<PAGE>

                                                                   EXHIBIT 10.12


EMPLOYMENT AGREEMENT AND FIRST AMENDMENT BETWEEN THE REGISTRANT AND MARTIN KELLY

     This agreement is dated and made effective the 9th day of August, 1999 (the
"Effective Date") between Martin Kelly ("Executive") and Pyramid Breweries Inc.,
a Washington Corporation ("Company").
<PAGE>

1.   Employment.  Company employs Executive and Executive accepts employment on
     ----------
     the terms and conditions in this agreement.

2.   Duties.  Executive is employed in the capacity of President and Chief
     ------
     Operating Officer. In this capacity, Executive shall have primary
     responsibility for the planning and execution of all brewing, retailing,
     sales and marketing operations. Executive shall report directly to, and
     take direction from, the Company's Chief Executive Officer. Executive shall
     perform the duties customarily performed by a president and chief operating
     officer, provided that Executive's precise duties may be changed, extended
     or curtailed, from time to time, at the Chief Executive Officer's
     direction, and Executive shall assume and perform the further reasonable
     responsibilities and duties so assigned from time to time.

3.   Intensity of Effort; Other Business.  Executive shall devote his entire
     -----------------------------------
     working time, attention, and efforts to Company's business and affairs,
     shall faithfully and diligently serve Company's interests and shall not
     engage in any business or employment activity that is not on Company's
     behalf (whether or not pursued for gain or profit) except for (a)
     activities approved in writing in advance by the Board and (b) passive
     investments that do not involve Executive providing any advice or services
     to the businesses in which the investments are made.

4.   Term.  The term of this agreement is of indefinite duration.  As stated in
     ----
     paragraph 9 below, this agreement and Executive's employment relationship
     may be terminated at any time, with or without cause.

5.   Compensation.  Executive's compensation shall be as follows:
     ------------

     (a)  Executive's salary shall be $7,423.00 payable every two weeks (equal
          to $193,000 on an annualized basis). Payday is the Friday following
          each two-week period. Beginning in the year 2001, Executive's salary
          shall be reviewed on January 1st each year and increased as determined
          in the Chief Executive Officer's sole discretion.

     (b)  Executive will be eligible to receive a personal performance bonus
          each year of up to an additional $30,000 as determined by the Chief
          Executive Officer based upon performance criteria established in the
          Quarterly Bonus Program at his discretion. Executive is eligible for
          the personal performance bonus for any quarter only if Executive
          remains employed by Company at least through the last day of each
          quarter. If Executive's employment ends prior to the last day of a
          quarter, Executive will be ineligible for any portion of the remaining
          personal performance bonus for that year, save that if the Company
          shall terminate employment without cause, Executive shall be eligible
          for a pro-rata portion of that quarter's personal performance bonus.
          The personal performance bonus, if any, shall be paid on or before the
          end of the following quarter.

     (c)  Executive will also be eligible to receive a corporate bonus each year
          of up to an additional $20,000 as determined by the Board of Directors
          Compensation Committee's review of the Company's performance in the
          past year compared to the budget plan for that year. If Executive's
          employment ends prior to December 31, Executive will be ineligible for
          any portion of the corporate performance bonus for that year. The
          corporate performance bonus, if any, shall be paid on or before April
          15 of the following year.

     (d)  Executive shall be eligible for stock options and/or other incentive
          compensation only as stated in Non-Qualified Stock Option Agreements
          between the Company and Executive.

     (e)  Executive shall receive a car allowance of $300 per month, plus
          reimbursement for gas purchased by employee for business use.

6.   Benefit Plans.  Executive (and qualifying immediate family members where
     -------------
     applicable) shall be eligible to participate in the Company's Employee
     Benefit Package offered generally to employees, which currently includes
     health insurance through Blue Cross of Washington, life and AD&D insurance,
     fifty percent (50%) Company-payment of vision and dental, maternity leave,
     health insurance continuation, sick leave, paid vacation, holidays, and
     401(k). The exact terms and
<PAGE>

     conditions of the Company's benefits, including eligibility are governed by
     the benefit plans, not this agreement or any summary provided to Executive.

