##### Table of Contents









SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549




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FORM 10-K

|                                                |  |                                                                                             
|----------------------------------------------- |  | --------------------------------------------------------------------------------------------
|þ                                               |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
    15(d) OF THE SECURITIES EXCHANGE ACT OF 1934    
|For the fiscal year ended December 31,
    2003
|                                               
|or                                             
|                                               
|o                                               |  | 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
    incorporation or organization) |  | (IRS Employer
    Identification No.)

203 Colorado Street, Suite 600, Austin,
Texas 78701

(Address of principal executive offices) (Zip
Code)


Registrants telephone number, including
area code:

(512) 236-3800


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

|                           |  |                                          
|-------------------------- |  | -----------------------------------------
|Title of each class        |  | Name of each exchange on which registered
|Common Stock, no par value |  | NASDAQ National Market                   

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

Preferred Stock Purchase Rights


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 þ          No o

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

Indicate by check mark whether the registrant is
an accelerated filer (as defined in Rule 12b-2 of the Act.
Yes  o          No
þ

The aggregate market value of the voting stock
held by non-affiliates of the registrant as of June 30,
2003, was approximately $13,092,600, based upon the last sales
price on June 30, 2003 on the NASDAQ National Market System
for the Companys common stock. Registrant had
7,338,661 shares of Common Stock outstanding on
March 26, 2004.

DOCUMENTS INCORPORATED BY REFERENCE

None.



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SCHLOTZSKYS, INC.


Index to Form 10-K

Year Ended December 31, 2003


|                                                  |          |  |                                                                                                        |          |  |    | 
|------------------------------------------------- | -------- |  | ------------------------------------------------------------------------------------------------------ | -------- |  | -- | 
|                                                  |          |  |                                                                                                        | Page No.
|                                                  |          |  |                                                                                                        |         
|Part I                                            |          |  |                                                                                                        |          |  |   
|                                                  | Item 1.  |  | Business                                                                                               |          |  | 2  | 
|                                                  | Item 2.  |  | Properties                                                                                             |          |  | 13 | 
|                                                  | Item 3.  |  | Legal Proceedings                                                                                      |          |  | 13 | 
|                                                  | Item 4.  |  | Submission of Matters to a
    Vote of Security Holders                                                |          |  | 15 | 
|                                                 
|Part II                                           |          |  |                                                                                                        |          |  |   
|                                                  | Item 5.  |  | Market for Registrants
    Common Equity and Related Stockholder Matters                              |          |  | 15 | 
|                                                  | Item 6.  |  | Selected Consolidated
    Financial Data                                                               |          |  | 15 | 
|                                                  | Item 7.  |  | Managements Discussion
    and Analysis of Financial Condition and Results of Operations              |          |  | 17 | 
|                                                  | Item 7A. |  | Quantitative and Qualitative
    Disclosures about Market Risk                                         |          |  | 29 | 
|                                                  | Item 8.  |  | Financial Statements and
    Supplementary Data                                                        |          |  | 29 | 
|                                                  | Item 9.  |  | Changes in and Disagreements
    with Accountants on Accounting and Financial Disclosure               |          |  | 29 | 
|                                                  | Item 9A. |  | Controls and Procedures                                                                                |          |  | 29 | 
|                                                 
|Part III                                          |          |  |                                                                                                        |          |  |   
|                                                  | Item 10. |  | Directors and Executive
    Officers of the Registrant                                                 |          |  | 30 | 
|                                                  | Item 11. |  | Executive Compensation                                                                                 |          |  | 32 | 
|                                                  | Item 12. |  | Security Ownership of
    Certain Beneficial Owners and Management and Related Stockholder
    Matters |          |  | 36 | 
|                                                  | Item 13. |  | Certain Relationships and
    Related Transactions                                                     |          |  | 38 | 
|                                                  | Item 14. |  | Principal Accountant Fees
    and Services                                                             |          |  | 40 | 
|                                                 
|Part IV                                           |          |  |                                                                                                        |          |  |   
|                                                  | Item 15. |  | Exhibits, Financial
    Statement Schedules and Reports on Form 8-K                                    |          |  | 41 | 
|By-Laws of the Company, as Amended               
|Change in Terms Agreement                        
|Change in Terms Agreement                        
|Restructuring Agreement                          
|Amended and Restated Promissory Note             
|Guaranty                                         
|Security Agreement                               
|Trademark Security Agreement                     
|Stock Pledge Agreement                           
|Stock Pledge Agreement                           
|Subordination Agreement                          
|Modification of Note and Security Agreement      
|Modification Agreement                           
|Modification, Extension and Renewal of Promissory
|Modification, Extension and Renewal of Promissory
|Modification, Extension and Renewal of Promissory
|Change in Terms Agreement                        
|List of Subsidiaries of the Company              
|Consent of Grant Thornton LLP                    
|Certification of Chief Executive Officer         
|Certification of Chief Financial Officer         
|Certification of Chief Executive Officer         
|Certification of Chief Financial Officer         



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PART I






|        |         
|------- | --------
|ITEM 1. | BUSINESS

INTRODUCTION

Schlotzskys, Inc., through its
wholly-owned subsidiaries, is a franchisor and operator of
restaurants in the fast casual sector under the
Schlotzskys® brand. Schlotzskys®
restaurants offer a menu of distinctive, high quality foods
featuring our proprietary breads, complemented by excellent
customer service in a visually appealing setting. Our current
menu includes upscale made-to-order hot sandwiches and pizzas
served on our proprietary buns and crusts, wraps, chips, salads,
soups, fresh baked cookies and other desserts, and beverages. At
December 31, 2003, the system included 524 franchised
restaurants and 37 Company-operated restaurants located in
37 states, the District of Columbia and six foreign
countries.

Our executive offices are located at 203 Colorado
Street, Suite 600, Austin, Texas 78701, our telephone
number is (512) 236-3800, and our website is
www.schlotzskys.com. Our filings with the Securities and
Exchange Commission and our Annual Reports to Shareholders are
available on our website but are not incorporated into this
Annual Report on Form 10-K.

We generated revenues of approximately
$56.2 million for 2003 through two business segments:



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1. Franchise Operations. Our
    Franchise Operations segment is a key source of revenues through
    royalties we collect from our franchisees for the use of our
    trademarks and operating systems and license fees we receive
    from manufacturers and supply chain managers of
    Schlotzskys brand products. This segment encompasses
    franchising of restaurants, assisting franchisees and licensing
    the manufacture of Schlotzskys brand products. Several
    brand products, including chips, cheeses and meats, are
    available for retail sale in grocery and other retail stores.                                                                                                                                                                                                                                                                                                                  
|
| | 2. Restaurant Operations. Our
    Restaurant Operations segment includes 15 restaurants in our
    long-term portfolio that we intend to operate for the purposes
    of leadership of the franchise system and, in certain cases, to
    stimulate the redevelopment of certain markets. These stores
    also are used to demonstrate sales potential and key operating
    metrics, to build brand awareness, and to serve as laboratories
    for product development, concept refinement, product and process
    testing, and training. We also operate 22 restaurants that were
    developed for or acquired from franchisees and are being
    operated until they are re-franchised or otherwise divested, or
    until their current leases expire. Beginning in late 2003, we
    designated four of the 37 restaurants as training restaurants
    where franchisees can learn or refine their operating techniques.

See Note 16 to the Consolidated Financial
Statements for financial information regarding our business
segments.

During the second quarter of 2003,
Schlotzskys, Inc. formed new wholly-owned Delaware
limited liability companies, including: Schlotzskys
Franchisor, LLC (Franchisor); Schlotzskys
Brand Products, LLC (Brand Products); and
Schlotzskys Franchise Operations, LLC (Franchise
Operations). On June 7, 2003, Schlotzskys
contributed to Franchisor all of its intellectual property,
including trademarks, and related economic interests in the
payments to be received pursuant to the franchise agreements and
brand licensing agreements for the Schlotzskys restaurant
concept and brand. Franchisor thus became the franchisor of the
Schlotzskys restaurant concept and licensor of the
Schlotzskys brand. Franchisor concurrently contributed the
brand licensing agreements to Brand Products. Franchisor and
Brand Products entered into a management agreement with
Franchise Operations to manage the intellectual property,
administer the franchise and brand license agreements, and enter
into additional franchise and brand agreements. As part of the
corporate change, Schlotzskys, Inc. transferred
certain personnel from several departments focused on franchise
services to Franchise Operations.

As used in this report, the terms
Company, Schlotzskys,
us, and we refer to
Schlotzskys, Inc. and its subsidiaries unless the
context indicates otherwise.

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SCHLOTZSKYS SYSTEM

Franchising

Franchise
Philosophy.We have generally adopted
the strategy of franchising, rather than owning, the majority of
the systems restaurants. Franchising allows us to expand
the number of restaurants and penetrate markets more quickly and
with less capital than developing Company-operated restaurants.
In general, the Company prefers that franchisees be on-premise
operators; however, we have allowed some franchisees to operate
multiple restaurants. Area developers play a role in our
franchising program in certain territories by monitoring and
providing support to franchised restaurants and in some
territories by also recruiting qualified franchisees.

Franchise
Agreements.Our franchise agreements
grant the franchisee the right to develop a restaurant within a
defined local market area for a finite period of time. In most
cases, we have reserved the right to license sales of
sandwiches, pizzas and other products in alternative retail
outlets or special event venues within that market area. Under
our current standard franchise agreement, the franchisee pays a
fee of $30,000 for each restaurant. The current standard
franchise agreement for an owner-operator provides for a term of
20 years (with one ten-year renewal option), payment of a
royalty of 6% of contractual restaurant sales, and advertising
contributions of 4% of contractual restaurant sales. Contractual
sales (as defined in our franchise agreements) add to net sales
any discounts for employee and manager meals. Contractual sales
are a principal driver of our royalty revenue because royalty
revenue is based on the contractual sales of our franchised
restaurants. Some of our earlier franchisees operate under older
forms of franchise agreements that require franchisees to pay a
royalty of only 4% of contractual sales.

Franchisee Training and
Support.We have approximately 320
franchisees for our 524 franchised restaurants. We will provide
on-the-job training for new and existing franchisees at our
designated Company-operated training restaurants. We also
provide updated operating and marketing information and maintain
ongoing communication with franchisees through conference calls,
a call center and internet and e-mail communications. Franchised
restaurants receive ongoing service and support, and are
periodically inspected by area developers and by our field
service representatives to monitor compliance with our standards
and specifications as set forth in the franchise agreement and
our manuals.

Area Developers.Beginning in the early 1990s, we entered into a series of
contracts for area developers who played a large role in
franchise sales and franchisee services in particular markets.
The area developer program has played an important part of our
growth strategy, but over the past five years we have
repurchased some of those area developer territories or modified
the contracts to decrease their responsibilities and their
compensation. We may enter into similar transactions with
existing area developers, but there can be no assurance that
such transactions will occur. In August 2002, we acquired the
territorial rights of our largest area developer. We do not
intend to expand the area developer program beyond our existing
markets at this time.

In exchange for a non-refundable fee, generally
paid by cash and a note, area developers were granted exclusive
rights to one or more development territories in the United
States, typically for a term of 50 years. We retain a right
of first refusal with respect to any proposed sale of rights by
an area developer. If an area developer fails to meet its
obligations, we can terminate the contract or repurchase its
territory.

We typically pay compensation to area developers
who retain and perform their original sales and service
obligations based on 50% of all franchise fees paid by
franchisees in their territories. In addition, we also pay these
area developers compensation generally based on 2.5% of
franchisees restaurant contractual sales, constituting
approximately 42% of the royalties received under franchise
agreements providing for 6% royalties. Compensation payable to
those area developers with reduced responsibilities has been
reduced to approximately 1.25% of franchisees restaurant
sales, or approximately 21% of royalties.

International Master
Licensees.We have granted master
licenses to develop restaurants in certain foreign countries. A
master licensee is typically licensed for 50 years to use
our trademarks in a designated territory and may grant area
development rights and franchises in that territory. Unlike area
developers,

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master licensees serve as sub-franchisors in
their respective territories. When a master license is granted,
the master licensee pays us a negotiated, nonrefundable license
fee.


Restaurant Development

Location and Design.We often assist franchisees in identifying restaurant sites,
although franchisees are responsible for selecting restaurant
locations acceptable to us. Site selection criteria are based on
several factors, such as accessibility and visibility of the
site, and selected demographic factors, including population,
residential and commercial density, income, age and traffic
patterns.

We also assist owners of older restaurants in
finding economically feasible ways to upgrade or remodel their
restaurants to maintain consistency with our brand image and
competitiveness in their markets. We have developed a variety of
standard restaurant designs and specifications for freestanding
and shopping center restaurants that can be adapted to a variety
of real estate layouts. These designs may be adapted to existing
restaurants and other retail spaces with our approval, such as
rehabilitating or renovating buildings that were originally
designed for completely different concepts.

In 2003, we initiated a gradual evolution and
transition of the concept from the Schlotzskys
Deli version of Schlotzskys which was first
implemented in 1991, to Schlotzskys Sandwich
Café & Bakery. This Sandwich Café
initiative, originally referred to as Concept 2005, was launched
as our response to changing consumer tastes and increased
competitive intrusion, particularly in the sandwich sector of
the restaurant industry. This initiative involves an enhanced
menu and design renovations that we believe will lead to a more
sophisticated dining experience for our customers. We have
enacted a phased development plan for our franchisees to meet
the Sandwich Café standards in place of the standard
remodel requirements under their franchise agreements. Although
franchisees are responsible for the costs of remodeling, they
have received funds from Schlotzskys NAMF, Inc., a
Texas not-for-profit corporation, for new menus and wall
banners. We believe that substantially all of the existing
franchised restaurants will be converted to Sandwich Cafés
by the third quarter of 2006. All new franchise licenses will be
for Sandwich Cafés.

Restaurant Cost.Capital requirements incurred by a franchisee to open a
restaurant vary depending on the location and size of the
restaurant, whether the restaurant is free-standing or in a
shopping center, development or rehabilitation costs, whether
the restaurant is owned or leased, and the specific terms of any
related loan or lease agreement. Shopping center restaurants are
currently estimated to cost approximately $300,000 to $650,000,
and vary based on size and the level of landlord contribution to
construction costs. Leased freestanding buildings have a similar
cost depending on the size of the building and the terms and
conditions of the lease. If a franchisee were to purchase the
land and own and develop the land and building instead of
leasing, then the total investment would vary greatly, with the
largest variables being cost of land and land development. In
addition, the franchisee will need adequate working capital to
support their business start-up and pay us required initial fees.

Schlotzskys Restaurant
Locations

At December 31, 2003, the Schlotzskys
system consisted of 561 restaurants open and operating in
37 states, the District of Columbia, and six foreign
countries. At December 31, 2002 and 2001, the system
included 643 and 674 restaurants open and operating,
respectively.

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RESTAURANT LOCATIONS AS OF DECEMBER 31, 2003

|                     |  |             |     | 
|-------------------- |  | ----------- | --- | 
|                     |  | Number of  
|Location             |  | Restaurants
|                     |  |            
|United States:       |  |             |     | 
|Texas                |  |             | 176 | 
|Georgia              |  |             | 25  | 
|Arizona              |  |             | 23  | 
|North Carolina       |  |             | 23  | 
|Tennessee            |  |             | 22  | 
|Colorado             |  |             | 20  | 
|Illinois             |  |             | 17  | 
|Florida              |  |             | 15  | 
|Oklahoma             |  |             | 15  | 
|South Carolina       |  |             | 15  | 
|Wisconsin            |  |             | 15  | 
|Missouri             |  |             | 13  | 
|Kansas               |  |             | 12  | 
|Alabama              |  |             | 11  | 
|Indiana              |  |             | 10  | 
|Arkansas             |  |             | 9   | 
|New Mexico           |  |             | 9   | 
|Ohio                 |  |             | 9   | 
|California           |  |             | 8   | 
|Louisiana            |  |             | 8   | 
|Nevada               |  |             | 8   | 
|Oregon               |  |             | 8   | 
|Virginia             |  |             | 8   | 
|Michigan             |  |             | 7   | 
|Kentucky             |  |             | 6   | 
|Minnesota            |  |             | 6   | 
|Mississippi          |  |             | 6   | 
|Washington           |  |             | 6   | 
|Idaho                |  |             | 5   | 
|Nebraska             |  |             | 5   | 
|Utah                 |  |             | 5   | 
|West Virginia        |  |             | 4   | 
|South Dakota         |  |             | 3   | 
|North Dakota         |  |             | 2   | 
|Pennsylvania         |  |             | 2   | 
|Alaska               |  |             | 1   | 
|District of Columbia |  |             | 1   | 

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|                                    |  |             |     | 
|----------------------------------- |  | ----------- | --- | 
|                                    |  | Number of  
|Location                            |  | Restaurants
|                                    |  |            
|New York                            |  |             | 1   | 
|                                    |  |             |     | 
|Total Domestic                      |  |             | 539 | 
|                                    |  |             |     | 
|International:                      |  |             |     | 
|South Korea                         |  |             | 9   | 
|Turkey                              |  |             | 5   | 
|China                               |  |             | 4   | 
|Guatemala                           |  |             | 2   | 
|Canada                              |  |             | 1   | 
|Germany                             |  |             | 1   | 
|                                    |  |             |     | 
|Total International:                |  |             | 22  | 
|                                    |  |             |     | 
|Total Domestic &
    International: |  |             | 561 | 
|                                    |  |             |     | 

Brand Products

We have licensed certain manufacturers to produce
Schlotzskys brand meats, cheeses, potato chips and other
products for use in the Schlotzskys restaurant system. We
receive licensing fees from these manufacturers and supply chain
managers based on their sales of brand products to distributors,
who in turn sell to our restaurants. While franchisees are
currently not required to purchase our brand products
exclusively, other than our proprietary flour mixes, logoed
paper products and certain special sauces, they are
contractually required to purchase products that meet our
quality standards and specifications.

Since 1999, we also have licensed certain brand
products for sale outside of the restaurant system.
Schlotzskys brand meats, cheeses and potato chips are
available for retail sale in certain grocery chains and other
retail outlets in selected markets. We are continuing to seek
distribution in additional retail outlets and markets and are
exploring additional products for inclusion in this program.

We do not manufacture, warehouse or distribute
Schlotzskys brand products. We do continually strive to
improve the supply chain for our franchisees and our
Company-operated restaurants. We have worked with a variety of
different food distributors, but currently one national food
distribution company distributes substantially all of the brand
products needed to operate our restaurants.

Restaurant Operations

Since the 1999 acquisition of certain restaurants
in Austin and the re-acquisition of the Austin development
territory, we have increased our commitment to restaurant
operations. Three of the 15 restaurants in our long-term
restaurant portfolio (all in Austin) are Sandwich Café
restaurants, which include a full bakery producing pastries,
muffins and other baked goods for sale in the restaurant and in
the coffee bar section of certain other Company-operated
restaurants. We intend to convert all long-term restaurants to
the Sandwich Café format to the extent financing becomes
available.

We also operate 22 other restaurants developed
for or acquired from franchisees on a purchase or lease basis.
We intend to re-franchise these restaurants and do not consider
these restaurants to be part of our long-term portfolio of
Company-operated units, but classify them as Restaurants
Available for Sale. In the interim, these restaurants
serve as a base of operations for Company personnel in their
respective markets and, as such, are an important part of the
franchising infrastructure. We also intend to convert these
restaurants to the Sandwich Café format to the extent
financing becomes available.

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MARKETING AND ADVERTISING

We seek to become a well-known national brand.
Schlotzskys N.A.M.F., Inc. (NAMF), a
Texas not-for-profit corporation, is primarily responsible for
developing, producing and funding the marketing and advertising
for our system. NAMF utilizes national, regional, local and
cable television advertising, as well as radio, freestanding
inserts, direct mail, point of purchase materials and other
forms of advertising to present advertising messages to
consumers. The allocation between national, regional and local
advertising will vary from time to time depending on pricing and
other factors.

Franchisees are required by the terms of their
franchise agreements to spend at least 4% of their
restaurants contractual sales on advertising and we
encourage them to spend more than the minimum. Effective
January 1, 2001, we began collecting three quarters of that
4% contribution for advertising through NAMF. The remainder of
the 4% was spent locally by individual franchisees or by local
advertising groups formed in order to maximize the benefits of
local advertising for members. Beginning in February 2003, 4% of
contractual sales has been collected on a national basis and has
been used for national, regional and local advertising and
marketing, managed on a centralized basis. Company-operated
restaurants contribute to advertising funds on the same basis as
franchised restaurants. NAMF reimburses us for personnel and
other costs that we incur related to the marketing and
advertising for our system.

COMPETITION

The food service industry, particularly the
sandwich sector, is intensely and increasingly competitive with
respect to concept, price, location, food quality and service.
There are many competitors, both new and well established, with
substantially greater financial strength, market share, media
presence, points of distribution and other resources than us.
Such competitors include a large number of national and regional
food service companies, including fast food and quick-service
restaurants, fast casual dining restaurants, casual dining
restaurants, delicatessens, pizza restaurants and other dining
establishments. We believe that we compete for franchisees with
franchisors of other restaurants and various concepts.

TRADEMARKS AND TRADE SECRETS

We own several trademarks that are protected
under common law and/or are registered with the United States
Patent and Trademark Office including the name and mark
Schlotzskys. We have also registered or
applied to register many of our trademarks in various foreign
countries. We, and our suppliers, protect our recipes and
techniques as trade secrets. We have not generally sought patent
protection for these recipes or techniques, and it is possible
that competitors could develop recipes and techniques that
duplicate or closely resemble ours, including the recipe and
techniques relating to our distinctive and proprietary breads
and pizza crusts.

GOVERNMENT REGULATION

We must comply with regulations adopted by the
Federal Trade Commission (the FTC) and with several
state laws that apply to and regulate the offer and sale of
franchises, and impose registration and disclosure requirements
on franchisors.

All Schlotzskys restaurants must comply
with federal, state and local laws and regulations regarding
health, sanitation, safety, fire, zoning, environment, wages,
working hours, working conditions, disabilities, and alcoholic
beverages (where applicable). Compliance with environmental and
other laws and regulations has impacted the cost of new
restaurants, but we believe it has not prevented development of
new restaurants. Compliance with securities law regulations and
new rules under the Sarbanes-Oxley Act has had, and is expected
to continue to have, an adverse impact on our operating costs.

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EMPLOYEES

As of December 31, 2003, we employed
105 full-time equivalent personnel at our corporate
headquarters or as field personnel and 982 personnel at
Company-operated restaurants. None of our employees is covered
by a collective bargaining agreement or represented by a labor
union. We believe our relationship with our employees is good.

FORWARD-LOOKING STATEMENTS

This report contains statements that are not
historical information and are considered forward-looking
statements, as defined under the federal securities laws.
Forward-looking statements may also be included from time to
time in other written and oral communications by us or by our
authorized representatives. Forward-looking statements include,
but are not limited to, those related to: our business and
growth strategies; the availability of financing for us and our
franchisees; the impact of payment upon guarantees and other
contingent liabilities; the impact of restaurant closings in the
Schlotzskys system; the impact of declines in sales in the
Schlotzskys system; the impact of increased competition
within the fast casual segment of the restaurant industry on
restaurant sales; new restaurant development; continued
viability of restaurants over time; sales, costs and earnings
projections; the sufficiency of operating cash flows, working
capital and borrowings for our future liquidity and capital
resource needs; the results of pending or threatened legal
proceedings; the disposition of restaurants available for sale;
future distribution of Schlotzskys brand products; the
expected recruitment of new franchisees; and the future
declaration and payment of dividends. Although forward-looking
statements reflect our expectations based on then-current
information, shareholders and prospective investors are
cautioned not to place undue reliance on such forward-looking
statements. We undertake no obligation to update any
forward-looking statements. There can be no assurance that
forward-looking statements will actually be achieved. Actual
results may be materially different from the forward-looking
statements because of various risks and uncertainties, including
but not limited to those identified in this report under the
heading Risk Factors.

RISK FACTORS

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

New Restaurant and Restaurant Upgrade
Strategy.We have initiated several
measures to stimulate the development of new Schlotzskys
restaurants or renovation of existing restaurants by our
franchisees, including updating model restaurant designs,
developing improved designs and menu formats, and increasing an
overall effort to recruit prospective franchisees. Although we
believe these actions are appropriate, there can be no assurance
they will result in the opening of more restaurants. Some
franchisees may choose to close their restaurants rather than
invest in remodels or upgrades under the Sandwich Café
transition as encouraged by us or required under the terms of
their franchise agreements. During 2003, 2002 and 2001, our
franchisees and we opened 7, 13 and 18 new Schlotzskys
restaurants, respectively. The number of openings and the
performance of new restaurants will depend on various factors,
including: the availability of suitable sites for new
restaurants; the ability to recruit financially and
operationally qualified franchisees; the ability of franchisees
to negotiate acceptable lease or purchase terms, obtain required
capital, meet construction schedules, and hire and train
qualified restaurant personnel; the establishment of brand
awareness in new markets; overall economic conditions; and our
ability to implement restaurant renovations and upgrades. See
Managements Discussion and Analysis of Financial
Condition and Results of Operations  Overview.

Availability of Appropriate Financing and/or
Renegotiation of Existing Debt.We
will require additional financing to support Company operations
and to refinance certain debt with relatively short maturities.
While we are working with potential lenders to develop
appropriate credit facilities, there can be no assurance that we
will obtain appropriate financing on acceptable terms to meet
these needs. We are also negotiating with certain creditors to
modify the terms of the obligations and required payments.
Failure to obtain such financing or modified terms with
creditors would require us to significantly modify our growth
strategies,

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reduce our operating and capital expenditures, or
potentially violate certain financial covenants to which we are
subject under certain third party agreements. This failure also
could materially adversely affect our ability to fund continuing
operations and working capital needs. See
Managements Discussion and Analysis of Financial
Condition and Results of Operations  Liquidity and
Capital Resources.


Operation of Company-operated
Restaurants.Our revenue from
Company-operated restaurants has increased significantly over
the past five years as we have increased the number of
restaurants we operate. Restaurant operations have different
financial characteristics, including higher capital requirements
and lower operating margins, than our franchising operations. In
addition, a majority of the restaurants operated by us were
developed for or acquired from franchisees that, in many cases,
did not operate these restaurants with consistent profitability.
We expect to further increase the number of restaurants we
operate in our available-for-sale portfolio. There can be no
assurance that we will increase the number of Company-operated
restaurants or achieve consistent profitability in restaurants
that we have or will acquire from franchisees in the future. See
Business.

Credit Risk and
Contingencies.We have charged our
area developers and master licensees a fee (developer
fee) for the rights to develop a defined territory and
have typically accepted a portion of the developer fee in the
form of a promissory note. As of December 31, 2003, we held
notes receivable from area developers and master licensees in an
aggregate net carrying value of approximately $1.4 million.
We also hold notes receivable from certain franchisees related
to their purchase of restaurants and certain other obligations.
As of December 31, 2003, the aggregate net carrying value
of these notes was approximately $3.5 million.
Noncollection on unreserved notes receivable as described above
could adversely affect our financial condition. See
Business and Managements Discussion and
Analysis of Financial Condition and Results of
Operations  Off Balance Sheet Arrangements.

We have guaranteed for the benefit of
Schlotzskys NAMF Funding, LLC (a wholly-owned subsidiary
of NAMF), a bank term note, with an outstanding balance of
approximately $4.14 million at December 31, 2003. See
Managements Discussion and Analysis of Financial
Condition and Results of Operations  Off Balance
Sheet Arrangements.

We have guaranteed certain loans, leases and
other obligations of certain franchisees. We entered into most
of these guarantees prior to 2000 in connection with restaurants
developed under the former Turnkey program. At December 31,
2003, the Company was contingently liable for approximately
$18.0 million of franchisees obligations, which was
principally comprised of guarantees on real estate leases and
mortgages, equipment leases, and loans of franchisees. We have,
from time to time, been called upon to perform under such
guarantees and there can be no assurance that we will not be so
called upon in the future. See Business and
Managements Discussion and Analysis of Financial
Condition and Results of Operations  Off Balance
Sheet Arrangements.

Directly and through a wholly owned subsidiary,
we are the general partner and a limited partner in a limited
partnership that owns a retail shopping center in the Austin,
Texas, area. We have guaranteed, subject to certain conditions,
the repayment of a loan for this project in the principal amount
of approximately $2.0 million due in October 2009 (our
subsidiary received the proceeds of the loan in repayment of its
loan to the partnership). We do not consider our 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  Off
Balance Sheet Arrangements.

Factors Affecting the Restaurant
Industry.We and our franchisees may
be affected by risks inherent in the restaurant industry,
including but not limited to the following: adverse changes in
national, regional or local economic conditions; weather
conditions; availability and cost of labor (including increases
in the minimum wage); health and safety concerns; increased
costs of food products; limited alternative uses for properties
and equipment; changing consumer tastes, habits and spending
priorities; increased concern with nutrition and health issues;
and changing demographics. The restaurant industry is subject to
numerous federal, state and local governmental regulations,
including those relating to food preparation, employment, zoning
and building requirements. If we implement changes to our menu,
our recipes, or our pricing, there is a risk that the consumer
market will respond negatively to those changes, which would
negatively affect our

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sales. Our advertising and marketing strategy
could be negatively impacted by an increase in advertising
costs, especially in the television market. None of these
factors can be predicted with any degree of certainty, and any
one or more of these factors could have a material adverse
effect on our financial condition and results of operations. See
Business.


Competition.The
food service industry is intensely and increasingly competitive
with respect to concept, price, location, food quality and
service. There are new competitors as well as many
well-established competitors with substantially greater
financial and other resources than us. These competitors include
a large number of national, regional and local food service
companies, including fast food and quick-service restaurants,
fast casual dining restaurants, casual dining restaurants,
delicatessens, pizza restaurants and other convenience dining
establishments. Some of our competitors have been in business
longer than us and may be better established in markets where
Schlotzskys restaurants are or may be located. There are
also new and growing competitors in the fast casual upscale
sandwich sector in which we primarily operate. Another
restaurant could emulate our distinctive bread, recipes and
store appearance or allege we are doing the same. Competition in
the food service business is affected by changes in consumer
taste, economic conditions, demographic trends, traffic
patterns, the cost and availability of real estate, availability
of qualified labor, product availability and local competitive
factors. We provide training and other assistance to our
franchisees in 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 Schlotzskys restaurants. We also
believe that we compete for franchisees with franchisors of
other restaurants and various concepts. See Business.

Dependence on Franchising
Concept.Because royalties from
franchised restaurants are a principal component of our revenue
base, our performance depends upon the ability of our
franchisees to capitalize on and properly execute the
Schlotzskys concept. The operation of a Schlotzskys
restaurant requires a franchisees significant and
continued effort in areas such as product quality, customer
service, employee training, local marketing and cost controls.
We believe that the costs for a franchisee to open a
Schlotzskys restaurant, including the cost to purchase or
lease real estate that meets our site selection criteria, are
higher than the restaurant opening costs of certain competing
concepts. This necessarily limits the number of persons who are
qualified to be our franchisees. We have established criteria to
use in evaluating prospective franchisees, as well as training
programs to assist in franchisee restaurant operations, but
there can be no assurance that franchisees will successfully
open and operate Schlotzskys restaurants consistent with
our expectations. In addition, franchisees set their own prices
which will affect their sales. Poor restaurant operations in
areas such as cleanliness, attentiveness of employees and
quality control, will also affect each stores sales.
Because franchisees are independent business owners, they make
their own decisions regarding new restaurant openings and
whether to close existing restaurants. There can be no assurance
that franchisees will open additional restaurants or continue
operations of existing restaurants. During 2003, 2002 and 2001
franchisees closed 95, 53 and 72 restaurants, respectively and
we closed 5 Company-operated restaurants in 2001-03. See
Business.

We are subject to various state and federal laws
relating to the franchisor relationship. If we fail to comply
with these laws, we could be subject to certain penalties by
governmental authorities or be liable for damages to
franchisees. We believe that we are in material compliance with
these laws and regulations and our agreements with franchisees.
There can be no assurance that such liability will not be
imposed in the future. We reserve the right to change the terms
of our franchise agreements from time to time as we deem
appropriate. See Business and
Business  Government Regulation.

Schlotzskys Brand Licensing
Arrangements.Our revenue from
Schlotzskys brand licensing arrangements (brand
contribution) is a significant portion of our overall revenue,
and is currently based primarily on franchisee purchases of our
brand products. There can be no assurance that franchisees will
maintain their future purchases of Schlotzskys brand
products. There also can be no assurance that the Companys
future licensing revenue will not be reduced due to pricing
considerations or market conditions. See Business.

Dependence on Suppliers and
Distributors.One national food
distribution company currently meets substantially all of our
systems distribution needs (other than certain beverages
and produce). If this company, or any other company significant
to our systems supply chain, were to go out of business or
stop

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performing their functions, we could suffer
adverse consequences while we move our business to another
company. See Business.


Investments in Intangible
Assets.We have substantial
investments in intangible assets with a carrying value of
$66.0 million as of December 31, 2003. The carrying
amount of such investments is dependent, in part, on projected
cash flows for the related business activities. Such projected
cash flows can be impacted by factors both within and outside of
managements control and projection of cash flows requires
the exercise of judgment. There can be no assurance that factors
adversely impacting these projected cash flows will not occur or
that managements judgments will not change in the future.
See Managements Discussion and Analysis of Financial
Condition and Results of Operations  Critical
Accounting Policies.

Litigation and
Claims.We are subject to various
lawsuits and claims that arise from our business operations. We
have obtained liability insurance to cover certain types of
claims, subject to significant deductibles, retentions and other
limitations. There can be no assurance that such insurance will
be available to us in the future on acceptable terms or that the
insurance obtained will be adequate to pay applicable claims.
See Legal Proceedings.

Food Quality and
Safety.We may be adversely affected
by publicity resulting from food quality, illness, injury or
other health concerns or operating issues or allegations
resulting from an occurrence at one restaurant or a limited
number of restaurants in the Schlotzskys system or in
other restaurant chains. We are impacted by both real and
perceived deficiencies by the public in safety and
health-related issues related to food production and
distribution.

Reliance on Area
Developers.We rely on certain area
developers along with our own staff to recruit qualified
franchisees and to perform quality inspections of franchised
restaurants and other services. Area developers are independent
contractors, and are not our employees. We provide training and
support to area developers, but the quality of restaurant
operations in their territories may differ, based on the area
developers level of training and experience. We cannot
guarantee that our area developers will be in full compliance
with inspection standards or other requirements, and there can
be no assurance that restaurants in the territories of such area
developers will conform to our standards. See
Business.

Geographic
Concentration.Of the 561 restaurants
in the Schlotzskys system at December 31, 2003, 176
were located in Texas. A downturn in the regional economy or
other significant adverse events in Texas could have a material
adverse effect on our financial condition and results of
operations. See Business  Schlotzskys
Restaurant Locations.

Dependence on Management and Key
Personnel.Our success is very
dependent upon the efforts of our management and key personnel,
including our President and Chief Executive Officer, John C.
Wooley. We have employment agreements with John C. Wooley and
Jeffrey J. Wooley, which include certain noncompetition
provisions that survive the termination of employment. Their
employment agreements were amended and restated effective
January 1, 2001, and will automatically extend for rolling
four-year terms. However, there can be no assurance that such
noncompetition agreements will be enforceable in any particular
situation. The loss of the services of John C. Wooley or other
management or key personnel could have a material adverse effect
on us. We do not carry key man life insurance on any of our
officers. See Directors and Executive Officers of the
Registrant.

Volatility of Stock Price and
Volume.There have been periods of
significant volatility in the market price and trading volume of
our Common Stock, which in many cases were unrelated to the
operating performance of, or announcements concerning, us.
General market price declines or market volatility in the future
could adversely affect the price of our Common Stock. In
addition, the trading price of the Common Stock has been and is
likely to continue to be subject to significant fluctuations in
response to many factors including, but not limited to:
variations in quarterly operating results, changes in
management, competitive factors, regulatory changes, general
trends in the industry, recommendations by securities industry
analysts and other events or factors. The low volume of public
trading of the Common Stock could exacerbate this volatility.
There can be no assurance that an adequate trading market can be
maintained for the Common Stock.

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As of December 31, 2003, we had
7,521,524 shares of Common Stock issued, of which
189,525 shares were held in treasury, and we had
outstanding an aggregate of 704,360 stock options and warrants
that were exercisable. A substantial number of shares may 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 our Common Stock. Sales of substantial
amounts of Common Stock in the public market, or the perception
that such sales may occur, could adversely affect the market
price for the Common Stock and could impair our ability to raise
capital through a public offering of equity securities. See
Market for Registrants Common Equity and Related
Stockholder Matters.

Anti-Takeover
Provisions.The Texas Business
Combination Law restricts certain transactions between a public
corporation and affiliated shareholders. The statute may have
the effect of inhibiting a non-negotiated merger or other
business combination involving us.

