximately $986,000 and are being amortized on a
straight-line basis over 40 years.

    Amortization of intangible assets totaled approximately $217,000, $285,000
and $340,000 in 1994, 1995 and 1996, respectively.

7. DEFERRED REVENUE:

    Franchise and developer fees collected but not yet recognized into income
less related direct incremental costs paid but not yet charged to expense are as
follows:

<TABLE>
<CAPTION>
                                                                          DECEMBER 31,
                                                                  ----------------------------
                                                                      1995           1996
                                                                  -------------  -------------
<S>                                                               <C>            <C>
Deferred franchise and developer fees...........................  $   3,282,500  $   2,992,500
Deferred direct incremental costs:
  Deferred franchise fee development service costs..............     (1,660,875)    (1,547,125)
  Deferred commissions..........................................        (26,500)       (21,750)
  Other deferred costs..........................................        (22,800)       (23,850)
Deferred revenue--real estate development.......................       --              263,990
                                                                  -------------  -------------
                                                                  $   1,572,325  $   1,663,765
                                                                  -------------  -------------
                                                                  -------------  -------------
</TABLE>

                                      F-17
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

8. LONG-TERM DEBT:

    Long-term debt consists of the following:

<TABLE>
<CAPTION>
                                                                           DECEMBER 31,
                                                                    --------------------------
                                                                        1995          1996
                                                                    ------------  ------------
<S>                                                                 <C>           <C>
Capitalized lease, bearing an effective interest rate of 11.24%,
  collateralized by real property; monthly principal and interest
  installments of $12,615 through 2020............................  $  1,260,780  $  1,250,583
Note payable to a financial institution bearing interest at 9.47%
  per annum through 2000. From 2000 through maturity, the note
  will bear interest at the lesser of a certain bank's prime
  lending rate plus 1.75%, or a mutually agreed upon rate.
  Payments are due in periodic principal and interest installments
  through December 2002, at which time all remaining principal and
  interest is due. The note is collateralized by equipment and
  assignment of royalties from certain franchisees................     1,094,345     1,024,696
Note payable to a bank, bearing interest at 9.25%, collateralized
  by certain real property currently used as Company headquarters.
  Monthly installments of $2,778 plus interest are due through
  March 2002, at which time all remaining principal and interest
  is due..........................................................       474,998       441,663
Various notes payable to individuals and corporations, bearing
  interest at 6% to 9% per annum, due in periodic principal and
  interest installments through 1999, and collateralized by
  equipment and assignment of royalties from certain
  franchisees.....................................................       352,341       694,600
Note payable to a Trust convertible into a maximum 100,000 shares
  common stock, bearing interest at a certain bank's prime lending
  rate plus 1.5% (10% at December 31, 1995) per annum, due in
  periodic principal and interest installments with all unpaid
  principal and interest due September 1998; collateralized by
  royalties from certain franchisees. This note was extinguished
  in February 1996................................................       650,000       --
Note payable to a financing institution bearing interest at 12%
  per annum, due in monthly principal and interest installments of
  $1,435 through December 1996. This note was extinguished in
  January 1996....................................................        99,000       --
Note payable to a limited partnership, bearing interest at 9%. One
  payment of principal and interest totaling $240,168 due January
  1998............................................................       --            200,000
Other.............................................................        10,968       --
                                                                    ------------  ------------
                                                                       3,942,432     3,611,542
  Current maturities..............................................      (913,915)     (482,205)
                                                                    ------------  ------------
    Long-term debt, less current maturities.......................  $  3,028,517  $  3,129,337
                                                                    ------------  ------------
                                                                    ------------  ------------
</TABLE>

                                      F-18
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

8. LONG-TERM DEBT: (CONTINUED)
    The aggregate annual maturities of long-term debt at December 31, 1996 are
as follows:

<TABLE>
<CAPTION>
                                  YEAR ENDING
                                  DECEMBER 31,
                                 -------------
<S>                                                                               <C>
1997............................................................................  $    482,205
1998............................................................................       250,789
1999............................................................................       533,382
2000............................................................................       176,741
2001............................................................................       164,878
Thereafter......................................................................     2,003,547
                                                                                  ------------
                                                                                  $  3,611,542
                                                                                  ------------
                                                                                  ------------
</TABLE>

    Interest expense, net of amounts capitalized, totaled approximately
$389,000, $435,000 and $331,000 in 1994, 1995 and 1996, respectively.