7.   Vacation and Sick Leave.  Executive shall be entitled to four weeks (20
     -----------------------
     days) of paid vacation and five days of paid sick leave per calendar year
     (prorated if this agreement begins and/or ends in the middle of a calendar
     year). Up to three weeks (15 days) of vacation not used in any calendar
     year may be carried over into the next calendar year; otherwise unused
     vacation is forfeited at the end of the calendar year. Upon termination of
     employment for any reason, Executive shall be paid for earned but unused
     vacation. Sick leave may be accumulated up to a maximum of twenty (20)
     days. Unused sick leave is not paid upon termination of employment,
     regardless of the reason.

8.   Business Expenses.  Executive is authorized to incur reasonable travel and
     -----------------
     entertainment expenses to promote Company's business. Company shall
     reimburse Executive for those expenses. Executive shall provide to Company
     the itemized expense account information that Company reasonably requests.

9.   Termination.  Executive's employment may be terminated as follows; in which
     -----------
     event Executive's compensation and benefits shall terminate except as
     otherwise provided below:

     (a)  Without Cause or Good Reason.  Either party may terminate Executive's
          ---------------------
          employment at any time by giving fourteen (14) calendar days' advance
          written notice of termination to the other without the necessity of
          cause or good reason.

     (b)  By Company for Cause.  Company may terminate Executive's employment
          --------------------
          for cause, without advance written notice of termination, by giving
          written notice of such termination. Any termination of Executive's
          employment for cause must be approved by a majority of the Board other
          than Executive. Executive must be given reasonable advance notice of
          the meeting at which his or her termination is to be considered, and a
          reasonable opportunity to address the Board. For purposes of this
          agreement "cause" means and is limited to dishonesty, fraud,
          commission of a felony or of a crime involving moral turpitude,
          harassment or illegal discrimination of any nature, including sexual
          harassment, destruction, theft, or unauthorized use or distribution of
          Company property or confidential information, fighting with an
          employee or customer or vendor, intoxication at work, use of alcohol
          to an extent that it impairs Executive's performance of his or her
          duties, use of illegal drugs at any time, malfeasance or gross
          negligence in the performance of Executive's duties, violation of law
          in the course of employment, Executive's failure or refusal to perform
          his or her duties, Executive's failure or refusal to follow reasonable
          instructions or directions, misconduct, or any material beach of
          Executive's duties or obligations to Company.

     (c)  Death.  Executive's employment shall terminate automatically upon
          -----
          Executive's death.

     (d)  Permanent Disability.  Company may terminate Executive's employment
          --------------------
          immediately if Executive becomes permanently disabled. For purposes of
          this agreement Executive will be considered "permanently disabled" if,
          for a continuous period of twenty-four (24) weeks or more, Executive
          has been unable to perform the essential functions of the job because
          one or more mental or physical illnesses and/or disabilities, provided
          that Company may grant Executive unpaid leave if and to the extent
          that, in Company's judgment, doing so is required by law.

10.  Termination Payments.
     --------------------

     (a)  Termination Without Cause.
          -------------------------

          (i)       If Company terminates Executive's employment when neither
               cause nor permanent disability exists, Company shall pay
               Executive, as liquidated damages and in lieu of all other
               remedies to which Executive might be entitled arising out of the
               termination, termination payments equal to six month's salary
               plus a pro rata share of any personal performance bonus for
<PAGE>

               which Executive is eligible in the year of termination. For the
               same six-month period, Company shall continue to provide at the
               Company's cost, the Company's medical benefits to employee and
               qualifying family members. Such liquidated damages shall be paid
               only if Executive executes a full and final general release of
               ----
               all claims against Company (including Company's officers,
               directors, agents, employees and assigns) arising out of
               Executive's employment relationship with Company.

          (ii)      In addition, if Company terminates Executive's employment
               when neither cause nor permanent disability exists, but Company
               gives Executive less than the fourteen (14) days' advance written
               notice called for above, Company shall pay Executive, as
               liquidated damages and in lieu of all other remedies to which
               Executive might be entitled arising out of Company's failure to
               give fourteen (14) days' advance written notice, termination
               payments equal to the additional salary Executive would have
               received if Company had given Executive fourteen (14) days'
               advance written notice of termination.