Our 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 to 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. The Bylaws provide that a director may only be
removed for cause by vote of the holders of at least two-thirds
of the shares present in person or by proxy at a meeting of
shareholders called expressly for that purpose. All other
shareholder action must be effected at a duly called annual or
special meeting and shareholders must follow an advance
notification procedure for certain shareholder proposals and
nominations 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 additional 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 Common Stockholders and could have the effect of
delaying, deferring or preventing a change in control of the
Company. The issuance of Preferred Stock could have other
adverse effects on Common Stockholders, including creation of a
preference upon liquidation or the payment of dividends in favor
of the holders of Preferred Stock.

The Board of Directors has adopted a Shareholder
Rights Plan, pursuant to which certain rights would become
exercisable upon the occurrence of certain events, such as a
purchase, tender offer, or exchange offer that would result in a
person obtaining 20% or more of our outstanding shares of Common
Stock. Upon becoming exercisable, the Rights may entitle the
holder to purchase our Common Stock or an acquiring
companys stock for less than market value or to receive
cash. The Rights have certain anti-takeover effects, including
the substantial dilution of value incurred by such a person who
acquires 20% or more of our Common Stock. Accordingly, the
existence of the Rights may deter takeover proposals or tender
offers. Of the 1,000,000 shares of Preferred Stock that are
authorized, 200,000 shares have been reserved for issuance
under the Shareholder Rights Plan as Class C Series A
Junior Participating Preferred Stock.

We have issued a promissory note payable to the
seller of certain rights to an area developer territory with a
principal amount outstanding of approximately $18.0 million
as of December 31, 2003. The note is subject to
acceleration by the payee, among other rights, if there is a
change in control of the Company (defined to include the
acquisition of at least 20% of the outstanding Common Stock by
someone other than NS Associates I, Ltd. and certain
affiliated parties.)

Stock Repurchase
Program.In January 2001, the Board of
Directors increased the existing authorization to repurchase
shares of our outstanding Common Stock to 1,000,000 shares.
Since then, the Company repurchased 179,525 shares at a
total cost of approximately $738,000. We do not have any current
plans to repurchase any shares in the near future.

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|        |           
|------- | ----------
|ITEM 2. | PROPERTIES

We lease our corporate headquarters facility in
Austin, Texas, from Third & Colorado, L.L.C., a company
of which John C. Wooley and Jeffrey J. Wooley are controlling
members. This lease will expire in 2007. The facility consists
of approximately 41,000 square feet of office and storage
space.

We operate 37 restaurants in
12 states.Fifteen of these
restaurants are in our portfolio of restaurants to be operated
for the long term. Of these units, 14 are in Texas and one is in
Georgia. The remaining 22 restaurants are considered available
for sale. Five of these restaurants are located in Texas, four
in Georgia, two each in North Carolina, Mississippi and
Tennessee, and one each in Alabama, Arkansas, Arizona,
Minnesota, New Mexico, New York and Utah. The properties
consist of land, building, leasehold improvements, and
restaurant equipment. The equipment is typically owned, and the
land and building are either owned or leased. In addition, we
have certain excess undeveloped or partially developed real
estate held for sale.






|        |                  
|------- | -----------------
|ITEM 3. | LEGAL PROCEEDINGS

New Florida Markets, Ltd. and Deli Keys,
Ltd. v. Schlotzskys, Inc., Schlotzskys
Franchise Limited Partnership, Schlotzskys Franchisor,
LLC, Schlotzskys Franchise Operations, LLC,
Schlotzskys NAMF, Inc., and Schlotzskys NAMF
Funding, LLC(Case
No. 701140045603), was filed on or about June 23, 2003
with the American Arbitration Association. Claimant is the area
developer for the Tampa, Orlando, and West Palm Beach
development areas. On July 14, 2003, Deli Keys, Ltd., an
area developer for the Miami development area, joined the
arbitration as an additional Claimant. They allege that
Respondents frustrated their ability to develop, in part because
of the Companys Turnkey program under which
Respondents developed a number of restaurants during the period
1995 until 2000 in which Respondents were involved in acquiring
sites, building restaurants for franchisees and, in certain
instances, guaranteeing franchise debts or leases. Claimant also
alleges Respondents breached the Area Developer Agreements by
failing to provide adequate licensing support, negotiating with
license prospects, failing to establish and administer a local
advertising group, pledging royalties, changing the area
developer manual, refunding franchise fees, and forcing
Claimants to purchase errors and omissions insurance. Other
claims include breach of the implied covenant of good faith and
fair dealing, constructive termination, and violation of the
Texas Deceptive Trade Practices Act. Claimants seek actual,
compensatory, and punitive damages of an unspecified amount,
attorneys fees, and costs. The arbitration proceeding is
scheduled to begin in May 2004.

John D. Wright and James E. Wright v.
Schlotzskys, Inc. and Schlotzskys Real
Estate, Inc.(U.S. District
Court for the Eastern District of Michigan  Case
No. 03-70244) was filed on or about June 9, 2003 as a
Counterclaim and Third Party Claim in a collection action
originally filed by Schlotzskys Real Estate, Inc.
(SREI) in January 2003. James Wright, John
Wright, Lorraine Wright, and Kimberly Wright v.
Schlotzskys, Inc. and Schlotzskys Real
Estate, Inc.,in the Circuit Court for the County of
Genessee, State of Michigan (Case No. 02-74931-CK), was
filed on or about July 1, 2003 as a Third Party Complaint
in a foreclosure action. The Wrights are principals and
guarantors of J. Wright Franchise Development, LLC, a former
franchisee that had operated a Schlotzskys Deli in Grand
Blanc, Michigan and filed Chapter 11 bankruptcy. In January
2003, SREI filed suit against John and James Wright for
collection of $283,872.68 due under a promissory note. In the
instant case, the Wrights allege that they were induced into
participating in the Companys Turnkey program and that an
employee of the Company represented that the restaurant would
attain a certain level of sales. The Wrights claims
include fraud in the inducement, fraudulent and negligent
misrepresentation, and breach of the Michigan Franchise
Investment Act. They sought damages of an unspecified amount,
attorneys fees, and costs. The parties agreed to settle
both lawsuits on March 5, 2004, with all parties
withdrawing their claims with prejudice.

Robert Coshott v.
Schlotzskys, Inc.(Cause
No. GN 1-02279), was filed on July 24, 2001, in the
200th Judicial District Court of Travis County, Texas. Plaintiff
is the Master Licensee for Australia and New Zealand, and he
opened a Schlotzskys Deli restaurant in Melbourne,
Australia. Plaintiff brings causes of action for fraud and/or
negligent misrepresentation. Plaintiff alleges that he
experienced problems with certain equipment specified or
approved by the Company, that the Companys system and
equipment did not generate

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enough finished food product to service his
potential customers; that the Company misrepresented the level
of revenue the restaurant could reasonably be expected to
achieve; that the Company delayed his ability to develop
restaurants by failing to timely secure certain trademarks and
trade names; and that the Company misrepresented whether it
would allow Plaintiff to franchise Schlotzskys Deli
restaurants in certain gas station or convenience store
locations in his territories. Plaintiff requests actual and
punitive damages of $3.75 million plus lost profits and
incidental and consequential damages of an unspecified amount.
On July 23, 2003, Coshott also filed a Demand for
Arbitration with the International Chamber of Commerce styled
Robert Gilbert Coshott v.
Schlotzskys, Inc. (Case. No. 12 838/JNK).
The claims in the Demand are similar to those brought in the
above-entitled action and include additional allegations that
the Company required the purchase of goods and services from
certain suppliers in violation of the Trade Practices Act of
1974 and that the Company failed to disclose the existence of a
predecessor Master License Agreement, in violation of the Fair
Trading Act of 1987 (New South) Wales, breach of contract, and
equitable estoppel. Claimant seeks unspecified actual,
compensatory and punitive damages, lost profits, attorneys
fees, prejudgment interest, and costs. On February 26,
2004, the Company obtained a declaratory judgment in the state
court case declaring that Plaintiff had waived any right to
arbitrate his claim by filing suit against the Company in state
court in Texas. The state court case is not yet set for trial.


Dae Kim, DWK Enterprises, Inc., and Aecon
International, Inc. v. John Wooley,
Schlotzskys, Inc., Schlotzskys Franchising
Limited Partnership, Schlotzskys N.A.M.F., Inc.,
Schlotzskys National Advertising Association, Inc.,
and Schlotzskys, Brands, Inc., Schlotzskys
Brand Products, L.P., Schlotzskys Real Estate, Inc.,
and Schlotzskys
Restaurants, Inc.(Cause
No. 2001-CI-13672) was originally filed in the
73rd Judicial District Court of Bexar County, Texas on or
about September 25, 2001 (after a similar lawsuit was filed
and later withdrawn in Harris County, Texas) against
Schlotzskys, Inc., John Wooley, Schlotzskys
Franchising Limited Partnership, and Schlotzskys
NAMF, Inc. (Defendants). Plaintiffs are, or
claim to be, franchisees in Houston and San Antonio Texas,
and Plaintiff Kim was an area developer for those markets.
Plaintiffs bring causes of action for breach of contract, breach
of fiduciary duty, breach of the duty of good faith and fair
dealing, civil conspiracy, tortious interference with contract,
tortious interference with prospective business relationship,
violation of the Texas Deceptive Trade Practices and Consumer
Protection Act, restraint of trade, detrimental reliance-fraud
in the inducement, and defamation-business disparagement. They
seek an unspecified amount of money damages plus exemplary
damages, attorneys fees, pre-judgment interest, costs, and
a jury trial. Defendants, except for Mr. Wooley, who was
previously dismissed from the case, answered and asserted
counterclaims alleging breach of contract and that
Plaintiffs claim under the Texas Deceptive Trade Practices
Act is groundless in fact or in law and brought in bad faith or
for the purpose of harassment, and seeks money damages, costs of
court, penalty fees, costs incurred in performing the
accounting, attorneys fees, and pre- and post-judgment
interest. Defendants (except for Mr. Wooley) removed the
case to federal court. The case was remanded to state court on
April 17, 2003. The case is not yet set for trial.

U.S. Restaurant Properties Operating
L.P. v.
Schlotzskys, Inc.(Cause
No. 03-01758) was filed on February 27, 2003, in the
District Court of Dallas County, B-44th Judicial District.
Plaintiff is a real estate investment company that owns certain
Schlotzskys restaurants and leases them to franchisees. It
alleges that in 1997 and 1998 we entered into several agreements
where we agreed to guarantee certain lease agreements. Plaintiff
claims that in 1998 the parties entered into an agreement
whereby Plaintiff agreed to release Schlotzskys from its
guaranty obligations pertaining to six properties in which the
tenants had defaulted, in exchange for Schlotzskys
agreement to purchase six other properties. Plaintiffs are
seeking an order requiring us to purchase six properties for a
total purchase price of over $4.5 million. In the
alternative, Plaintiff is seeking damages or an order
reinstating the previously released guaranties. Plaintiffs
claims include breach of contract and a request for
attorneys fees. The trial date has been scheduled for
September 20, 2004.

In addition to the matters discussed above, we
are defendants in various other legal proceedings arising from
our business. The ultimate outcome of these pending proceedings
cannot be projected with certainty. However, based on our
experience to date, we believe any such proceeding will not have
a material effect on our business or financial condition.

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

Not applicable.




PART II






|        |                                                                          
|------- | -------------------------------------------------------------------------
|ITEM 5. | MARKET FOR REGISTRANTS 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 (including 200,000 shares of
Class C Series A Junior Participating Preferred Stock
reserved for issuance under our Shareholder Rights Plan). Our
Common Stock is traded on the NASDAQ National Market under the
symbol BUNZ. As of March 26, 2004,
7,338,661 shares of outstanding Common Stock were owned by
approximately 280 beneficial owners and 4,500 shareholders
of record.

The following table shows, for our Common Stock
in each fiscal quarter in the last two years, the highest and
lowest sales price (reflecting actual transactions reported by
NASDAQ).

|            |                |              |   |      |  |  |   |      | 
|----------- | -------------- | ------------ | - | ---- |  |  | - | ---- | 
|            |                |             
|            |                | Sales Prices
|            |                |             
|            |                | High         |   | Low 
|            |                |              |   |     
|Fiscal 2002 |                |              |   |      |  |  |   |     
|            | First Quarter  |              | $ | 6.50 |  |  | $ | 5.15 | 
|            | Second Quarter |              |   | 5.75 |  |  |   | 4.04 | 
|            | Third Quarter  |              |   | 4.84 |  |  |   | 3.40 | 
|            | Fourth Quarter |              |   | 3.99 |  |  |   | 2.82 | 
|Fiscal 2003 |                |              |   |      |  |  |   |     
|            | First Quarter  |              | $ | 3.47 |  |  | $ | 2.36 | 
|            | Second Quarter |              |   | 3.49 |  |  |   | 2.40 | 
|            | Third Quarter  |              |   | 2.99 |  |  |   | 1.70 | 
|            | Fourth Quarter |              |   | 3.65 |  |  |   | 1.85 | 

We have never paid cash dividends on our Common
Stock and we do not have current plans to pay dividends. The
declaration and payment of future dividends will be at the sole
discretion of the Board of Directors and will depend on our
profitability, financial condition, capital needs, future
prospects, financing restrictions and other factors deemed
relevant by the Board of Directors.

The Transfer Agent and Registrar for our Common
Stock is Computershare Investor Services, LLC.

The Company discloses information about its
securities authorized for issuance under equity compensation
plans in Item 12 of this report.






|        |                                     
|------- | ------------------------------------
|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 consolidated balance sheet data as of
December 31, 2003 and 2002 and the consolidated statement
of operations data for the years ended December 31, 2003,
2002 and 2001 have been derived from the audited consolidated
financial statements of the Company, included elsewhere herein.
The consolidated balance sheet data as of December 31, 2000
and 1999 and consolidated statement of operations data for the
years ended December 31, 2000 and 1999 have been derived
from the Companys audited financial statements not
included or incorporated herein. The selected financial data
should be read in

15



---



##### Table of Contents



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.


|                                                                       |                                                                                  |                                       |                                                                                               |                               |        |         |         |        |        |      |         |        |        |       |         |        |        |        |         |        |       |       |        | 
|---------------------------------------------------------------------- | -------------------------------------------------------------------------------- | ------------------------------------- | --------------------------------------------------------------------------------------------- | ----------------------------- | ------ | ------- | ------- | ------ | ------ | ---- | ------- | ------ | ------ | ----- | ------- | ------ | ------ | ------ | ------- | ------ | ----- | ----- | ------ | 
|                                                                       |                                                                                  |                                      
|                                                                       |                                                                                  | Fiscal Years Ended December 31,      
|                                                                       |                                                                                  |                                      
|                                                                       |                                                                                  | 2003                                  |                                                                                               | 2002                          |        | 2001    |         | 2000   |        | 1999
|                                                                       |                                                                                  |                                       |                                                                                               |                               |        |         |         |        |        |     
|                                                                       |                                                                                  |                                      
|                                                                       |                                                                                  | (In thousands, except per share data)
|Consolidated Statement of Operations
    Data:                         |                                                                                  |                                       |                                                                                               |                               |        |         |         |        |        |      |         |        |        |       |         |        |        |        |         |       
|Revenue:                                                               |                                                                                  |                                       |                                                                                               |                               |        |         |         |        |        |      |         |        |        |       |         |        |        |        |         |       
|                                                                       | Royalties                                                                        |                                       | $                                                                                             | 16,617                        |        |         | $       | 19,967 |        |      | $       | 21,765 |        |       | $       | 22,478 |        |        | $       | 21,547 |      
|                                                                       | Franchise fees                                                                   |                                       |                                                                                               | 20                            |        |         |         | 122    |        |      |         | 348    |        |       |         | 511    |        |        |         | 843    |      
|                                                                       | Developer fees(1)                                                                |                                       |                                                                                               | 168                           |        |         |         | 231    |        |      |         | 455    |        |       |         | 740    |        |        |         | 1,058  |      
|                                                                       | Restaurant sales                                                                 |                                       |                                                                                               | 32,011                        |        |         |         | 31,723 |        |      |         | 29,906 |        |       |         | 25,738 |        |        |         | 18,533 |      
|                                                                       | Brand contribution                                                               |                                       |                                                                                               | 6,405                         |        |         |         | 7,309  |        |      |         | 7,397  |        |       |         | 7,142  |        |        |         | 6,173  |      
|                                                                       | Other fees and revenue                                                           |                                       |                                                                                               | 957                           |        |         |         | 1,194  |        |      |         | 1,981  |        |       |         | 2,566  |        |        |         | 3,254  |      
|                                                                       |                                                                                  |                                       |                                                                                               |                               |        |         |         |        |        |      |         |        |        |       |         |        |        |        |         |       
|                                                                       |                                                                                  |                                       |                                                                                               | Total revenue                 |        |         | 56,178  |        |        |      | 60,546  |        |        |       | 61,852  |        |        |        | 59,175  |        |       |       | 51,408 | 
|                                                                       |                                                                                  |                                       |                                                                                               |                               |        |         |         |        |        |      |         |        |        |       |         |        |        |        |         |       
|Expenses:                                                              |                                                                                  |                                       |                                                                                               |                               |        |         |         |        |        |      |         |        |        |       |         |        |        |        |         |       
|                                                                       | Service costs:                                                                   |                                       |                                                                                               |                               |        |         |         |        |        |      |         |        |        |       |         |        |        |        |         |        |      
|                                                                       |                                                                                  | Royalties                             |                                                                                               |                               | 2,463  |         |         |        | 3,975  |      |         |        | 4,745  |       |         |        | 5,295  |        |         |        | 6,601 |      
|                                                                       |                                                                                  | Franchise fees                        |                                                                                               |                               |       |         |         |        | 53     |      |         |        | 149    |       |         |        | 216    |        |         |        | 389   |      
|                                                                       |                                                                                  |                                       |                                                                                               |                               |        |         |         |        |        |      |         |        |        |       |         |        |        |        |         |       
|                                                                       |                                                                                  |                                       | 2,463                                                                                         |                               |        |         | 4,028   |        |        |      | 4,894   |        |        |       | 5,511   |        |        |        | 6,990   |       
|                                                                       |                                                                                  |                                       |                                                                                               |                               |        |         |         |        |        |      |         |        |        |       |         |        |        |        |         |       
|                                                                       | Restaurant operations:                                                           |                                       |                                                                                               |                               |        |         |         |        |        |      |         |        |        |       |         |        |        |        |         |        |      
|                                                                       |                                                                                  | Cost of sales                         |                                                                                               |                               | 9,318  |         |         |        | 8,935  |      |         |        | 8,363  |       |         |        | 7,353  |        |         |        | 5,457 |      
|                                                                       |                                                                                  | Personnel and benefits                |                                                                                               |                               | 13,551 |         |         |        | 12,998 |      |         |        | 12,515 |       |         |        | 10,693 |        |         |        | 7,374 |      
|                                                                       |                                                                                  | Operating expenses                    |                                                                                               |                               | 8,027  |         |         |        | 7,557  |      |         |        | 6,945  |       |         |        | 5,661  |        |         |        | 4,233 |      
|                                                                       |                                                                                  |                                       |                                                                                               |                               |        |         |         |        |        |      |         |        |        |       |         |        |        |        |         |       
|                                                                       |                                                                                  |                                       | 30,896                                                                                        |                               |        |         | 29,490  |        |        |      | 27,823  |        |        |       | 23,707  |        |        |        | 17,064  |       
|                                                                       |                                                                                  |                                       |                                                                                               |                               |        |         |         |        |        |      |         |        |        |       |         |        |        |        |         |       
|                                                                       | Equity loss on investments                                                       |                                       |                                                                                               | 471                           |        |         |         | 194    |        |      |         | 109    |        |       |         | 55     |        |        |         |       |      
|                                                                       |                                                                                  |                                       |                                                                                               |                               |        |         |         |        |        |      |         |        |        |       |         |        |        |        |         |       
|                                                                       | General and administrative                                                       |                                       |                                                                                               | 24,072                        |        |         |         | 19,489 |        |      |         | 18,721 |        |       |         | 27,865 |        |        |         | 18,078 |      
|                                                                       |                                                                                  |                                       |                                                                                               |                               |        |         |         |        |        |      |         |        |        |       |         |        |        |        |         |       
|                                                                       | Depreciation and amortization(2)                                                 |                                       |                                                                                               | 5,179                         |        |         |         | 5,020  |        |      |         | 4,224  |        |       |         | 3,771  |        |        |         | 3,186  |      
|                                                                       |                                                                                  |                                       |                                                                                               |                               |        |         |         |        |        |      |         |        |        |       |         |        |        |        |         |       
|                                                                       |                                                                                  |                                       |                                                                                               | Total expenses                |        |         | 63,081  |        |        |      | 58,221  |        |        |       | 55,771  |        |        |        | 60,909  |        |       |       | 45,318 | 
|                                                                       |                                                                                  |                                       |                                                                                               |                               |        |         |         |        |        |      |         |        |        |       |         |        |        |        |         |       
|                                                                       |                                                                                  |                                       |                                                                                               | Income (loss) from operations |        |         | (6,903  | )      |        |      | 2,325   |        |        |       | 6,081   |        |        |        | (1,734  | )      |       |       | 6,090  | 
|Other:                                                                 |                                                                                  |                                       |                                                                                               |                               |        |         |         |        |        |      |         |        |        |       |         |        |        |        |         |       
|                                                                       | Interest income                                                                  |                                       |                                                                                               | 323                           |        |         |         | 652    |        |      |         | 943    |        |       |         | 2,265  |        |        |         | 3,097  |      
|                                                                       | Interest expense                                                                 |                                       |                                                                                               | (4,005                        | )      |         |         | (3,073 | )      |      |         | (2,822 | )      |       |         | (3,586 | )      |        |         | (2,316 | )    
|                                                                       |                                                                                  |                                       |                                                                                               |                               |        |         |         |        |        |      |         |        |        |       |         |        |        |        |         |       
|                                                                       |                                                                                  |                                       | Income (loss) before income taxes and cumulative
    effect of change in accounting principle |                               |        | (10,585 | )       |        |        | (96  | )       |        |        | 4,202 |         |        |        | (3,055 | )       |        |       | 6,871 |       
|Provision (credit) for income taxes                                    |                                                                                  |                                       | 1,164                                                                                         |                               |        |         | 103     |        |        |      | 1,713   |        |        |       | (744    | )      |        |        | 2,525   |       
|                                                                       |                                                                                  |                                       |                                                                                               |                               |        |         |         |        |        |      |         |        |        |       |         |        |        |        |         |       
|                                                                       | Net income (loss) before cumulative effect of
    change in accounting principle |                                       |                                                                                               | (11,749                       | )      |         |         | (199   | )      |      |         | 2,489  |        |       |         | (2,311 | )      |        |         | 4,346  |      
|Cumulative effect of change in accounting
    principle, net of tax(1) |                                                                                  |                                       |                                                                                              |                               |        |         |        |        |        |      |        |        |        |       |        |        |        |        | (3,820  | )     
|                                                                       |                                                                                  |                                       |                                                                                               |                               |        |         |         |        |        |      |         |        |        |       |         |        |        |        |         |       
|                                                                       | Net income (loss)                                                                |                                       | $                                                                                             | (11,749                       | )      |         | $       | (199   | )      |      | $       | 2,489  |        |       | $       | (2,311 | )      |        | $       | 526    |      
|                                                                       |                                                                                  |                                       |                                                                                               |                               |        |         |         |        |        |      |         |        |        |       |         |        |        |        |         |       
|Earnings per share  basic, before
    cumulative effect               |                                                                                  | $                                     | (1.60                                                                                         | )                             |        | $       | (0.03   | )      |        | $    | 0.34    |        |        | $     | (0.31   | )      |        | $      | 0.59    |       
|Earnings per share  basic                                             |                                                                                  |                                       | (1.60                                                                                         | )                             |        |         | (0.03   | )      |        |      | 0.34    |        |        |       | (0.31   | )      |        |        | 0.07    |       
|Earnings per share  diluted, before
    cumulative effect             |                                                                                  |                                       | (1.60                                                                                         | )                             |        |         | (0.03   | )      |        |      | 0.33    |        |        |       | (0.31   | )      |        |        | 0.58    |       
|Earnings per share  diluted                                           |                                                                                  |                                       | (1.60                                                                                         | )                             |        |         | (0.03   | )      |        |      | 0.33    |        |        |       | (0.31   | )      |        |        | 0.07    |       
|Consolidated Balance Sheet Data:                                       |                                                                                  |                                       |                                                                                               |                               |        |         |         |        |        |      |         |        |        |       |         |        |        |        |         |       
|Total assets                                                           |                                                                                  | $                                     | 125,776                                                                                       |                               |        | $       | 137,526 |        |        | $    | 114,149 |        |        | $     | 113,501 |        |        | $      | 132,759 |       
|Long-term debt, less current maturities                                |                                                                                  |                                       | 42,586                                                                                        |                               |        |         | 46,064  |        |        |      | 25,897  |        |        |       | 26,251  |        |        |        | 21,275  |       
|Stockholders equity                                                   |                                                                                  |                                       | 62,862                                                                                        |                               |        |         | 74,319  |        |        |      | 74,402  |        |        |       | 72,522  |        |        |        | 74,735  |       

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---



|    |                                                                                                                                                                  
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Effective January 1, 1999, the Company
    implemented a change in accounting principle regarding revenue
    recognition of developer fees.                     
|   
|(2) | Effective January 1, 2002, the Company
    adopted Statement of Financial Accounting Standards
    No. 142. See Notes to Consolidated Financial
    Statements.






|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|ITEM 7. | MANAGEMENTS DISCUSSION AND ANALYSIS OF
    FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

We are a franchisor and operator of restaurants
in the fast-casual sector in 37 states, the District of
Columbia, and six foreign countries. We derived approximately
98.0% of our revenue in 2003 from three recurring sources:
royalties from franchisees, restaurant sales at Company-operated
restaurants and brand contribution (license fees from the sales
of Schlotzskys brand products to the restaurant system and
in the retail sector). Royalties are generally reported and
collected weekly. Our revenues declined in 2003 as a result of,
among other factors, economic difficulties in local economies
and trade areas, decreased store count and increased
competition. These economic difficulties continued to depress
sales levels across the system to below 2001 levels and had a
tempering effect on franchisee development and new restaurant
openings.

In 2003 we began to enhance and expand the menu
of the Schlotzskys system to increase the culinary
sophistication of menu offerings and to improve nutritional
value through increased offerings of lower calorie and reduced
fat menu items. At the same time, restaurant designs were
updated to complement the new menu and to improve restaurant
efficiency and the quality of the customers dining
experience. These changes, introduced through our Sandwich
Café (originally known as Concept 2005) initiative, are
intended to increase restaurant sales volumes and improve gross
margins and restaurant profitability. We began to test the menu
and format enhancements with several Company-operated
restaurants in Austin, Texas, starting in the second quarter of
2003, and we began to introduce several of the successful
enhancements to the franchise system in the fourth quarter of
2003. We expect to implement these changes throughout most of
the Schlotzskys system in 2004 and 2005.

We are pursuing long-term financing to provide
additional liquidity for the Company, to refinance certain
shorter-term or higher-rate debt and to support operations.
Potential financing alternatives include asset-backed financing,
secured by intellectual property and related royalty rights and
agreements, conventional real estate mortgages, and equity
financing. In addition, we are negotiating with certain
creditors to modify the terms of the obligations and required
payments. We undertook significant cost savings measures in
2003, including a reduction in force and cuts in our general and
administrative expenses.

CRITICAL ACCOUNTING POLICIES

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, liabilities, revenues and
expenses and related disclosure of contingent liabilities. We
base our estimates on historical experience and various other
assumptions that we believe are reasonable under the
circumstances. Estimates and assumptions are reviewed
periodically. Actual results may vary from these estimates.

We believe the following critical accounting
policies require estimates about the effect of matters that are
inherently uncertain and require subjective judgments. Changes
in the estimates and judgments, or the assumptions underlying
these estimates and judgments, could significantly impact our
results of operations and financial conditions in future periods.



| |   |                                                                                             
| | - | --------------------------------------------------------------------------------------------
| |  | Determination of the appropriate valuation
    allowances for accounts and notes receivable.



| |                                                                                                                                                                                                                 
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our accounts and notes receivable are primarily
    from franchisees of the Schlotzskys system. We require
    personal guarantees for all franchise accounts and, for notes
    receivable, generally obtain a

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##### Table of Contents



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | secondary secured interest in the related
    property and equipment or rights. Many of the notes receivable
    are fully subordinated to the franchisees senior mortgage
    debt. In reviewing the adequacy of the valuation allowances for
    accounts and notes receivable, we consider factors such as
    historical collection experience, the estimated value of
    personal guarantees and real property collateral, the
    franchisees sales and operating trends, including
    potential for improvement in operations, and general and local
    economic conditions that may affect the franchisees
    ability to pay. Actual realization of amounts receivable could
    differ materially from our estimates.



| |   |                                                                                     
| | - | ------------------------------------------------------------------------------------
| |  | Determination of appropriate valuation allowances
    for real estate held for sale.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our real estate held for sale consists primarily
    of pad sites. As these sites are being actively marketed, they
    are periodically assessed for estimated net realizable value.
    Factors considered in this assessment are offers and letters of
    intent received on properties, discussions with local real
    estate brokers, property tax and bank appraisals, sale prices of
    similar properties and level of activity and interest exhibited
    by potential buyers. Actual realizeability could differ
    materially from our estimates.



| |   |                                                                             
| | - | ----------------------------------------------------------------------------
| |  | Determination of appropriate valuation allowances
    for intangible assets.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Amortizing intangible assets consist primarily of
    amounts paid to reacquire various developer and franchise
    rights. Annually, and whenever an event or circumstance
    indicating impairment may be present, we compare projected
    undiscounted cash flows to the carrying value of the related
    assets to determine if impairment has occurred. In estimating
    future cash flows, we consider such factors as current results,
    trends, future prospects, and other economic factors. Actual
    future cash flows could differ materially from our estimates.



| |   |                                                                               
| | - | ------------------------------------------------------------------------------
| |  | Determination of appropriate valuation allowances
    for deferred tax assets.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our deferred tax assets represent expenses and
    losses that will offset future income tax liability. If the
    Company is unable to generate income tax liability resulting
    from future net income the value of this tax asset would be
    impaired. The Company considers such factors as current trends,
    operating margins and future system growth in determining
    projected net income, and projected net income is used to assess
    realizable value of the deferred tax asset.

18



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##### Table of Contents



The following table sets forth the percentage
relationship to total revenue of the listed items included in
our consolidated statements of operations, except as otherwise
indicated.

|                                                   |                               |                                   |                |      |       |       |     |      |      |       |     |      |      |       |  
|-------------------------------------------------- | ----------------------------- | --------------------------------- | -------------- | ---- | ----- | ----- | --- | ---- | ---- | ----- | --- | ---- | ---- | ----- | -
|                                                   |                               |                                  
|                                                   |                               | Fiscal Years Ended               
|                                                   |                               | December 31,                     
|                                                   |                               |                                  
|                                                   |                               | 2003                              |                | 2002 |       | 2001 
|                                                   |                               |                                   |                |      |       |      
|Consolidated Statement of Operations Data
    (4): |                               |                                   |                |      |       |       |     |      |      |       |     |     
|Revenue:                                           |                               |                                   |                |      |       |       |     |      |      |       |     |     
|                                                   | Royalties                     |                                   |                | 29.6 | %     |       |     | 33.0 | %    |       |     | 35.2 | %   
|                                                   | Franchise fees                |                                   |                |     |       |       |     | 0.2  |      |       |     | 0.6  |     
|                                                   | Developer fees                |                                   |                | 0.3  |       |       |     | 0.4  |      |       |     | 0.7  |     
|                                                   | Restaurant sales              |                                   |                | 57.0 |       |       |     | 52.4 |      |       |     | 48.3 |     
|                                                   | Brand contribution            |                                   |                | 11.4 |       |       |     | 12.1 |      |       |     | 12.0 |     
|                                                   | Other fees and revenue        |                                   |                | 1.7  |       |       |     | 1.9  |      |       |     | 3.2  |     
|                                                   |                               |                                   |                |      |       |       |     |      |      |       |     |     
|                                                   |                               |                                   | Total revenue  |      |       | 100.0 |     |      |      | 100.0 |     |      |      | 100.0 |  
|                                                   |                               |                                   |                |      |       |       |     |      |      |       |     |     
|Expenses:                                          |                               |                                   |                |      |       |       |     |      |      |       |     |     
|                                                   | Service costs:                |                                   |                |      |       |       |     |      |      |       |     |      |     
|                                                   |                               | Royalties(1)                      |                |      | 14.8  |       |     |      | 19.9 |       |     |      | 21.8 |      
|                                                   |                               | Franchise fees(2)                 |                |      |      |       |     |      | 43.8 |       |     |      | 42.8 |      
|                                                   | Restaurant operations:        |                                   |                |      |       |       |     |      |      |       |     |      |     
|                                                   |                               | Cost of sales(3)                  |                |      | 29.1  |       |     |      | 28.2 |       |     |      | 28.0 |      
|                                                   |                               | Personnel and benefits(3)         |                |      | 42.3  |       |     |      | 41.0 |       |     |      | 41.8 |      
|                                                   |                               | Operating expenses(3)             |                |      | 25.1  |       |     |      | 23.7 |       |     |      | 23.2 |      
|                                                   | Equity loss on investments    |                                   |                | 0.8  |       |       |     | 0.3  |      |       |     | 0.2  |     
|                                                   | General and administrative    |                                   |                | 42.8 |       |       |     | 32.2 |      |       |     | 30.3 |     
|                                                   | Depreciation and amortization |                                   |                | 9.2  |       |       |     | 8.3  |      |       |     | 6.8  |     
|                                                   |                               |                                   | Total expenses |      |       | 112.2 |     |      |      | 96.1  |     |      |      | 90.2  |  
|                                                   |                               |                                   |                |      |       |       |     |      |      |       |     |     
|                                                   |                               | Income (loss) from operations     |                |      | (12.2 | )     |     |      | 3.9  |       |     |      | 9.8  |      
|Other:                                             |                               |                                   |                |      |       |       |     |      |      |       |     |     
|                                                   | Interest income               |                                   |                | 0.6  |       |       |     | 1.2  |      |       |     | 1.5  |     
|                                                   | Interest expense              |                                   |                | (7.1 | )     |       |     | (5.2 | )    |       |     | (4.6 | )   
|                                                   |                               |                                   |                |      |       |       |     |      |      |       |     |     
|                                                   |                               |                                   | Total other    |      |       | (6.5  | )   |      |      | (4.0  | )   |      |      | (3.1  | )
|                                                   |                               |                                   |                |      |       |       |     |      |      |       |     |     
|                                                   |                               | Income (loss) before income taxes |                |      | (18.5 | )     |     |      | (0.1 | )     |     |      | 6.8  |      
|Provision (credit) for income taxes                |                               |                                   | 2.1            |      |       |       | 0.2 |      |      |       | 2.8 |     
|                                                   |                               |                                   |                |      |       |       |     |      |      |       |     |     
|                                                   |                               | Net income (loss)                 |                |      | (20.9 | )%    |     |      | (0.3 | )%    |     |      | 4.0  | %    
|                                                   |                               |                                   |                |      |       |       |     |      |      |       |     |     



---



|    |                                               
|--- | ----------------------------------------------
|(1) | Expressed as a percentage of royalties.       
|   
|(2) | Expressed as a percentage of franchise fees.  
|   
|(3) | Expressed as a percentage of restaurant sales.
|   
|(4) | Amounts may not sum due to rounding.          

19



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##### Table of Contents



RESULTS OF OPERATIONS



| |                                  
| | ---------------------------------
| | Fiscal Year 2003 Compared to 2002

REVENUE. Total revenue decreased 7.2% from
$60,546,000 to $56,178,000.

ROYALTIES decreased 16.8% from $19,967,000 to
$16,617,000. The decrease was due to a decrease in the average
number of franchised restaurants operating during 2003 compared
to 2002 and a decrease in same store contractual sales of 10.9%.