9. INCOME TAXES:

    The provision for federal and state income taxes consists of the following:

<TABLE>
<CAPTION>
                                                                     DECEMBER 31,
                                                        --------------------------------------
                                                           1994         1995          1996
                                                        ----------  ------------  ------------
<S>                                                     <C>         <C>           <C>
Federal:
  Current provision...................................  $  866,498  $  1,136,317  $  1,886,719
  Deferred benefit....................................     (49,039)     (183,694)      (75,578)
                                                        ----------  ------------  ------------
    Total federal.....................................     817,459       952,623     1,811,141
                                                        ----------  ------------  ------------
State--current provision..............................     109,701        63,973        91,149
                                                        ----------  ------------  ------------
Provision for federal and state income taxes before
  extraordinary item..................................     927,160     1,016,596     1,902,290
Tax provision of extraordinary item...................      20,676        18,271       --
                                                        ----------  ------------  ------------
Total provision for income taxes......................  $  947,836  $  1,034,867  $  1,902,290
                                                        ----------  ------------  ------------
                                                        ----------  ------------  ------------
</TABLE>

    The difference between the income tax expense from continuing operations and
the amount that would result if the statutory rates were applied to the pretax
financial income was as follows:

<TABLE>
<CAPTION>
                                                           1994         1995          1996
                                                        ----------  ------------  ------------
<S>                                                     <C>         <C>           <C>
Expense at statutory rate of 34%......................  $  827,053  $    908,342  $  1,733,070
Nondeductible items, including amortization...........      52,755        66,540        86,915
State income taxes, net...............................      68,028        42,222        60,158
Other.................................................      --            17,763        22,147
                                                        ----------  ------------  ------------
                                                        $  947,836  $  1,034,867  $  1,902,290
                                                        ----------  ------------  ------------
                                                        ----------  ------------  ------------
</TABLE>

                                      F-19
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

9. INCOME TAXES: (CONTINUED)

    The tax effects of the significant temporary differences which comprise the
deferred tax assets and liabilities are as follows:

<TABLE>
<CAPTION>
                                                                      DECEMBER 31,
                                                           ----------------------------------
                                                              1994        1995        1996
                                                           ----------  ----------  ----------
<S>                                                        <C>         <C>         <C>
Assets:
  Non-current:
    Deferred revenue.....................................  $  344,815  $  534,590  $  475,924
    Accrued liabilities..................................      --          --         145,451
    Other................................................      24,382      12,910      27,711
                                                           ----------  ----------  ----------
    Gross deferred tax assets............................     369,197     547,500     649,086
                                                           ----------  ----------  ----------
Liabilities:
  Current:
    Deferred costs.......................................      --          15,630      --
    Property, equipment and intangibles..................      --          --          41,638
  Non-current:
    Installment sale.....................................      21,021      --          --
                                                           ----------  ----------  ----------
  Gross deferred tax liabilities.........................      21,021      15,630      41,638
                                                           ----------  ----------  ----------
      Net deferred asset.................................  $  348,176  $  531,870  $  607,448
                                                           ----------  ----------  ----------
                                                           ----------  ----------  ----------
</TABLE>

10. STOCKHOLDERS' EQUITY:

    REDEEMABLE PREFERRED STOCK

    The Preferred Stock was convertible to Common Stock, at the holder's option,
any time prior to redemption, and was also subject to automatic conversion on
similar terms upon the registration and sale of at least $5,000,000 of the
Company's common stock or upon a two thirds vote of Preferred Stockholders.
During December 1995, all of the Company's outstanding shares of preferred stock
were converted in connection with the sale in a public offering of 1,850,000
shares of the Company's Common Stock (See note on "Stockholders' Equity") at a
conversion price of $5.34 and $7.20 for Class A and B, respectively.
Additionally, the Company's amended Articles of Incorporation provide that
subsequent to the conversion, the shares of Class A and Class B Preferred Stock
shall be canceled and shall not again be issuable by the Company. See note on
"Common Stock."