          (iii)     Termination payments shall be paid out at Executive's normal
               payroll rate on regular payroll days subject to normal payroll
               deductions, commencing first with the termination payments called
               for by subpart (ii), if any, followed by the termination payments
               called for by subpart (i). Any reimbursable expenses incurred
               prior to termination will be paid immediately upon termination.

     (b)  All Other Terminations.  In all cases of termination or expiration of
          ---------------------
          this agreement or of Executive's employment (including, but not
          limited to, a termination of Executive by Company for cause of
          Executive's resignation of employment), Executive's compensation and
          benefits shall terminate on the date the employment ends and Executive
          shall not be entitled to any termination payments or damages.

11.  Confidentiality/Unfair Competition.  Executive agrees that Company has many
     ----------------------------------
     substantial, legitimate business interests that can be protected only by
     Executive agreeing not to compete with Company unfairly. These interests
     include, without limitation, Company's contacts and relationships with its
     supply sources, Company's reputation and goodwill in the industry, and
     Company's rights in its confidential information. Executive agrees that
     information not generally known to the public to which Executive has been
     or will be exposed as a result of Executive's employment by Company is
     confidential information that belongs to Company. This includes information
     developed by Executive, alone or with others, or entrusted to Company by
     its supply sources, customers or others. Company's confidential information
     includes, without limitation, information relating to Company's trade
     secrets, know-how, procedures, pricing, products, services, purchasing,
     accounting, marketing, sales, supply sources, employees, and customers and
     active prospects and their related needs. Executive will hold Company's
     confidential information in strict confidence and will not disclose or use
     it except as authorized by Company and for Company's benefit. Executive
     also will not disparage Company or its business or services. Executive will
     not, apart from good faith competition, interfere with Company's
     relationships with its clients, employees, vendors, bankers or others.

12.  Possession of Materials.  Executive agrees that upon conclusion of
     -----------------------
     employment or request by Company, Executive shall turn over to Company all
     documents, files, office supplies and any other material or work product in
     Executive's possession or control that were created pursuant to or derived
     from Executive's services for Company.

13.  Nonraiding of Employees.  Executive recognizes that Company's workforce is
     -----------------------
     a vital part of its business. Therefore, Executive agrees that for twelve
     (12) months after Executive's employment with Company ends, regardless of
     the reason it ends, Executive will not solicit, directly or indirectly, any
     employee to leave his or her employment with Company. For purposes of this
     agreement, the phrase "shall not
<PAGE>

     solicit, directly or indirectly," includes, without limitation, that
     Executive (a) shall not identify any Company employees to any third party
     as potential candidates for employment, such as by disclosing the names,
     backgrounds and qualifications of any Company employees; (b) shall not
     personally or through any other person approach, recruit or otherwise
     solicit employees of Company to work for any other employer; and (c) shall
     not participate in any pre-employment interviews with any person who was
     employed by Company while Executive was employed or retained by Company.

14.  Dispute Resolution.  Company and Executive agree to resolve all disputes
     ------------------
     arising out of their employment relationship by the following alternate
     dispute resolution process: (a) Company and Executive agree to seek a fair
     and prompt negotiated resolution; but if this is not successful, (b) all
     disputes shall be resolved by binding arbitration; provided that during
     this process, (c) at the request of either party, not made later than
     seventy-five (75) days after the initial arbitration demand, the parties
     agree to attempt to resolve any dispute by non-binding third-party
     intervention including either mediation or evaluation or both (but without
     delaying the arbitration hearing date). By entering into this contract,
     both parties give up their right to have the dispute decided in court by a
     judge or jury. The provisions of the Washington arbitration statute,
     Chapter 7.04 RCW, are incorporated herein to the extent not inconsistent
     with the other terms of this agreement.