The following table sets forth additional data
concerning the domestic franchised restaurant system:

|                                                                   |            |                         |                         |      |    |      |        |    |    |    |        |    |    |    | 
|------------------------------------------------------------------ | ---------- | ----------------------- | ----------------------- | ---- | -- | ---- | ------ | -- | -- | -- | ------ | -- | -- | -- | 
|                                                                   |            |                        
|                                                                   |            | Year Ended December 31,
|                                                                   |            |                        
|                                                                   |            | 2003                    |                         | 2002 |    | 2001
|                                                                   |            |                         |                         |      |    |     
|Restaurant Data                                                    |            |                         |                         |      |    |      |        |    |    |    |        |   
|Restaurants opened:                                                |            |                         |                         |      |    |      |        |    |    |    |        |   
|                                                                   | Domestic  |                         |                         |      |    |      |        |    |    |    |        |    |   
|                                                                   |            | New                     |                         |      | 2  |      |        |    | 8  |    |        |    | 17 |   
|                                                                   |            | Re-openings             |                         |      | 5  |      |        |    | 11 |    |        |    | 18 |   
|                                                                   |            |                         |                         |      |    |      |        |    |    |    |        |   
|                                                                   |            |                         | Total domestic openings |      |    | 7    |        |    |    | 19 |        |    |    | 35 | 
|                                                                   |            | Domestic closings       |                         |      | 95 |      |        |    | 45 |    |        |    | 69 |   
|                                                                   |            |                         |                         |      |    |      |        |    |    |    |        |   
|Operating domestic restaurants at end of year                      |            |                         | 539                     |      |    |      | 627    |    |    |    | 653    |   
|                                                                   |            |                         |                         |      |    |      |        |    |    |    |        |   
|Average weekly sales for domestic franchised
    restaurants       |            | $                       | 10,199                  |      |    | $    | 11,143 |    |    | $  | 11,466 |   
|                                                                   |            |                         |                         |      |    |      |        |    |    |    |        |   
|Change in same store sales for domestic
    franchised restaurants |            |                         | (10.9                   | )%   |    |      | (5.9   | )% |    |    | (1.7   | )%
|                                                                   |            |                         |                         |      |    |      |        |    |    |    |        |   

FRANCHISE FEES decreased 83.6% from $122,000 to
$20,000. The decrease was principally the result of fewer
openings of franchised restaurants as well as a decrease in
average franchise fee recognized per opening during 2003 as
compared to the prior year.

DEVELOPER FEES decreased 27.3% from $231,000 to
$168,000. The decrease is primarily attributed to the full
recognition of revenue on certain agreements during 2003.

RESTAURANT SALES increased 0.9% from $31,723,000
to $32,011,000. The increase was primarily due to an increase in
the average number of Company-operated restaurants during 2003
compared to 2002, partially offset by an 8.6% decrease in same
store sales. As of December 31, 2003, there were
37 Company-operated restaurants, compared to 36 at
December 31, 2002, of which 23 and 22, respectively, were
available for sale. During 2003, we closed two available for
sale restaurants. During 2003, we also acquired an additional
two restaurants from franchisees and opened one new restaurant.

SCHLOTZSKYS BRAND LICENSING FEES (BRAND
CONTRIBUTION) decreased 12.4% from $7,309,000 to $6,405,000. The
decrease was primarily due to the effect of the decrease in
franchisee sales, partially offset by more favorable terms with
certain major suppliers than in the prior year and an increase
in sales through retail channels. Sales of Schlotzskys
brand products through retail channels of distribution accounted
for 9.0% of brand contribution in 2003, up from 6.5% in 2002.

OTHER FEES AND REVENUE decreased 19.8% from
$1,195,000 to $958,000. The decrease was due to reduced vendor
contributions to conventions and franchisee meetings and a
decrease in expired franchise fees and transfer fees.

OPERATING EXPENSES. SERVICE COSTS decreased 38.9%
from $4,028,000 to $2,463,000, and as a percentage of royalties
and franchise fees decreased from 20.1% to 14.8%. This decrease
was primarily due to the full year impact of the reacquisition
of certain area developer territory rights during 2002, a
decrease in franchise fee costs due to fewer restaurant openings
during 2003 as compared to the prior year, and a decrease in
royalty and franchise fee revenue.

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RESTAURANT OPERATIONS EXPENSES increased 4.8%
from $29,490,000 to $30,896,000. This increase was primarily due
to product, process and equipment testing associated with the
Sandwich Café initiative and partially due to the increase
in restaurant sales and by training and pre-opening costs for
Company-operated restaurants not yet opened. RESTAURANT COST OF
SALES increased 4.3% from $8,935,000 to $9,318,000, and
increased as a percentage of net restaurant sales from 28.2% to
29.1%. This increase, as a percentage of net restaurant sales,
was primarily due to increased commodity prices and product
testing. RESTAURANT PERSONNEL AND BENEFITS COST increased 4.3%
from $12,998,000 to $13,551,000, and increased as a percentage
of net restaurant sales from 41.0% to 42.3%. The increase, as a
percentage of net restaurant sales, was due to increased
personnel time associated with product and process testing.
RESTAURANT OPERATING EXPENSES increased 6.2% from $7,557,000 to
$8,027,000, and increased as a percentage of net restaurant
sales from 23.8% to 25.1%. The increase, as a percentage of net
restaurant sales, was primarily due to fixed costs relating to
the decrease in average sale volumes.

EQUITY LOSS ON INVESTMENTS increased 142.8% from
a loss of $194,000 to a loss of $471,000. The equity loss on
investment represents the Companys 50% interest in a
limited liability partnership that operates a Schlotzskys
restaurant which opened in 2000. In the 3rd quarter of 2003 the
Company agreed to acquire the other 50% interest in the venture
and began to consolidate the entity.

GENERAL AND ADMINISTRATIVE EXPENSES increased
23.5% from $19,489,000 to $24,071,000, and increased from 34.9%
to 42.8% as a percentage of total revenue. General and
administrative expenses include such costs as the Companys
bad debt expense, project abandonment costs, and franchisee
programs expense, in addition to salaries and benefits costs and
corporate overhead. In 2003 general and administrative expenses
increased due to a significant increase in notes receivable
valuation allowances, to $2.4 million, up from
$0.8 million in 2002, primarily related to impairment
allowances for notes receivable the Company issued to
franchisees prior to 2001; an increase in reserves for royalties
receivable from the franchise system, up to $0.8 million
from $0.5 million in 2002; an increase in lease and
mortgage guarantees on franchisee liabilities, up to
$0.9 million from $0.5 million in 2002; a
$1.4 million charge to expense accumulated financing costs,
of which there was no comparable cost in 2002; and approximately
$1.3 million in costs for franchisee programs, up from
approximately $0.3 million in 2002. Additionally, insurance
and legal and professional costs increased in 2003. The costs
were offset by salary reductions of approximately
$0.5 million realized in the fourth quarter due to a
corporate reduction in force in the third quarter.

DEPRECIATION AND AMORTIZATION increased 3.2% from
$5,020,000 to $5,179,000, and increased from 8.3% to 9.2% as a
percentage of total revenue. The increase was primarily due to
the amortization of reacquired area developer territory rights,
and an increase in the average number of Company-operated
restaurants.

INTEREST INCOME decreased 50.5% from $652,000 to
$323,000. The decrease was due to the decrease in the amount of
outstanding notes receivable and the non-recognition of interest
income on certain subordinated or under-performing notes
receivable.

INTEREST EXPENSE increased 30.3% from $3,073,000
to $4,005,000 due to debt incurred in August 2002 in conjunction
with the reacquisition of our largest area developer territorial
rights, partially offset by a decrease in total debt outstanding
during 2003.

PROVISION FOR INCOME TAXES reflected a provision
for 2003, although there was a pretax loss, due to the
impairment of the Companys deferred tax assets and a state
tax provision.

NET INCOME decreased from a loss of $199,000 to a
loss of $11,749,000, and earnings per share, both basic and
diluted, were $(1.60) for the twelve months ended
December 31, 2003, compared to $(0.03), both basic and
diluted, in the prior year, due to the foregoing factors.

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Supplemental Restaurant Operations
Information 

Performance of Long-term Portfolio
Restaurants


We use certain key performance indicators,
including without limitation, the financial and non-financial
performance indicators identified in the following table, to
manage the business and believe that such performance indicators
may be useful to an understanding and evaluation of the
Companys financial condition and operating performance, as
well as its prospects for the future.

The following table is presented for the
Schlotzskys restaurants in the Companys long-term
portfolio for the twelve months ended December 31, 2003. As
of December 31, 2003, this restaurant group included ten
restaurants in the Austin area, two in the Houston area, two in
College Station, Texas and one in suburban Atlanta, Georgia.
This group includes fifteen freestanding restaurants and one
shopping center end cap restaurant. In accordance with our
internal management reporting practices for consistent
comparisons, line item categories have been expanded and
percentages are calculated based on gross sales, instead of net
sales as used elsewhere in this report. Facility costs vary by
restaurant because some facilities are rented and some are
owned. The table provides the average percentage results for
each line item for the 15 Schlotzskys restaurants in
the long-term portfolio group as a whole, as well as the best
and worst percentage performance for each line item for any
restaurant in the group.

|                        |                       |                                                                               |        |            |       |                 |       |                |      |   |      |      |      |   |      |      |      |  
|----------------------- | --------------------- | ----------------------------------------------------------------------------- | ------ | ---------- | ----- | --------------- | ----- | -------------- | ---- | - | ---- | ---- | ---- | - | ---- | ---- | ---- | -
|                        |                       | Year Ended                                                                    |        | Percentage |       |                 |       | Worst         
|                        |                       | December 31,                                                                  |        | of Gross   |       | Best Percentage |       | Percentage    
|                        |                       | 2003                                                                          |        | Sales      |       | Performance(1)  |       | Performance(1)
|                        |                       |                                                                               |        |            |       |                 |       |               
|                        |                       | (In thousands)                                                                |        |            |       |                 |       |               
|Gross sales             |                       | $                                                                             | 14,695 |            |       |                 | 100.0 | %              |      |   |      |      |      |   |      |     
|Less-discounts          |                       |                                                                               | 685    |            |       |                 | 4.7   |                |      |   | 4.1  | %    |      |   | 5.6  | %   
|                        |                       |                                                                               |        |            |       |                 |       |                |      |   |      |      |      |   |      |     
|                        | Net sales             |                                                                               |        | 14,010     |       |                 |       | 95.3           |      |   |      |      |      |   |      |      |     
|Cost of sales           |                       |                                                                               | 3,993  |            |       |                 | 27.2  |                |      |   | 25.7 |      |      |   | 29.0 |     
|Personnel and benefits: |                       |                                                                               |        |            |       |                 |       |                |      |   |      |      |      |   |      |     
|                        | Crew costs            |                                                                               |        | 3,369      |       |                 |       | 23.0           |      |   |      | 21.2 |      |   |      | 25.7 |     
|                        | Management costs      |                                                                               |        | 1,659      |       |                 |       | 11.3           |      |   |      | 9.3  |      |   |      | 16.7 |     
|Operating expenses:     |                       |                                                                               |        |            |       |                 |       |                |      |   |      |      |      |   |      |     
|                        | Advertising           |                                                                               |        | 754        |       |                 |       | 5.1            |      |   |      | 3.6  |      |   |      | 5.3  |     
|                        | Controllable expenses |                                                                               |        | 1,082      |       |                 |       | 7.4            |      |   |      | 5.7  |      |   |      | 9.5  |     
|                        |                       |                                                                               |        |            |       |                 |       |                |      |   |      |      |      |   |      |     
|                        |                       | Operating income before facility costs, and
    depreciation and amortization |        |            | 3,153 |                 |       |                | 21.5 |   |      |      | 26.3 |   |      |      | 14.1 |  
|                        | Facility costs        |                                                                               |        | 671        |       |                 |       | 4.6            |      |   |      | 1.3  |      |   |      | 9.6  |     
|                        |                       |                                                                               |        |            |       |                 |       |                |      |   |      |      |      |   |      |     
|                        |                       | Operating income before depreciation and
    amortization                     |        | $          | 2,482 |                 |       |                | 16.9 | % |      |      | 25.0 | % |      |      | 4.6  | %
|                        |                       |                                                                               |        |            |       |                 |       |                |      |   |      |      |      |   |      |     



---



|    |                                                                                                                                        
|--- | ---------------------------------------------------------------------------------------------------------------------------------------
|(1) | Represents the actual best and worst percentage
    performance among restaurants in this group for this income
    statement category.



| |                                  
| | ---------------------------------
| | Fiscal Year 2002 Compared to 2001

REVENUE. Total revenue decreased 2.1% from
$61,851,000 to $60,546,000.

ROYALTIES decreased 8.3% from $21,765,000 to
$19,967,000. The decrease was due to a decrease in the average
number of franchised restaurants operating during 2002 compared
to 2001 and a decrease in same store contractual sales of 6.1%,
partially offset by a continuing shift in restaurant mix towards
larger, higher volume units.

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FRANCHISE FEES decreased 64.9% from $348,000 to
$122,000. The decrease was principally the result of fewer
openings of franchised restaurants as well as a decrease in
average franchise fee recognized per opening during 2002 as
compared to the prior year.

DEVELOPER FEES decreased 49.2% from $455,000 to
$231,000. The decrease was primarily attributed to the
expiration of amortization on certain agreements, and an
increase in income related to the recognition of deferred
developer fees based upon the termination of one international
master licensee in the third quarter of 2001.

RESTAURANT SALES increased 6.1% from $29,906,000
to $31,723,000. The increase was primarily due to an increase in
the average number of Company-operated restaurants during 2002
compared to 2001, partially offset by an 8.0% decrease in same
store sales. As of December 31, 2002, there were 36
Company-operated restaurants, compared to 33 at
December 31, 2001, of which 22 and 18, respectively, were
available for sale. During 2002, we closed two restaurants, one
in the Schlotzskys long-term portfolio and one available
for sale restaurant. Also during 2002, we acquired an additional
four restaurants from franchisees and reopened one restaurant,
which was previously operated by a franchisee. In the normal
course of business, we expect to acquire additional restaurants
from franchisees. While it is our intention to re-franchise
these restaurants, the restaurants serve as a base of operations
for Company personnel in their respective markets and, as such,
are an important part of the franchising infrastructure.

SCHLOTZSKYS BRAND LICENSING FEES (BRAND
CONTRIBUTION) decreased 1.2% from $7,397,000 to $7,309,000. The
decrease was primarily due to the effect of the decrease in
systemwide contractual sales, partially offset by more favorable
terms with certain major suppliers than in the prior year, the
recognition of $151,000 in past due fees from a licensee during
the second quarter of 2002, and an increase in sales through
retail channels. Sales of Schlotzskys brand products
through retail channels of distribution accounted for 6.5% of
brand contribution in 2002, up from 4.8% in 2001.

OTHER FEES AND REVENUE decreased 39.7% from
$1,981,000 to $1,195,000. The decrease was due to reduced vendor
contributions to conventions and franchisee meetings, a decrease
in expired franchise fees and transfer fees, gains of
approximately $330,000 on the sale of certain restaurants
available for sale and restaurant equipment recognized in the
prior year, and approximately $170,000 in real estate and
transaction fees from the former Turnkey program recorded in the
prior year.

OPERATING EXPENSES. SERVICE COSTS decreased 17.7%
from $4,894,000 to $4,028,000, and as a percentage of royalties
and franchise fees decreased from 22.1% to 20.1%. This decrease
was primarily due to our reacquisition of certain area developer
territory rights during 2002 and 2001, a decrease in franchise
fee costs due to fewer restaurant openings during 2002 as
compared to the prior year, and a decrease in royalty and
franchise fee revenue.

RESTAURANT OPERATIONS EXPENSES increased 6.0%
from $27,823,000 to $29,490,000. This increase was primarily due
to the increase in restaurant sales. RESTAURANT COST OF SALES
increased 6.8% from $8,363,000 to $8,935,000, and increased as a
percentage of net restaurant sales from 28.0% to 28.2%.
RESTAURANT PERSONNEL AND BENEFITS COST increased 3.9% from
$12,515,000 to $12,998,000, and decreased as a percentage of net
restaurant sales from 41.8% to 41.0%. The decrease, as a
percentage of net restaurant sales, was due to improved labor
scheduling. RESTAURANT OPERATING EXPENSES increased 8.8% from
$6,945,000 to $7,557,000, and increased as a percentage of net
restaurant sales from 23.2% to 23.8%. The increase as a
percentage of net restaurant sales was primarily due to fixed
cost expense components related to acquired restaurants as well
as a reduction in the leverage on fixed costs, due to the
decrease in average sale volumes. All cost components were
adversely impacted by training and pre-opening costs for
Company-operated restaurants that will open in the future. The
use of some Company-operated restaurants in the long-term
portfolio for product, process and equipment testing and for
systemwide training also adversely impacted their operating
performance.

EQUITY LOSS ON INVESTMENTS increased 78.0% from a
loss of $109,000 to a loss of $194,000. The equity investment
represents the Companys 50% interest in a limited
liability company that operates a Schlotzskys restaurant
which opened in 2000.

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GENERAL AND ADMINISTRATIVE EXPENSES increased
4.1% from $18,719,000 to $19,489,000, and increased from 30.3%
to 32.2% as a percentage of total revenue. The increase was
primarily due to increases in insurance costs, advertising and
marketing and legal and professional fees, partially offset by
reduced salaries and benefits, due to a reduced number of
employees, reduced convention and franchisee meeting expenses,
and property taxes.

DEPRECIATION AND AMORTIZATION increased 18.8%
from $4,224,000 to $5,020,000, and increased from 6.8% to 8.3%
as a percentage of total revenue. The increase was primarily due
to the amortization of reacquired area developer territory
rights, depreciation related to an increase in the average
number of Company-operated restaurants during 2002 as compared
to the prior year, and a $300,000 impairment charge, related to
restaurants, partially offset by a reduction of approximately
$241,000 in intangible asset amortization expense related to the
adoption of SFAS No. 142.

INTEREST INCOME decreased 30.9% from $943,000 to
$652,000. The decrease was due to the decrease in the amount of
outstanding notes receivable, the non-recognition of interest
income on certain subordinated or under-performing notes
receivable and a decrease in average interest rate during 2002
as compared to the prior year, partially offset by the cash
receipt of $77,000 in interest in 2002 on a non-accruing note
receivable.

INTEREST EXPENSE increased 8.9% from $2,822,000
to $3,073,000 due to debt incurred in conjunction with the
reacquisition of our largest area developer territorial rights
and an increase in the average number of Company-operated
restaurants during 2002 as compared to the prior year, partially
offset by lower average interest rates and a decrease of
approximately $32,000 of interest capitalized on
Company-operated restaurants under construction as compared to
the prior year.

PROVISION (CREDIT) FOR INCOME TAXES reflected a
provision for 2002, even though there was a pretax loss and the
effective combined tax benefit rate was 40.8% for 2001, due both
to income levels and certain state taxes being based in part on
factors other than income.

NET INCOME decreased from $2,489,000 to a loss of
$199,000, and earnings per share, both basic and diluted, were
$(0.03) for the twelve months ended December 31, 2002,
compared to $0.34 and $0.33, basic and diluted, respectively, in
the prior year, due to the factors discussed above.

OFF-BALANCE SHEET ARRANGEMENTS

We have outstanding guarantees of indebtedness of
others, including related parties, of approximately
$24.6 million as of December 31, 2003. These
guarantees include approximately $4.7 million of lease
guarantees for the benefit of franchisees, approximately
$13.1 million of mortgage loan guarantees for the benefit
of franchisees, approximately $6.2 million of loan
guarantees for the benefit of related parties, and $573,000 in
guarantees related to the sale of assets.

The lease guarantees for the benefit of
franchisees arose primarily through our former Turnkey program,
in which we developed the restaurants, leased the restaurants to
franchisees, and then sold them to a leasing company. The
guarantees range from limited guarantees, either in dollar
amount or term, to full guarantees for the life of the lease.
The maximum guarantee for a single lease is approximately
$1.3 million. Certain guarantees extend through 2018. We
may be required by the lessor to make monthly rental payments or
property tax and common area maintenance payments if the
franchisee does not make the required payments in a timely
manner. We have indemnification agreements with the franchisees
under which the franchisee would be obligated to reimburse us
for any amounts paid under such guarantees. We also have net
deferred gain related to the sale of these leases in the amount
of approximately $342,000 as of December 31, 2003. (See
Note 7 to the Consolidated Financial
Statements.)

The mortgage loan guarantees for the benefit of
franchisees also arose primarily through our former Turnkey
program, in which we developed the related restaurants, sold the
restaurant to a franchisee, and guaranteed all or a portion of
the franchisees mortgage loan. The guarantees range from
limited guarantees, either in dollar amount or term, to full
guarantees of the mortgage. The maximum amount of a single

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##### Table of Contents



guarantee is approximately $1.2 million. Certain
guarantees extend through 2016. We may be required by the lender
to make monthly mortgage payments if the franchisee does not
make the required payments in a timely manner, or we may be
required to make up any deficiency, up to the amount of the
guarantee, if the related restaurant is sold for net proceeds
less than the amount of the outstanding mortgage. We have
indemnification agreements with the franchisees under which the
franchisee would be obligated to reimburse us for any amount
paid under such guarantees. In the event that we purchase the
loan from the lender in the event of a default, we would succeed
to the lenders security interest in the related property.


The loan guarantees in favor of related parties
primarily arose when we guaranteed certain debt of related
parties for which the proceeds of the loans were used to repay
outstanding debt to us. One of the guarantees, for the benefit
of our real estate venture, is of mortgage debt, totaling
approximately $2.0 million. This guarantee extends through
2009. Another guarantee, in the amount of approximately
$4.14 million, is for the benefit of NAMF, the advertising
entity of the Schlotzskys restaurant system, for which we
received the net proceeds of the loan in repayment of
outstanding debt to us. This guarantee expires in 2004. We may
extend the guarantee in connection with the renewal of the loan.

We have been called upon, from time to time, to
make payments on obligations we have guaranteed on behalf of
franchisees under the former Turnkey program. We will make
additional payments in the future to the extent that franchised
stores developed under the Turnkey program default on
obligations that we have guaranteed. During 2003, we paid
approximately $610,000 in various lease guarantees and
approximately $250,000 under various loan guarantees, both for
the benefit of franchisees. In addition, pursuant to a guarantee
of a franchisees debt obligation, we purchased that
obligation from a bank, in the amount of approximately $665,000,
in August 2003 of which $298,000 was outstanding and secured
with an agreed judgment at December 31, 2003.

LIQUIDITY AND CAPITAL RESOURCES

Cash and cash equivalents increased $379,000 in
2003, and decreased $1,889,000 in 2002. Cash flows are impacted
by operating, investing and financing activities.

Operating activities provided $6,130,000 of cash
in 2003 and $6,669,000 of cash in 2002. The decrease in cash
provided was primarily the result of the decline in net income
partially offset by increased impairment and bad debt expense,
which are generally non-cash events in the year they occur.
Additionally, increases in accounts payable and decreases in
accounts receivable further offset the decline in net income.

Investing activities provided $1,102,000 and used
$4,055,000 of cash in 2003 and 2002, respectively. The decrease
in cash used in 2003 compared to 2002 was the net result of an
increase in proceeds from the sale of real estate held for sale,
an increase in collections of notes receivable, and a decrease
in expenditures for intangible assets, partially offset by an
increase in expenditures for new Company-operated restaurants.

Financing activities used $6,593,000 and
$4,503,000 of cash in 2003 and 2002, respectively. The increase
in cash used in 2003 compared to 2002 is primarily the net
result of less borrowing by the Company, partially offset by
reduced debt service.

At December 31, 2003, we had approximately
$50,285,000 of total debt outstanding. Scheduled maturities of
debt through December 31, 2004 approximate $7,699,000
(including short-term debt).

Schlotzskys Franchisor, LLC entered into a
loan agreement in November 2003 in the amount of approximately
$2,500,000 with John C. Wooley and Jeffrey J. Wooley (the
Loan) and the Loan was extended in January 2004. The
Loan and other previous personal guarantees provided by the
Wooleys on our behalf were initially secured by a first lien on
our intellectual property, contract rights, and other
intangibles before they were subordinated as discussed below.
The Loan matures in December 2006 and has an annual interest
rate of 2.5% over prime. The proceeds of the Loan were used to
pay certain accounts payable and to provide us with additional
liquidity while we seek a longer term financing. In connection
with the Loan, the Wooleys received $1.00 in excess of their
costs.

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##### Table of Contents



In December 2003, we negotiated modifications to
the debt held by NS Associates, Ltd., a former area developer,
of approximately $18.0 million (the NS Loan).
These modifications decreased the monthly payments under the NS
Loan from $520,000 to $120,000 for 12 months, after which
payments increase to $420,000 a month. The term of the NS Loan
was extended from June 2005 to December 2006. In addition, the
interest on the balance was fixed at 3% for 12 months and
then fluctuates thereafter at four points over the prime rate.
In exchange, NS Associates received a first lien on our
intellectual property. John C. Wooley and Jeffrey J. Wooley
agreed to subordinate their first lien securing, among other
things, the Loan to repayment of the NS Loan. In addition, NS
Associates agreed to subordinate its security interest to any
new lender who provides up to $3,000,000 in senior debt to the
Company. We are subject to certain covenants under the terms of
the NS Loan. If we fail to satisfy the terms of those covenants,
it would constitute a default under the terms of the NS Loan,
and NS Associates would have the right to accelerate the
maturity of its debt. In the first quarter of 2004 the Company
borrowed $1,500,000 of this senior debt and is seeking an
additional $1,500,000.

Certain of our mortgage debt requires the
maintenance of financial ratios, including debt-to-equity and
working capital ratios. At December 31, 2003, the Company
was in compliance with or had obtained a waiver of such
covenants. However, any failure to remain in compliance with the
restrictive covenants of the Companys mortgages in the
future could have material adverse consequences to the Company.
In addition, one of our mortgages requires the application to
the mortgage of the net cash proceeds from the sale of certain
real estate held for sale.

The following tables present certain of our
obligations and commitments to make future payments, excluding
interest payments, under contracts and contingent commitments as
of December 31, 2003:

|                        |  |                         |            |           |  |           |           |           |  |               |            |  |  |   |           |  |  |   |           | 
|----------------------- |  | ----------------------- | ---------- | --------- |  | --------- | --------- | --------- |  | ------------- | ---------- |  |  | - | --------- |  |  | - | --------- | 
|                        |  |                        
|                        |  | Payments Due by Period 
|                        |  | As of December 31, 2003
|                        |  |                        
|                        |  |                         |            | Less than |  |          
|Contractual Obligations |  | Total                   |            | 1 Year    |  | 1-3 Years |           | 4-5 Years |  | After 5 Years
|                        |  |                         |            |           |  |           |           |           |  |              
|Short-term Debt         |  | $                       | 1,134,000  |           |  | $         | 1,134,000 |           |  | $             |           |  |  | $ |          |  |  | $ |          | 
|Long-term Debt          |  |                         | 49,151,000 |           |  |           | 6,565,000 |           |  |               | 31,684,000 |  |  |   | 3,247,000 |  |  |   | 7,655,000 | 
|Operating Leases        |  |                         | 18,852,000 |           |  |           | 2,436,000 |           |  |               | 5,930,000  |  |  |   | 2,221,000 |  |  |   | 8,265,000 | 

|                             |  |           |            |                                            |  |           |           |           |  |               |           |  |  |   |           |  |  |   |           | 
|---------------------------- |  | --------- | ---------- | ------------------------------------------ |  | --------- | --------- | --------- |  | ------------- | --------- |  |  | - | --------- |  |  | - | --------- | 
|                             |  |           |            |                                           
|                             |  |           |            | Amount of Commitment Expiration Per Period
|                             |  |           |            | As of December 31, 2003                   
|                             |  | Total     |            |                                           
|                             |  | Amounts   |            | Less than                                  |  |          
|Other Commercial Commitments |  | Committed |            | 1 Year                                     |  | 1-3 Years |           | 4-5 Years |  | After 5 Years
|                             |  |           |            |                                            |  |           |           |           |  |              
|Guarantees                   |  | $         | 24,622,000 |                                            |  | $         | 9,424,000 |           |  | $             | 1,747,000 |  |  | $ | 4,173,000 |  |  | $ | 9,278,000 | 

We have experienced net reductions in the number
of restaurants systemwide quarterly since early 2000 and have
experienced decreased royalty collections quarterly since
mid-2001. In addition to the net decline in restaurants, we have
also experienced declines in same store sales for franchised
restaurants since mid-2001. This decline in same store sales has
led to a decrease in royalty collections from our franchisees.
We have developed and implemented strategies, including the
re-imaging of restaurants, the introduction of an enhanced menu
with new items and combinations, and the resumed marketing of
our franchise licensing program, in an effort to reverse and
mitigate the impact of these trends. We expect that the number
of restaurants will continue to decline, however, during the
first two quarters of 2004 and possibly thereafter. Continuation
of these trends would have a material adverse impact on our
royalty revenue, brand contribution, cash flow and liquidity.

On July 31, 2003 we effected a reduction in
force eliminating 39 positions on the corporate staff, reducing
the personnel employed at our corporate headquarters or as field
personnel to approximately 110 at that time. We believe that
these reductions, along with certain salary adjustments, began
to impact operating results in the third quarter of 2003, but
were offset by separation expenses incurred during the same
quarter. The impact of these position reductions and salary
adjustments were more fully reflected in the fourth quarter of
2003, and we anticipate a significant effect in 2004. We also
developed and implemented plans to significantly reduce
non-compensation general and administrative expenses and certain
employee benefits in an effort to achieve a reduction in total
general and administrative expenses.

26



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##### Table of Contents



The decline in store revenues and closings have
decreased our advertising collections by NAMF. Due to these
decreased collections, we have had less funds available for
advertising than in prior periods.

We may develop additional Company-operated
restaurants in the future and plan to convert existing
Company-operated restaurants to the Sandwich-Café format.
One Company-operated restaurant opened in the Austin area in
June 2003. We also have acquired building sites for four
additional restaurants in the Austin area and entered into a
lease for a site in the Houston area. Sites for additional
restaurants in Texas and other markets are under consideration.
However, future development of these sites and conversion of
existing restaurants is limited until we have obtained
additional financing to fund this growth in our Company-operated
restaurants.

We made improvements to our operations of the
Company-operated restaurants in 2003. We modified internal
reporting procedures and focused our restaurant managers on
seeking to improve daily and weekly results, which improved our
operating accountability. In addition, we moved franchisee
training, product research and development, and operations
experimentation from our core stores into four stores that are
located in different regions of the country, rather than having
all training occur in a few stores in Texas. The refinement of
the Sandwich Café operating procedures also enhanced
operations at certain Company-operated restaurants as the
training for the new menus was completed.

In addition, we believe that we have also begun
to see potential improvement in our franchise licensing efforts.
We have increased advertising for sales of franchise licenses
and we have improved our Internet presence for that purpose.
These two factors have led to increased interest in our
franchise opportunities.

We are currently attempting to generate
additional working capital with third party financing and are
pursuing financing alternatives, including senior debt, real
estate mortgages, asset-backed financing secured by our
intellectual property and related royalty rights and agreements,
and equity financing. While we are in discussions with several
potential lenders or investors at this time, there can be no
assurances that such financing will be available or
accomplished. Should these discussions not result in an
acceptable financing, we would need to continue to seek
additional financing that would be sufficient, with our
operating income, to allow us to fund our operating expenses and
debt service. If we are unable to obtain adequate financing
during the first half of 2004 or are unable to negotiate waivers
or favorable payment terms with creditors, our ability to fund
continuing operations and working capital needs could be
materially adversely affected, and we might violate certain
financial covenants to which we are subject under certain third
party agreements, including loan agreements.

Because of the decline in restaurant count and
the debt obligation under certain seller financed debt which
initially was scheduled to mature in 2005, the Company increased
its accounts payable during 2003. The Company extended the
payment terms for many of its vendors, and this change in terms
is primarily responsible for the $3,879,000 shown as changes in
accounts payable and accrued liabilities. Waivers and deferred
payment terms have been negotiated and, in some cases, are being
negotiated with certain of these creditors. The Company intends
to improve vendor terms as its liquidity situation improves, and
plans on using future financing to reduce accounts payable and
improve aging of vendor accounts.

The Company sold $2.7 million of undeveloped
real estate in 2003, and continues to market its remaining held
for sale real estate assets. Proceeds from the sale of real
estate are pledged to reduce a credit facility with a remaining
balance of $1,723,000 at December 31, 2003.

QUARTERLY COMPARISONS

We utilize a 4-4-5 week
quarterly reporting schedule for royalties, restaurant
operations and royalty service costs. Fiscal years 2002 and 2001
included 52 weeks, while 2003 included 53 weeks,
including 14 weeks, instead of 13, in the fourth
quarter of 2003. For all other areas of the financial
statements, we report all fiscal quarters as ending on
March 31, June 30, September 30 and
December 31.

We believe that we experience only moderate
seasonality.