    COMMON STOCK

    In December 1995, the Company sold in a public offering 1,850,000 shares of
its Common Stock (the "Offering") which generated net proceeds of approximately
$17.6 million. A portion of the proceeds were used to repay debt incurred in
connection with the Company's Turnkey Program and other debt owed to banks,
corporations and individuals. The Company used the remaining proceeds to finance
and refinance the purchase of real estate and the construction of stores under
the Turnkey Program and for other working capital needs.

    As previously discussed, the Company's amended Articles of Incorporation
states that the outstanding shares of Class A and Class B Preferred Stock were
converted to common stock in connection with the

                                      F-20
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

10. STOCKHOLDERS' EQUITY: (CONTINUED)
Company's public offering and as a result, these preferred shares have been
canceled. See note on "Redeemable Preferred Stock".

    WARRANTS

    During 1994, the Company issued a warrant to purchase 23,438 shares of
common stock at an initial exercise price of $9.60 per share. The warrant
expires in 2001.

11. STOCK-BASED COMPENSATION PLANS

    The Company sponsors the "Schlotzsky's Employee Compensation and Stock
Options Plan" (the "Plan"), which is a stock-based incentive compensation plan,
as described below. The Company applies Accounting Principles Board ("APB")
Opinion No. 25 and related Interpretations in accounting for the Plan. In 1995,
the FASB issued SFAS No. 123 "Accounting for Stock-Based Compensation" which, if
adopted by the Company, would change the methods the Company applies in
recognizing the cost of the Plan. Adoption of the cost recognition provisions of
SFAS No. 123 is optional and the Company has decided not to elect these
provisions of SFAS No. 123. However, pro forma disclosures as if the Company
adopted the cost recognition provisions of SFAS No. 123 in 1995 are required by
SFAS No. 123 and are presented below.

    THE EMPLOYEE COMPENSATION AND STOCK OPTIONS PLAN

    Under the Plan, the Company is authorized to issue 650,000 shares of Common
Stock pursuant to "Awards" granted in the form of incentive stock options
(qualified under Section 422 of the Internal Revenue Code of 1986, as amended)
and non-qualified stock options. Awards may be granted to key employees of the
Company.

    According to the Plan, Awards may be granted with respect to a maximum of
650,000 shares of Common Stock. In 1994, the Company granted a total of 14,844
Awards in the form of incentive stock options under the Plan. In 1995, the
Company granted a total of 313,814 Awards in the form of incentive stock options
under the Plan. In 1996, the Company granted a total of 82,850 Awards in the
form of incentive stock options under the Plan. Under the Plan, the options
granted on December 12, 1994, vest based on tenure, from the hire date to
December 31, 1993. The vesting is as follows: the formula is 5% of total options
per year of tenure vesting on June 6, 1994 for those with five years of tenure
or more, and the remaining options vest over a five-year period, 20% per year,
beginning on the first anniversary of the date of grant. All other options vest
over a five-year period, 20% per year, beginning on the first anniversary of the
hire date.

                                      F-21
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

11. STOCK-BASED COMPENSATION PLANS (CONTINUED)
    A summary of the status of the Company's stock options as of December 31,
1994, 1995 and 1996 and the changes during the years ended on those dates are
presented below:

<TABLE>
<CAPTION>
                                                                       OPTIONS OUTSTANDING
                                                                   ----------------------------
                                                                              WEIGHTED AVERAGE
                                                                               EXERCISE PRICES
                                                                    SHARES        PER SHARE
                                                                   ---------  -----------------
<S>                                                                <C>        <C>
BALANCE, JANUARY 1, 1994.........................................    350,945      $    7.33

  Granted........................................................     14,844      $    8.00
  Exercised......................................................     --             --
  Forfeited......................................................    (53,125)     $    8.00
  Expired........................................................     --             --
                                                                   ---------

BALANCE, DECEMBER 31, 1994.......................................    312,664      $    7.03
                                                                   ---------