     (a)  Binding Arbitration.  Any controversy or claim arising out of or
          -------------------
          connected with Executive's employment at Company, including but not
          limited to claims for compensation or severance and claims of wrongful
          termination, age, sex, racial or other discrimination, or civil rights
          violations shall be determined by arbitration commenced in accordance
          with RCW 7.04.060, provided that the total award by a single
          arbitrator (as opposed to a majority of three arbitrators) shall not
          exceed Two Hundred Fifty Thousand Dollars ($250,000). If either party
          asserts in good faith that it is entitled to an award over Two Hundred
          Fifty Thousand Dollars ($250,000), there shall be three (3)
          arbitrators. The location of the arbitration shall be Seattle,
          Washington, or such other city to which the parties may agree. If
          Company and Executive cannot agree on the arbitrator(s), then the
          arbitrator(s) shall be selected by the administrator of the American
          Arbitration Association (AAA) office nearest the city where the
          arbitration is to be conducted. Each arbitrator shall be an attorney
          with at least 15 years' experience in commercial law or judicial
          arbitration experience. All statutes of limitations, which would
          otherwise be applicable, shall apply to any arbitration proceeding
          hereunder. Any issue about whether a controversy or claim is covered
          by this agreement shall be determined by the arbitrator(s).

     (b)  Procedures.  The arbitration shall be conducted in accordance with
          ----------
          this agreement using as appropriate the AAA Employment Dispute
          Resolution Rules in effect on the date hereof. There shall be no
          discovery or dispositive motion practice (such as motions for summary
          judgment or to dismiss or the like) except that the arbitrator(s)
          shall authorize such discovery as may be shown to be necessary to
          ensure a fair hearing, and no such discovery shall extend the time
          limits contained herein. The arbitrator(s) shall not be bound by the
          rules of evidence or of civil procedure, but rather may consider such
          writings and oral presentations as reasonable business people would
          use in the conduct of their day-to-day affairs, and may require both
          parties to submit some or all of their respective cases by written
          declaration or such other manner of presentation as the arbitrator(s)
          may determine to be appropriate. The par-ties agree to limit live
          testimony and cross-examination to the extent necessary to ensure a
          fair hearing on material issues.

     (c)  Hearing; Law; Appeal Limited.  The arbitrator(s) shall take such steps
          ----------------------------
          as may be necessary to hold a private hearing within one hundred
          twenty (120) days of the initial request for arbitration and to
          conclude the hearing within two (2) days; and the arbitrator(s)'s
          written decision shall be made not later than fourteen (14) calendar
          days after the hearing. The parties agree that they have included
          these
<PAGE>

          time limits in order to expedite the proceeding, but they are not
          jurisdictional, and the arbitrator(s) may for good cause allow
          reasonable extensions or delays, which shall not affect the validity
          of the award. The written decision shall contain a brief statement of
          the claim(s) determined and the award made on each claim. In making
          the decision and award the arbitrator(s) shall apply applicable
          substantive law. Absent fraud, collusion or willful misconduct by an
          arbitrator, the award shall be final and judgment may be entered in
          any court having jurisdiction thereof. The arbitrator(s) may award
          injunctive relief or any other remedy available from a judge,
          including the joinder of parties or consolidation of this arbitration
          with any other involving common issues of law or fact or which may
          promote judicial economy, and may award attorneys' fees and costs to
          the prevailing party, but shall not have the power to award attorneys'
          fees and costs to the prevailing party, but shall not have the power
          to award punitive or exemplary damages. The decision and award of the
          arbitrators need not be unanimous; rather, the decision and award of
          two (2) arbitrators shall be final.

     (d)  Injunctive Relief.  In the case of a breach of any of Executive's
          -----------------
          obligations to Company, Company may request a court of competent
          jurisdiction to issue such temporary or interim relief (including
          temporary restraining orders and preliminary injunctions as may be
          appropriate, either before arbitration is commenced or pending the
          outcome of arbitration. No such request shall be a waiver of the right
          to submit any claim or controversy to arbitration. Any issues of law
          or fact, which arise in connection with such request, shall, at
          Company's election, be determined by arbitration in accordance with
          subparagraph (a) through (c) above,

15.  Attorneys' Fees; Venue and Jurisdiction.  In any lawsuit or arbitration
     ---------------------------------------
     arising out of or relating to this agreement or Executive's employment,
     including without limitation arising from any alleged tort or statutory
     violation, the prevailing party shall recover reasonable costs and
     attorneys' fees, including on appeal. Venue and jurisdiction of any lawsuit
     involving this agreement or Executive's employment shall exist exclusively
     in state and federal courts in King County, Washington, unless injunctive
     relief is sought by Company and, in Company's judgment, that relief might
     not be effective unless obtained in some other venue. The provisions of
     this Section are subject to and do not supersede the dispute resolution
     provisions described above.