27



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##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES

CONDENSED QUARTERLY RESULTS OF
OPERATIONS


(UNAUDITED)


The following tables present unaudited condensed
quarterly results of operations and selected restaurant data for
2003 and 2002.

|                                    |                               |                                               |                                   |        |       |        |        |        |       |        |        |       |       |        |       |        |       |        |       |       |       |        |       |       |       |        |       |       |       |        |       |        |       |        |  
|----------------------------------- | ----------------------------- | --------------------------------------------- | --------------------------------- | ------ | ----- | ------ | ------ | ------ | ----- | ------ | ------ | ----- | ----- | ------ | ----- | ------ | ----- | ------ | ----- | ----- | ----- | ------ | ----- | ----- | ----- | ------ | ----- | ----- | ----- | ------ | ----- | ------ | ----- | ------ | -
|                                    |                               |                                               |                                   |       
|                                    |                               | 2003                                          |                                   | 2002  
|                                    |                               |                                               |                                   |       
|                                    |                               | 1st                                           |                                   | 2nd    |       | 3rd    |        | 4th    |       | 1st    |        | 2nd   |       | 3rd    |       | 4th   
|                                    |                               |                                               |                                   |        |       |        |        |        |       |        |        |       |       |        |       |       
|                                    |                               |                                              
|                                    |                               | (Dollars in thousands, except per share data)
|Revenue:                            |                               |                                               |                                   |        |       |        |        |        |       |        |        |       |       |        |       |        |       |        |       |       |       |        |       |       |       |        |       |       |       |        |       |       
|                                    | Royalties                     |                                               | $                                 | 4,304  |       |        | $      | 4,285  |       |        | $      | 3,977 |       |        | $     | 4,051  |       |        | $     | 5,120 |       |        | $     | 5,264 |       |        | $     | 4,984 |       |        | $     | 4,599  |      
|                                    | Franchise fees                |                                               |                                   |       |       |        |        | 3      |       |        |        | 17    |       |        |       |       |       |        |       | 20    |       |        |       | 42    |       |        |       |      |       |        |       | 60     |      
|                                    | Developer fees                |                                               |                                   | 50     |       |        |        | 44     |       |        |        | 37    |       |        |       | 37     |       |        |       | 60    |       |        |       | 60    |       |        |       | 59    |       |        |       | 52     |      
|                                    | Restaurant sales              |                                               |                                   | 7,612  |       |        |        | 8,001  |       |        |        | 7,937 |       |        |       | 8,461  |       |        |       | 7,871 |       |        |       | 8,269 |       |        |       | 7,935 |       |        |       | 7,648  |      
|                                    | Brand contribution            |                                               |                                   | 1,651  |       |        |        | 1,709  |       |        |        | 1,601 |       |        |       | 1,444  |       |        |       | 1,883 |       |        |       | 1,991 |       |        |       | 1,820 |       |        |       | 1,615  |      
|                                    | Other fees and revenue        |                                               |                                   | 213    |       |        |        | 220    |       |        |        | 280   |       |        |       | 244    |       |        |       | 292   |       |        |       | 276   |       |        |       | 295   |       |        |       | 331    |      
|                                    |                               |                                               |                                   |        |       |        |        |        |       |        |        |       |       |        |       |        |       |        |       |       |       |        |       |       |       |        |       |       |       |        |       |       
|                                    |                               |                                               | Total revenue                     |        |       | 13,830 |        |        |       | 14,262 |        |       |       | 13,849 |       |        |       | 14,237 |       |       |       | 15,246 |       |       |       | 15,902 |       |       |       | 15,093 |       |        |       | 14,305 |  
|                                    |                               |                                               |                                   |        |       |        |        |        |       |        |        |       |       |        |       |        |       |        |       |       |       |        |       |       |       |        |       |       |       |        |       |       
|Expenses:                           |                               |                                               |                                   |        |       |        |        |        |       |        |        |       |       |        |       |        |       |        |       |       |       |        |       |       |       |        |       |       |       |        |       |       
|                                    | Service costs:                |                                               |                                   |        |       |        |        |        |       |        |        |       |       |        |       |        |       |        |       |       |       |        |       |       |       |        |       |       |       |        |       |        |      
|                                    |                               | Royalties                                     |                                   |        | 664   |        |        |        | 667   |        |        |       | 607   |        |       |        | 527   |        |       |       | 1,135 |        |       |       | 1,106 |        |       |       | 1,009 |        |       |        | 725   |       
|                                    |                               | Franchise fees                                |                                   |        |      |        |        |        |      |        |        |       |      |        |       |        | (2    | )      |       |       | 10    |        |       |       | 16    |        |       |       |      |        |       |        | 27    |       
|                                    |                               |                                               |                                   |        |       |        |        |        |       |        |        |       |       |        |       |        |       |        |       |       |       |        |       |       |       |        |       |       |       |        |       |       
|                                    |                               |                                               | 664                               |        |       |        | 667    |        |       |        | 607    |       |       |        | 525   |        |       |        | 1,145 |       |       |        | 1,122 |       |       |        | 1,009 |       |       |        | 752   |       
|                                    |                               |                                               |                                   |        |       |        |        |        |       |        |        |       |       |        |       |        |       |        |       |       |       |        |       |       |       |        |       |       |       |        |       |       
|                                    | Restaurant operations:        |                                               |                                   |        |       |        |        |        |       |        |        |       |       |        |       |        |       |        |       |       |       |        |       |       |       |        |       |       |       |        |       |        |      
|                                    |                               | Cost of sales                                 |                                   |        | 2,172 |        |        |        | 2,349 |        |        |       | 2,419 |        |       |        | 2,378 |        |       |       | 2,196 |        |       |       | 2,312 |        |       |       | 2,247 |        |       |        | 2,180 |       
|                                    |                               | Personnel and benefits                        |                                   |        | 3,365 |        |        |        | 3,445 |        |        |       | 3,458 |        |       |        | 3,283 |        |       |       | 3,169 |        |       |       | 3,293 |        |       |       | 3,305 |        |       |        | 3,231 |       
|                                    |                               | Operating expenses                            |                                   |        | 1,902 |        |        |        | 2,202 |        |        |       | 1,997 |        |       |        | 1,926 |        |       |       | 1,767 |        |       |       | 1,869 |        |       |       | 1,989 |        |       |        | 1,932 |       
|                                    |                               |                                               |                                   |        |       |        |        |        |       |        |        |       |       |        |       |        |       |        |       |       |       |        |       |       |       |        |       |       |       |        |       |       
|                                    |                               |                                               | 7,439                             |        |       |        | 7,996  |        |       |        | 7,874  |       |       |        | 7,587 |        |       |        | 7,132 |       |       |        | 7,474 |       |       |        | 7,541 |       |       |        | 7,343 |       
|                                    |                               |                                               |                                   |        |       |        |        |        |       |        |        |       |       |        |       |        |       |        |       |       |       |        |       |       |       |        |       |       |       |        |       |       
|                                    | Equity loss on investments    |                                               |                                   | 67     |       |        |        | 83     |       |        |        | 320   |       |        |       | 1      |       |        |       | 30    |       |        |       | 48    |       |        |       | 59    |       |        |       | 57     |      
|                                    |                               |                                               |                                   |        |       |        |        |        |       |        |        |       |       |        |       |        |       |        |       |       |       |        |       |       |       |        |       |       |       |        |       |       
|                                    | General and administrative    |                                               |                                   | 5,071  |       |        |        | 6,713  |       |        |        | 7,115 |       |        |       | 5,172  |       |        |       | 4,480 |       |        |       | 4,835 |       |        |       | 4,834 |       |        |       | 5,340  |      
|                                    |                               |                                               |                                   |        |       |        |        |        |       |        |        |       |       |        |       |        |       |        |       |       |       |        |       |       |       |        |       |       |       |        |       |       
|                                    | Depreciation and amortization |                                               |                                   | 1,249  |       |        |        | 1,283  |       |        |        | 1,271 |       |        |       | 1,377  |       |        |       | 1,083 |       |        |       | 1,086 |       |        |       | 1,274 |       |        |       | 1,577  |      
|                                    |                               |                                               |                                   |        |       |        |        |        |       |        |        |       |       |        |       |        |       |        |       |       |       |        |       |       |       |        |       |       |       |        |       |       
|                                    |                               |                                               | Total expenses                    |        |       | 14,490 |        |        |       | 16,742 |        |       |       | 17,187 |       |        |       | 14,662 |       |       |       | 13,870 |       |       |       | 14,565 |       |       |       | 14,717 |       |        |       | 15,069 |  
|                                    |                               |                                               |                                   |        |       |        |        |        |       |        |        |       |       |        |       |        |       |        |       |       |       |        |       |       |       |        |       |       |       |        |       |       
|                                    |                               |                                               | Income (loss) from operations     |        |       | (660   | )      |        |       | (2,480 | )      |       |       | (3,338 | )     |        |       | (425   | )     |       |       | 1,376  |       |       |       | 1,337  |       |       |       | 376    |       |        |       | (764   | )
|Other:                              |                               |                                               |                                   |        |       |        |        |        |       |        |        |       |       |        |       |        |       |        |       |       |       |        |       |       |       |        |       |       |       |        |       |       
|                                    | Interest income               |                                               |                                   | 104    |       |        |        | 104    |       |        |        | 53    |       |        |       | 62     |       |        |       | 217   |       |        |       | 95    |       |        |       | 119   |       |        |       | 221    |      
|                                    | Interest expense              |                                               |                                   | (1,016 | )     |        |        | (1,010 | )     |        |        | (954  | )     |        |       | (1,024 | )     |        |       | (603  | )     |        |       | (655  | )     |        |       | (797  | )     |        |       | (1,018 | )    
|                                    |                               |                                               |                                   |        |       |        |        |        |       |        |        |       |       |        |       |        |       |        |       |       |       |        |       |       |       |        |       |       |       |        |       |       
|                                    |                               |                                               | Income (loss) before income taxes |        |       | (1,572 | )      |        |       | (3,386 | )      |       |       | (4,239 | )     |        |       | (1,387 | )     |       |       | 990    |       |       |       | 777    |       |       |       | (302   | )     |        |       | (1,561 | )
|Provision (credit) for income taxes |                               |                                               | (506                              | )      |       |        | (1,119 | )      |       |        | (1,463 | )     |       |        | 4,252 |        |       |        | 362   |       |       |        | 288   |       |       |        | (60   | )     |       |        | (487  | )     
|                                    |                               |                                               |                                   |        |       |        |        |        |       |        |        |       |       |        |       |        |       |        |       |       |       |        |       |       |       |        |       |       |       |        |       |       
|                                    |                               |                                               | Net income (loss)                 |        | $     | (1,066 | )      |        | $     | (2,267 | )      |       | $     | (2,776 | )     |        | $     | (5,639 | )     |       | $     | 628    |       |       | $     | 489    |       |       | $     | (242   | )     |        | $     | (1,074 | )
|                                    |                               |                                               |                                   |        |       |        |        |        |       |        |        |       |       |        |       |        |       |        |       |       |       |        |       |       |       |        |       |       |       |        |       |       
|Earnings per share  basic          |                               | $                                             | (0.15                             | )      |       | $      | (0.31  | )      |       | $      | (0.38  | )     |       | $      | (0.76 | )      |       | $      | 0.09  |       |       | $      | 0.07  |       |       | $      | (0.03 | )     |       | $      | (0.15 | )     
|                                    |                               |                                               |                                   |        |       |        |        |        |       |        |        |       |       |        |       |        |       |        |       |       |       |        |       |       |       |        |       |       |       |        |       |       
|Earnings per share 
    diluted    |                               | $                                             | (0.15                             | )      |       | $      | (0.31  | )      |       | $      | (0.38  | )     |       | $      | (0.76 | )      |       | $      | 0.08  |       |       | $      | 0.07  |       |       | $      | (0.03 | )     |       | $      | (0.15 | )     
|                                    |                               |                                               |                                   |        |       |        |        |        |       |        |        |       |       |        |       |        |       |        |       |       |       |        |       |       |       |        |       |       |       |        |       |       

28



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##### Table of Contents



IMPACT OF INFLATION

We believe that inflation did not have a material
impact on our 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 and Company-operated restaurant operations.






|         |                                                               
|-------- | --------------------------------------------------------------
|ITEM 7A. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
    MARKET RISK

Changes in short-term interest rates on loans
from financial institutions could materially affect our earnings
because the interest rates charged on certain underlying
obligations are variable.

At December 31, 2003, a hypothetical
100 basis point increase in interest rates would result in
a decrease of approximately $77,200 in annual pre-tax earnings.
The estimated decrease is based upon the increased interest
expense of our variable rate debt and assumes no change in the
volume or composition of debt at December 31, 2003.






|        |                                                
|------- | -----------------------------------------------
|ITEM 8. | FINANCIAL STATEMENTS AND SUPPLEMENTARY
    DATA

Reference is made to the consolidated financial
statements and schedule referred to in the index on page F-1
setting forth the Consolidated Financial Statements of
Schlotzskys, Inc. and Subsidiaries, together with the
reports thereon of Grant Thornton LLP.






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

None.






|         |                        
|-------- | -----------------------
|ITEM 9A. | CONTROLS AND PROCEDURES

The Companys management, including the
Companys principal executive officer and principal
financial officer, has evaluated the effectiveness of the
Companys disclosure controls and procedures (as defined in
Rules 13a-15(e) and 15d-15(e) under the Securities Exchange
Act of 1934) as of the end of the period covered by this Annual
Report on Form 10-K. Based upon that evaluation, the
Companys principal executive officer and principal
financial officer have concluded that the disclosure controls
and procedures were effective as of the end of the period
covered by this Annual Report on Form 10-K.

There were no changes in the Companys
internal control over financial reporting that occurred during
the Companys last fiscal quarter that has materially
affected, or is reasonably likely to materially affect, the
Companys internal control over financial reporting.

29



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##### Table of Contents






PART III






|         |                                                       
|-------- | ------------------------------------------------------
|ITEM 10. | DIRECTORS AND EXECUTIVE OFFICERS OF THE
    REGISTRANT

DIRECTORS AND EXECUTIVE OFFICERS

The current directors and executive officers of
the Company are:

|                                                |                                                   |     |  |         |  |            |  |      |  |  |  |      | 
|----------------------------------------------- | ------------------------------------------------- | --- |  | ------- |  | ---------- |  | ---- |  |  |  | ---- | 
|                                                |                                                   |     |  | Present |  | Year First
|                                                |                                                   |     |  | Term    |  | Elected   
|Name/Position(s) and Office(s) with the Company |                                                   | Age |  | Expires |  | Director  
|                                                |                                                   |     |  |         |  |           
|Floor Mouthaan (1)(2)                           |                                                   |     |  |         |  |            |  |      |  |  |  |     
|                                                | Director                                          |     |  | 58      |  |            |  | 2006 |  |  |  | 1994 | 
|Pike Powers(3)                                  |                                                   |     |  |         |  |            |  |      |  |  |  |     
|                                                | Director                                          |     |  | 63      |  |            |  | 2006 |  |  |  | 2003 | 
|Raymond A. Rodriguez                            |                                                   |     |  |         |  |            |  |      |  |  |  |     
|                                                | Director                                          |     |  | 46      |  |            |  | 2005 |  |  |  | 1994 | 
|John Sharp (1)(3)                               |                                                   |     |  |         |  |            |  |      |  |  |  |     
|                                                | Director                                          |     |  | 53      |  |            |  | 2005 |  |  |  | 2003 | 
|Sarah Weddington (2)(3)                         |                                                   |     |  |         |  |            |  |      |  |  |  |     
|                                                | Director                                          |     |  | 59      |  |            |  | 2006 |  |  |  | 2003 | 
|John C. Wooley(4)                               |                                                   |     |  |         |  |            |  |      |  |  |  |     
|                                                | Chairman of the Board, President and CEO          |     |  | 55      |  |            |  | 2004 |  |  |  | 1981 | 
|Jeffrey J. Wooley(4)                            |                                                   |     |  |         |  |            |  |      |  |  |  |     
|                                                | Director, Senior Vice President and Secretary     |     |  | 58      |  |            |  | 2005 |  |  |  | 1981 | 
|Darrell W. Kolinek                              |                                                   |     |  |         |  |            |  |      |  |  |  |     
|                                                | Senior Vice President  Restaurant
    Operations |     |  | 52      |  |            |  | N/A  |  |  |  | N/A  | 
|Joyce Cates                                     |                                                   |     |  |         |  |            |  |      |  |  |  |     
|                                                | Senior Vice President  Franchise
    Operations  |     |  | 56      |  |            |  | N/A  |  |  |  | N/A  | 



---



|    |                                                                 
|--- | ----------------------------------------------------------------
|(1) | Member of the Audit Committee.                                  
|   
|(2) | Member of the Compensation Committee.                           
|   
|(3) | Member of the Nominating and Corporate Governance
    Committee.
|   
|(4) | Member of the Executive Committee.                              

Floor Mouthaanhas
been a managing director of Gold-Zack AG, a German investment
banking firm, since July 2000. He was the managing director of
Greenfield Capital Partners, B.V., from 1995 to 2000.
Mr. Mouthaan was the chief executive officer of Noro
(Nederland) B.V., an international venture capital fund located
in Zeist, the Netherlands, from 1988 to 1995.

Pike Powershas been
a partner in the law firm of Fulbright & Jaworski,
L.L.P. since 1978. He served as a Texas State Representative
from 1972 to 1979 and was executive assistant to Texas Governor
Mark White in 1983. Mr. Powers received a BA from Lamar
University in 1962 and a JD from The University of Texas School
of Law in 1965.

Raymond A. Rodriguezhas been President of RAR Service
Group, Inc., a financial services and consulting firm
located in Long Grove, Illinois, since 1985.
Mr. Rodriguez is an officer and principal shareholder of
Barmar Enterprises, Inc., an area developer for the Company
in the Chicago, Illinois area since 1992, and has been an
owner of several Schlotzskys restaurants in Illinois since
1993.

John Sharphas
served as a principal in the tax consulting firm Ryan &
Company since 1998. Mr. Sharp served as Texas Comptroller
of Public Accounts from 1991 to 1998 and as a Texas Railroad
Commissioner from 1985 to 1991. He served as a Texas State
Senator from 1982 to 1985 and as a Texas State Representative
from 1979 to 1982. Mr. Sharp received a BA from Texas
A&M University in 1972 and a MPA in public administration
from Southwest Texas State University in 1975.

30



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Sarah Weddingtonis
a lawyer, author, speaker and adjunct professor at The
University of Texas at Austin. She served as director of the
Texas Office of State-Federal Relations from 1983 to 1985, as
Assistant to President Jimmy Carter from 1978 to 1981 and as
General Counsel of the U.S. Department of Agriculture from
1977 to 1978. Dr. Weddington served as a Texas State
Representative from 1973 to 1977. Dr. Weddington received a
BA from McMurry University in 1964 and a JD from The University
of Texas School of Law in 1967.

John C. Wooleyhas
served as Chairman of the Board and President of the Company
since 1981 and as Chief Executive Officer since 1995. From 1974
to 1981, he participated in various real estate development and
investment activities. Mr. Wooley earned a BBA in
accounting in 1970 and a JD in 1974, both from The University of
Texas at Austin.

Jeffrey J. Wooleyhas served the Company as Secretary
since 1981 and as Senior Vice President since 1995.
Mr. Wooley also served the Company as General Counsel from
1981 through 1997, and as Vice President from 1981 through 1995.
Prior to 1981, Mr. Wooley was engaged in the private
practice of law in Colorado and Texas. Mr. Wooley received
a BA degree from Rice University in 1968 and a JD from The
University of Texas at Austin in 1972. Jeffrey Wooley and John
Wooley are brothers.

Darrell W. Kolinekjoined the Company in 1980 as
Operations Supervisor. He became Director of Franchise Services
in 1991. Mr. Kolinek was appointed Vice President of
Franchise Services in January 1995, Senior Vice President of
Franchise Services in July 1995, Senior Vice President of
Franchise Relations in February 1999, and Senior Vice President
of Restaurant Operations in July 1999. Mr. Kolinek attended
Southwest Texas State University.

Joyce Catesjoined
the Company in 1994 as Franchise Sales Administrator. In
February 1995, she was appointed Office Administrator. In
December 1995, she was promoted to Vice President of Corporate
Administration. In January 1998, she became Vice President of
Executive Administration. In October 1999, she was named Vice
President of Franchise Operations. In October 2000, she was
named Senior Vice President of Franchise Operations.
Ms. Cates received a Bachelor of Science degree from Texas
Womans University in 1969.

SECTION 16(a) BENEFICIAL OWNERSHIP
REPORTING COMPLIANCE

Section 16(a) of the Securities Exchange Act
of 1934, as amended, requires our directors, officers and
beneficial owners of more than 10% of our common stock to report
beneficial ownership and changes in beneficial ownership with
the SEC. Based solely upon a review of Forms 3, 4 and 5 and
amendments thereto furnished to the Company, we believe that all
these persons filed the reports required by Section 16(a)
of the Exchange Act with the SEC on a timely basis during fiscal
year 2003.

AUDIT COMMITTEE FINANCIAL EXPERT

The Company has a separately designated standing
audit committee comprised of Floor Mouthaan and John Sharp. The
Companys Board of Directors has determined that while none
of the Audit Committee members is an audit committee
financial expert, as defined in the rules adopted by the
SEC, the Audit Committee meets the requirements of the
applicable NASDAQ rules. The Board has concluded that the
ability of the Audit Committee to perform its duties will not be
impaired by the absence of an audit committee financial
expert if the Audit Committee otherwise satisfies the
NASDAQ standards.

CODE OF BUSINESS CONDUCT AND ETHICS AND
CORPORATE GOVERNANCE

The Company has adopted a code of ethics that
applies to all of its directors, officers and employees,
including its principal executive officer, principal financial
officer, principal accounting officer or controller, or persons
performing similar functions. This code of ethics, designated as
the Code of Business Conduct and Ethics by the
Company, can be found on the Companys website at
www.schlotzskys.com. The Company intends to satisfy the
disclosure requirement under Item 10 of Form 8-K
regarding any amendment to, or

31



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##### Table of Contents



waiver from, any applicable provision (related to
elements listed under Item 406(b) of Regulation S-K)
of the Code of Business Conduct and Ethics that
applies to the Companys principal executive officer,
principal financial officer, principal accounting officer or
controller, or persons performing similar functions by posting
such information on the Companys website at
www.schlotzskys.com.


The Board of Directors also has adopted and
approved written charters for its Nominating and Corporate
Governance, Audit and Compensation Committees. All of the
foregoing documents are available on the Companys website
at www.schlotzskys.com.






|         |                       
|-------- | ----------------------
|ITEM 11. | EXECUTIVE COMPENSATION

SUMMARY COMPENSATION TABLE

The following table sets forth certain
information with respect to the compensation paid by the Company
for services rendered during the fiscal years ended
December 31, 2003, 2002 and 2001 to the Companys
chief executive officer and the next top five paid employees in
2003.

|                            |                         |      |      |                     |  |            |         |                        |  |                 |        |         |      |  |     |        |  |  |        |         |     
|--------------------------- | ----------------------- | ---- | ---- | ------------------- |  | ---------- | ------- | ---------------------- |  | --------------- | ------ | ------- | ---- |  | --- | ------ |  |  | ------ | ------- | ----
|                            |                         |      |      |                     |  |            |         |                       
|                            |                         |      |      |                     |  |            |         | Long Term Compensation
|                            |                         |      |      |                     |  |            |         |                       
|                            |                         |      |      |                     |  |            |         | Awards                 |  | Payouts        
|                            |                         |      |      |                     |  |            |         |                       
|                            |                         |      |      | Annual Compensation |  | Securities |         |                       
|                            |                         |      |      |                     |  | Underlying |         | All Other             
|Name and Principal Position |                         | Year |      | Salary($)           |  | Bonus($)   |         | Options/SARs (#)       |  | Compensation($)
|                            |                         |      |      |                     |  |            |         |                        |  |                
|John C. Wooley              |                         |      | 2003 |                     |  |            | 361,870 |                        |  |                 | -0-    |         |      |  | -0- |        |  |  | 34,176 | (2)    
|                            | Chairman of the Board,  |      |      | 2002                |  |            |         | 377,287                |  |                 |        | -0-     |      |  |     | -0-    |  |  |        | 186,462 | (3) 
|                            | President and CEO       |      |      | 2001                |  |            |         | 300,000                |  |                 |        | 150,000 | (1)  |  |     | -0-    |  |  |        | 184,212 | (4) 
|Jeffrey J. Wooley           |                         |      | 2003 |                     |  |            | 271,298 |                        |  |                 | -0-    |         |      |  | -0- |        |  |  | 44,205 | (6)    
|                            | Director, Senior VP and |      |      | 2002                |  |            |         | 282,965                |  |                 |        | -0-     |      |  |     | -0-    |  |  |        | 183,811 | (7) 
|                            | Secretary               |      |      | 2001                |  |            |         | 225,000                |  |                 |        | 112,500 | (5)  |  |     | -0-    |  |  |        | 119,100 | (8) 
|Richard H. Valade           |                         |      | 2003 |                     |  |            | 182,250 | (9)                    |  |                 | -0-    |         |      |  | -0- |        |  |  | 91,761 | (10)   
|                            | Executive VP,           |      |      | 2002                |  |            |         | 243,000                |  |                 |        | -0-     |      |  |     | -0-    |  |  |        | 16,479  | (11)
|                            | Treasurer and CFO       |      |      | 2001                |  |            |         | 225,000                |  |                 |        | 112,500 | (1)  |  |     | -0-    |  |  |        | 12,757  | (12)
|Darrell W. Kolinek          |                         |      | 2003 |                     |  |            | 166,250 |                        |  |                 | -0-    |         |      |  | -0- |        |  |  | 19,757 | (13)   
|                            | Senior VP  Restaurant  |      |      | 2002                |  |            |         | 170,000                |  |                 |        | -0-     |      |  |     | -0-    |  |  |        | 7,472   | (14)
|                            | Operations              |      |      | 2001                |  |            |         | 155,000                |  |                 |        | -0-     |      |  |     | 40,000 |  |  |        | 340     | (15)
|Joyce Cates                 |                         |      | 2003 |                     |  |            | 165,833 |                        |  |                 | -0-    |         |      |  | -0- |        |  |  | 6,633  | (15)   
|                            | Senior VP  Franchise   |      |      | 2002                |  |            |         | 170,000                |  |                 |        | -0-     |      |  |     | -0-    |  |  |        | 6,800   | (15)
|                            | Operations              |      |      | 2001                |  |            |         | 128,750                |  |                 |        | -0-     |      |  |     | 25,000 |  |  |        | 2,281   | (15)
|Karl Martin                 |                         |      | 2003 |                     |  |            | 140,000 |                        |  |                 | 30,000 | (16)    |      |  | -0- |        |  |  | 3,277  | (17)   
|                            | Senior Franchise        |      |      | 2002                |  |            |         | 160,000                |  |                 |        | 10,000  | (16) |  |     | -0-    |  |  |        | 4,240   | (18)
|                            | Sales Manager           |      |      | 2001                |  |            |         | 160,000                |  |                 |        | -0-     |      |  |     | -0-    |  |  |        | 4,818   | (19)



---



|    |                                                                                                                                                                                                                                                                                                                                                                                       
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Paid pursuant to the applicable executive
    officers employment agreements.                                                                                                                                                                                                                                                                                                        
|   
|(2) | Includes (i) a $26,176 payment for unused
    vacation accrued during 2003, to be paid by the Company in 2004,
    and (ii) a $8,000 employer matching contribution to his
    401K plan account.                                                                                                                                                                                     
|   
|(3) | Includes (i) a bonus advance of $150,000
    paid in January 2002, to be repaid to the Company with 60% of
    the net bonus, if any, for each year beginning with the 2002
    bonus, (ii) a $29,021 payment for unused vacation accrued
    during 2002, but not paid by the Company until 2004, and
    (iii) a $7,441 employer matching contribution to his 401K
    plan account.
|   
|(4) | Includes (i) a bonus advance of $150,000
    paid in January 2001, to be repaid to the Company with 60% of
    the net bonus, if any, for each year beginning with the 2002
    bonus, (ii) a $28,962 payment for unused vacation accrued
    during 2001, and (iii) a $5,250 employer matching
    contribution to his 401K plan                                                     

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|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    | account. His employment agreement was amended in
    January 2002 to eliminate the provision for 150,000 stock
    options, or an economically equivalent benefit, which was to
    have been granted in 2001.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   
|(5) | Earned pursuant to Mr. Jeffrey Wooleys
    employment agreement, but the company issued a note for $112,500
    instead of paying the bonus in cash. The note is due and payable
    January 31, 2005.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|   
|(6) | Includes (i) a $19,613 payment for unused
    vacation accrued during 2003, to be paid by the Company in 2004,
    (ii) a $9,314 premium paid for dependent medical insurance,
    (iii) a $7,278 premium paid for life and disability
    insurance, and (iv) a $8,000 employer matching contribution
    to his 401K plan account.                                                                                                                                                                                                                                                                                                                                                                           
|   
|(7) | Includes (i) a bonus advance of $140,000 to
    be repaid to the Company with 60% of the net bonus, if any, for
    each year beginning with the 2002 bonus, (ii) a $21,766
    payment for unused vacation accrued during 2001, but not paid by
    the Company until 2004, (iii) a $8,467 premium paid for
    dependent medical insurance, (iv) a $6,151 premium paid for
    life and disability insurance, and (v) a $7,427 employer
    matching contribution to his 401K plan account. In lieu of the
    $140,000 advance referenced in (i) above, the Company
    executed a promissory note with Jeff due and payable by
    January 31, 2005.                                                       
|   
|(8) | Includes (i) a bonus advance of $70,000 to
    be repaid to the Company with 60% of the net bonus, if any, for
    each year beginning with the 2002 bonus, (ii) an advance of
    $17,000 that was repaid in April 2002, (iii) a $21,721
    payment for accrued and unused vacation, (iv) a $4,018
    premium paid for dependent medical insurance, (v) a $1,113
    premium paid for supplemental life insurance, and (vi) a
    $5,248 employer matching contribution to his 401K plan account.
    His employment agreement was amended in December 2001 to
    eliminate the provision for 100,000 stock options, or an
    economically equivalent benefit, which was to have been granted
    in 2001.
|   
|(9) | Mr. Valade resigned as our Executive Vice
    President, Treasurer and Chief Financial Officer and ended his
    employment with us in September 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         



|     |                                                                                                                                                                                                                                                                                                                                                                                                                                             
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(10) | Includes (i) a $584 payment for unused
    vacation accrued during 2002, (ii) a $14,016 payment for
    unused vacation accrued during 2003, (iii) a $6,985 premium
    paid for dependent medical insurance, (iv) a $3,288 premium
    paid for COBRA insurance, (v) a $5,888 employer matching
    contribution to his 401K plan account, (vi) $60,750 of
    employment separation pay pursuant to Mr. Valades
    employment agreement.
|    
|(11) | Includes (i) a $8,467 premium paid for
    dependent medical insurance, and (ii) a $722 premium paid
    for supplemental life insurance, and (iii) a $7,290
    employer matching contribution to his 401K plan account.                                                                                                                                                                                                                   
|    
|(12) | Includes (i) $7,200 of relocation expenses,
    (ii) a $4,082 premium paid for dependent medical insurance,
    (iii) a $912 premium paid for supplemental life insurance,
    and (iv) a $563 employer matching contribution to his 401K
    plan account.                                                                                                                                                                                 
|    
|(13) | Includes (i) a $12,385 payment for accrued
    but unused vacation in 2003 to be paid in 2004, (ii) a $722
    premium paid for supplemental life insurance, and (iii) a
    $6,650 employer matching contribution to his 401K plan account.                                                                                                                                                                                                
|    
|(14) | Includes (i) a $672 premium paid for
    supplemental life insurance, and (ii) a $6,800 employer
    matching contribution to his 401K plan account.                                                                                                                                                                                                                                                                                        
|    
|(15) | Employer matching contribution to 401K plan
    account.                                                                                                                                                                                                                                                                                                                                                                                    
|    
|(16) | Paid pursuant to a supply chain management
    agreement between the Company and a third party relating to the
    Companys proprietary brand products.                                                                                                                                                                                                                                                                                    
|    
|(17) | Includes (i) a $1,760 premium paid for
    dependent medical insurance, and (ii) a $1,517 employer
    matching contribution to his 401K account.                                                                                                                                                                                                                                                                                           
|    
|(18) | Includes (i) a $2,640 premium paid for
    dependent medical insurance, and (ii) a $1,600 employer
    matching contribution to his 401K account.                                                                                                                                                                                                                                                                                           
|    
|(19) | Includes (i) a $4,018 premium paid for
    dependent medical insurance, and (ii) a $800 employer
    matching contribution to his 401K account.                                                                                                                                                                                                                                                                                             

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##### Table of Contents



OPTION GRANTS IN LAST FISCAL YEAR

We did not grant any stock options or stock
appreciation rights to any named executive officers during
fiscal year 2003.

AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL
YEAR AND FISCAL YEAR-END OPTION VALUES

The following table sets forth certain
information concerning the fiscal year-end value of the
unexercised options of each named executive officer for fiscal
year 2003. No named executive officers exercised any stock
options or stock appreciation rights during fiscal year 2003.

|                   |  |                        |        |                         |  |             |     |               |  |  |     |  |  |  |     | 
|------------------ |  | ---------------------- | ------ | ----------------------- |  | ----------- | --- | ------------- |  |  | --- |  |  |  | --- | 
|                   |  |                        |        |                         |  |            
|                   |  | Number of Securities   |        |                        
|                   |  | Underlying Unexercised |        | Value of Unexercised   
|                   |  | Options at             |        | In-the-Money Options at
|                   |  | Fiscal Year-End(#)     |        | Fiscal Year-End($)(1)  
|                   |  |                        |        |                        
|Name               |  | Exercisable            |        | Unexercisable           |  | Exercisable |     | Unexercisable
|                   |  |                        |        |                         |  |             |     |              
|John C. Wooley     |  |                        | -0-    |                         |  |             | -0- |               |  |  | -0- |  |  |  | -0- | 
|Jeffrey J. Wooley  |  |                        | -0-    |                         |  |             | -0- |               |  |  | -0- |  |  |  | -0- | 
|Richard H. Valade  |  |                        | -0-    |                         |  |             | -0- |               |  |  | -0- |  |  |  | -0- | 
|Darrell W. Kolinek |  |                        | 80,938 |                         |  |             | -0- |               |  |  | -0- |  |  |  | -0- | 
|Joyce Cates        |  |                        | 57,000 |                         |  |             | -0- |               |  |  | -0- |  |  |  | -0- | 
|Karl Martin        |  |                        | 67,498 |                         |  |             | -0- |               |  |  | -0- |  |  |  | -0- | 






|    |                                                                                
|--- | -------------------------------------------------------------------------------
|(1) | The closing price per share of Common Stock on
    December 31, 2003 was $2.04.

COMPENSATION OF DIRECTORS

Directors who are not officers or employees of,
or consultants to, the Company received a retainer of
$2,000 per month, $1,500 for each meeting of the Board of
Directors attended, $2,000 for each Audit Committee meeting
attended and $1,500 for any other committee meeting attended
during fiscal year 2003. Floor Mouthaan is reimbursed for travel
expenses for each trip to the site of a Board or committee
meeting. He was reimbursed a total of approximately $14,000 in
2003 for travel expenses related to Board and committee meetings.

EMPLOYMENT AGREEMENTS

As amended, the employment agreement of John C.
Wooley, the Companys Chairman of the Board, President and
Chief Executive Officer, includes the following provisions:



| |   |                                                                                                                                                                                                                                                                                                     
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | a rolling four-year term to be automatically
    extended on December 31 of each year;                                                                                                                                                                                                              
|
| |  | base salary in 2003 of $361,870, calculated
    according to formula based on 2002 base salary and the
    Companys 2002 EBITDA (earnings before interest, taxes,
    depreciation and amortization), and voluntarily decreased by
    John in connection with the reduction in force in July 2003;
|
| |  | base salary increase in future years according to
    formula based on prior years base salary and increase in
    the Companys EBITDA, up to a maximum increase of
    100% per year;                                                                                                            
|
| |  | possible cash bonus based on increase in the
    Companys EBITDA, up to 100% of base salary;                                                                                                                                                                                                       
|
| |  | advances of $150,000 in January 2001 and in
    January 2002, with repayment from a portion of future cash
    bonuses;                                                                                                                                                                             
|
| |  | other employment benefits related to insurance
    premiums;                                                                                                                                                                                                                                        

34



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##### Table of Contents





| |   |                                                                                                                                                                                                                                                                            
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | upon any termination of employment by the Company
    or upon certain events following a change in control of the
    Company, salary and other benefits paid for up to four years,
    and remaining 2001 and 2002 advance balance, if any, will be
    deemed earned; and
|
| |  | repayment of certain loans from the Company to
    John to commence when certain personal guaranties by John of
    Company obligations are released. See Certain
    Relationships and Related Transactions below.                                                      

Johns employment agreement also provided
for a grant of 150,000 stock options on June 1, 2001, at
the then-current market price and with immediate vesting,
subject to any Compensation Committee action and approval by the
Companys shareholders necessary to increase the shares
issuable under the 1993 Stock Option Plan, or a benefit
economically equivalent to the foregoing stock options, if
required Compensation Committee or shareholder action did not
occur. In December 2001 and January 2002, the Compensation
Committee approved amendments to his employment agreement,
resulting in: (i) the elimination of the stock option grant
and the economic equivalent benefit provisions; and
(ii) the addition of the bonus advances described above. In
addition, in April 2000, the Compensation Committee cancelled,
at Johns request, all 346,875 stock options
previously granted to him by the Company.

As amended, the employment agreement of Jeffrey
J. Wooley, the Companys Secretary and Senior Vice
President, includes the following provisions:



| |   |                                                                                                                                                                                                                                                                                                     
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | a rolling four-year term to be automatically
    extended on December 31 of each year;                                                                                                                                                                                                              
|
| |  | base salary in 2003 of $271,298, calculated
    according to formula based on 2002 base salary and the
    Companys 2002 EBITDA (earnings before interest, taxes,
    depreciation and amortization), and voluntarily decreased by
    Jeff in connection with the reduction in force in July 2003;
|
| |  | base salary increase in future years according to
    formula based on prior years base salary and increase in
    the Companys EBITDA, up to a maximum increase of
    100% per year;                                                                                                            
|
| |  | cash bonus based on increase in the
    Companys EBITDA, up to 100% of base salary;                                                                                                                                                                                                                
|
| |  | advances of $50,000 in January 2001 and $140,000
    in January 2002, with repayment from a portion of future cash
    bonuses;                                                                                                                                                                     
|
| |  | other employment benefits related to insurance
    premiums;                                                                                                                                                                                                                                        
|
| |  | upon any termination of employment by the Company
    or upon certain events following a change in control of the
    Company, salary and other benefits paid for up to four years,
    and remaining 2001 and 2002 advance balance, if any, will be
    deemed earned; and                         
|
| |  | repayment of certain loans from the Company to
    Jeff to commence when certain personal guaranties by Jeff of
    Company obligations are released. See Certain
    Relationships and Related Transactions below.                                                                               

Jeffs employment agreement also provided
for a grant of 100,000 stock options on June 1, 2001, at
the then-current market price and with immediate vesting,
subject to any Compensation Committee action and approval by the
Companys shareholders necessary to increase the shares
issuable under the 1993 Stock Option Plan, or a benefit
economically equivalent to the foregoing stock options, if
required Compensation Committee or shareholder action did not
occur. In December 2001 and January 2002, the Compensation
Committee approved amendments to his employment agreement,
resulting in: (i) the elimination of the stock option grant
and the economic equivalent benefit provisions; and
(ii) the addition of the bonus advances described above. In
addition, in April 2000, the Compensation Committee cancelled,
at Jeffs request, all 131,250 stock options
previously granted to him by the Company.

In 2000, the Company entered into an employment
agreement with Richard H. Valade, the former Executive Vice
President, Treasurer and Chief Financial Officer of the Company.
This agreement provided for base salary, bonus parameters, an
option grant, other employment benefits and payment of salary
and benefits for one year upon certain events.

35



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##### Table of Contents



COMPENSATION COMMITTEE INTERLOCKS AND INSIDER
PARTICIPATION

There are no relationships or transactions
required to be reported in this section under the applicable
securities regulations.