  Granted........................................................    313,814      $   10.39
  Exercised......................................................     --             --
  Forfeited......................................................     (4,688)     $   11.20
  Expired........................................................     --             --
                                                                   ---------

BALANCE, DECEMBER 31, 1995.......................................    621,790      $    8.70
                                                                   ---------

  Granted........................................................     82,850      $   10.50
  Exercised......................................................    (29,924)     $    6.75
  Forfeited......................................................    (78,444)     $    8.05
  Expired........................................................     --             --
                                                                   ---------

BALANCE, DECEMBER 31, 1996.......................................    596,272      $    9.13
                                                                   ---------
                                                                   ---------

Exercisable at December 31, 1994.................................    166,019      $    6.59
Exercisable at December 31, 1995.................................    298,211      $    8.43
Exercisable at December 31, 1996.................................    339,981      $    8.75

Weighted-average fair value of options granted during 1995.......                 $    2.73
Weighted-average fair value of options granted during 1996.......                 $    4.96
</TABLE>

    The fair value of each stock option granted in 1995 and 1996 when the
Company was public is estimated on the date of grant using the Black-Scholes
option-pricing model with the following weighted-average assumptions: no
dividend yield; risk-free interest rate of 6.37%; the expected lives of the
options are six years; and volatility of 37.01%. The fair value of each stock
option granted before the Company became publicly traded was determined using
the following assumptions: no dividend yield; risk-free rates are from 5.83% to
7.81%; and the expected lives of the options are six years. In determining the
"minimum value," SFAS No. 123 does not require the volatility of the Company's
common stock underlying the options to be calculated or considered because the
Company was not publicly-traded when the 1995 options were granted.

                                      F-22
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

11. STOCK-BASED COMPENSATION PLANS (CONTINUED)
    The following table summarizes information about stock options outstanding
at December 31, 1996:

<TABLE>
<CAPTION>
                                        OPTIONS OUTSTANDING                  OPTIONS EXERCISABLE
                            --------------------------------------------  --------------------------
                                NUMBER         WEIGHTED       WEIGHTED       NUMBER       WEIGHTED
                            OUTSTANDING AT      AVERAGE        AVERAGE     EXERCISABLE     AVERAGE
         RANGE OF            DECEMBER 31,      REMAINING      EXERCISE     AT DECEMBER    EXERCISE
     EXERCISE PRICES             1996        CONTRACT LIFE      PRICE       31, 1996        PRICE
--------------------------  --------------  ---------------  -----------  -------------  -----------
<S>                         <C>             <C>              <C>          <C>            <C>
$5.60 to $10.00...........       335,142            3.27      $    7.36        231,194    $    7.07
$10.01 to $12.80..........       261,130            5.94          11.41        108,787        11.08
                                 -------           -----     -----------  -------------  -----------
$5.60 to $12.80...........       596,272            4.44      $    9.13        339,981    $    8.75
</TABLE>

    PRO FORMA NET INCOME AND NET INCOME PER COMMON SHARE

    During 1996 and 1995, the Company did not incur any compensation costs for
the Plan under APB No. 25. Had the compensation cost for the Company's Plan been
determined consistent with SFAS No. 123, the Company's net income and net income
per common share for 1996 and 1995 would approximate the pro forma amounts
below:

<TABLE>
<CAPTION>
                                           DECEMBER 31, 1996           DECEMBER 31, 1995
                                       --------------------------  --------------------------
                                       AS REPORTED    PRO FORMA    AS REPORTED    PRO FORMA
                                       ------------  ------------  ------------  ------------
<S>                                    <C>           <C>           <C>           <C>
SFAS No. 123 charge, net of
  applicable income taxes of $65,414
  and $120,126 for 1996 and 1995,
  respectively.......................  $    --       $    109,959  $    --       $    188,681
APB No. 25 charge....................       --            --            --            --
Net income...........................  $  3,194,975  $  3,085,016  $  1,632,897  $  1,444,216
Net income per common share--
  primary............................  $       0.57  $       0.55  $       0.44  $       0.37
Net income per common share-- fully
  diluted............................  $       0.57  $       0.55  $       0.42  $       0.36
</TABLE>

    The effects of applying SFAS No. 123 in this pro forma disclosure are not
indicative of future amounts. SFAS No. 123 does not apply to awards prior to
1995 and the Company anticipates making awards in the future under its Plan. As
the Company's options typically vest over five years, the full impact of the pro
forma disclosure requirements will not be reflected until 2000.