16.  Governing Law.  This agreement shall be governed by the internal laws of
     -------------
     the state of Washington without giving effect to provisions thereof related
     to choice of laws or conflict of laws.

17.  Saving Provision.  If any part of this agreement is held to be
     ----------------
     unenforceable, it shall not affect any other part. If any part of this
     agreement is held to be unenforceable as written, it shall be enforced to
     the maximum extent allowed by applicable law. The confidentiality,
     possession of materials, non-competition and nonraiding provisions of this
     agreement shall survive after Executive's employment by Company ends,
     regardless of the reason it ends, and shall be enforceable regardless of
     any claim Executive may have against Company.

18.  Waiver.  No waiver of any provision of this agreement shall be valid unless
     ------
     in writing, signed by the party against whom the waiver is sought to be
     enforced. The waiver of any breach of this agreement or failure to enforce
     any provision of this agreement shall not waive any later breach.

19.  Assignment; Successors.  Company may assign its rights and delegate its
     ----------------------
     duties under this agreement.  Executive may not assign his or her rights or
     delegate his or her duties under this agreement.

20.  Binding Effect.  This agreement is binding upon the parties and their
     --------------
     personal representatives, heirs, successors and assigns.

21.  Counterparts.  This agreement may be executed in any number of
     ------------
     counterparts, each of which shall be an original and all of which, taken
     together, shall constitute a single agreement.
<PAGE>

     22.  Complete Agreement.  This agreement, together with the Employee Stock
          ------------------
          Option Agreement dated August 9, 1999, and the offer letter to
          Executive dated June 18, 1999, is the final and complete expression of
          the parties' agreement relating to Executive's employment. Only a
          writing signed by both parties may amend this agreement; it may not be
          amended orally or by course of dealing. The parties are not entering
          into this agreement relying on anything not set out in this agreement.
          This agreement shall control over any contrary policies or procedures
          of Company, whether in effect now or adopted later. Company's policies
          and procedures that do not conflict with this agreement, whether in
          effect now or adopted later, shall apply or not apply to Executive as
          determined by Company in its discretion.

DATED as of the date first written above.



                                         EXECUTIVE: /s/ Martin Kelly
                                                    ----------------



                                         COMPANY:   PYRAMID BREWERIES INC.


                                         By       /s/ GEORGE HANCOCK
                                              ----------------------------
                                         Its: Chief Executive Officer
<PAGE>

                    FIRST AMENDMENT TO EMPLOYMENT AGREEMENT
                BETWEEN MARTIN KELLY AND PYRAMID BREWERIES INC.

2.   Modification.  Pursuant to paragraph 22 of the Employment Agreement dated
     ------------
     August 9, 1999, (the "Original Agreement") between Pyramid Breweries Inc.,
     a Washington corporation ("Company"), and Martin Kelly ("Executive")
     requiring a writing signed by both parties to amend the Original Agreement,
     effective this 16th day of February, 2000 (the "Effective Date"), Executive
     and Company hereby agree to rescind in its entirety paragraph 5 of the
     Original Agreement and replace the same with the following:

               "5.  Compensation.  Executive's compensation will be as follows:
                    ------------

     (a)  Salary.  From December 9, 1999 through December 31, 2000, Company will
          ------
          pay Executive a base salary in the gross amount of $8,076.92, less
          authorized and required deductions, payable every two weeks (equal to
          the gross amount of $210,000.00 on an annualized basis). Payday is the
          Friday following each two-week period. Beginning in the year 2001,
          Executive's salary will be reviewed January 1st each year and adjusted
          as determined in the sole discretion of the Chairman of the Board of
          Directors ("Chairman") and the Board of Directors Compensation
          Committee ("Compensation Committee").

     (b)  Stock Options.  Company grants Executive the option to purchase 50,000
          -------------
          shares of Company at a price equal to the average closing price of all
          trading days from December 16, 1999, to December 31, 1999, in
          accordance with the terms and conditions of the Fast Forward Program
          and the Parties' January 3, 2000 Non-Qualified Stock Option Agreement,
          copies of each of which are attached hereto and incorporated herein by
          reference.