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

The following table sets forth certain
information regarding the beneficial ownership of shares of
common stock, as of the close of business on March 26, 2004
(except as otherwise indicated), by each person or group (as
that term is used in Section 13(d)(3) of the Exchange Act)
known to the Company to be the beneficial owner of more than 5%
of the outstanding common stock, each current director of the
Company, each executive officer included in the Summary
Compensation Table, and all current directors and executive
officers of the Company as a group. Except as otherwise
indicated, the persons named in the table have sole voting and
investment power with respect to the shares of Common Stock
shown as beneficially owned by them. Beneficial ownership as
reported in the table has been determined in accordance with
Rule 13d-3 under the Exchange Act and represents the number
of shares of Common Stock for which a person, directly or
indirectly, through any contract, management, understanding,
relationship or otherwise, has or shares voting power, including
the power to vote or direct the voting of such shares, or
investment power, including the power to dispose or to direct
the disposition of such shares, and includes shares which may be
acquired within 60 days after March 26, 2004. There
were 7,338,661 shares outstanding as of March 26,
2004, excluding shares owned by the Company.

|                                                                  |  |                           |           |          |  |  |      |  
|----------------------------------------------------------------- |  | ------------------------- | --------- | -------- |  |  | ---- | -
|                                                                  |  |                          
|                                                                  |  | Shares Beneficially Owned
|                                                                  |  |                          
|                                                                  |  |                           |           | Percent 
|Name                                                              |  | Number                    |           | of Class
|                                                                  |  |                           |           |         
|Cahispa, S.A. de Seguros de Vida                                  |  |                           | 678,028   | (1)      |  |  | 9.2  | %
|Dimensional Fund Advisors, Inc.                                   |  |                           | 526,750   | (2)      |  |  | 7.2  | %
|Joseph G. Beard                                                   |  |                           | 1,200,950 | (3)      |  |  | 16.4 | %
|Floor Mouthaan                                                    |  |                           | 10,000    | (4)      |  |  | *    |  
|Pike Powers                                                       |  |                           | 3,334     | (5)      |  |  | *    |  
|Raymond A. Rodriguez                                              |  |                           | 28,169    | (4)      |  |  | *    |  
|John Sharp                                                        |  |                           | 3,334     | (5)      |  |  | *    |  
|Sarah Weddington                                                  |  |                           | 3,334     | (5)      |  |  | *    |  
|John C. Wooley                                                    |  |                           | 794,662   | (6)      |  |  | 10.8 | %
|Jeffrey J. Wooley                                                 |  |                           | 157,651   | (7)      |  |  | 2.1  | %
|Richard H. Valade                                                 |  |                           | 8,008     | (8)      |  |  | *    |  
|Darrell W. Kolinek                                                |  |                           | 116,493   | (9)      |  |  | 1.6  | %
|Joyce Cates                                                       |  |                           | 57,000    | (10)     |  |  | *    |  
|Karl Martin                                                       |  |                           | 67,766    | (11)     |  |  | *    |  
|                                                                 
|All executive officers and directors as a group
    (ten persons) |  |                           | 1,240,601 | (12)     |  |  | 16.3 | %



---



|  |             
|- | ------------
|* | Less than 1%



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                             
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Based on review of Schedule 13 G, and
    current as of December 12, 2003. The address for Cahispa,
    S.A. de Seguros de Vida is Calle Lauria No. 18, Barcelona,
    08010, Spain.                                                                                                                                                                                                                                                        
|   
|(2) | Based on review of Schedule 13G/ A, and
    current as of February 6, 2004. The address for Dimensional
    Fund Advisors, Inc. is 1299 Ocean Avenue, 11th Floor, Santa
    Monica, California 90401.                                                                                                                                                                                                                                       
|   
|(3) | Based on review of Schedule 13D/ A and
    current as of February 3, 2004. Includes
    437,900 shares owned by Mr. Beard, directly or through
    accounts for his children, for which sole voting and investment
    power is held by Mr. Beard, and 763,050 shares owned
    by Westdale Properties America I, Ltd. (WPA),
    for which shared voting and investment power is held by
    Mr. Beard, WPA, JGB Ventures I, Ltd. (JV),

36



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##### Table of Contents



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                       
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    | JGB Holdings, Inc. (JH), and
    Ronald Kimel as Trustee. The address of Mr. Beard, WPA, JV
    and JH is 3300 Commerce Boulevard East, Dallas, Texas 75226. The
    address of Mr. Kimel is 444 Adelaide Street West, Toronto,
    Ontario M5V1S7, Canada. The Schedule 13D/ A indicates that
    the persons and entities identified in this footnote may be
    deemed to comprise a group under applicable
    securities law.
|   
|(4) | Includes 10,000 shares which may be
    purchased from the Company pursuant to currently exercisable
    stock options at $3.7406 per share.                                                                                                                                                                                                                                                                                          
|   
|(5) | Includes 3,334 shares which may be purchased
    from the Company pursuant to currently exercisable stock options
    at $2.06 per share.                                                                                                                                                                                                                                                                                             
|   
|(6) | Includes 1,142 shares held by a trust for
    the benefit of John Wooley and Jeffrey Wooley (the Wooley
    Trust), for which John Wooley is a co-trustee.                                                                                                                                                                                                                                                                          
|   
|(7) | Includes 1,142 shares held by the Wooley
    Trust, for which Jeffrey Wooley is a co-trustee.                                                                                                                                                                                                                                                                                                                                         
|   
|(8) | Includes 5,000 shares held in an investment
    account jointly owned by Mr. Valade and his wife.
    Mr. Valade is no longer an employee of the Company.                                                                                                                                                                                                                                                                             
|   
|(9) | Includes (i) 80,938 shares purchasable
    by Mr. Kolinek from the Company within 60 days of
    March 26, 2004, pursuant to options granted by the Company,
    and (ii) 31,000 shares purchasable by
    Mr. Kolineks wife from the Company within
    60 days of March 26, 2004, pursuant to options granted
    by the Company to her in her capacity as an employee of the
    Company.                                         



|     |                                                                                                                                                                                                                                                                                                                                                              
|---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(10) | Includes 57,000 shares purchasable from the
    Company within 60 days of March 26, 2004, pursuant to
    options granted by the Company to Ms. Cates.                                                                                                                                                                                                       
|    
|(11) | Includes 67,498 shares purchasable from the
    Company within 60 days of March 26, 2004, pursuant to
    options granted by the Company to Mr. Martin.                                                                                                                                                                                                      
|    
|(12) | Shares deemed to be beneficially owned by more
    than one executive officer or director have only been counted
    once in determining total shares beneficially owned by all
    executive officers as a group. Includes 266,438 shares
    purchasable from the Company within 60 days of
    March 26, 2004, pursuant to options granted by the Company.

Substantially all of the shares beneficially
owned by John Wooley and Jeffrey Wooley are pledged to secure
personal indebtedness.

EQUITY COMPENSATION PLAN INFORMATION

|                                                               |  |                   |         |                   |  |                 |      |  |  |  |         | 
|-------------------------------------------------------------- |  | ----------------- | ------- | ----------------- |  | --------------- | ---- |  |  |  | ------- | 
|                                                               |  | Number of         |         |                   |  |                
|                                                               |  | securities to be  |         | Weighted-         |  |                
|                                                               |  | issued upon       |         | average           |  | Number of      
|                                                               |  | exercise of       |         | exercise price of |  | securities     
|                                                               |  | outstanding       |         | outstanding       |  | remaining      
|                                                               |  | options, warrants |         | options, warrants |  | available for  
|Plan Category                                                  |  | and rights        |         | and rights        |  | future issuance
|                                                               |  |                   |         |                   |  |                
|Equity compensation plans approved by security
    holders     |  |                   | 931,131 |                   |  | $               | 5.44 |  |  |  | 154,864 | 
|Equity compensation plans not approved by
    security holders |  |                   | 30,000  |                   |  | $               | 4.50 |  |  |  | -0-     | 
|                                                               |  |                   |         |                   |  |                 |      |  |  |  |         | 
|Total                                                          |  |                   | 961,131 |                   |  | $               | 5.41 |  |  |  | 154,864 | 
|                                                               |  |                   |         |                   |  |                 |      |  |  |  |         | 

The Company has three equity compensation plans
that have been approved by security holders.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (i) The Third Amended and Restated 1993
    Stock Option Plan, as amended (the 1993 Option
    Plan), terminated on December 23, 2003 except for
    options granted as of that date. Under the 1993 Option Plan
    there were options for 909,831 shares of common stock
    issued as of December 31, 2003, with a weighted average
    exercise price of $5.50 per share, and no options are
    available for future issuance.
|
| | (ii) The 1995 Non-Employee Director Stock
    Option Plan, has options for 22,300 shares of common stock
    issued as of December 31, 2003, with a weighted average
    exercise price of $2.90 per share, and has no options
    remaining available for future issuance.                                                                                                                                                          

37



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##### Table of Contents





| |                                                                                                                                   
| | ----------------------------------------------------------------------------------------------------------------------------------
| | (iii) As of December 31, 2003 the
    Employee Stock Purchase Plan has 154,864 shares remaining
    available for future issuance.

In connection with a Schlotzskys
N.A.M.F., Inc. (NAMF) subordinated debt
financing in 2001, the Company issued warrants for the purchase
of 30,000 shares of common stock to the lender, an entity
of which a member of the Companys Board of Directors was
then a managing director. These warrants have an exercise price
of $4.50 per share and expire in 2006. NAMF reimbursed the
Company the cost of issuing the warrants. These warrants were
not approved by securities holders.






|         |                                                   
|-------- | --------------------------------------------------
|ITEM 13. | CERTAIN RELATIONSHIPS AND RELATED
    TRANSACTIONS

John C. Wooley and Jeffrey J. Wooley have
personally guaranteed and pledged collateral in connection with
obligations of the Company to various lenders and lessors. The
Company has agreed to indemnify both of them against
liabilities, costs and expenses they may incur under such
guarantees. The approximate total amount of the guaranteed
obligations was $2,484,084 at December 31,
2003.

John Wooley and Jeffrey Wooley signed various
promissory notes to the Company to evidence obligations owed to
predecessor entities. As amended, these loans accrue interest at
8% per year, as long as certain personal guarantees
(described above) by John Wooley and Jeffrey Wooley in favor of
the Company remain outstanding, and then convert to a five-year
term. The largest aggregate amount of such indebtedness during
2003, and the balance of these loans as of December 31,
2003, was approximately $161,290 for John Wooley and $328,818
for Jeffrey Wooley.

In 2001, the Company issued promissory notes to
Jeffrey Wooley in the amounts of (i) $112,500 in lieu of
payment for his 2001 bonus, and (ii) $140,000 for his bonus
advance payable in 2002 under the terms of his employment
agreement. As amended, these notes will mature on
January 31, 2005. The notes accrue interest at 7% per
year, with accrued interest payable monthly. In February and
March 2004, the Company paid a total of $170,000 toward the
outstanding principal of these notes.

A predecessor-in-interest to Third &
Colorado, LP (T&C), in which John Wooley and
Jeffrey Wooley are controlling members, is the borrower under a
term loan and a line of credit from the Company, secured by
mortgages on a parcel of land in Austin, Texas previously sold
by the Company to T&Cs predecessor-in-interest. As
amended, both loans accrue interest at 8% per year as long
as certain personal guarantees (described above) by John Wooley
and Jeffrey Wooley in favor of the Company remain outstanding,
and then convert to a ten-year term. The largest aggregate
amount of such indebtedness during 2003, and the balance of
these loans as of December 31, 2003, was $1,292,277.

The Company leases its corporate headquarters in
the central business district of Austin, Texas from T&C
under a ten-year lease which began in November 1997. The lease
provides for: approximately 29,400 square feet of office
space at $12.95 per square foot of annual net rent;
approximately 11,950 square feet of additional space
originally designated for storage but now used primarily for
offices, rent free for the first three years, $1.25 per
square foot for the next three years, and $2.50 per square
foot for the last five years; varying numbers of parking spaces
at below-market rates for the first five years and market rates
for the last five years; and reimbursement of certain expenses.
In 1996, after review of an analysis by an independent
appraiser, the disinterested members of the Board of Directors
approved the terms of the lease and determined that such terms
were no less favorable to the Company than those available from
unaffiliated third parties. In 2003, the Company paid to T&C
$397,910 for office and storage space, $123,734 for
approximately 150 parking spaces, and $128,796 for taxes and
insurance.

Bonner Carrington Corporation European Market
(BCCE), is the master licensee of the Company for
Germany, France and certain other territories. In connection
with such master licenses, BCCE has executed promissory notes
payable to the Company. As amended, the notes bear interest at
9% per annum and provide for installment payments of
principal and interest through December 2007. The largest
aggregate amount of indebtedness during 2003, and the balance
outstanding on December 31, 2003, owed by BCCE to the
Company under such notes was approximately $582,561. The Company
owns a 7.5% preferred stock interest in BCCE, has an option to
acquire an additional 10% preferred stock interest in BCCE, and
has options to

38



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##### Table of Contents



acquire BCCE and its territories at predetermined
prices through December 2011. The Company also holds a
promissory note of Bonner Carrington LP, a Texas limited
partnership and affiliate of BCCE (BCLP). The
largest aggregate amount of such indebtedness during 2003, and
the balance outstanding on December 31, 2003, owed under
such note was approximately $413,697. In 1998, affiliates of
BCCE acquired a minority membership interest in T&C. As of
December 31, 2003 BCCE had ceased operations and the
Company was carrying the above notes, net of reserves and
unrecognized deferred revenue, at approximately $258,000.


In 2002, the Company paid $50,000 to BCLP for an
option to take over a long-term ground lease for a
Company-operated restaurant site in the Austin area. The Company
exercised this option in January 2003 at the exercise price of
$100,000. During 2003, the Company paid to BCLP approximately
$10,610 for construction coordination and consulting services in
connection with the development of this and other restaurant
sites.

In February 2001, the Company granted to Triad
Media Ventures LLC (Triad) warrants to purchase
30,000 shares of the Companys Common Stock at an
exercise price of $4.50 per share. The warrants were
granted in connection with a credit facility from Triad to
Schlotzskys National Advertising Association, Inc.
and Schlotzskys N.A.M.F., Inc. which are affiliates
of the Company, in the principal amount of $3,000,000 to fund
the purchase of certain cable television advertising rights.
Floor Mouthaan, a director of the Company, served on the
investment committee of Triad until May 2002, but he did not
have management control over Triad and he expressly disclaimed
beneficial ownership of the shares underlying these warrants.
Nevertheless, the grant of warrants was treated as a related
party transaction, was determined to be on terms no less
favorable to the Company than those available from unaffiliated
third parties, and was approved by the disinterested members of
the Board of Directors.

Sino-Caribbean Corporation (SCC), a
Texas corporation, is the master licensee of the Company for
China. In connection with such master licenses, SCC has executed
promissory notes payable to the Company. As amended, the notes
bear interest at 8% per year and provide for installment
payments of principal and interest through December 2006. The
largest aggregate amount of indebtedness during 2003, and the
balance outstanding on December 31, 2003, owed by SCC to
the Company under such notes was approximately $775,000. Karl
Martin, an employee of the Company, has an ownership interest in
SCC. In March, 2004 the Company entered into an agreement to
acquire the assets of SCC in exchange for forgiveness of debt
and $150,000 in other considerations.

In 2003, John Wooley and Jeffrey Wooley provided
a $1,000,000 credit facility for the Company. As amended, this
facility bears interest at 6% per year and provides for
monthly payments of interest until the maturity date on
July 16, 2004. The loan is secured by the Companys
intellectual property, contract rights and certain intangibles,
although that security interest was subordinated to NS
Associates I, Ltd. (NS Associates) under the Subordination
Agreement in connection with the 2003 renegotiation of the NS
Associates loan. The largest aggregate amount of such
indebtedness during 2003 was $560,000, and the balance of this
loan as of December 31, 2003, was $360,000.

In 2003, the Company entered into a short-term
bridge loan with a commercial lender in the principal amount of
$150,000. As amended, this loan accrues interest at
5.2% per year, matures on June 25, 2004, and is
collateralized by a certificate of deposit pledged by Jeffrey
Wooley. The largest aggregate amount of such indebtedness during
2003, and the balance of this loan as of December 31, 2003,
was $150,000.

In 2003, Schlotzskys Franchisor, LLC, a
wholly-owned subsidiary of the Company (Franchisor),
borrowed from John Wooley and Jeffrey Wooley a loan in the
principal amount of $2,500,000. As amended, this facility bears
annual interest at a rate of 2.5% over the prime rate, and
provides for monthly installment payments of principal and
interest from May 2004 until the earlier of December 2006 or the
end of Franchisors obligations under the Subordination
Agreement in connection with the 2003 renegotiation of the
NS Associates loan. The loan is secured by the
Companys intellectual property, contract rights and
certain intangibles, although that security interest is
subordinated to NS Associates. The largest aggregate amount
of such indebtedness during 2003, and the balance of this loan
as of December 31, 2003, was $2,500,000.

39



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##### Table of Contents



In 2003, the Company and John and Jeff Wooley
guaranteed a bank note in the amount of $4,300,000, for the
benefit of Schlotzskys N.A.M.F. Funding, LLC, the
advertising entity of the Schlotzskys restaurant system,
for which the Company had received a portion of the net proceeds
of the loan in repayment of outstanding debt to the Company.
Additionally, the Company pledged certain restaurant assets to
secure this facility. The largest aggregate amount of such
indebtedness during 2003 was $4,300,000, and the balance of this
loan as of December 31, 2003, was $4,140,000.

In 2003, the Company guaranteed payments under
the Amended and Restated Promissory Note between DFW Restaurant
Transfer Corp., a wholly-owned subsidiary of the Company, and NS
Associates as lender, in connection with the restructuring of
the seller-financed acquisition of the Companys largest
area developer territory. As amended, the note bears interest at
3% through November 2004 and 4% over prime thereafter, and
provides for principal and interest payments of $120,000 for
12 months beginning December 2003 and payments of $420,000
from December 2004 until the maturity date of December 2006. The
loan is secured by the Companys intellectual property,
contract rights, and certain intangibles and is subordinate to a
$3.0 million senior debt facility. The largest aggregate
amount of such post-amendment indebtedness during 2003, and the
balance of this loan as of December 31, 2003, was
$18,012,000.

Certain of the transactions described above were
entered into between related parties and therefore were not the
result of arms-length negotiations. Accordingly, certain of the
terms of these transactions may be more or less favorable to the
Company than might have been obtained from unaffiliated third
parties. During fiscal year 2003, the Company did not, and in
the future will not, enter into any transactions in which the
directors, executive officers or principal shareholders of the
Company and their affiliates have a material interest, unless
such transactions are determined to be on terms that are no less
favorable to the Company than those that the Company could
obtain from unaffiliated third parties, and are approved, by a
majority of the independent and disinterested members of the
Board of Directors and any appropriate Board Committees.






|         |                                           
|-------- | ------------------------------------------
|ITEM 14. | PRINCIPAL ACCOUNTANT FEES AND
    SERVICES

AUDIT FEES 2003

The Audit Committee has engaged Grant Thornton
LLP as the independent accountants to audit the Companys
financial statements for fiscal year 2003. Grant Thornton LLP
served as the Companys independent accountants and
provided tax preparation and consulting services to the Company
during fiscal year 2003. Representatives of Grant Thornton LLP
are expected to be present at the 2004 Annual Meeting of
Shareholders, will have the opportunity to make a statement if
they desire to do so, and are expected to be available to
respond to appropriate questions.

The following table sets forth the aggregate
amount of fees billed to the Company by Grant Thornton LLP for
services rendered for fiscal year 2002 and 2003. Grant Thornton
LLP does not provide any tax consulting services to any Company
executive.

|                      |  |      |         |      |  |   |         | 
|--------------------- |  | ---- | ------- | ---- |  | - | ------- | 
|                      |  | 2003 |         | 2002
|                      |  |      |         |     
|Audit Fees            |  | $    | 179,139 |      |  | $ | 129,590 | 
|Audit Related Fees(1) |  | $    | 16,955  |      |  | $ | 24,262  | 
|Tax Fees(2)           |  | $    | 48,569  |      |  | $ | 84,264  | 
|All Other Fees(3)     |  | $    | -0-     |      |  | $ | 2,682   | 



---



|    |                                                                                                                                                                                                                                                           
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Audit Related Fees include primarily audits of
    certain affiliated entities, the Companys 401K plan and
    services performed in connection with inclusion of the
    Companys financial statements in its Uniform Franchise
    Offering Circulars.
|   
|(2) | Tax Fees primarily include fees for federal and
    state and local tax consulting and compliance services.                                                                                                                                               
|   
|(3) | All Other Fees relate to consultations and
    services related to a proposed transaction.                                                                                                                                                                

40



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##### Table of Contents






PART IV






|         |                                                                    
|-------- | -------------------------------------------------------------------
|ITEM 15. | 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

| |       |  |  |   |  |                                                                                                                                                                                                                 
| | ----- |  |  | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 3.1   |  |  |  |  | Articles of Incorporation of the Company, as
    amended.(1)                                                                                                                                                    
| | 3.2   |  |  |  |  | Statement of Resolutions Regarding the
    Designation, Preferences and Rights of Class C
    Series A Junior Participating Preferred Stock of the
    Company.(2)                                              
| | 3.3   |  |  |  |  | Bylaws of the Company, as amended.(17)                                                                                                                                                                          
| | 4.1   |  |  |  |  | Specimen stock certificate evidencing the Common
    Stock of the Company.(1)                                                                                                                                   
| | 4.2   |  |  |  |  | Rights Agreement dated December 18, 1998
    between the Company and Harris Trust and Savings Bank.(2)                                                                                                          
| | 4.3   |  |  |  |  | Warrant Certificate dated February 15, 2001
    from the Company to Triad Media Ventures LLC.(9)                                                                                                                
| | 10.1  |  |  |  |  | Form of Guaranty from the Company to landlord for
    Turnkey restaurants.(5)                                                                                                                                   
| | 10.2  |  |  |  |  | Form of Limited Guaranty from the Company to
    mortgage lender for Turnkey restaurants.(6)                                                                                                                    
| | 10.3  |  |  |  |  | Employee Stock Purchase Plan of the Company.(3)*                                                                                                                                                                
| | 10.4  |  |  |  |  | Third Amended and Restated 1993 Stock Option Plan
    of the Company.(4)*                                                                                                                                       
| | 10.5  |  |  |  |  | Amendments to Third Amended and Restated 1993
    Stock Option Plan of the Company.(3)*                                                                                                                         
| | 10.6  |  |  |  |  | Form of Incentive Stock Option Agreement, as
    amended, between the Company and certain employees.(7)*                                                                                                        
| | 10.7  |  |  |  |  | 1995 Non-employee Directors Stock Option Plan of
    the Company, and form of Stock Option Agreement.(1)*                                                                                                       
| | 10.8  |  |  |  |  | Form of Indemnification Agreement between the
    Company and its directors and officers.(1)*                                                                                                                   
| | 10.9  |  |  |  |  | Employment Agreement dated August 15, 2000,
    between the Company and Richard H. Valade.(8)*                                                                                                                  
| | 10.10 |  |  |  |  | Form of Employment Agreement between the Company
    and John C. Wooley and Jeffrey J. Wooley.(9)*                                                                                                              
| | 10.11 |  |  |  |  | First Amendment to Employment Agreement between
    the Company and John C. Wooley.(11)*                                                                                                                        
| | 10.12 |  |  |  |  | First Amendment to Employment Agreement between
    the Company and Jeffrey J. Wooley.(11)*                                                                                                                     
| | 10.13 |  |  |  |  | Second Amendment to Employment Agreement between
    the Company and John C. Wooley.(11)*                                                                                                                       
| | 10.14 |  |  |  |  | Second Amendment to Employment Agreement between
    the Company and Jeffrey J. Wooley.(11)*                                                                                                                    
| | 10.15 |  |  |  |  | Amended and Restated Promissory Note dated
    January 1, 2001, from John C. Wooley to the Company.(9)*                                                                                                         
| | 10.16 |  |  |  |  | Amended and Restated Promissory Note dated
    January 1, 2001, from Jeffrey J. Wooley to the Company.(9)*                                                                                                      
| | 10.17 |  |  |  |  | Promissory Note, dated effective January 31,
    2002, from the Company to Jeffrey J. Wooley.(12)*                                                                                                              
| | 10.18 |  |  |  |  | Modification, Extension and Renewal of Promissory
    Note, dated effective December 30, 2002, amending that
    certain Promissory Note dated January 31, 2002, from the
    Company to Jeffrey J. Wooley.(13)*

41



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##### Table of Contents



| |       |  |  |   |  |                                                                                                                                                                                                                         
| | ----- |  |  | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 10.19 |  |  |  |  | Promissory Note, dated effective January 31,
    2002, from the Company to Jeffrey J. Wooley.(12)*                                                                                                                      
| | 10.20 |  |  |  |  | Modification, Extension and Renewal of Promissory
    Note, dated effective December 30, 2002, amending that
    certain Promissory Note dated January 31, 2002, from the
    Company to Jeffrey J. Wooley.(13)*        
| | 10.21 |  |  |  |  | Lease Agreement dated March 21, 1997,
    between the Company and Third & Colorado 19, L.L.C.(9)                                                                                                                        
| | 10.22 |  |  |  |  | Modification Agreement Regarding Promissory Note
    dated January 1, 2001, from Third & Colorado,
    L.L.C. to the Company.(9)*                                                                                       
| | 10.23 |  |  |  |  | Amended and Restated Promissory Note dated
    January 1, 2001, from Third & Colorado, L.L.C. to
    Schlotzskys Real Estate, Inc.(9)*                                                                                 
| | 10.24 |  |  |  |  | Amended and Restated Option Agreement dated
    February 7, 2001, between DFW Restaurant Transfer Corp. and
    NS Associates I, Ltd.(9)                                                                                
| | 10.25 |  |  |  |  | Amended and Restated Management Agreement dated
    February 7, 2001, between DFW Restaurant Transfer Corp. and
    NS Associates I, Ltd.(9)                                                                            
| | 10.26 |  |  |  |  | Amendment to Amended and Restated Option
    Agreement, dated effective June 1, 2002, between DFW
    Restaurant Transfer Corp., NS Associates I, Ltd. and the
    Company.(12)                                         
| | 10.27 |  |  |  |  | Amendment to Amended and Restated Management
    Agreement, dated effective June 1, 2002, between DFW
    Restaurant Transfer Corp., NS Associates I, Ltd. and the
    Company.(12)                                     
| | 10.28 |  |  |  |  | Modification Agreement, dated effective
    January 27, 2003, to the Promissory Note from the Company
    to NS Associates I, Ltd.(13)                                                                                  
| | 10.29 |  |  |  |  | Note and Security Agreement dated March 27,
    2003 from the Company to American Bank of Commerce.(14)                                                                                                                 
| | 10.30 |  |  |  |  | Promissory Note dated April 8, 2003, from
    the Company to John C. Wooley and Jeffrey J. Wooley.(14)                                                                                                                  
| | 10.31 |  |  |  |  | Security Agreement dated April 8, 2003
    between the Company and John C. Wooley and Jeffrey J. Wooley.(14)                                                                                                            
| | 10.32 |  |  |  |  | Guaranty Agreement, dated June 12, 2003
    between the Company, as Guarantor, Commerce National Bank, as
    Lender, and Schlotzskys NAMF Funding, LLC, as Borrower.(15)                                              
| | 10.33 |  |  |  |  | Equipment Finance Agreement dated July 24,
    2003 from the Company to American Express Business Finance
    Corporation.(15)                                                                                          
| | 10.34 |  |  |  |  | Modification, Extension and Renewal dated
    August 8, 2003 of that certain Promissory Note dated
    April 8, 2003, between the Company as borrower and John C.
    Wooley and Jeffrey J. Wooley as lenders. (15).    
| | 10.35 |  |  |  |  | Modification, Extension and Renewal dated
    October 31, 2003 of that certain Promissory Note dated
    April 8, 2003, between the Company as borrower and John C.
    Wooley and Jeffrey J. Wooley as lenders.(16)    
| | 10.36 |  |  |  |  | Promissory Note dated November 14, 2003,
    from Schlotzskys Franchisor, LLC to John C. Wooley and
    Jeffrey J. Wooley.(16)                                                                                         
| | 10.37 |  |  |  |  | Security Agreement dated November 14, 2003,
    between Schlotzskys Franchisor, LLC and John C. Wooley and
    Jeffrey J. Wooley.(16)                                                                                  
| | 10.38 |  |  |  |  | Change in Terms Agreement dated October 25,
    2003, amending that certain Note and Security Agreement dated
    March 27, 2003, from the Company to American Bank of
    Commerce.(17)                                
| | 10.39 |  |  |  |  | Change in Terms Agreement dated December 25,
    2003, amending that certain Note and Security Agreement dated
    March 27, 2003, as amended, from the Company to American
    Bank of Commerce.(17)                   
| | 10.40 |  |  |  |  | Restructuring Agreement dated December 29,
    2003, between DFW Restaurant Transfer Corp., NS
    Associates I, Ltd., the Company, Schlotzskys
    Franchisor, LLC and Schlotzskys Franchise Operations,
    LLC.(17)
| | 10.41 |  |  |  |  | Amended and Restated Promissory Note dated
    December 29, 2003, from DFW Restaurant Transfer Corp. to NS
    Associates I, Ltd.(17)                                                                                   

42



---



##### Table of Contents



| |       |  |  |   |  |                                                                                                                                                                                                                                                                    
| | ----- |  |  | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 10.42 |  |  |  |  | Guaranty dated December 29, 2003, between
    Schlotzskys Franchisor, LLC and NS Associates I,
    Ltd.(17)                                                                                                                                                       
| | 10.43 |  |  |  |  | Security Agreement dated December 29, 2003,
    between NS Associates I, Ltd. and Schlotzskys
    Franchisor, LLC.(17)                                                                                                                                            
| | 10.44 |  |  |  |  | Trademark Security Agreement dated
    December 29, 2003, between Schlotzskys Franchisor,
    LLC and NS Associates I, Ltd.(17)                                                                                                                                   
| | 10.45 |  |  |  |  | Stock Pledge Agreement dated December 29,
    2003, between Schlotzskys Franchisor, LLC and NS
    Associates I, Ltd.(17)                                                                                                                                         
| | 10.46 |  |  |  |  | Stock Pledge Agreement dated December 29,
    2003, between the Company and NS Associates I, Ltd.(17)                                                                                                                                                              
| | 10.47 |  |  |  |  | Subordination Agreement dated December 29,
    2003, between John C. Wooley, Jeffrey J. Wooley,
    Schlotzskys Franchisor, LLC, the Company,
    Schlotzskys Franchise Operations, LLC, DFW Restaurant
    Transfer Corp. and NS Associates I, Ltd.(17)         
| | 10.48 |  |  |  |  | Modification of Note and Security Agreement dated
    December 29, 2003, amending the Promissory Note and
    Security Agreement dated November 14, 2003, from
    Schlotzskys Franchisor, LLC to John C. Wooley and Jeffrey
    J. Wooley.(17)                   
| | 10.49 |  |  |  |  | Modification Agreement dated January 16,
    2004, amending the Promissory Note and Security Agreement dated
    November 14, 2003, between Schlotzskys Franchisor,
    LLC and John C. Wooley and Jeffrey J. Wooley.(17)                                         
| | 10.50 |  |  |  |  | Modification, Extension and Renewal of Promissory
    Note dated January 16, 2004, of that certain Promissory
    Note dated April 8, 2003, as previously amended, between
    the Company as borrower and John C. Wooley and Jeffrey J. Wooley
    as lenders.(17)
| | 10.51 |  |  |  |  | Modification, Extension and Renewal of Promissory
    Note dated January 31, 2004, of that certain Promissory
    Note dated January 31, 2002, as amended, from the Company
    to Jeffrey J. Wooley.(17)*                                                         
| | 10.52 |  |  |  |  | Modification, Extension and Renewal of Promissory
    Note dated January 31, 2004, of that certain Promissory
    Note dated January 31, 2002, as amended, from the Company
    to Jeffrey J. Wooley.(17)*                                                         
| | 10.53 |  |  |  |  | Change in Terms Agreement dated March 21,
    2004, amending that certain Note and Security Agreement dated
    March 27, 2003, as amended, from the Company to American
    Bank of Commerce.(17)                                                                 
| | 21.1  |  |  |  |  | List of subsidiaries of the Company.(17)                                                                                                                                                                                                                           
| | 23.1  |  |  |  |  | Consent of Grant Thornton LLP.(17)                                                                                                                                                                                                                                 
| | 31.1  |  |  |  |  | Certification pursuant to Section 302 of the
    Sarbanes-Oxley Act of 2002, signed by John C. Wooley, Chief
    Executive Officer.(17)                                                                                                                            
| | 31.2  |  |  |  |  | Certification pursuant to Section 302 of the
    Sarbanes-Oxley Act of 2002, signed by Matthew D. Osburn,
    principal financial officer.(17)                                                                                                                     
| | 32.1  |  |  |  |  | Certification pursuant to Section 906 of the
    Sarbanes-Oxley Act of 2002, signed by John C. Wooley, Chief
    Executive Officer.(17)                                                                                                                            
| | 32.2  |  |  |  |  | Certification pursuant to Section 906 of the
    Sarbanes-Oxley Act of 2002, signed by Matthew D. Osburn,
    principal financial officer.(17)                                                                                                                     



---



| |                                                                                              
| | ---------------------------------------------------------------------------------------------
| | *                    Indicates
    a management contract or compensatory plan or arrangement.



|    |                                                                                                                                
|--- | -------------------------------------------------------------------------------------------------------------------------------
|(1) | Incorporated by reference from the Companys
    Registration Statement on Form S-1 filed on
    October 12, 1995, as amended. 
|   
|(2) | Incorporated by reference from the Companys
    Registration of certain Securities on Form 8-A filed on
    December 18, 1998.
|   
|(3) | Incorporated by reference from the Companys
    Registration Statement on Form S-8 filed on June 17,
    1998.                
|   
|(4) | Incorporated by reference from the Companys
    Registration Statement on Form S-1 filed on
    September 4, 1997.            

43



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##### Table of Contents





|    |                                                                                                                  
|--- | -----------------------------------------------------------------------------------------------------------------
|(5) | Incorporated by reference from the Companys
    Annual Report on Form 10-K filed on April 14, 1998.             
|   
|(6) | Incorporated by reference from the Companys
    Annual Report on Form 10-K filed on March 31, 1999.             
|   
|(7) | Incorporated by reference from the Companys
    Quarterly Report on Form 10-Q filed on August 14, 2000.         
|   
|(8) | Incorporated by reference from the Companys
    Quarterly Report on Form 10-Q/ A filed on November 17,
    2000.
|   
|(9) | Incorporated by reference from the Companys
    Annual Report on Form 10-K filed on April 2, 2001.              



|     |                                                                                                               
|---- | --------------------------------------------------------------------------------------------------------------
|(10) | Incorporated by reference from the Companys
    Annual Report on Form 10-K filed on March 29, 2002.          
|    
|(11) | Incorporated by reference from the Companys
    Quarterly Report on Form 10-Q filed on May 15, 2002.         
|    
|(12) | Incorporated by reference from the Companys
    Quarterly Report on Form 10-Q filed on August 14, 2002.      
|    
|(13) | Incorporated by reference from the Companys
    Annual Report on Form 10-K filed on March 31, 2003.          
|    
|(14) | Incorporated by reference from the Companys
    Quarterly Report on Form 10-Q filed on May 15, 2003.         
|    
|(15) | Incorporated by reference from the Companys
    Quarterly Report on Form 10-Q filed on August 14, 2003.      
|    
|(16) | Incorporated by reference from the Companys
    Quarterly Report on Form 10-Q filed on November 14,
    2003.
|    
|(17) | Filed with this Annual Report on Form 10-K.                                                                   

(b) Current Reports on Form 8-K:



| |                                                                                                                                                                                                                                                           
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Registrant filed a Current Report on
    Form 8-K dated April 3, 2003, containing a press
    release dated March 28, 2003, announcing the Companys
    release of financial results for the quarter and fiscal year
    ended December 31, 2002.    
|
| | The Registrant filed a Current Report on
    Form 8-K dated May 15, 2003, containing a press
    release dated May 15, 2003, announcing the Companys
    release of financial results for the quarter ended
    March 31, 2003.                          
|
| | The Registrant filed a Current Report on
    Form 8-K dated June 24, 2003, containing a press
    release dated June 23, 2003, announcing the results of
    shareholder voting at the Companys Annual Meeting of
    Shareholders held on June 23, 2003.
|
| | The Registrant filed a Current Report on
    Form 8-K dated August 4, 2003, containing a press
    release dated July 31, 2003, announcing a realignment and
    reduction in force effected on July 31, 2003.                                            
|
| | The Registrant filed a Current Report on
    Form 8-K dated August 14, 2003, containing a press
    release dated August 14, 2003, announcing the
    Companys release of financial results for the quarter
    ended June 30, 2003.                     
|
| | The Registrant filed a Current Report on
    Form 8-K dated November 14, 2003, containing a press
    release dated November 14, 2003, announcing the
    Companys release of financial results for the quarter
    ended September 30, 2003.            
|
| | The Registrant filed a Current Report on
    Form 8-K dated January 9, 2004, containing a press
    release dated January 9, 2004, announcing the modification
    and extension of certain debt with NS Associates I, Ltd.                               