                                      F-23
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

12. SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:

    Cash paid during 1994, 1995 and 1996 for interest amounted to approximately
$361,000, $435,000 and $313,000, net of approximately $8,500 and $250,000,
capitalized in 1994 and 1995.

    Cash paid for taxes totaled approximately $668,000, $1,145,000 and
$2,614,000 in 1994, 1995 and 1996, respectively.

    During 1994, the Company had the following noncash activity, in addition to
transactions described in other notes:

    Notes receivable totaling approximately $1,791,000 were issued for
    non-refundable Area Developer, Master Licensee, and other fees.

    Note receivable for $300,000 was issued in the sale of certain restaurants
    resulting in a gain of $57,000.

    Mandatory redeemable preferred stock dividends totaling $280,000 at December
    31, 1994 are accrued but not yet paid.

    During 1995, the Company had the following noncash activity:

    Notes receivable totaling approximately $1,800,000 were issued for
    nonrefundable Area Developer, Master Licensee, Territorial and other fees.

    Mandatory redeemable preferred stock, totaling approximately $7,978,000 net
    of issue costs was converted to common stock.

    Mandatory redeemable preferred stock dividends totaling $700,000 were
    converted to common stock.

    During 1996, the Company had the following noncash activity:

    Notes receivable totaling approximately $1,785,000 were issued for
    nonrefundable Area Developer, Master Licensee, Territorial and other fees.

13. RELATED PARTY TRANSACTIONS:

    Franchises contribute 1% of gross sales to Schlotzsky's N.A.M.F., Inc.
("NAMF") to be used solely for the production of programs and materials for
marketing and advertising. The Company charges NAMF an amount equal to certain
cost allocations and salaries for administering NAMF. Advances to NAMF totaled
approximately $130,000 and $87,000 at December 31, 1995 and 1996, respectively,
and are included in other receivables in the accompanying consolidated balance
sheets.

    One or more principal stockholders of the Company is guarantor of the
Company's notes payable and long-term debt, totaling approximately $2,078,000
and $2,983,000 at December 31, 1995 and 1996.

    A member of the Company's Board of Directors controls a corporation that is
an Area Developer to which during 1994 the Company paid approximately $47,000 in
connection with its share of franchise fees and royalties under an Area
Developer agreement. During 1994, the Company received approximately $20,000 in
royalties in connection with this agreement.

    In December 1994, the Company entered into Territorial and Master License
Agreements with Master Licensees pursuant to which the Master Licensees paid the
Company $47,000 in cash and $328,000 by promissory notes for the right to obtain
a master license for the respective territories. The cash was paid to the
Company from the proceeds of one or more loans made to the Master Licensees by
Austin CBD 29,

                                      F-24
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

13. RELATED PARTY TRANSACTIONS: (CONTINUED)
Inc. ("CBD 29"), a corporation controlled by a stockholder of the Company, or
its affiliates. The promissory notes to the Company are guaranteed by the parent
of CBD 29 which has the right to acquire the master licenses for the territories
in the event that the Master Licensees default on the promissory notes. Further,
one of these Master Licensees has the right to elect to sell its master license
to CBD 29 and certain stockholders of the Company have guaranteed CBD 29's
obligations under this put option.

    Also in December 1994, CBD 29 guaranteed a $70,000 promissory note from an
area developer. CBD 29 has the right to acquire the area developer rights for
the area in the event that the area developer defaults on the promissory note.
Further, the area developer has the right to elect to sell its area developer
rights to CBD 29 and certain stockholders of the Company have guaranteed CBD
29's obligations under this put option. In September 1995, the Area Developer
and CBD 29 agreed to waive any further rights and obligations in connection with
this put option and the related guarantee.