     (c)  Year 2000 Incentive Compensation.
          --------------------------------

          (1)  Annual EBITDA Bonuses.  If, during the period January 1, 2000
               ---------------------
               through December 31, 2000, Executive achieves Company's Earnings
               Before Interest Taxes Depreciation and Amortization ("EBITDA")
               goal set forth in Company's Year 2000 Business Plan (the "Plan"),
               a copy of which is attached hereto and incorporated herein by
               reference, Company will pay Executive a one-time, lump sum EBITDA
               Bonus in the gross amount of $25,000.00, less authorized and
               required deductions. Further, if, during the same period, the
               actual EBITDA results exceed Company's EBITDA budget by at least
               10%, Company will pay Executive an additional one-time, lump sum
               EBITDA Bonus in the gross amount of $21,000.00 (10% of base
               salary), less authorized and required deductions. Further,
               Company will pay Executive an additional lump sum EBITDA Bonus in
               the gross amount of $2,100, less authorized and required
               deductions, for each additional one percent (I%) that the actual
               EBITDA results exceed Company's EBITDA budget during the same
               period by greater than ten percent (10%).

          (2)  Annual Consolidated Net Sales Bonus.  If, during the period
               -----------------------------------
               January 1, 2000 through December 31, 2000, Executive achieves
               Company's Consolidated Net Sales goal set forth in the Plan,
               Company will pay Executive a one-time, lump sum Consolidated Net
               Sales Bonus in the gross amount of $12,500.00, less authorized
               and required deductions.

          (3)  Quarterly Project Bonuses.
               -------------------------

               (i)       First Quarter.  If, prior to the end of the first
                         -------------
                    quarter of 2000, Executive performs, and presents to the
                    Board of Directors ("Board") in a form to be determined by
                    the Chairman and the Compensation Committee, a strategic
                    analysis with recommendations exploring and evaluating
                    whether Company's Alehouse Division should expand to
                    additional markets to support deeper penetration by
                    Company's core beer and soda business, Company will pay
                    Executive a one-time, lump sum Project Bonus in the gross
                    amount of $6,250.00, less authorized and required
                    deductions.

               (ii)      Second Quarter.  If, prior to the end of the second
                         --------------
                    quarter of 2000, Executive performs, and presents to the
                    Board in a form to be determined by the Chairman and the
                    Compensation Committee, a strategic analysis with
                    recommendations exploring and evaluating whether new beer
                    and soda brand acquisitions will expand Company's current
                    revenue and profit base at a faster rate than organic growth
                    alone, Company will pay Executive a one-time, lump sum
                    Project Bonus in the gross amount of $6,250.00, less
                    authorized and required deductions.

          (4)  Eligibility and Payment.  If Executive's employment ends prior to
               -----------------------
               December 31, 2000, in the event of any annual bonus, or the last
               day of the quarter in the event of any quarterly bonus,
<PAGE>

               Executive will be ineligible for any portion of that bonus;
               provided, however, that if Company terminates Executive's
               employment without cause, Company will pay Executive a pro-rata
               share of that bonus. Quarterly bonuses, if any, will be paid on
               or before the last day of the following quarter, and annual
               bonuses, if any, will be paid on or before April 15, 2001.

     (d)  Car Allowance.  Executive shall receive a car allowance of $300 per
          -------------
          month in addition to reimbursement for gas purchased by Executive for
          business use."

3.   Full Effect of Remaining Terms/Complete Agreement. Any and all terms and
     conditions contained in the Original Agreement, other than those contained
     in paragraph 5 and with the exception of paragraph 10 (a)(i) which is to be
     amended to "termination payments and medical benefits equal to one year's
     salary" (increased from six months), are unchanged by this Amendment and
     remain in full effect. This Agreement, together with the Original Agreement
     and exhibits attached hereto and incorporated herein by reference, is the
     final and complete expression of the parties' amendment to the Original
     Agreement.

          DATED as of the Effective Date first written above.

                         EXECUTIVE: /s/ Martin Kelly
                                    ----------------



                         COMPANY:   PYRAMID BREWERIES INC.


                         By         /s/ GEORGE HANCOCK
                            -------------------------------
                         Its: Chief Executive Officer