44



---



##### Table of Contents



SIGNATURES

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



| |                   
| | ------------------
| | SCHLOTZSKYS, INC.



| |     |                   
| | --- | ------------------
| | By: | /s/ JOHN C. WOOLEY

| |                                      
| | -------------------------------------
| |                                      
| | John C. Wooley,                      
| | President and Chief Executive Officer

Date: March 30, 2004

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.

|                                             |  |                                                                                       |  |                |  | 
|-------------------------------------------- |  | ------------------------------------------------------------------------------------- |  | -------------- |  | 
|                                             |  |                                                                                       |  |               
|Signature                                    |  | Capacity                                                                              |  | Date          
|                                             |  |                                                                                       |  |               
|                                            
|/s/ JOHN C. WOOLEYJohn C. Wooley             |  | Director, President and Chief Executive Officer
    (Principal Executive Officer)     |  | March 30, 2004
|                                            
|/s/ MATTHEW D. OSBURNMatthew D. Osburn       |  | Vice President, Controller and Assistant
    Treasurer (Principal Accounting Officer) |  | March 30, 2004
|                                            
|/s/ JEFFREY J. WOOLEYJeffrey J. Wooley       |  | Director, Senior Vice President and Secretary                                         |  | March 30, 2004
|                                            
|/s/ FLOOR MOUTHAANFloor Mouthaan             |  | Director                                                                              |  | March 30, 2004
|                                            
|/s/ PIKE POWERSPike Powers                   |  | Director                                                                              |  | March 30, 2004
|                                            
|/s/ RAYMOND A. RODRIGUEZRaymond A. Rodriguez |  | Director                                                                              |  | March 30, 2004
|                                            
|/s/ JOHN SHARPJohn Sharp                     |  | Director                                                                              |  | March 30, 2004
|                                            
|/s/ SARAH WEDDINGTONSarah Weddington         |  | Director                                                                              |  | March 30, 2004

45



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##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES

INDEX TO CONSOLIDATED FINANCIAL
STATEMENTS


|                                   |                                                                                                              |      |  |     | 
|---------------------------------- | ------------------------------------------------------------------------------------------------------------ | ---- |  | --- | 
|                                   |                                                                                                              | Page
|                                   |                                                                                                              |     
|Consolidated Financial Statements: |                                                                                                              |      |  |    
|                                   | Report of Independent Certified Public Accountants                                                           |      |  | F-2 | 
|                                   | Consolidated Balance Sheets at December 31,
    2003 and 2002                                                |      |  | F-3 | 
|                                   | Consolidated Statements of Income for the years
    ended December 31, 2003, 2002 and 2001                   |      |  | F-4 | 
|                                   | Consolidated Statements of Stockholders
    Equity for the years ended December 31, 2003, 2002 and 2001     |      |  | F-5 | 
|                                   | Consolidated Statements of Cash Flows for the
    years ended December 31, 2003, 2002 and 2001               |      |  | F-6 | 
|                                   | Notes to Consolidated Financial Statements                                                                   |      |  | F-7 | 
|Financial Statement Schedule:      |                                                                                                              |      |  |    
|                                   | Report of Independent Certified Public Accountants                                                           |      |  | S-1 | 
|                                   | Schedule II  Valuation and
    Qualifying Accounts for the years ended December 31, 2003,
    2002 and 2001 |      |  | S-2 | 

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

F-1



---



##### Table of Contents



REPORT OF INDEPENDENT CERTIFIED PUBLIC
ACCOUNTANTS

To the Board of Directors and Stockholders,

Schlotzskys, Inc.:


We have audited the accompanying consolidated
balance sheets of Schlotzskys, Inc. (a Texas
corporation) and Subsidiaries as of December 31, 2003 and
2002, and the related consolidated statements of income,
stockholders equity, and cash flows for each of the three
years in the period ended December 31, 2003. These
financial statements are the responsibility of the
Companys management. Our responsibility is to express an
opinion on these financial statements based on our audits.

We conducted our audits in accordance with
auditing standards generally accepted in the United States of
America. 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 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, 2003 and 2002, and the
consolidated results of their operations and their consolidated
cash flows for each of the three years in the period ended
December 31, 2003, in conformity with accounting principles
generally accepted in the United States of America.

As discussed in Note 1 to the financial
statements, effective January 1, 2002, the Company adopted
Statement of Financial Accounting Standards No. 142,
Goodwill and Intangible Assets.

GRANT THORNTON LLP

Dallas, Texas

March 6, 2004


F-2



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##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS


|                                                                |                                                                                                                                                                |                                  |                                            |            |           |             |            |            |           |             | 
|--------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------------- | ------------------------------------------ | ---------- | --------- | ----------- | ---------- | ---------- | --------- | ----------- | 
|                                                                |                                                                                                                                                                |                                 
|                                                                |                                                                                                                                                                | December 31,                    
|                                                                |                                                                                                                                                                |                                 
|                                                                |                                                                                                                                                                | 2003                             |                                            | 2002      
|                                                                |                                                                                                                                                                |                                  |                                            |           
|ASSETS                                                         
|Current Assets:                                                 |                                                                                                                                                                |                                  |                                            |            |           |             |            |           
|                                                                | Cash and cash equivalents                                                                                                                                      |                                  | $                                          | 1,058,300  |           |             | $          | 678,895    |          
|                                                                | Accounts receivable, net:                                                                                                                                      |                                  |                                            |            |           |             |            |            |          
|                                                                |                                                                                                                                                                | Royalties                        |                                            |            | 884,098   |             |            |            | 650,376   |            
|                                                                |                                                                                                                                                                | Brands                           |                                            |            | 905,085   |             |            |            | 1,269,759 |            
|                                                                |                                                                                                                                                                | Other                            |                                            |            | 1,494,513 |             |            |            | 1,332,990 |            
|                                                                | Refundable income taxes                                                                                                                                        |                                  |                                            | 9,350      |           |             |            | 1,837,628  |          
|                                                                | Prepaids, inventories and other assets                                                                                                                         |                                  |                                            | 1,250,193  |           |             |            | 1,356,516  |          
|                                                                | Real estate held for sale                                                                                                                                      |                                  |                                            | 3,208,533  |           |             |            | 5,167,563  |          
|                                                                | Current portion of:                                                                                                                                            |                                  |                                            |            |           |             |            |            |          
|                                                                |                                                                                                                                                                | Notes receivable                 |                                            |            | 50,570    |             |            |            | 510,573   |            
|                                                                |                                                                                                                                                                | Notes receivable  related party |                                            |            | 3,500     |             |            |            | 72,353    |            
|                                                                |                                                                                                                                                                | Deferred tax asset               |                                            |            |          |             |            |            | 2,275,941 |            
|                                                                |                                                                                                                                                                |                                  |                                            |            |           |             |            |           
|                                                                |                                                                                                                                                                |                                  | Total current assets                       |            |           | 8,864,142   |            |            |           | 15,152,594  | 
|Property, equipment and leasehold improvements,
    net         |                                                                                                                                                                |                                  | 42,396,145                                 |            |           |             | 39,709,461 |           
|Notes receivable, net, less current portion                     |                                                                                                                                                                |                                  | 4,121,951                                  |            |           |             | 5,972,058  |           
|Notes receivable  related party, net,
    less current portion |                                                                                                                                                                |                                  | 2,613,170                                  |            |           |             | 5,377,647  |           
|Investments                                                     |                                                                                                                                                                |                                  | 567,850                                    |            |           |             | 1,852,765  |           
|Intangible assets, net                                          |                                                                                                                                                                |                                  | 62,523,367                                 |            |           |             | 65,308,249 |           
|Goodwill, net                                                   |                                                                                                                                                                |                                  | 3,519,242                                  |            |           |             | 2,985,679  |           
|Other non-current assets                                        |                                                                                                                                                                |                                  | 1,179,687                                  |            |           |             | 1,168,029  |           
|                                                                |                                                                                                                                                                |                                  |                                            |            |           |             |            |           
|                                                                |                                                                                                                                                                |                                  | Total assets                               |            | $         | 125,785,554 |            |            | $         | 137,526,482 | 
|                                                                |                                                                                                                                                                |                                  |                                            |            |           |             |            |           
|LIABILITIES AND STOCKHOLDERS
    EQUITY                       
|Current Liabilities:                                            |                                                                                                                                                                |                                  |                                            |            |           |             |            |           
|                                                                | Short-term debt                                                                                                                                                |                                  | $                                          | 1,133,701  |           |             | $          |           |          
|                                                                | Current maturities of long-term debt                                                                                                                           |                                  |                                            | 6,564,646  |           |             |            | 7,441,120  |          
|                                                                | Accounts payable                                                                                                                                               |                                  |                                            | 5,768,117  |           |             |            | 2,841,607  |          
|                                                                | Accrued liabilities                                                                                                                                            |                                  |                                            | 5,243,563  |           |             |            | 3,812,727  |          
|                                                                | Deferred revenue, current portion                                                                                                                              |                                  |                                            | 376,633    |           |             |            | 234,552    |          
|                                                                |                                                                                                                                                                |                                  |                                            |            |           |             |            |           
|                                                                |                                                                                                                                                                |                                  | Total current liabilities                  |            |           | 19,086,660  |            |            |           | 14,330,006  | 
|Long-term debt, less current portion                            |                                                                                                                                                                |                                  | 42,586,141                                 |            |           |             | 46,063,599 |           
|Deferred revenue, less current portion                          |                                                                                                                                                                |                                  | 1,450,300                                  |            |           |             | 1,597,443  |           
|Deferred tax liability                                          |                                                                                                                                                                |                                  |                                           |            |           |             | 1,216,109  |           
|                                                                |                                                                                                                                                                |                                  |                                            |            |           |             |            |           
|                                                                |                                                                                                                                                                |                                  | Total liabilities                          |            |           | 63,123,101  |            |            |           | 63,207,157  | 
|                                                                |                                                                                                                                                                |                                  |                                            |            |           |             |            |           
|Commitments and contingencies                                   |                                                                                                                                                                |                                  |                                           |            |           |             |           |           
|Stockholders equity:                                           |                                                                                                                                                                |                                  |                                            |            |           |             |            |           
|                                                                | Preferred stock, Class C, no par value,
    1,000,000 shares authorized, none issued                                                                           |                                  |                                            |           |           |             |            |           |          
|                                                                | Common stock, no par value,
    30,000,000 shares authorized, 7,521,524 shares and
    7,496,778 shares issued at December 31, 2003 and 2002,
    respectively |                                  |                                            | 64,073     |           |             |            | 63,826     |          
|                                                                | Additional paid-in capital                                                                                                                                     |                                  |                                            | 58,213,945 |           |             |            | 58,122,469 |          
|                                                                | Retained earnings                                                                                                                                              |                                  |                                            | 5,227,591  |           |             |            | 16,976,186 |          
|                                                                | Treasury stock (189,525 shares at
    December 31, 2003 and 2002, respectively), at cost                                                                       |                                  |                                            | (843,156   | )         |             |            | (843,156   | )        
|                                                                |                                                                                                                                                                |                                  |                                            |            |           |             |            |           
|                                                                |                                                                                                                                                                |                                  | Total stockholders equity                 |            |           | 62,662,453  |            |            |           | 74,319,325  | 
|                                                                |                                                                                                                                                                |                                  |                                            |            |           |             |            |           
|                                                                |                                                                                                                                                                |                                  | Total liabilities and stockholders equity |            | $         | 125,785,554 |            |            | $         | 137,526,482 | 
|                                                                |                                                                                                                                                                |                                  |                                            |            |           |             |            |           

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

F-3



---



##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME


|                             |                                                                                                            |                         |                   |                                   |            |             |             |            |            |          |            |            |            |           |            | 
|---------------------------- | ---------------------------------------------------------------------------------------------------------- | ----------------------- | ----------------- | --------------------------------- | ---------- | ----------- | ----------- | ---------- | ---------- | -------- | ---------- | ---------- | ---------- | --------- | ---------- | 
|                             |                                                                                                            |                        
|                             |                                                                                                            | Year Ended December 31,
|                             |                                                                                                            |                        
|                             |                                                                                                            | 2003                    |                   | 2002                              |            | 2001       
|                             |                                                                                                            |                         |                   |                                   |            |            
|Revenue:                     |                                                                                                            |                         |                   |                                   |            |             |             |            |            |          |            |           
|                             | Royalties                                                                                                  |                         | $                 | 16,616,612                        |            |             | $           | 19,966,768 |            |          | $          | 21,765,314 |           
|                             | Franchise fees                                                                                             |                         |                   | 19,998                            |            |             |             | 122,000    |            |          |            | 347,500    |           
|                             | Developer fees                                                                                             |                         |                   | 168,062                           |            |             |             | 230,740    |            |          |            | 455,266    |           
|                             | Restaurant sales                                                                                           |                         |                   | 32,010,566                        |            |             |             | 31,723,161 |            |          |            | 29,905,593 |           
|                             | Brand contribution                                                                                         |                         |                   | 6,404,711                         |            |             |             | 7,308,973  |            |          |            | 7,396,514  |           
|                             | Other fees and revenue                                                                                     |                         |                   | 957,790                           |            |             |             | 1,194,851  |            |          |            | 1,980,528  |           
|                             |                                                                                                            |                         |                   |                                   |            |             |             |            |            |          |            |           
|                             |                                                                                                            |                         |                   | Total revenue                     |            |             | 56,177,739  |            |            |          | 60,546,493 |            |            |           | 61,850,715 | 
|                             |                                                                                                            |                         |                   |                                   |            |             |             |            |            |          |            |           
|Expenses:                    |                                                                                                            |                         |                   |                                   |            |             |             |            |            |          |            |           
|                             | Service costs:                                                                                             |                         |                   |                                   |            |             |             |            |            |          |            |            |           
|                             |                                                                                                            | Royalties               |                   |                                   | 2,462,542  |             |             |            | 3,974,638  |          |            |            | 4,745,284  |          
|                             |                                                                                                            | Franchise fees          |                   |                                   |           |             |             |            | 53,455     |          |            |            | 148,750    |          
|                             |                                                                                                            |                         |                   |                                   |            |             |             |            |            |          |            |           
|                             |                                                                                                            |                         | 2,462,542         |                                   |            |             | 4,028,093   |            |            |          | 4,894,034  |           
|                             |                                                                                                            |                         |                   |                                   |            |             |             |            |            |          |            |           
|                             | Restaurant operations:                                                                                     |                         |                   |                                   |            |             |             |            |            |          |            |            |           
|                             |                                                                                                            | Cost of sales           |                   |                                   | 9,317,703  |             |             |            | 8,934,727  |          |            |            | 8,363,389  |          
|                             |                                                                                                            | Personnel and benefits  |                   |                                   | 13,551,440 |             |             |            | 12,997,969 |          |            |            | 12,514,714 |          
|                             |                                                                                                            | Operating expenses      |                   |                                   | 8,027,169  |             |             |            | 7,556,929  |          |            |            | 6,945,362  |          
|                             |                                                                                                            |                         |                   |                                   |            |             |             |            |            |          |            |           
|                             |                                                                                                            |                         | 30,896,312        |                                   |            |             | 29,489,625  |            |            |          | 27,823,465 |           
|                             |                                                                                                            |                         |                   |                                   |            |             |             |            |            |          |            |           
|                             | Equity loss on investments                                                                                 |                         |                   | 471,329                           |            |             |             | 193,861    |            |          |            | 109,212    |           
|                             |                                                                                                            |                         |                   |                                   |            |             |             |            |            |          |            |           
|                             | General and administrative                                                                                 |                         |                   | 24,070,930                        |            |             |             | 19,489,200 |            |          |            | 18,719,088 |           
|                             |                                                                                                            |                         |                   |                                   |            |             |             |            |            |          |            |           
|                             | Depreciation and amortization                                                                              |                         |                   | 5,179,407                         |            |             |             | 5,020,470  |            |          |            | 4,224,417  |           
|                             |                                                                                                            |                         |                   |                                   |            |             |             |            |            |          |            |           
|                             |                                                                                                            |                         |                   | Total expenses                    |            |             | 63,080,520  |            |            |          | 58,221,249 |            |            |           | 55,770,216 | 
|                             |                                                                                                            |                         |                   |                                   |            |             |             |            |            |          |            |           
|                             |                                                                                                            |                         |                   | Income (loss) from operations     |            |             | (6,902,781  | )          |            |          | 2,325,244  |            |            |           | 6,080,499  | 
|Other:                       |                                                                                                            |                         |                   |                                   |            |             |             |            |            |          |            |           
|                             | Interest income                                                                                            |                         |                   | 322,955                           |            |             |             | 651,936    |            |          |            | 943,300    |           
|                             | Interest expense, net of capitalized interest of
    $101,160 and $198,030 for 2002 and 2001, respectively |                         |                   | (4,004,769                        | )          |             |             | (3,073,228 | )          |          |            | (2,821,660 | )         
|                             |                                                                                                            |                         |                   |                                   |            |             |             |            |            |          |            |           
|                             |                                                                                                            |                         |                   | Income (loss) before income taxes |            |             | (10,584,595 | )          |            |          | (96,048    | )          |            |           | 4,202,139  | 
|Provision for income taxes   |                                                                                                            |                         | 1,164,000         |                                   |            |             | 103,000     |            |            |          | 1,713,000  |           
|                             |                                                                                                            |                         |                   |                                   |            |             |             |            |            |          |            |           
|                             |                                                                                                            |                         | Net income (loss) |                                   | $          | (11,748,595 | )           |            | $          | (199,048 | )          |            | $          | 2,489,139 |           
|                             |                                                                                                            |                         |                   |                                   |            |             |             |            |            |          |            |           
|Earnings per share  basic   |                                                                                                            | $                       | (1.60             | )                                 |            | $           | (0.03       | )          |            | $        | 0.34       |           
|                             |                                                                                                            |                         |                   |                                   |            |             |             |            |            |          |            |           
|Earnings per share  diluted |                                                                                                            | $                       | (1.60             | )                                 |            | $           | (0.03       | )          |            | $        | 0.33       |           
|                             |                                                                                                            |                         |                   |                                   |            |             |             |            |            |          |            |           

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

F-4



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##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS
EQUITY


|                                                                             |  |              |           |                |  |         |        |          |  |          |            |               |  |   |             |   |  |   |          |   |  |   |             |  
|---------------------------------------------------------------------------- |  | ------------ | --------- | -------------- |  | ------- | ------ | -------- |  | -------- | ---------- | ------------- |  | - | ----------- | - |  | - | -------- | - |  | - | ----------- | -
|                                                                             |  |              |           |                |  |         |        |          |  |         
|                                                                             |  | Common Stock |           |                |  |         |        |          |  |         
|                                                                             |  |              |           | Additional     |  |         |        |          |  | Total   
|                                                                             |  | Number of    |           | Stated Capital |  | Paid-In |        | Retained |  | Treasury |            | Stockholders
|                                                                             |  | Shares       |           | Amount         |  | Capital |        | Earnings |  | Stock    |            | Equity       
|                                                                             |  |              |           |                |  |         |        |          |  |          |            |              
|Balance, January 1, 2001                                                     |  |              | 7,443,342 |                |  | $       | 63,291 |          |  | $        | 57,877,642 |               |  | $ | 14,686,095  |   |  | $ | (105,000 | ) |  | $ | 72,522,028  |  
|Issuance of common stock in connection with
    employee stock purchase plan |  |              | 18,348    |                |  |         | 184    |          |  |          | 38,806     |               |  |   |            |   |  |   |         |   |  |   | 38,990      |  
|Issuance of warrants                                                         |  |              |          |                |  |         |       |          |  |          | 57,000     |               |  |   |            |   |  |   |         |   |  |   | 57,000      |  
|Treasury stock purchases (176,300 shares)                                    |  |              |          |                |  |         |       |          |  |          |           |               |  |   |            |   |  |   | (718,242 | ) |  |   | (718,242    | )
|Options exercised                                                            |  |              | 2,300     |                |  |         | 23     |          |  |          | 6,877      |               |  |   |            |   |  |   |         |   |  |   | 6,900       |  
|Tax benefit from employee stock transactions                                 |  |              |          |                |  |         |       |          |  |          | 6,221      |               |  |   |            |   |  |   |         |   |  |   | 6,221       |  
|Net income                                                                   |  |              |          |                |  |         |       |          |  |          |           |               |  |   | 2,489,139   |   |  |   |         |   |  |   | 2,489,139   |  
|                                                                             |  |              |           |                |  |         |        |          |  |          |            |               |  |   |             |   |  |   |          |   |  |   |             |  
|Balance, December 31, 2001                                                   |  |              | 7,463,990 |                |  |         | 63,498 |          |  |          | 57,986,546 |               |  |   | 17,175,234  |   |  |   | (823,242 | ) |  |   | 74,402,036  |  
|Issuance of common stock in connection with
    employee stock purchase plan |  |              | 16,467    |                |  |         | 165    |          |  |          | 66,726     |               |  |   |            |   |  |   |         |   |  |   | 66,891      |  
|Treasury stock purchases (3,225 shares)                                      |  |              |          |                |  |         |       |          |  |          |           |               |  |   |            |   |  |   | (19,914  | ) |  |   | (19,914     | )
|Options exercised                                                            |  |              | 16,321    |                |  |         | 163    |          |  |          | 61,889     |               |  |   |            |   |  |   |         |   |  |   | 62,052      |  
|Tax benefit from employee stock transactions                                 |  |              |          |                |  |         |       |          |  |          | 7,308      |               |  |   |            |   |  |   |         |   |  |   | 7,308       |  
|Net loss                                                                     |  |              |          |                |  |         |       |          |  |          |           |               |  |   | (199,048    | ) |  |   |         |   |  |   | (199,048    | )
|                                                                             |  |              |           |                |  |         |        |          |  |          |            |               |  |   |             |   |  |   |          |   |  |   |             |  
|Balance, December 31, 2002                                                   |  |              | 7,496,778 |                |  |         | 63,826 |          |  |          | 58,122,469 |               |  |   | 16,976,186  |   |  |   | (843,156 | ) |  |   | 74,319,325  |  
|Issuance of common stock in connection with
    employee stock purchase plan |  |              | 24,746    |                |  |         | 247    |          |  |          | 76,766     |               |  |   |            |   |  |   |         |   |  |   | 77,013      |  
|Issuance of employee stock options                                           |  |              |          |                |  |         |       |          |  |          | 14,710     |               |  |   |            |   |  |   |         |   |  |   | 14,710      |  
|Net loss                                                                     |  |              |          |                |  |         |       |          |  |          |           |               |  |   | (11,748,595 | ) |  |   |         |   |  |   | (11,748,595 | )
|                                                                             |  |              |           |                |  |         |        |          |  |          |            |               |  |   |             |   |  |   |          |   |  |   |             |  
|Balance, December 31, 2003                                                   |  |              | 7,521,524 |                |  | $       | 64,073 |          |  | $        | 58,213,945 |               |  | $ | 5,227,591   |   |  | $ | (843,156 | ) |  | $ | 62,662,453  |  
|                                                                             |  |              |           |                |  |         |        |          |  |          |            |               |  |   |             |   |  |   |          |   |  |   |             |  

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

F-5



---



##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH
FLOWS


|                                                         |                                                                                              |                                                                    |                                          |                                           |            |           |            |             |            |            |           |            |            |          |           | 
|-------------------------------------------------------- | -------------------------------------------------------------------------------------------- | ------------------------------------------------------------------ | ---------------------------------------- | ----------------------------------------- | ---------- | --------- | ---------- | ----------- | ---------- | ---------- | --------- | ---------- | ---------- | -------- | --------- | 
|                                                         |                                                                                              |                                                                   
|                                                         |                                                                                              | Year Ended December 31,                                           
|                                                         |                                                                                              |                                                                   
|                                                         |                                                                                              | 2003                                                               |                                          | 2002                                      |            | 2001     
|                                                         |                                                                                              |                                                                    |                                          |                                           |            |          
|Cash flows from operating activities:                    |                                                                                              |                                                                    |                                          |                                           |            |           |            |             |            |            |           |           
|                                                         | Net income (loss)                                                                            |                                                                    | $                                        | (11,748,595                               | )          |           | $          | (199,048    | )          |            | $         | 2,489,139  |           
|                                                         | Adjustments to reconcile net income (loss) to net
    cash provided by operating activities: |                                                                    |                                          |                                           |            |           |            |             |            |            |           |            |           
|                                                         |                                                                                              | Depreciation and amortization                                      |                                          |                                           | 5,179,407  |           |            |             | 5,020,470  |            |           |            | 4,224,417  |         
|                                                         |                                                                                              | Provisions for uncollectable accounts and
    impairment of assets |                                          |                                           | 3,700,304  |           |            |             | 1,569,077  |            |           |            | 1,852,374  |         
|                                                         |                                                                                              | Provision for deferred taxes                                       |                                          |                                           | 1,059,832  |           |            |             | 1,090,126  |            |           |            | 1,231,705  |         
|                                                         |                                                                                              | Recognition of previously deferred financing costs                 |                                          |                                           | 1,355,697  |           |            |             |           |            |           |            |           |         
|                                                         |                                                                                              | Provision for stock-based compensation expense                     |                                          |                                           | 29,491     |           |            |             |           |            |           |            |           |         
|                                                         |                                                                                              | Amortization of deferred revenue                                   |                                          |                                           | 4,468      |           |            |             | (266,616   | )          |           |            | (1,023,959 | )       
|                                                         |                                                                                              | Equity loss on investments                                         |                                          |                                           | 471,329    |           |            |             | 193,861    |            |           |            | 109,212    |         
|                                                         |                                                                                              | Changes in:                                                        |                                          |                                           |            |           |            |             |            |            |           |            |            |         
|                                                         |                                                                                              |                                                                    | Accounts receivable                      |                                           |            | 1,352,130 |            |             |            | (1,471,016 | )         |            |            | (45,305  | )        
|                                                         |                                                                                              |                                                                    | Prepaid expenses and other assets        |                                           |            | 94,446    |            |             |            | (540,704   | )         |            |            | (476,893 | )        
|                                                         |                                                                                              |                                                                    | Accounts payable and accrued liabilities |                                           |            | 3,858,677 |            |             |            | 1,273,099  |           |            |            | 356,834  |          
|                                                         |                                                                                              |                                                                    |                                          |                                           |            |           |            |             |            |            |           |           
|                                                         |                                                                                              |                                                                    |                                          | Net cash provided by operating activities |            |           | 5,357,186  |             |            |            | 6,669,249 |            |            |          | 8,717,524 | 
|                                                         |                                                                                              |                                                                    |                                          |                                           |            |           |            |             |            |            |           |           
|Cash flows from investing activities:                    |                                                                                              |                                                                    |                                          |                                           |            |           |            |             |            |            |           |           
|                                                         | Purchases of property, equipment and real estate
    held for sale                           |                                                                    |                                          | (3,623,077                                | )          |           |            | (2,196,739  | )          |            |           | (7,888,870 | )         
|                                                         | Sale of property, equipment and real estate held
    for sale                                |                                                                    |                                          | 2,693,583                                 |            |           |            | 1,187,113   |            |            |           | 3,383,465  |           
|                                                         | Acquisition of investments and intangible assets                                             |                                                                    |                                          | (312,446                                  | )          |           |            | (3,042,563  | )          |            |           | (2,616,909 | )         
|                                                         | Issuance of notes receivable                                                                 |                                                                    |                                          | (593,614                                  | )          |           |            | (97,475     | )          |            |           | (1,038,784 | )         
|                                                         | Repayments of notes receivable                                                               |                                                                    |                                          | 2,937,951                                 |            |           |            | 95,045      |            |            |           | 5,455,908  |           
|                                                         | Sale of investments and intangible assets                                                    |                                                                    |                                          |                                          |            |           |            |            |            |            |           | 70,011     |           
|                                                         |                                                                                              |                                                                    |                                          |                                           |            |           |            |             |            |            |           |           
|                                                         |                                                                                              | Net cash provided by (used in) investing
    activities            |                                          |                                           | 1,102,397  |           |            |             | (4,054,619 | )          |           |            | (2,635,179 | )       
|                                                         |                                                                                              |                                                                    |                                          |                                           |            |           |            |             |            |            |           |           
|Cash flows from financing activities:                    |                                                                                              |                                                                    |                                          |                                           |            |           |            |             |            |            |           |           
|                                                         | Sale of common stock                                                                         |                                                                    |                                          | 62,232                                    |            |           |            | 136,251     |            |            |           | 52,111     |           
|                                                         | Issuance of warrants                                                                         |                                                                    |                                          |                                          |            |           |            |            |            |            |           | 57,000     |           
|                                                         | Acquisition of treasury stock                                                                |                                                                    |                                          |                                          |            |           |            | (19,914     | )          |            |           | (718,242   | )         
|                                                         | Proceeds from issuance of debt                                                               |                                                                    |                                          | 3,473,436                                 |            |           |            | 10,008,345  |            |            |           | 3,415,769  |           
|                                                         | Repayment of debt                                                                            |                                                                    |                                          | (9,615,847                                | )          |           |            | (14,628,321 | )          |            |           | (7,484,918 | )         
|                                                         |                                                                                              |                                                                    |                                          |                                           |            |           |            |             |            |            |           |           
|                                                         |                                                                                              | Net cash used in financing activities                              |                                          |                                           | (6,080,178 | )         |            |             | (4,503,639 | )          |           |            | (4,678,280 | )       
|                                                         |                                                                                              |                                                                    |                                          |                                           |            |           |            |             |            |            |           |           
|Net increase (decrease) in cash and cash
    equivalents |                                                                                              |                                                                    | 379,405                                  |                                           |            |           | (1,889,009 | )           |            |            | 1,404,065 |           
|Cash and cash equivalents at beginning of year           |                                                                                              |                                                                    | 678,895                                  |                                           |            |           | 2,567,904  |             |            |            | 1,163,839 |           
|                                                         |                                                                                              |                                                                    |                                          |                                           |            |           |            |             |            |            |           |           
|Cash and cash equivalents at end of year                 |                                                                                              | $                                                                  | 1,058,300                                |                                           |            | $         | 678,895    |             |            | $          | 2,567,904 |           
|                                                         |                                                                                              |                                                                    |                                          |                                           |            |           |            |             |            |            |           |           

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

F-6



---



##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS




|   |                                                                         
|-- | ------------------------------------------------------------------------
|1. | Basis of Presentation and Summary of
    Significant Accounting Policies



| |                            
| | ---------------------------
| | Principles of Consolidation

The accompanying consolidated financial
statements include the accounts of Schlotzskys, Inc.,
a Texas corporation, its wholly owned subsidiaries
(collectively, the Company) and a restaurant
partnership venture it maintains a controlling interest in. All
significant inter-company balances and transactions are
eliminated in consolidation.



| |         
| | --------
| | Business

The Company is a franchisor and operator of
Schlotzskys fast-casual restaurants that feature upscale
made-to-order sandwiches with unique sourdough buns. As of
December 31, 2003, there were 561 Schlotzskys
restaurants, of which 37 are Company-operated and 524 are
franchised, located in 37 states, the District of Columbia
and six foreign countries. Approximately 31.4% of the
restaurants are located in Texas and 3.9% in foreign countries.



| |                    
| | -------------------
| | Revenue Recognition

Royalties and Franchise Fees:



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Royalties and franchise fees are paid to the
    Company based on individual franchise agreements. Royalties are
    based on franchisees restaurant sales, as defined in the
    franchise agreement, and are recognized as revenue in the period
    of the related sales. Franchise fees are recognized as revenue
    when the Company has performed substantially all services,
    typically at restaurant opening. Franchise fees collected but
    not yet earned are included in deferred revenue.

Developer Fees:



| |                                                                                                                                                                                                                                                                                                          
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Fees from area developers and international
    master licensees for the purchase of their territorial rights
    are recognized as revenue ratably over the development schedule
    specific to each contract, generally for a ten-year period.
    Unrecognized fees are included in deferred revenue.
|
| | Recognition of deferred fees is contingent on the
    licensees performance on the payment terms specified in
    the license agreement.                                                                                                                                                                

Restaurant Sales:



| |                                                                                                                                                                     
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Restaurant sales are comprised of sales of food
    and beverage through Company-operated restaurants and are
    recognized, net of discounts, at the time of sale.

Brand Contribution:



| |                                                                                                                                                                                                                                                                                                      
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Brand contribution is comprised of license fees
    received from third-party manufacturers based on their sales of
    Schlotzskys brand products to distributors for resale to
    franchisees or to retailers. These fees are recognized upon sale
    of the licensed products by manufacturers.

Interest Income:



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Interest income is recognized based on the terms
    specified in the Companys notes receivable. Recognition of
    interest income on notes that are not performing according to
    terms, or for which collectability is in doubt, is deferred
    until the interest is paid. Recognition of approximately
    $628,000 in interest revenue was deferred for the year ended
    December 31, 2003 related to $3,895,000 in net notes
    receivable balances.

F-7



---



##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




| |            
| | -----------
| | Fiscal Year

The Company utilizes a
4-4-5 week quarterly reporting schedule for
royalties, restaurant operations and royalty service costs. As a
result of this reporting schedule, the fiscal year will include
53 weeks of activity for these line items once every
5-6 years. The financial statements for 2002 and 2001
reflect 52 weeks of operations for these items, whereas the
financial statements for 2003 reflect 53 weeks. For all
other areas of the financial statements, the Company reports all
fiscal quarters as ending on March 31, June 30,
September 30 and December 31.



| |                 
| | ----------------
| | 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, 2003 and 2002, cash
consisted primarily of funds on deposit with commercial banks.



| |            
| | -----------
| | Credit Risk

The Companys financial instruments that are
exposed to concentrations of credit risk consist primarily of
cash and cash equivalents and notes receivable from franchisees,
area developers, master licensees and affiliates. The Company
places its cash and cash equivalents with high credit quality
financial institutions, which, at times, may exceed federally
insured limits. The Company has not experienced any losses in
such accounts.



| |          
| | ---------
| | Inventory

Inventory represents food and supplies at
Company-operated restaurants and is accounted for at the lower
of cost or market on the first-in, first-out method.



| |                 
| | ----------------
| | Notes Receivable

Notes receivable consist of area developer,
master licensee, franchisee and related-party promissory notes
and presented net of impairment allowances.

F-8



---



##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)


In reviewing the adequacy of the valuation
allowances for notes receivable, we consider factors such as
historical collection experience, the estimated value of
personal guarantees and real property collateral, the
debtors sales and operating trends, including potential
for improvement in operations, and general and local economic
conditions that may affect the debtors ability to pay.
Impairment allowances are as follows:

|                                                           |  |                                 |           |      |  |      |           |   |  |   |           |  
|---------------------------------------------------------- |  | ------------------------------- | --------- | ---- |  | ---- | --------- | - |  | - | --------- | -
|                                                           |  |                                
|                                                           |  | For the Year Ended December 31,
|                                                           |  |                                
|                                                           |  | 2003                            |           | 2002 |  | 2001
|                                                           |  |                                 |           |      |  |     
|Allowance for impairment of notes, beginning of
    period |  | $                               | 1,925,000 |      |  | $    | 1,788,000 |   |  | $ | 1,887,000 |  
|Additions to allowances expensed to operations             |  |                                 | 2,418,000 |      |  |      | 831,000   |   |  |   | 604,000   |  
|Other                                                      |  |                                 | 13,000    |      |  |      |          |   |  |   |          |  
|Less write-downs of notes receivable                       |  |                                 |          |      |  |      | (694,000  | ) |  |   | (703,000  | )
|                                                           |  |                                 |           |      |  |      |           |   |  |   |           |  
|                                                           |  | $                               | 4,356,000 |      |  | $    | 1,925,000 |   |  | $ | 1,788,000 |  
|                                                           |  |                                 |           |      |  |      |           |   |  |   |           |  



| |                                                   
| | --------------------------------------------------
| | Property, Equipment and Leasehold
    Improvements

Property, equipment and leasehold improvements,
which includes capitalized leases at a carrying value of
$2,542,000 and $2,625,000, net of accumulated amortization of
$1,186,000 and $955,000 at December 31, 2003 and 2002,
respectively, 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 that 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 are calculated using the
straight-line method over the estimated useful lives of the
assets or the term of the lease, including renewal options,
whichever is shorter, for leasehold improvements.



| |                          
| | -------------------------
| | Real Estate Held for Sale

Real estate held for sale consists primarily of
land owned by the Company that it is actively marketing. These
properties are stated at the lower of cost or net realizable
value. Each property is reviewed in terms of its carrying value
and the expected net realizable value.



| |            
| | -----------
| | Investments

Limited partnership investments are accounted for
under the equity method and, accordingly, the Companys
investment is adjusted for allocated profits, losses and
distributions.



| |                                                         
| | --------------------------------------------------------
| | Intangible Assets and Change in Accounting
    Principle

Intangible assets consist primarily of the
Companys original franchise rights, royalty values and
goodwill, and developer and franchise rights related to the
Companys reacquisition of franchises and area developer
territory rights. Intangible assets with determinable lives are
amortized over their estimated useful lives ranging from four to
40 years.

The Company evaluates the propriety of the
carrying amount of its intangible assets, as well as the
amortization period for each intangible, when conditions
warrant. If an indicator of impairment is present, the Company
compares the projected undiscounted cash flows for the related
business activity with the unamortized balance of the related
intangible asset. If the undiscounted cash flows are less than
the carrying value, management estimates the fair value of the
intangible asset based on expected future operating cash flows
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 amortization.
During 2002, the Company recorded an impairment provision of
$150,000 for certain intangible assets related to restaurants.