    In 1995, the Company entered into a Master License Agreement with Buxtehude
Holdings, B.V., an organization of which a member of the Company's Board of
Directors is managing director. Pursuant to the terms of the agreement,
Buxtehude paid the Company $150,000 in cash and $350,000 by promissory note. The
Company recorded developer revenue totaling $500,000 in 1995 in connection with
this transaction.

    In 1995, the Company entered into an Area Developer Agreement pursuant to
which the Area Developer paid the Company $50,000 in cash and $100,000 by
promissory note. The cash was paid to the Company from one or more loans made to
the Area Developer by CBD 29 or its affiliates. Further, CBD 29 or its
affiliates could obtain a security interest in the rights of the Area Developer
to receive a portion of the royalties paid by certain franchisees and could
acquire these rights in the event of default by the Area Developer.

    Also in 1995, the Company entered into Master License Agreements pursuant to
which the Master Licensees paid the Company $75,000 in cash and $190,000 by
promissory note. The cash paid to the Company from one or more loans made to the
Master Licensee by an organization who is a significant stockholder of the
Company. In addition, one of the members of the Company's Board of Directors is
the managing director of the organization providing the funding to the Master
Licensee.

    Effective January 1, 1996, the majority of assets and liabilities of CBD 29
were transferred and assumed by Third & Colorado 29, L.L.C., and entity owned by
two stockholders of the Company.

    In 1996, the Company entered into a Territorial Agreement pursuant to which
Sino-Caribbean Development, Inc. ("Sino") paid $150,000 in cash and $600,000 by
a promissory note for the right to obtain a master license for certain
territories in the Pacific Rim. In addition, Sino agreed to assume a promissory
note in the amount of $275,000 in exchange for territorial rights under an
existing Master License Agreement. The outstanding balance on the combined notes
was $875,000 at December 31, 1996. Sino is an organization of which an officer
of the Company held 60% of its outstanding common stock at December 31, 1996.
Subsequent to year-end, Sino made note payments of $420,000 to the Company, and
in an unrelated transaction, Sino issued shares of its convertible preferred
stock of which upon conversion, will effectively reduce the officer's interest
in the organization to less than 40%.

    During 1996, the Company paid $300,000 to Bonner Carrington Corporation
European Market ("BCCE") and agreed to serve as guarantor for additional
financing not to exceed $400,000. In return, the Company received: (i) preferred
stock representing 7.5% of the total outstanding shares of BCCE; (ii) an

                                      F-25
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

13. RELATED PARTY TRANSACTIONS: (CONTINUED)
option to buy additional preferred stock representing an additional 10% of the
total outstanding shares of BCCE; and (iii) options to purchase BCCE and its
respective territories at predetermined prices effective during the period
covering December 1999 through December 2011. In a separate transaction in June
1996, the Company entered into a Master License Agreement pursuant to which BCCE
paid the Company $25,000 in cash and $75,000 by promissory note.

14.  COMMITMENTS AND CONTINGENCIES:

    LEASES

    The Company leases office facilities and certain equipment for its stores.
Rent expense for 1994, 1995 and 1996 consisted of approximately $139,000,
$73,000 and $118,000 respectively. Future minimum rental payments under
operating leases that have initial or remaining noncancelable lease terms in
excess of one year as of December 31, 1996 are as follows:

<TABLE>
<CAPTION>
YEAR ENDING DECEMBER 31
--------------------------------------------------------------------------------
<S>                                                                               <C>
1997............................................................................  $    674,419
1998............................................................................       688,788
1999............................................................................       694,288
2000............................................................................       663,117
2001............................................................................       681,503
Thereafter......................................................................     3,340,450
                                                                                  ------------
                                                                                  $  6,742,565
                                                                                  ------------
                                                                                  ------------
</TABLE>

    WORKERS' COMPENSATION

    The Company has elected not to provide workers' compensation insurance to
its employees under the Texas Workers' Compensation Act. This election is called
"non-subscription." Non-subscription may result in potentially large liabilities
through adverse judgements, punitive damages and multiple catastrophe claims.
The measurement of these potential liabilities is complicated by the uncertainty
of legal outcomes. No significant workers' compensation claims were reported
during 1994, 1995 and 1996 and management does not anticipate any material
losses for workers' compensation claims incurred as December 31, 1996.

                                      F-26
<PAGE>
                      SCHLOTZSKY'S, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

14.  COMMITMENTS AND CONTINGENCIES: (CONTINUED)
    GUARANTOR ON FRANCHISE OPERATING LEASES AND DEBT OBLIGATIONS

    The Company, and in some cases certain stockholders are guarantors of
certain franchisee operating leases and debt obligations with future minimum
payments as follows:

<TABLE>
<CAPTION>
YEAR ENDING DECEMBER 31,
-------------------------------------------------------------------------------
<S>                                                                              <C>
1997...........................................................................  $   4,898,891
1998...........................................................................      2,151,918
1999...........................................................................      1,184,368
2000...........................................................................        565,859
2001...........................................................................        408,676
Thereafter.....................................................................        871,470
                                                                                 -------------
                                                                                 $  10,081,182
                                                                                 -------------
                                                                                 -------------
</TABLE>

    GUARANTOR ON FRANCHISE CREDIT FACILITY

    The Company has entered into two credit facilities which provide up to
$15,000,000 and $5,000,000, under each program, in financing to Company
franchisees, whose obligations under which are guaranteed by the Company. At
December 31, 1996, obligations totaling approximately $2,189,000 are outstanding
under these facilities. These amounts are included in the future minimum payment
schedule above.

    LITIGATION

    The Company is a defendant in various lawsuits arising in the ordinary
course of business. Management is of the opinion that all such matters are
without merit or are of such kind, or involve such amounts, as would not have a
significant effect on the financial position, results of operations or cash
flows of the Company if disposed unfavorably. The Company's federal, state and
local tax assessments are periodically subject to review by regulatory agencies.
Management is of the opinion that where such liabilities are estimable, they do
not involve amounts, which significantly exceed existing provisions.

15.  CONCENTRATION OF CREDIT RISK:

    The Company's financial instruments that are exposed to concentrations of
credit risk consist primarily of cash and cash equivalents, notes receivable
from Area Developers and Master Licensees and notes receivable from affiliates.
The Company places its cash and cash equivalents with high credit quality
financial institutions. At December 31, 1995 and 1996, the Company had amount on
deposit in excess of the Federal Deposit Insurance Corporation limitations
totaling approximately $12,259,000 and $4,713,000 respectively. The Company has
not incurred losses related to these deposits and investments.

    The Company grants notes receivable to individuals and licensees who have,
in the opinion of the Company, adequate reserves to repay the notes independent
of the franchise rights. Although the Company has extended terms on certain of
the notes receivable they have not experienced significant credit losses to
date.

                                      F-27
<PAGE>
                                                                     SCHEDULE 11

                               SCHLOTZSKY'S, INC.

                          SUPPLEMENTAL SCHEDULES--10K

                       VALUATION AND QUALIFYING ACCOUNTS

              FOR THE YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996

<TABLE>
<CAPTION>
                                   BALANCE
                                 BEGINNING OF     CHARGED TO COSTS     CHARGED TO                      BALANCE
DESCRIPTION                         PERIOD          AND EXPENSES    OTHER ACCOUNTS(1)  DEDUCTIONS   END OF PERIOD
----------------------------  ------------------  ----------------  -----------------  -----------  -------------
<S>                           <C>                 <C>               <C>                <C>          <C>
Notes Receivable Reserve:
1994........................     $   (270,000)                        $     270,000                  $         0
1995........................                0                              (155,000)                    (155,000)
1996........................         (155,000)          (187,774)                 0                     (342,774)

Deferred Interest
  Income--N/R:
1994........................          (72,437)                              (33,716)                    (106,153)
1995........................         (106,153)                               70,918                      (35,235)
1996........................          (35,235)                               35,235                            0
</TABLE>

------------------------

(1) Reserve for notes receivable was charged directly to Developer Fee Revenue.
    Deferred Interest Income was charged to Interest Income.

                                      S-1