F-9



---



##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)


Under SFAS No. 142, Goodwill and
Other Intangible Assets, which the Company adopted
January 1, 2002, the Company is required to test goodwill
for impairment by comparing the carrying value of its reporting
units, including goodwill, to the fair value of the unit. The
Company determines fair value by projecting discounted cash
flows expected from the units. Both interim testing, completed
during the second quarter of 2002, and year-end testing
indicated no goodwill impairment was present.



| |              
| | -------------
| | Service Costs

Royalties and franchise fees service costs
represent payments, generally computed as a percentage of
royalties and franchise fees, to area developers in accordance
with their individual contracts.



| |             
| | ------------
| | Income Taxes

The Company recognizes deferred tax assets or
liabilities computed based on the difference between the
financial statement and income tax bases of assets and
liabilities using the enacted statutory tax rate. Deferred
income tax expenses or credits are based on the changes in the
asset or liability from period to period. The recognized
deferred tax assets are reviewed for impairment on a quarterly
basis by reviewing the Companys internal estimates for
future net income. If the Company determines it to be more
likely than not the recovery of the asset is in question in the
immediate, foreseeable future, the Company records a valuation
allowance. In the fourth quarter of 2003, the Company determined
its deferred tax assets were impaired and recorded a full
valuation allowance against the net deferred tax asset.



| |                                    
| | -----------------------------------
| | Fair Value of Financial Instruments

The Companys financial instruments include
cash and cash equivalents, accounts receivable, notes
receivable, accounts payable, accrued liabilities and debt. The
carrying value of financial instruments approximates fair value
at December 31, 2003 and 2002.



| |                    
| | -------------------
| | Advertising Expense

The Company expenses advertising costs as
incurred. Total advertising expense amounted to approximately
$1,662,000, $2,077,000, and $1,468,000 for the years ended
December 31, 2003, 2002 and 2001, respectively.



| |                  
| | -----------------
| | Insurance Program

The Company is partially self-insured for medical
and dental claims effective January 1, 2000. Stop loss
insurance is maintained on an individual claim and aggregate
basis. An accrual has been made for claims incurred but not
reported.



| |                   
| | ------------------
| | Earnings Per Share

The Company computes basic earnings per share
based on the weighted average number of common shares
outstanding. Diluted earnings per share is computed based on the
weighted average number of shares outstanding, plus the
additional common shares that would have been outstanding, if
dilutive potential common shares consisting of stock options and
warrants had been issued. No dilutive effect is considered
during periods in which there is a net loss.



| |                         
| | ------------------------
| | Stock-based Compensation

The Company adopted a Third Amended and
Restated Stock Option Plan, as further amended (the
Option Plan), which was a stock-based incentive
compensation plan, as described below. The plan expired in
December 2003, but options granted under the plan have remaining
lives of up to ten years. In 1995, the

F-10



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##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)


FASB issued SFAS No. 123 Accounting
for Stock-Based Compensation which, if adopted, changes
the method the Company applied in recognizing the cost of the
Option Plan. The Company had not elected to apply the provisions
of SFAS No. 123 through December 31, 2002, but
effective January 1, 2003 the Company applied the cost
recognition provisions of SFAS No. 123 under the
prospective method of adoption authorized by SFAS No. 148.
Additionally, pro forma disclosures as if the Company adopted
the cost recognition provisions of SFAS No. 123 are
required by SFAS No. 123 and are presented below. The
Company also has an employee stock purchase plan that it adopted
in 1998.

During 2002 and 2001, the Company did not incur
any compensation costs for the Option Plan or the Employee Stock
Purchase Plan under APB Opinion No. 25 for options granted
prior to January 1, 2003, and recognized expenses
prospectively in 2003. Had compensation cost for the
Companys Stock Option Plan and Employee Stock Purchase
Plan been determined consistent with SFAS No. 123, the
Companys net income and earnings per common share for
2003, 2002 and 2001 would approximate the pro forma amounts
below:

|                                                                                                                                            |                     |                                 |         |       |   |      |      |       |   |   |       |      | 
|------------------------------------------------------------------------------------------------------------------------------------------- | ------------------- | ------------------------------- | ------- | ----- | - | ---- | ---- | ----- | - | - | ----- | ---- | 
|                                                                                                                                            |                     |                                
|                                                                                                                                            |                     | For the Year Ended December 31,
|                                                                                                                                            |                     |                                
|                                                                                                                                            |                     | 2003                            |         | 2002  |   | 2001
|                                                                                                                                            |                     |                                 |         |       |   |     
|Net income (loss), as reported                                                                                                              |                     | $                               | (11,749 | )     |   | $    | (199 | )     |   | $ | 2,489 |     
|Add: Stock-based employee compensation expense
    included in net income                                                                   |                     |                                 | 29      |       |   |      |     |       |   |   |      |     
|Add (deduct): Total stock-based employee
    compensation forfeitures (expense) determined under fair
    value based method for all awards |                     |                                 | 117     |       |   |      | (349 | )     |   |   | (722  | )   
|                                                                                                                                            |                     |                                 |         |       |   |      |      |       |   |   |       |     
|Pro forma net income (loss)                                                                                                                 |                     | $                               | (11,603 | )     |   | $    | (548 | )     |   | $ | 1,767 |     
|                                                                                                                                            |                     |                                 |         |       |   |      |      |       |   |   |       |     
|Earnings per share:                                                                                                                         |                     |                                 |         |       |   |      |      |       |   |   |       |     
|                                                                                                                                            | Basic-as reported   |                                 | $       | (1.60 | ) |      | $    | (0.03 | ) |   | $     | 0.34 | 
|                                                                                                                                            |                     |                                 |         |       |   |      |      |       |   |   |       |     
|                                                                                                                                            | Basic-pro forma     |                                 | $       | (1.57 | ) |      | $    | (0.08 | ) |   | $     | 0.24 | 
|                                                                                                                                            |                     |                                 |         |       |   |      |      |       |   |   |       |     
|                                                                                                                                            | Diluted-as reported |                                 | $       | (1.60 | ) |      | $    | (0.03 | ) |   | $     | 0.33 | 
|                                                                                                                                            |                     |                                 |         |       |   |      |      |       |   |   |       |     
|                                                                                                                                            | Diluted-pro forma   |                                 | $       | (1.57 | ) |      | $    | (0.08 | ) |   | $     | 0.24 | 
|                                                                                                                                            |                     |                                 |         |       |   |      |      |       |   |   |       |     

See Note 12 for a further discussion of the
Companys stock-based compensation.



| |                  
| | -----------------
| | 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.

F-11



---



##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|   |                 
|-- | ----------------
|2. | Notes Receivable

Notes receivable consist of the following:

|                                                                                                                                                                                                    |  |              |            |      |  |   |            |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------ | ---------- | ---- |  | - | ---------- | -
|                                                                                                                                                                                                    |  |             
|                                                                                                                                                                                                    |  | December 31,
|                                                                                                                                                                                                    |  |             
|                                                                                                                                                                                                    |  | 2003         |            | 2002
|                                                                                                                                                                                                    |  |              |            |     
|Notes receivable from area developers and
    international master licensees, secured by their respective
    territories, interest ranging from 6% to 8%, due in installments
    through 2004.    |  | $            | 343,450    |      |  | $ | 343,450    |  
|Notes receivable from franchisees, secured by
    real estate and equipment, generally subordinated to a first
    mortgage, interest ranging from 5% to 12%, due in installments
    through 2023. |  |              | 7,124,319  |      |  |   | 6,995,684  |  
|Notes receivable, unsecured, interest at 8 %, due
    in installments through 2010                                                                                                                  |  |              | 428,695    |      |  |   | 435,693    |  
|Less  allowance for doubtful accounts                                                                                                                                                              |  |              | (3,723,943 | )    |  |   | (1,292,196 | )
|                                                                                                                                                                                                    |  |              |            |      |  |   |            |  
|                                                                                                                                                                                                    |  |              | 4,172,521  |      |  |   | 6,482,631  |  
|Less  current portion                                                                                                                                                                              |  |              | (50,570    | )    |  |   | (510,573   | )
|                                                                                                                                                                                                    |  |              |            |      |  |   |            |  
|Notes receivable, less current portion                                                                                                                                                              |  | $            | 4,121,951  |      |  | $ | 5,972,058  |  
|                                                                                                                                                                                                    |  |              |            |      |  |   |            |  



|   |                                          
|-- | -----------------------------------------
|3. | Notes Receivable From Related
    Parties

Notes receivable from related parties consist of
the following:

|                                                                                                                                                                                                                                   |  |              |           |      |  |   |           |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------ | --------- | ---- |  | - | --------- | -
|                                                                                                                                                                                                                                   |  |             
|                                                                                                                                                                                                                                   |  | December 31,
|                                                                                                                                                                                                                                   |  |             
|                                                                                                                                                                                                                                   |  | 2003         |           | 2002
|                                                                                                                                                                                                                                   |  |              |           |     
|Note receivable from Schlotzskys
    N.A.M.F., Inc. (NAMF), unsecured, bearing
    interest at prime, due on demand at any time on or before
    December 31, 2010, subordinated to a bank term loan
    expiring in April 2004 |  | $            |          |      |  | $ | 2,862,644 |  
|Notes receivable from related entities controlled
    by stockholders of the Company, bearing interest at 8%,
    collateralized by real estate, due in installments upon certain
    events                                       |  |              | 963,356   |      |  |   | 930,837   |  
|Notes receivable from master licensee, of which
    the Company is a preferred shareholder, bearing interest at 9%,
    due in installments through December 2007                                                                  |  |              | 996,258   |      |  |   | 996,258   |  
|Notes receivable from officers of the Company,
    bearing interest at 8%, due in installments upon certain events                                                                                                                 |  |              | 396,562   |      |  |   | 396,562   |  
|Notes receivable from employees of the Company,
    bearing interest at 6.0%, due in installments through 2004                                                                                                                     |  |              | 118,041   |      |  |   | 121,246   |  
|Note receivable from master licensee, of which a
    member of the Companys management is a shareholder,
    bearing interest at 10%, due in installments through December
    2006                                               |  |              | 775,000   |      |  |   | 775,000   |  
|Less  allowance for doubtful accounts                                                                                                                                                                                             |  |              | (632,547  | )    |  |   | (632,547  | )
|                                                                                                                                                                                                                                   |  |              |           |      |  |   |           |  
|                                                                                                                                                                                                                                   |  |              | 2,616,670 |      |  |   | 5,450,000 |  
|Less  current portion                                                                                                                                                                                                             |  |              | (3,500    | )    |  |   | (72,353   | )
|                                                                                                                                                                                                                                   |  |              |           |      |  |   |           |  
|Notes receivable from related parties, less
    current portion                                                                                                                                                                    |  | $            | 2,613,170 |      |  | $ | 5,377,647 |  
|                                                                                                                                                                                                                                   |  |              |           |      |  |   |           |  

From time to time, the Company makes advances to
certain stockholders, related partnerships and affiliates (see
Notes 5 and 14).

F-12



---



##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|   |                                                   
|-- | --------------------------------------------------
|4. | Property, Equipment and Leasehold
    Improvements

Property, equipment and leasehold improvements,
recorded at cost, consist of the following:

|                                                        |  |              |               |             |  |              |             |      |  |   |            |  |  |   |            | 
|------------------------------------------------------- |  | ------------ | ------------- | ----------- |  | ------------ | ----------- | ---- |  | - | ---------- |  |  | - | ---------- | 
|                                                        |  |              |               |             |  |             
|                                                        |  |              |               | Depreciable |  | December 31,
|                                                        |  | Depreciation |               | Life        |  |             
|                                                        |  | Method       |               | (Years)     |  | 2003         |             | 2002
|                                                        |  |              |               |             |  |              |             |     
|Buildings                                               |  |              | Straight Line |             |  |              | 32          |      |  | $ | 12,833,931 |  |  | $ | 11,214,764 | 
|Capitalized leases for land and buildings               |  |              | Straight Line |             |  |              | 19 to 25    |      |  |   | 2,603,313  |  |  |   | 2,603,313  | 
|Furniture, fixtures and equipment                       |  |              | Straight Line |             |  |              | 3 to 7      |      |  |   | 15,628,844 |  |  |   | 14,551,386 | 
|Leasehold improvements                                  |  |              | Straight Line |             |  |              | 7 to 32     |      |  |   | 13,161,823 |  |  |   | 10,396,744 | 
|                                                        |  |              |               |             |  |              |             |      |  |   |            |  |  |   |            | 
|                                                        |  |              |               |             |  |              |             |      |  |   | 44,227,911 |  |  |   | 38,766,207 | 
|Accumulated depreciation and amortization               |  |              | (16,403,253   | )           |  |              | (12,708,978 | )   
|                                                        |  |              |               |             |  |              |             |     
|                                                        |  |              |               |             |  |              |             |      |  |   | 27,824,658 |  |  |   | 26,057,229 | 
|Land                                                    |  |              | 14,571,487    |             |  |              | 13,652,232  |     
|                                                        |  |              |               |             |  |              |             |     
|Property, equipment and leasehold improvements,
    net |  | $            | 42,396,145    |             |  | $            | 39,709,461  |     
|                                                        |  |              |               |             |  |              |             |     

Certain of these properties, with a net carrying
value of $15,959,000 and $16,646,000 at December 31, 2003
and 2002, respectively, represent operating restaurants which
are not part of the Companys long-term portfolio of
restaurants and are available for sale.

Depreciation and amortization of property,
equipment and leasehold improvements totaled approximately
$3,349,000, $3,475,000 and $3,074,000 for the years ended
December 31, 2003, 2002 and 2001, respectively.

Accumulated depreciation related to the
capitalized leases was $726,000 and $617,000 at
December 31, 2003 and 2002, respectfully.

During 2002, an impairment provision of $150,000
was taken against restaurant carrying value. This impairment was
determined through a review of the discounted estimated cash
flows of the related properties.



|   |            
|-- | -----------
|5. | Investments

Investments consist of the following:

|                                |  |              |         |      |  |   |           | 
|------------------------------- |  | ------------ | ------- | ---- |  | - | --------- | 
|                                |  |             
|                                |  | December 31,
|                                |  |             
|                                |  | 2003         |         | 2002
|                                |  |              |         |     
|Restaurant venture investment   |  | $            |        |      |  | $ | 1,285,632 | 
|Real estate venture investment  |  |              | 4,779   |      |  |   | 4,062     | 
|Building artwork                |  |              | 263,071 |      |  |   | 263,071   | 
|Investments in master licensees |  |              | 300,000 |      |  |   | 300,000   | 
|                                |  |              |         |      |  |   |           | 
|                                |  | $            | 567,850 |      |  | $ | 1,852,765 | 
|                                |  |              |         |      |  |   |           | 



| |                   
| | ------------------
| | Restaurant Venture

The Company acquired in 2000 a 50% interest in a
limited liability company engaged in the operation of a
Schlotzskys restaurant. During 2003, the Company acquired
the remaining 50% interest and is now consolidating the
entity.

F-13



---



##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




| |                    
| | -------------------
| | Real Estate Venture

The Company owns a 10% limited partnership
interest and a 1% general partnership interest in a limited
partnership that owns a shopping center in Austin, Texas. The
partnership has the following assets, liabilities and capital
(unaudited):

|            |  |             |           |      |  |   |           | 
|----------- |  | ----------- | --------- | ---- |  | - | --------- | 
|            |  |            
|            |  | December 31
|            |  |            
|            |  | 2003        |           | 2002
|            |  |             |           |     
|Assets      |  | $           | 2,414,910 |      |  | $ | 2,384,070 | 
|Liabilities |  |             | 2,110,500 |      |  |   | 2,073,629 | 
|Capital     |  |             | 304       |      |  |   | 310,441   | 

The limited partnerships net profits,
losses and distributions are allocated based upon methods set
forth in the partnership agreement. Net profits and all losses
are allocated 1% to the Company.

The Company is the guarantor, subject to certain
conditions, of the partnership debt in the amount of
approximately $1,986,000 at December 31, 2003 and
$2,005,000 at December 31, 2002, which is also
collateralized by real estate and related leases and rents.



| |                                
| | -------------------------------
| | Investments in Master Licensees

The Company has a preferred stock minority
interest in a master licensee. The Company is also a lender to
this master licensee (see Note 3).



|   |                  
|-- | -----------------
|6. | Intangible Assets

As of December 31, 2003, and
December 31, 2002, intangible assets consisted of the
following:

|                                               |                                       |              |  |                   |  |                   |            |             |  |              |           |           |  |   |            |            |  |   |           |           | 
|---------------------------------------------- | ------------------------------------- | ------------ |  | ----------------- |  | ----------------- | ---------- | ----------- |  | ------------ | --------- | --------- |  | - | ---------- | ---------- |  | - | --------- | --------- | 
|                                               |                                       |              |  |                   |  |                  
|                                               |                                       |              |  | December 31, 2003 |  | December 31, 2002
|                                               |                                       | Amortization |  |                   |  |                  
|                                               |                                       | Period       |  |                   |  | Accumulated       |            |             |  | Accumulated 
|                                               |                                       | (Years)      |  | Gross Value       |  | Amortization      |            | Gross Value |  | Amortization
|                                               |                                       |              |  |                   |  |                   |            |             |  |             
|Intangible assets subject to amortization:     |                                       |              |  |                   |  |                   |            |             |  |              |           |           |  |   |            |            |  |   |           |          
|                                               | Royalty value                         |              |  | 20                |  |                   | $          | 2,473,687   |  |              | $         | 896,675   |  |   | $          | 2,473,687  |  |   | $         | 779,243   | 
|                                               | Developer and franchise rights        |              |  | 20 to 40          |  |                   |            | 59,373,997  |  |              |           | 3,866,684 |  |   |            | 59,383,997 |  |   |           | 2,492,493 | 
|                                               | Restaurant development rights         |              |  | 13 to 25          |  |                   |            | 1,653,268   |  |              |           | 568,080   |  |   |            | 1,619,044  |  |   |           | 406,689   | 
|                                               | Debt issue costs                      |              |  | 3 to 20           |  |                   |            | 529,368     |  |              |           | 210,789   |  |   |            | 1,561,254  |  |   |           | 76,631    | 
|                                               | Other intangible assets               |              |  | 5                 |  |                   |            | 645,433     |  |              |           | 438,627   |  |   |            | 560,624    |  |   |           | 363,770   | 
|                                               |                                       |              |  |                   |  |                   |            |             |  |              |           |           |  |   |            |            |  |   |           |          
|                                               |                                       |              |  |                   |  |                   | 64,675,753 |             |  |              | 5,980,855 |           |  |   | 65,598,606 |            |  |   | 4,118,826 |          
|                                               |                                       |              |  |                   |  |                   |            |             |  |              |           |           |  |   |            |            |  |   |           |          
|Intangible assets not subject to amortization: |                                       |              |  |                   |  |                   |            |             |  |              |           |           |  |   |            |            |  |   |           |          
|                                               | Original franchise and royalty rights |              |  |                   |  |                   |            | 5,688,892   |  |              |           | 1,860,423 |  |   |            | 5,688,892  |  |   |           | 1,860,423 | 
|                                               | Goodwill                              |              |  |                   |  |                   |            | 3,850,083   |  |              |           | 330,841   |  |   |            | 3,316,520  |  |   |           | 330,841   | 
|                                               |                                       |              |  |                   |  |                   |            |             |  |              |           |           |  |   |            |            |  |   |           |          
|                                               |                                       |              |  |                   |  |                   | 9,538,975  |             |  |              | 2,191,264 |           |  |   | 9,005,412  |            |  |   | 2,191,264 |          
|                                               |                                       |              |  |                   |  |                   |            |             |  |              |           |           |  |   |            |            |  |   |           |          
|Total intangible assets                        |                                       |              |  |                   |  | $                 | 74,214,728 |             |  | $            | 8,172,119 |           |  | $ | 74,604,018 |            |  | $ | 6,310,090 |          
|                                               |                                       |              |  |                   |  |                   |            |             |  |              |           |           |  |   |            |            |  |   |           |          

Approximately $1.4 million in debt issue
costs were written off in 2003 in conjunction with the
abandonment of a financing transaction.

F-14



---



##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)


Estimated amortization expense for intangible
assets with determinable lives is as follows:

|     |  |   |           | 
|---- |  | - | --------- | 
|2004 |  | $ | 1,733,000 | 
|2005 |  |   | 1,673,000 | 
|2006 |  |   | 1,668,000 | 
|2007 |  |   | 1,640,000 | 
|2008 |  |   | 1,745,000 | 
|     |  |   |           | 
|     |  | $ | 8,459,000 | 
|     |  |   |           | 

The changes in the gross value of goodwill for
the year ended December 31, 2003, are as follows:

|                                |                   |            |           |            |  |       |         |   |  |   |           |         | 
|------------------------------- | ----------------- | ---------- | --------- | ---------- |  | ----- | ------- | - |  | - | --------- | ------- | 
|                                |                   | Restaurant |           | Franchise  |  |      
|                                |                   | Operations |           | Operations |  | Total
|                                |                   |            |           |            |  |      
|Balance as of December 31, 2002 |                   | $          | 3,055,520 |            |  | $     | 261,000 |   |  | $ | 3,316,520 |        
|                                | Goodwill acquired |            |           | 533,563    |  |       |         |  |  |   |           | 533,563 | 
|                                | Impairment        |            |           |           |  |       |         |  |  |   |           |        | 
|                                |                   |            |           |            |  |       |         |   |  |   |           |        
|Balance as of December 31, 2003 |                   | $          | 3,589,083 |            |  | $     | 261,000 |   |  | $ | 3,850,083 |        
|                                |                   |            |           |            |  |       |         |   |  |   |           |        

The following table provides a reconciliation of
reported net income for the year ended December 31, 2001,
adjusted as though SFAS No. 142 had been effective
January 1, 2001 (in thousands, except per share data):

|                                           |                     |                   |       |       |  |         |      |      |  |   |      |      | 
|------------------------------------------ | ------------------- | ----------------- | ----- | ----- |  | ------- | ---- | ---- |  | - | ---- | ---- | 
|                                           |                     |                  
|                                           |                     | Year ended       
|                                           |                     | December 31, 2001
|                                           |                     |                  
|                                           |                     |                   |       | Basic |  | Diluted
|                                           |                     | Amount            |       | EPS   |  | EPS    
|                                           |                     |                   |       |       |  |        
|Reported net income (loss)                 |                     | $                 | 2,489 |       |  | $       | 0.34 |      |  | $ | 0.33 |     
|Add back amortization expense (net of tax) |                     |                   | 147   |       |  |         | 0.02 |      |  |   | 0.02 |     
|                                           |                     |                   |       |       |  |         |      |      |  |   |      |     
|                                           | Adjusted net income |                   | $     | 2,636 |  |         | $    | 0.36 |  |   | $    | 0.35 | 
|                                           |                     |                   |       |       |  |         |      |      |  |   |      |     

Original franchise and royalty rights represent
an amount allocated in connection with a 1993 merger of
predecessor entities to form the current
Schlotzskys, Inc.

Developer and franchise rights acquired, royalty
value and goodwill represent the fair value of various rights
reacquired from area developers, master licensees and
franchisees in various transactions to reduce or eliminate the
percentage of royalties and franchise fees paid to area
developers and master licensees and to reacquire franchise and
other rights to develop certain territories and restaurant
locations.

The adoption of SFAS No. 142 had the
effect of decreasing amortization expense and decreasing loss
before provision for income taxes for 2002 by approximately
$241,000, and net income and diluted earnings per share
increased by approximately $150,000 and $0.02, respectively.

Amortization of intangible assets totaled
approximately $1,830,000, $1,245,000 and $1,150,000 for the
years ended December 31, 2003, 2002 and 2001, respectively.

F-15



---



##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|   |                 
|-- | ----------------
|7. | Deferred Revenue

Deferred revenue consists of the following:

|                                            |  |              |           |      |  |   |           |  
|------------------------------------------- |  | ------------ | --------- | ---- |  | - | --------- | -
|                                            |  |             
|                                            |  | December 31,
|                                            |  |             
|                                            |  | 2003         |           | 2002
|                                            |  |              |           |     
|Deferred developer and master licensee fees |  | $            | 1,274,458 |      |  | $ | 1,442,520 |  
|Deferred franchise fees                     |  |              | 210,000   |      |  |   | 77,000    |  
|Deferred franchise fee service costs        |  |              |          |      |  |   | (30,000   | )
|Deferred gain on property sales             |  |              | 342,475   |      |  |   | 342,475   |  
|                                            |  |              |           |      |  |   |           |  
|                                            |  |              | 1,826,933 |      |  |   | 1,831,995 |  
|Less  current portion                      |  |              | (376,633  | )    |  |   | (234,552  | )
|                                            |  |              |           |      |  |   |           |  
|Deferred revenue, less current portion      |  | $            | 1,450,300 |      |  | $ | 1,597,443 |  
|                                            |  |              |           |      |  |   |           |  

The Companys policy is to reduce the basis
of reacquired intangible rights by the amount of deferred
revenue associated with the rights remaining at the time of
acquisition. Deferred revenue was reduced by approximately
$77,000 due to the reacquisition of certain master licensees and
area developer territory rights during 2002.



|   |     
|-- | ----
|8. | Debt

The Companys short-term debt consists of
the following:

|                                                                                                              |  |              |           |      |  |   |   | 
|------------------------------------------------------------------------------------------------------------- |  | ------------ | --------- | ---- |  | - | - | 
|                                                                                                              |  |             
|                                                                                                              |  | December 31,
|                                                                                                              |  |             
|                                                                                                              |  | 2003         |           | 2002
|                                                                                                              |  |              |           |     
|Notes payable to related parties, interest at
    6.0%, secured by royalty rights, due April 2004             |  | $            | 360,000   |      |  | $ |  | 
|Notes payable to related parties, interest at
    5.2%, secured by a certificate of deposit, due June 2004    |  |              | 150,000   |      |  |   |  | 
|Mortgage note payable to financial institution
    interest at 6.8%, secured by real estate, due July 1, 2004 |  |              | 623,701   |      |  |   |  | 
|                                                                                                              |  |              |           |      |  |   |   | 
|Short-term debt                                                                                               |  | $            | 1,133,701 |      |  | $ |  | 
|                                                                                                              |  |              |           |      |  |   |   | 

F-16



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##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)


The Companys long-term debt consists of the
following:

|                                                                                                                                                                                                                                                                       |  |              |            |      |  |   |            |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------ | ---------- | ---- |  | - | ---------- | -
|                                                                                                                                                                                                                                                                       |  |             
|                                                                                                                                                                                                                                                                       |  | December 31,
|                                                                                                                                                                                                                                                                       |  |             
|                                                                                                                                                                                                                                                                       |  | 2003         |            | 2002
|                                                                                                                                                                                                                                                                       |  |              |            |     
|Notes payable to former area developer, interest
    at 3.0% increasing to 8% in November 2004, secured by first lien
    on intellectual property, due in installments through May 2008                                                                               |  | $            | 18,012,099 |      |  | $ | 21,790,409 |  
|Notes payable to former area developers, interest
    at 8.0%, secured by interest in area developer rights, due in
    installments through May 2008                                                                                                                  |  |              | 2,129,036  |      |  |   | 2,647,935  |  
|Mortgage notes payable to various financial
    institutions, interest rates ranging from 6.25% to 9.6%, secured
    by related restaurants, due in monthly installments through 2016                                                                                  |  |              | 21,588,813 |      |  |   | 23,839,398 |  
|Capitalized lease obligations, net of imputed
    interest of $4,482,985 and $5,550,162 as of December 31,
    2003 and 2002, respectively, imputed rates ranging from 8.0% to
    16.9%, due in monthly installments through 2027                                     |  |              | 2,659,336  |      |  |   | 3,028,750  |  
|Note payable to shareholders, interest rate at
    2.5% over prime due in monthly installments through December 2006                                                                                                                                                   |  |              | 2,500,000  |      |  |   |           |  
|Note payable to former area developer,
    non-interest bearing, discounted to reflect 8.0% imputed
    interest, unsecured, due in monthly installments through 2009,
    net of discount of $809,199 and $939,753 as of December 31,
    2003 and 2002, respectively |  |              | 1,710,252  |      |  |   | 1,868,118  |  
|Other                                                                                                                                                                                                                                                                  |  |              | 551,251    |      |  |   | 330,109    |  
|                                                                                                                                                                                                                                                                       |  |              |            |      |  |   |            |  
|                                                                                                                                                                                                                                                                       |  |              | 49,150,787 |      |  |   | 53,504,719 |  
|Less  current maturities                                                                                                                                                                                                                                              |  |              | (6,564,646 | )    |  |   | (7,441,120 | )
|                                                                                                                                                                                                                                                                       |  |              |            |      |  |   |            |  
|Long term debt, less current maturities                                                                                                                                                                                                                                |  | $            | 42,586,141 |      |  | $ | 46,063,599 |  
|                                                                                                                                                                                                                                                                       |  |              |            |      |  |   |            |  

The Companys $40,000,000 1999 Credit
Agreement was fully repaid in 2002 with the proceeds of real
estate mortgages. In August 2002, the Company exercised its
option to reacquire the territorial rights of its largest area
developer. The acquisition was primarily financed through a
$23,268,000 promissory note to the seller secured by the rights
reacquired. This note was modified in December 2003, and the
major changes were to decrease the monthly payments from
$520,000 to $120,000 for 12 months, before payments
increase to $420,000 a month. The term of the debt was extended
from June 2005 to December 2006. In addition, the interest on
the balance was set at 3% for 12 months before it begins to
fluctuate at four points over prime. In exchange, NS Associates
received a first lien on our intellectual property, subject to
certain conditions. The Company is subject to certain covenants
under the terms of the renegotiated agreement. If the Company
fails to satisfy the terms of those covenants, it would
constitute a default under the terms of the agreement, and NS
Associates would have the right to accelerate the terms of the
note.

In January, 2004 the Company entered into a
$3 million credit facility with a commercial bank, of which
approximately $1.5 million has been funded. The credit
facility requires interest-only payments through June, 2004 at
prime plus 2.5%, and then requires monthly principal and
interest payments through December, 2005.

Certain of the Companys real estate
mortgages contain covenants requiring the maintenance of certain
financial ratios, including working capital, debt to equity and
debt service coverage. The Company has received waivers as of
December 31, 2003 from lender and through December 31,
2004 from another lender on such covenants related to
$10,576,000 in long-term debt. If the Company is unable to
obtain such waivers in the future it will have adverse material
consequences for the Company.

F-17



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##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)


Aggregate scheduled maturities of long-term debt
at December 31, 2003, are as follows:

|             |  |   |            | 
|------------ |  | - | ---------- | 
|Year Ending  |  |  
|December 31, |  |  
|             |  |  
|2004         |  | $ | 6,565,000  | 
|2005         |  |   | 10,902,000 | 
|2006         |  |   | 16,441,000 | 
|2007         |  |   | 4,341,000  | 
|2008         |  |   | 1,447,000  | 
|Thereafter   |  |   | 9,455,000  | 
|             |  |   |            | 
|             |  | $ | 49,151,000 | 
|             |  |   |            | 

F-18



---



##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|   |                      
|-- | ---------------------
|9. | Restaurant Operations

The Company operates two groups of restaurants,
one group which it intends to own and operate on a long-term
basis and another group which are available for sale. The
restaurants in the long-term portfolio include, as of
December 31, 2003, three Marketplace restaurants which,
along with a Schlotzskys, include a full bakery producing
pastries, muffins and other baked goods for sale in the
Marketplace restaurant and in the coffee bar section of other
Company-operated restaurants. A summary of certain operating
information for Company-operated restaurants is presented below
for the years ending December 31, 2003, 2002 and 2001:

|                             |                                                                  |                                 |            |                    |           |              |           |           |           |  |            |            |           | 
|---------------------------- | ---------------------------------------------------------------- | ------------------------------- | ---------- | ------------------ | --------- | ------------ | --------- | --------- | --------- |  | ---------- | ---------- | --------- | 
|                             |                                                                  |                                 |            | Available for Sale
|                             |                                                                  | Long-Term Portfolio Restaurants |            | Restaurants       
|                             |                                                                  |                                 |            |                   
|                             |                                                                  | Schlotzskys                    |            | Marketplaces       |           | Schlotzskys
|                             |                                                                  |                                 |            |                    |           |             
|Year Ended December 31, 2003 |                                                                  |                                 |            |                    |           |              |           |           |           |  |            |           
|                             | Restaurant sales                                                 |                                 | $          | 14,010,427         |           |              | $         | 5,546,864 |           |  | $          | 12,453,275 |          
|                             |                                                                  |                                 |            |                    |           |              |           |           |           |  |            |           
|                             | Restaurant operations                                            |                                 |            |                    |           |              |           |           |           |  |            |            |          
|                             |                                                                  | Cost of sales                   |            |                    | 3,993,453 |              |           |           | 1,797,599 |  |            |            | 3,526,651 | 
|                             |                                                                  | Personnel and benefits          |            |                    | 5,028,069 |              |           |           | 2,734,707 |  |            |            | 5,788,664 | 
|                             |                                                                  | Operating expenses              |            |                    | 2,506,681 |              |           |           | 1,526,297 |  |            |            | 3,994,191 | 
|                             |                                                                  |                                 |            |                    |           |              |           |           |           |  |            |           
|                             |                                                                  |                                 | 11,528,203 |                    |           |              | 6,058,603 |           |           |  | 13,309,506 |           
|                             |                                                                  |                                 |            |                    |           |              |           |           |           |  |            |           
|                             | Operating income (loss) before depreciation and
    amortization |                                 | $          | 2,482,224          |           |              | $         | (511,739  | )         |  | $          | (856,231   | )        
|                             |                                                                  |                                 |            |                    |           |              |           |           |           |  |            |           
|Year Ended December 31, 2002 |                                                                  |                                 |            |                    |           |              |           |           |           |  |            |           
|                             | Restaurant sales                                                 |                                 | $          | 15,395,412         |           |              | $         | 4,943,749 |           |  | $          | 11,384,000 |          
|                             |                                                                  |                                 |            |                    |           |              |           |           |           |  |            |           
|                             | Restaurant operations                                            |                                 |            |                    |           |              |           |           |           |  |            |            |          
|                             |                                                                  | Cost of sales                   |            |                    | 4,219,035 |              |           |           | 1,509,826 |  |            |            | 3,205,866 | 
|                             |                                                                  | Personnel and benefits          |            |                    | 5,407,822 |              |           |           | 2,431,590 |  |            |            | 5.158,557 | 
|                             |                                                                  | Operating expenses              |            |                    | 2,731,695 |              |           |           | 1,262,387 |  |            |            | 3,562,847 | 
|                             |                                                                  |                                 |            |                    |           |              |           |           |           |  |            |           
|                             |                                                                  |                                 | 12,358,552 |                    |           |              | 5,203,803 |           |           |  | 11,927,270 |           
|                             |                                                                  |                                 |            |                    |           |              |           |           |           |  |            |           
|                             | Operating income (loss) before depreciation and
    amortization |                                 | $          | 3,036,860          |           |              | $         | (260,054  | )         |  | $          | (543,270   | )        
|                             |                                                                  |                                 |            |                    |           |              |           |           |           |  |            |           
|Year Ended December 31, 2001 |                                                                  |                                 |            |                    |           |              |           |           |           |  |            |           
|                             | Restaurant sales                                                 |                                 | $          | 14,399,533         |           |              | $         | 5,220,013 |           |  | $          | 10,286,047 |          
|                             |                                                                  |                                 |            |                    |           |              |           |           |           |  |            |           
|                             | Restaurant operations                                            |                                 |            |                    |           |              |           |           |           |  |            |            |          
|                             |                                                                  | Cost of sales                   |            |                    | 3,844,658 |              |           |           | 1,588,047 |  |            |            | 2,930,684 | 
|                             |                                                                  | Personnel and benefits          |            |                    | 5,273,458 |              |           |           | 2,504,561 |  |            |            | 4,736,695 | 
|                             |                                                                  | Operating expenses              |            |                    | 2,422,503 |              |           |           | 1,367,057 |  |            |            | 3,155,802 | 
|                             |                                                                  |                                 |            |                    |           |              |           |           |           |  |            |           
|                             |                                                                  |                                 | 11,540,619 |                    |           |              | 5,459,665 |           |           |  | 10,823,181 |           
|                             |                                                                  |                                 |            |                    |           |              |           |           |           |  |            |           
|                             | Operating income (loss) before depreciation and
    amortization |                                 | $          | 2,858,914          |           |              | $         | (239,652  | )         |  | $          | (537,134   | )        
|                             |                                                                  |                                 |            |                    |           |              |           |           |           |  |            |           

Beginning in 2004, the Company will redesignate
its restaurant categories from Long-term,
Marketplace, and Available for Sale to
Sandwich-Café, Training, and
Available for Sale and reallocate stores according
to the new designations.

F-19



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##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|    |             
|--- | ------------
|10. | Income Taxes

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

|                                          |          |                                  |           |           |           |      |         |            |         |   |           |           |           | 
|----------------------------------------- | -------- | -------------------------------- | --------- | --------- | --------- | ---- | ------- | ---------- | ------- | - | --------- | --------- | --------- | 
|                                          |          |                                 
|                                          |          | For the Years Ended December 31,
|                                          |          |                                 
|                                          |          | 2003                             |           | 2002      |           | 2001
|                                          |          |                                  |           |           |           |     
|Federal:                                  |          |                                  |           |           |           |      |         |            |         |   |           |          
|                                          | Current  |                                  | $         |          |           |      | $       | (1,115,102 | )       |   | $         | 221,107   |          
|                                          | Deferred |                                  |           | 1,059,832 |           |      |         | 1,090,127  |         |   |           | 1,231,705 |          
|                                          |          |                                  |           |           |           |      |         |            |         |   |           |          
|                                          |          | Total federal                    |           |           | 1,059,832 |      |         |            | (24,975 | ) |           |           | 1,452,812 | 
|State                                     |          |                                  | 104,168   |           |           |      | 127,975 |            |         |   | 260,188   |          
|                                          |          |                                  |           |           |           |      |         |            |         |   |           |          
|Total provision (credit) for income taxes |          | $                                | 1,164,000 |           |           | $    | 103,000 |            |         | $ | 1,713,000 |          
|                                          |          |                                  |           |           |           |      |         |            |         |   |           |          

The differences between the provision
(credit) for income tax and the amount that would result if
the federal statutory rate were applied to the pretax financial
income were as follows:

|                                                          |  |                                  |            |      |  |      |         |   |  |   |           | 
|--------------------------------------------------------- |  | -------------------------------- | ---------- | ---- |  | ---- | ------- | - |  | - | --------- | 
|                                                          |  |                                 
|                                                          |  | For the Years Ended December 31,
|                                                          |  |                                 
|                                                          |  | 2003                             |            | 2002 |  | 2001
|                                                          |  |                                  |            |      |  |     
|Federal statutory rate of 34%                             |  | $                                | (3,598,762 | )    |  | $    | (32,656 | ) |  | $ | 1,428,727 | 
|Change in valuation allowance for deferred tax
    assets |  |                                  | 4,901,207  |      |  |      |        |   |  |   |          | 
|Nondeductible items                                       |  |                                  | 17,428     |      |  |      | 25,416  |   |  |   | 84,797    | 
|State income taxes, before valuation allowance            |  |                                  | (205,570   | )    |  |      | 84,464  |   |  |   | 171,724   | 
|Other, net                                                |  |                                  | 49,697     |      |  |      | 25,776  |   |  |   | 27,752    | 
|                                                          |  |                                  |            |      |  |      |         |   |  |   |           | 
|                                                          |  | $                                | 1,164,000  |      |  | $    | 103,000 |   |  | $ | 1,713,000 | 
|                                                          |  |                                  |            |      |  |      |         |   |  |   |           | 

Deferred taxes are provided for the temporary
differences between the financial reporting bases and the tax
bases of the Companys assets and liabilities. The
temporary differences that give rise to the deferred tax assets
or liabilities are as follows:

|                          |                                                   |                           |           |            |           |   |           |            |           | 
|------------------------- | ------------------------------------------------- | ------------------------- | --------- | ---------- | --------- | - | --------- | ---------- | --------- | 
|                          |                                                   |                          
|                          |                                                   | December 31,             
|                          |                                                   |                          
|                          |                                                   | 2003                      |           | 2002      
|                          |                                                   |                           |           |           
|Deferred Tax Assets:      |                                                   |                           |           |            |           |   |           |           
|                          | Federal and state net operating loss carryforward |                           | $         | 3,600,335  |           |   | $         |           |          
|                          | Allowances for receivables                        |                           |           | 3,403,156  |           |   |           | 1,602,766  |          
|                          | Deferred revenue                                  |                           |           | 664,865    |           |   |           | 688,938    |          
|                          | Property and intangibles                          |                           |           | 230,473    |           |   |           | 506,809    |          
|                          | Accrued liabilities                               |                           |           | 330,040    |           |   |           | 263,449    |          
|                          | Other                                             |                           |           | 210,325    |           |   |           | 355,030    |          
|                          |                                                   |                           |           |            |           |   |           |           
|                          |                                                   | Gross deferred tax assets |           |            | 8,439,194 |   |           |            | 3,416,992 | 
|                          | Valuation allowance                               |                           |           | (4,901,207 | )         |   |           |           |          
|                          |                                                   |                           |           |            |           |   |           |           
|                          |                                                   |                           | 3,537,987 |            |           |   | 3,416,992 |           
|Deferred Tax Liabilities: |                                                   |                           |           |            |           |   |           |           
|                          | Property and intangibles                          |                           |           | (3,531,995 | )         |   |           | (2,334,251 | )        
|                          | Other                                             |                           |           | (5,992     | )         |   |           | (22,909    | )        
|                          |                                                   |                           |           |            |           |   |           |           
|Net deferred tax asset    |                                                   | $                         |          |            |           | $ | 1,059,832 |           
|                          |                                                   |                           |           |            |           |   |           |           

F-20



---



##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)


As a result of our cumulative losses over the
past three years and the full utilization of our loss carry back
potential, we concluded during the fourth quarter of 2003 that a
full valuation allowance against our net deferred tax assets was
necessary under generally accepted accounting principles. In
addition, we expect to provide a full valuation allowance on any
future tax benefits until we can sustain a level of
profitability that demonstrates our ability to utilize these
assets.

The net operating loss carryforward will expire
in 2023, and the Company will need to generate approximately
$13.4 million in pre-tax earnings to realize this asset.



|    |                     
|--- | --------------------
|11. | Stockholders Equity



| |                        
| | -----------------------
| | Shareholder Rights Plan

In December 1998, the Company adopted a
Shareholder Rights Plan and approved a dividend of one Right for
each share of Company Common Stock outstanding. Under the plan,
each shareholder of record is deemed to have received one Right
for each share of Common Stock held. Initially, the Rights are
not exercisable and automatically trade with the Common Stock.
There are no separate Rights certificates at this time. Each
Right entitles the holder to purchase one one-hundredth of a
share of Company Class C Series A Junior Participating
Preferred Stock for $75.00 (the Exercise Price).

The Rights separate and become exercisable upon
the occurrence of certain events, such as an announcement that
an acquiring person (which may be a group of
affiliated persons) beneficially owns, or has acquired the
rights to own, 20% or more of the outstanding Common Stock, or
upon the commencement of a tender offer or exchange offer that
would result in an acquiring person obtaining 20% or more of the
outstanding shares of Common Stock.

Upon becoming exercisable, the Rights entitle the
holder to purchase Common Stock with a value of $150 for $75.
Accordingly, assuming the Common Stock had a per share value of
$75 at the time, the holder of a Right could purchase two shares
for $75. Alternatively, the Company may permit a holder to
surrender a Right in exchange for stock or cash equivalent to
one share of Common Stock (with a value of $75) without the
payment of any additional consideration. In certain
circumstances, the holders have the right to acquire common
stock of an acquiring company having a value equal to two times
the Exercise Price of the Rights.



|    |                                                                                               
|--- | ----------------------------------------------------------------------------------------------
|12. | Stock-Based Compensation Plans and Warrants
    and Prospective Change in Accounting Principle

The Company adopted a Third Amended and
Restated Stock Option Plan, as further amended (the
Option Plan), which was a stock-based incentive
compensation plan, as described below. The plan expired in
December 2003, but options granted under the plan have remaining
lives of up to ten years. In 1995, the FASB issued
SFAS No. 123 Accounting for Stock-Based
Compensation which, if adopted, changes the method the
Company applies in recognizing the cost of the Option Plan. The
Company had not elected to apply the provisions of
SFAS No. 123 through December 31, 2002, but
effective January 1, 2003 the Company applied the cost
recognition provisions of SFAS No. 123 under the
prospective method of adoption authorized by
SFAS No. 148. Additionally, pro forma disclosures as
if the Company adopted the cost recognition provisions of
SFAS No. 123 are required by SFAS No. 123
and are presented in footnote 1. The Company also has an
employee stock purchase plan that it adopted in 1998.



| |            
| | -----------
| | Option Plan

Under the expired Option Plan, as amended, the
Company was authorized to grant options for up to
1,450,000 shares of common stock. Options awarded have been
in the form of incentive stock options (qualified under
Section 422 of the Internal Revenue Code of 1986, as
amended) or non-qualified stock options.

F-21



---



##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)


Options granted from 1998 to present generally
vested ratably over three years, except 248,500 of the options
granted in 2001, which had immediate vesting provisions, and
100,000 of the options granted in 2000, which vested over two
years. Options granted before 1998 generally vest ratably over
five years.

A summary of the status of the Companys
stock options as of December 31, 2003, 2002 and 2001, and
the changes during the years then ended is presented below:

|                                 |                                                              |                     |           |                  |   |  |      |      | 
|-------------------------------- | ------------------------------------------------------------ | ------------------- | --------- | ---------------- | - |  | ---- | ---- | 
|                                 |                                                              |                    
|                                 |                                                              | Options Outstanding
|                                 |                                                              |                    
|                                 |                                                              |                     |           | Weighted Average
|                                 |                                                              |                     |           | Exercise Prices 
|                                 |                                                              | Shares              |           | Per Share       
|                                 |                                                              |                     |           |                 
|Balance, December 31, 2000       |                                                              |                     | 849,080   |                  |   |  | 7.69 |     
|                                 | Granted (weighted average fair value of
    $1.92 per share) |                     |           | 496,962          |   |  |      | 3.41 | 
|                                 | Exercised                                                    |                     |           | (2,300           | ) |  |      | 3.00 | 
|                                 | Forfeited                                                    |                     |           | (115,987         | ) |  |      | 7.96 | 
|                                 |                                                              |                     |           |                  |   |  |      |     
|Balance, December 31, 2001       |                                                              |                     | 1,227,755 |                  |   |  | 5.93 |     
|                                 | Granted (weighted average fair value of
    $2.98 per share) |                     |           | 63,700           |   |  |      | 5.27 | 
|                                 | Exercised                                                    |                     |           | (16,321          | ) |  |      | 3.40 | 
|                                 | Forfeited                                                    |                     |           | (142,141         | ) |  |      | 5.33 | 
|                                 |                                                              |                     |           |                  |   |  |      |     
|Balance, December 31, 2002       |                                                              |                     | 1,132,993 |                  |   |  | 6.00 |     
|                                 | Granted (weighted average fair value of $0.87 per
    share) |                     |           | 122,500          |   |  |      | 2.89 | 
|                                 | Exercised                                                    |                     |           |                 |   |  |      | N/A  | 
|                                 | Forfeited                                                    |                     |           | (345,662         | ) |  |      | 6.46 | 
|                                 |                                                              |                     |           |                  |   |  |      |     
|Balance, December 31, 2003       |                                                              |                     | 909,831   |                  |   |  | 5.50 |     
|                                 |                                                              |                     |           |                  |   |  |      |     
|Exercisable at December 31, 2001 |                                                              |                     | 764,383   |                  |   |  | 6.51 |     
|Exercisable at December 31, 2002 |                                                              |                     | 910,290   |                  |   |  | 6.27 |     
|Exercisable at December 31, 2003 |                                                              |                     | 704,360   |                  |   |  | 5.84 |     

The following table summarizes information about
stock options outstanding:

|                         |  |                     |         |                     |  |          |      |                |  |          |      |  |  |  |         |  |  |   |      | 
|------------------------ |  | ------------------- | ------- | ------------------- |  | -------- | ---- | -------------- |  | -------- | ---- |  |  |  | ------- |  |  | - | ---- | 
|                         |  |                     |         |                    
|                         |  | Options Outstanding |         | Options Exercisable
|                         |  |                     |         |                    
|                         |  | Number              |         | Weighted            |  | Weighted |      | Number         |  | Weighted
|                         |  | Outstanding at      |         | Average             |  | Average  |      | Exercisable at |  | Average 
|                         |  | December 31,        |         | Remaining           |  | Exercise |      | December 31,   |  | Exercise
|Range of Exercise Prices |  | 2003                |         | Contract Life       |  | Price    |      | 2003           |  | Price   
|                         |  |                     |         |                     |  |          |      |                |  |         
|$2.05 to $3.74           |  |                     | 424,667 |                     |  |          | 5.28 |                |  | $        | 3.09 |  |  |  | 289,495 |  |  | $ | 3.16 | 
|$5.00 to $6.32           |  |                     | 218,544 |                     |  |          | 4.67 |                |  |          | 5.82 |  |  |  | 172,741 |  |  |   | 5.88 | 
|$8.00 to $12.50          |  |                     | 266,620 |                     |  |          | 4.11 |                |  |          | 9.08 |  |  |  | 242,124 |  |  |   | 9.02 | 
|                         |  |                     |         |                     |  |          |      |                |  |          |      |  |  |  |         |  |  |   |      | 
|Total                    |  |                     | 909,831 |                     |  |          | 4.79 |                |  |          | 5.50 |  |  |  | 704,360 |  |  |   | 5.84 | 
|                         |  |                     |         |                     |  |          |      |                |  |          |      |  |  |  |         |  |  |   |      | 



| |                             
| | ----------------------------
| | Employee Stock Purchase Plan

The Company adopted the Employee Stock Purchase
Plan (the Stock Purchase Plan) and authorized
250,000 shares of common stock to be sold to employees
through the Stock Purchase Plan. As of December 31, 2003,
154,864 shares are available for purchase under the Stock
Purchase Plan. Under the terms of the Stock Purchase Plan,
employees may elect to contribute up to 15% of compensation
through payroll deductions for the purchase of Company stock at
85% of the lesser of the market price at the beginning

F-22



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##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)


or the end of the offering period. An offering
period begins on January 1 and July 1 of each year and
expires in six months.

During 2003, 39 participants purchased
24,746 shares of stock for prices ranging from $2.16 to
$2.86 per share. During 2002, 36 participants purchased
16,467 shares of stock at a price of $2.13 to
$3.61 per share. During 2001, 34 participants purchased
18,348 shares of stock at a price of $2.13 per share.
Under APB Opinion No. 25, the Stock Purchase Plan is
considered non-compensatory (the shares are purchased with
after-tax dollars). Therefore, no compensation expense was
recognized for shares sold under this plan in 2001 and 2002.
With the adoption of the cost recognition provisions of
SFAS No. 123 under the prospective method of adoption
authorized by SFAS No. 148, the Company recorded
approximately $15,000 in pre-tax expense for the Stock Purchase
Plan in 2003.

Pro Forma net income and earnings per share
information included in footnote 1 was determined in
accordance with SFAS 123, as were expenses recognized
prospectively in 2003. SFAS 123 specifies determining the
fair value of options at the date of grant using a Black-Scholes
option-pricing model. The weighted-average assumptions used in
pricing grants are as follows:

|                      |                                   |      |   |       |   |      |   |       |   |  |   |       |  
|--------------------- | --------------------------------- | ---- | - | ----- | - | ---- | - | ----- | - |  | - | ----- | -
|                      |                                   | 2003 |   | 2002  |   | 2001
|                      |                                   |      |   |       |   |     
|Stock Options         |                                   |      |   |       |   |      |   |       |   |  |   |      
|                      | Weighted-average risk-free rate   |      |   | 3.23  | % |      |   | 4.57  | % |  |   | 4.96  | %
|                      | Expected life of options (months) |      |   | 72    |   |      |   | 72    |   |  |   | 72    |  
|                      | Volatility                        |      |   | 48.70 | % |      |   | 58.04 | % |  |   | 61.94 | %
|                      | Weighted-average fair value       |      | $ | 0.87  |   |      | $ | 2.98  |   |  | $ | 1.92  |  
|Stock Purchase Rights |                                   |      |   |       |   |      |   |       |   |  |   |      
|                      | Weighted-average risk-free rate   |      |   | 2.69  | % |      |   | 4.23  | % |  |   | 4.96  | %
|                      | Expected life of options (months) |      |   | 6     |   |      |   | 6     |   |  |   | 6     |  
|                      | Volatility                        |      |   | 51.9  | % |      |   | 59.1  | % |  |   | 58.4  | %
|                      | Weighted-average fair value       |      | $ | 0.93  |   |      | $ | 1.50  |   |  | $ | 1.02  |  

No dividend yield was assumed in computing the
fair value of either the stock options or stock purchase rights
grants.



| |         
| | --------
| | Warrants

In connection with a Schlotzskys
N.A.M.F., Inc. (NAMF) subordinated debt
financing in 2001, the Company issued warrants for the purchase
of 30,000 shares of common stock to the lender, an entity
of which a member of the Companys Board of Directors was
then a managing director. These warrants have an exercise price
of $4.50 per share and expire in 2006. Utilizing the
Black-Scholes option-pricing model, the warrants were valued at
$57,000. NAMF reimbursed the Company the cost of issuing the
warrants.



|    |                                                     
|--- | ----------------------------------------------------
|13. | Supplemental Disclosure of Cash Flow
    Information

Cash paid for interest during the years ended
December 31, 2003, 2002 and 2001 was approximately
$3,965,000, $3,176,000 and $2,796,000, respectively.

Cash paid for income taxes during the years ended
December 31, 2003, 2002 and 2001 was approximately
$367,000, $455,000 and $1,194,000, respectively, net.

F-23



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##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)


Non-cash investing and financing activities:



| |     
| | ----
| | 2003

A note payable of $665,000 was issued to a
financial institution in exchange for a note receivable from a
franchisee of approximately the same amount.

Due to a change in the management agreement for a
restaurant venture 50% owned by the Company, the Company began
consolidating a restaurant venture it had previously accounted
for under the equity investment method. This consolidation added
approximately $3,140,000 in property, plant, and equipment to
the balance sheet, $2,548,000 in liabilities, and reduced the
Companys investments by approximately $362,000 and its
receivables by $230,000.



| |     
| | ----
| | 2002

A note payable for $23,268,000 was issued for
acquisition of area developer territorial rights.

A capital lease liability of approximately
$339,000 was recorded in conjunction with a program to provide
computers to franchisees and area developers.

Notes payable and other liabilities totaling
approximately $1,360,000 were recorded in conjunction with a
transaction to acquire from a franchisee the land, building,
equipment, and franchise rights for a restaurant.

Rent receivables totaling approximately $242,000
were converted into notes receivable.

The Company converted a bonus and a bonus advance
due to an executive totaling approximately $252,000 to notes
payable.

The Company converted other receivables of
approximately $353,000 due from the restaurant venture related
party into a capital contribution to that limited liability
entity.



| |     
| | ----
| | 2001

Notes payable totaling approximately $2,961,000
were issued for acquisition of area developer territory rights.

A capital lease liability totaling approximately
$564,000 was recorded in conjunction with computers provided to
franchisees and area developers.

Accounts receivable and notes receivable totaling
approximately $274,000 and $2,233,000, respectively, were
cancelled in exchange for real estate and intangible assets
acquired.

Accounts receivable and notes receivable totaling
approximately $240,000 and $335,000, respectively, were
cancelled in exchange for acquisition of area developer
territory rights.

Interest and other accounts receivable of
approximately $738,000 were converted to notes receivable.



|    |                           
|--- | --------------------------
|14. | Related Party Transactions

John C. Wooley and Jeffrey J. Wooley have
personally guaranteed and pledged collateral in connection with
obligations of the Company to various lenders and lessors. The
Company has agreed to indemnify both of them against
liabilities, costs and expenses they may incur under such
guarantees. The approximate total amount of the guaranteed
obligations was $2,484,084 at December 31,
2003.

John Wooley and Jeffrey Wooley signed various
promissory notes to the Company to evidence obligations owed to
predecessor entities. As amended, these loans accrue interest at
8% per year, as long as certain personal guarantees
(described above) by John Wooley and Jeffrey Wooley in favor of
the Company remain

F-24



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##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)


outstanding, and then convert to a five-year
term. The largest aggregate amount of such indebtedness during
2003, and the balance of these loans as of December 31,
2003, was approximately $161,290 for John Wooley and $328,818
for Jeffrey Wooley.

In 2001, the Company issued promissory notes to
Jeffrey Wooley in the amounts of (i) $112,500 in lieu of
payment for his 2001 bonus, and (ii) $140,000 for his bonus
advance payable in 2002 under the terms of his employment
agreement. As amended, these notes will mature on
January 31, 2005. The notes accrue interest at 7% per
year, with accrued interest payable monthly. In February and
March 2004, the Company paid a total of $170,000 toward the
outstanding principal of these notes.

A predecessor-in-interest to Third &
Colorado, LP (T&C), in which John Wooley and
Jeffrey Wooley are controlling members, is the borrower under a
term loan and a line of credit from the Company, secured by
mortgages on a parcel of land in Austin, Texas previously sold
by the Company to T&Cs predecessor-in-interest. As
amended, both loans accrue interest at 8% per year as long
as certain personal guarantees (described above) by John Wooley
and Jeffrey Wooley in favor of the Company remain outstanding,
and then convert to a ten-year term. The largest aggregate
amount of such indebtedness during 2003, and the balance of
these loans as of December 31, 2003, was $1,292,277.

The Company leases its corporate headquarters in
the central business district of Austin, Texas from T&C
under a ten-year lease which began in November 1997. The lease
provides for: approximately 29,400 square feet of office
space at $12.95 per square foot of annual net rent;
approximately 11,950 square feet of additional space
originally designated for storage but now used primarily for
offices, rent free for the first three years, $1.25 per
square foot for the next three years, and $2.50 per square
foot for the last five years; varying numbers of parking spaces
at below-market rates for the first five years and market rates
for the last five years; and reimbursement of certain expenses.
In 1996, after review of an analysis by an independent
appraiser, the disinterested members of the Board of Directors
approved the terms of the lease and determined that such terms
were no less favorable to the Company than those available from
unaffiliated third parties. In 2003, the Company paid to T&C
$397,910 for office and storage space, $123,734 for
approximately 150 parking spaces, and $128,796 for taxes and
insurance.

Bonner Carrington Corporation European Market
(BCCE), is the master licensee of the Company for
Germany, France and certain other territories. In connection
with such master licenses, BCCE has executed promissory notes
payable to the Company. As amended, the notes bear interest at
9% per annum and provide for installment payments of
principal and interest through December 2007. The largest
aggregate amount of indebtedness during 2003, and the balance
outstanding on December 31, 2003, owed by BCCE to the
Company under such notes was approximately $582,561. The Company
owns a 7.5% preferred stock interest in BCCE, has an option to
acquire an additional 10% preferred stock interest in BCCE, and
has options to acquire BCCE and its territories at predetermined
prices through December 2011. The Company also holds a
promissory note of Bonner Carrington LP, a Texas limited
partnership and affiliate of BCCE (BCLP). The
largest aggregate amount of such indebtedness during 2003, and
the balance outstanding on December 31, 2003, owed under
such note was approximately $413,697. In 1998, affiliates of
BCCE acquired a minority membership interest in T&C. As of
December 31, 2003 BCCE had ceased operations and the
Company was carrying the above notes, net of reserves and
unrecognized deferred revenue, at approximately $258,000.

In 2002, the Company paid $50,000 to BCLP for an
option to take over a long-term ground lease for a
Company-operated restaurant site in the Austin area. The Company
exercised this option in January 2003 at the exercise price of
$100,000. During 2003, the Company paid to BCLP approximately
$10,610 for construction coordination and consulting services in
connection with the development of this and other restaurant
sites.

In February 2001, the Company granted to Triad
Media Ventures LLC (Triad) warrants to purchase
30,000 shares of the Companys Common Stock at an
exercise price of $4.50 per share. The warrants were
granted in connection with a credit facility from Triad to
Schlotzskys National Advertising Association, Inc.

F-25



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##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)


and Schlotzskys N.A.M.F., Inc. which
are affiliates of the Company, in the principal amount of
$3,000,000 to fund the purchase of certain cable television
advertising rights. Floor Mouthaan, a director of the Company,
served on the investment committee of Triad until May 2002, but
he did not have management control over Triad and he expressly
disclaimed beneficial ownership of the shares underlying these
warrants. Nevertheless, the grant of warrants was treated as a
related party transaction, was determined to be on terms no less
favorable to the Company than those available from unaffiliated
third parties, and was approved, by the disinterested members of
the Board of Directors.

Sino-Caribbean Corporation (SCC), a
Texas corporation, is the master licensee of the Company for
China. In connection with such master licenses, SCC has executed
promissory notes payable to the Company. As amended, the notes
bear interest at 8% per year and provide for installment
payments of principal and interest through December 2006. The
largest aggregate amount of indebtedness during 2003, and the
balance outstanding on December 31, 2003, owed by SCC to
the Company under such notes was approximately $775,000. Karl
Martin, an employee of the Company, has an ownership interest in
SCC. In March, 2004 the Company entered into an agreement to
acquire the assets of SCC in exchange for forgiveness of debt
and $150,000 in other considerations.

In 2003, John Wooley and Jeffrey Wooley provided
a $1,000,000 credit facility for the Company. As amended, this
facility bears interest at 6% per year and provides for
monthly payments of interest until the maturity date on
July 16, 2004. The loan is secured by the Companys
intellectual property, contract rights and certain intangibles,
although that security interest was subordinated to NS
Associates I, Ltd. (NS Associates) under the Subordination
Agreement in connection with the 2003 renegotiation of the NS
Associates loan. The largest aggregate amount of such
indebtedness during 2003 was $560,000, and the balance of this
loan as of December 31, 2003, was $360,000.

In 2003, the Company entered into a short-term
bridge loan with a commercial lender in the principal amount of
$150,000. As amended, this loan accrues interest at
5.2% per year, matures on June 25, 2004, and is
collateralized by a certificate of deposit pledged by Jeffrey
Wooley. The largest aggregate amount of such indebtedness during
2003, and the balance of this loan as of December 31, 2003,
was $150,000.

In 2003, Schlotzskys Franchisor, LLC, a
wholly-owned subsidiary of the Company (Franchisor),
borrowed from John Wooley and Jeffrey Wooley a loan in the
principal amount of $2,500,000. As amended, this facility bears
annual interest at a rate of 2.5% over the prime rate, and
provides for monthly installment payments of principal and
interest from May 2004 until the earlier of December 2006 or the
end of Franchisors obligations under the Subordination
Agreement in connection with the 2003 renegotiation of the NS
Associates loan. The loan is secured by the Companys
intellectual property, contract rights and certain intangibles,
although that security interest in subordinated to NS
Associates. The largest aggregate amount of such indebtedness
during 2003, and the balance of this loan as of
December 31, 2003, was $2,500,000.

In 2003, the Company and John and Jeff Wooley
guaranteed a bank note in the amount of $4,300,000, for the
benefit of Schlotzskys N.A.M.F. Funding, LLC, the
advertising entity of the Schlotzskys restaurant system,
for which the Company had received a portion of the net proceeds
of the loan in repayment of outstanding debt to the Company.
Additionally, the Company pledge certain restaurants to secure
this facility. The largest aggregate amount of such indebtedness
during 2003 was $4,300,000, and the balance of this loan as of
December 31, 2003, was $4,140,000.

In 2003, the Company guaranteed payments under
the Amended and Restated Promissory Note between DFW Restaurant
Transfer Corp., a wholly-owned subsidiary of the Company, and NS
Associates as lender, in connection with the restructuring of
the seller-financed acquisition of the Companys largest
area developer territory. As amended, the note bears interest at
3% through November 2004 and 4% over prime thereafter and
provides for principal and interest payments of $120,000 for
12 months beginning December 2003 and payments of $420,000
from December 2004 until the maturity date of December 2006. The
loan is secured by the Companys intellectual property,
contract rights, and certain intangibles and is subordinate to a

F-26



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##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)


$3.0 million senior debt facility. The
largest aggregate amount of such post-amendment indebtedness
during 2003, and the balance of this loan as of
December 31, 2003, was $18,012,000.

Certain of the transactions described above were
entered into between related parties and therefore were not the
result of arms-length negotiations. Accordingly, certain of the
terms of these transactions may be more or less favorable to the
Company than might have been obtained from unaffiliated third
parties. During fiscal year 2003, the Company did not, and in
the future will not, enter into any transactions in which the
directors, executive officers or principal shareholders of the
Company and their affiliates have a material interest, unless
such transactions are determined to be on terms that are no less
favorable to the Company than those that the Company could
obtain from unaffiliated third parties, and are approved, by a
majority of the independent and disinterested members of the
Board of Directors and any appropriate Board Committees.



|    |                              
|--- | -----------------------------
|15. | Commitments and Contingencies



| |       
| | ------
| | Leases

The Company leases office facilities and certain
land, buildings and equipment under operating leases. Lease
terms are generally for three months to 25 years and, in
some cases, provide for rent escalations and renewal options,
with certain leases providing purchase options. Certain leases
also provide for the payment of additional rent based on sales
levels. Future minimum rental payments, net of sublease revenue,
under operating leases that have initial or remaining
non-cancelable lease terms in excess of one year as of
December 31, 2003, are as follows:

|             |  |   |            | 
|------------ |  | - | ---------- | 
|Year Ending  |  |  
|December 31, |  |  
|             |  |  
|2004         |  | $ | 2,436,000  | 
|2005         |  |   | 2,361,000  | 
|2006         |  |   | 2,103,000  | 
|2008         |  |   | 1,466,000  | 
|2008         |  |   | 1,139,000  | 
|Thereafter   |  |   | 9,347,000  | 
|             |  |   |            | 
|             |  | $ | 18,852,000 | 
|             |  |   |            | 

Rent expense for the years ended
December 31, 2003, 2002 and 2001, was approximately
$3,249,000, $3,018,000 and $2,647,000, respectively.



| |                                     
| | ------------------------------------
| | Guarantees of Indebtedness of Others

The Company has outstanding guarantees of
indebtedness of others, including related parties, of
approximately $24.6 million as of December 31, 2003.
These guarantees include approximately $4.7 million in
lease guarantees for the benefit of franchisees, approximately
$13.7 million of mortgage loan and FF&E guarantees for
the benefit of franchisees and approximately $6.2 million
of loan guarantees for the benefit of related parties.

The lease guarantees for the benefit of
franchisees primarily arose through the Companys former
Turnkey program, in which the Company developed the related
restaurants, leased the restaurant to a franchisee and then sold
them to a leasing company. The guarantees range from limited
guarantees, either in dollar amount or term, to full guarantees
for the life of the lease. The maximum guarantee for a single
lease is approximately $1.2 million. Certain guarantees
extend through 2018. The Company may be required by the lessor
to make monthly rental payments or property tax and common area
maintenance payments if the franchisee does not make the
required payments in a timely manner. The Company has
indemnification agreements with the franchisees under which the
franchisee would be obligated to reimburse the Company for

F-27



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##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)


any amounts paid under such guarantees. The
Company also has net deferred gain related to the sale of these
leases in the amount of approximately $342,000, as of
December 31, 2003 (see Note 7).

The mortgage loan guarantees for the benefit of
franchisees also primarily arose through the Companys
former Turnkey program, in which the Company developed the
related restaurants, sold the restaurant to a franchisee, and
guaranteed all or a portion of the franchisees mortgage
loan. The guarantees range from limited guarantees, either in
dollar amount or term, to full guarantees of the mortgage. The
maximum amount of a single guarantee is approximately
$1.1 million. Certain guarantees extend through 2016. The
Company may be required by the lender to make monthly mortgage
payments if the franchisee does not make the required payments
in a timely manner or may be required to make up any deficiency,
up to the amount of the guarantee, if the related restaurant is
sold for not proceeds less than the amount of the outstanding
mortgage. The Company has indemnification agreements with the
franchisees, under which the franchisee would be obligated to
reimburse the Company for any amounts paid under such
guarantees. In the event the Company purchases the loan from the
lender in the event of a default, the Company would succeed to
the lenders security interest in the related property.

The loan guarantees in favor of related parties
primarily arose when the Company guaranteed certain debt of
related parties for which the proceeds of the loans were used to
repay outstanding debt to the Company. One of the guarantees,
for the benefit of our real estate venture, is of mortgage debt,
totaling approximately $2.0 million (see Note 5). This
guarantee extends through 2009. Another guarantee, in the amount
of approximately $4.1 million at December 31, 2003, is
for the benefit of the advertising entity of the
Schlotzskys restaurant system, for which the Company
received the net proceeds of the loan in repayment of
outstanding debt to the Company (see Note 14). This
guarantee expires in 2004.



| |           
| | ----------
| | Litigation

New Florida Markets, Ltd. and Deli Keys,
Ltd. v. Schlotzskys, Inc., Schlotzskys
Franchise Limited Partnership, Schlotzskys Franchisor,
LLC, Schlotzskys Franchise Operations, LLC,
Schlotzskys NAMF, Inc., and Schlotzskys NAMF
Funding, LLC(Case
No. 701140045603), was filed on or about June 23, 2003
with the American Arbitration Association. Claimant is the area
developer for the Tampa, Orlando, and West Palm Beach
development areas. On July 14, 2003, Deli Keys, Ltd., an
area developer for the Miami development area, joined the
arbitration as an additional Claimant. They allege that
Respondents frustrated their ability to develop, in part because
of the Companys Turnkey program under which
Respondents developed a number of restaurants during the period
1995 until 2000 in which Respondents were involved in acquiring
sites, building restaurants for franchisees and, in certain
instances, guaranteeing franchise debts or leases. Claimant also
alleges Respondents breached the Area Developer Agreements by
failing to provide adequate licensing support, negotiating with
license prospects, failing to establish and administer a local
advertising group, pledging royalties, changing the area
developer manual, refunding franchise fees, and forcing
Claimants to purchase errors and omissions insurance. Other
claims include breach of the implied covenant of good faith and
fair dealing, constructive termination, and violation of the
Texas Deceptive Trade Practices Act. Claimants seek actual,
compensatory, and punitive damages of an unspecified amount,
attorneys fees, and costs. The arbitration proceeding is
scheduled to begin in May 2004.

John D. Wright and James E. Wright v.
Schlotzskys, Inc. and Schlotzskys Real
Estate, Inc.(U.S. District
Court for the Eastern District of Michigan  Case
No. 03-70244) was filed on or about June 9, 2003 as a
Counterclaim and Third Party Claim in a collection action
originally filed by Schlotzskys Real Estate, Inc.
(SREI) in January 2003. James Wright, John
Wright, Lorraine Wright, and Kimberly Wright v.
Schlotzskys, Inc. and Schlotzskys Real
Estate, Inc.,in the Circuit Court for the County of
Genessee, State of Michigan (Case No. 02-74931-CK), was
filed on or about July 1, 2003 as a Third Party Complaint
in a foreclosure action. The Wrights are principals and
guarantors of J. Wright Franchise Development, LLC, a former
franchisee that had operated a Schlotzskys Deli in Grand
Blanc, Michigan and filed Chapter 11 bankruptcy. In January
2003, SREI filed suit against John and James Wright for
collection of

F-28



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##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)


$283,872.68 due under a promissory note. In the
instant case, the Wrights allege that they were induced into
participating in the Companys Turnkey program and that an
employee of the Company represented that the restaurant would
attain a certain level of sales. The Wrights claims
include fraud in the inducement, fraudulent and negligent
misrepresentation, and breach of the Michigan Franchise
Investment Act. They sought damages of an unspecified amount,
attorneys fees, and costs. The parties agreed to settle
both lawsuits on March 5, 2004, with all parties
withdrawing their claims with prejudice.

Robert Coshott v.
Schlotzskys, Inc.(Cause
No. GN 1-02279), was filed on July 24, 2001, in the
200th Judicial District Court of Travis County, Texas. Plaintiff
is the Master Licensee for Australia and New Zealand, and he
opened a Schlotzskys Deli restaurant in Melbourne,
Australia. Plaintiff brings causes of action for fraud and/or
negligent misrepresentation. Plaintiff alleges that he
experienced problems with certain equipment specified or
approved by the Company, that the Companys system and
equipment did not generate enough finished food product to
service his potential customers; that the Company misrepresented
the level of revenue the restaurant could reasonably be expected
to achieve; that the Company delayed his ability to develop
restaurants by failing to timely secure certain trademarks and
trade names; and that the Company misrepresented whether it
would allow Plaintiff to franchise Schlotzskys Deli
restaurants in certain gas station or convenience store
locations in his territories. Plaintiff requests actual and
punitive damages of $3.75 million plus lost profits and
incidental and consequential damages of an unspecified amount.
On July 23, 2003, Coshott also filed a Demand for
Arbitration with the International Chamber of Commerce styled
Robert Gilbert Coshott v.
Schlotzskys, Inc. (Case. No. 12 838/JNK).
The claims in the Demand are similar to those brought in the
above-entitled action and include additional allegations that
the Company required the purchase of goods and services from
certain suppliers in violation of the Trade Practices Act of
1974 and that the Company failed to disclose the existence of a
predecessor Master License Agreement, in violation of the Fair
Trading Act of 1987 (New South) Wales, breach of contract, and
equitable estoppel. Claimant seeks unspecified actual,
compensatory and punitive damages, lost profits, attorneys
fees, prejudgment interest, and costs. On February 26,
2004, the Company obtained a declaratory judgment in the state
court case declaring that Plaintiff had waived any right to
arbitrate his claim by filing suit against the Company in state
court in Texas. The state court case is not yet set for trial.

Dae Kim, DWK Enterprises, Inc., and Aecon
International, Inc. v. John Wooley,
Schlotzskys, Inc., Schlotzskys Franchising
Limited Partnership, Schlotzskys N.A.M.F., Inc.,
Schlotzskys National Advertising Association, Inc.,
and Schlotzskys, Brands, Inc., Schlotzskys
Brand Products, L.P., Schlotzskys Real Estate, Inc.,
and Schlotzskys
Restaurants, Inc.(Cause
No. 2001-CI-13672) was originally filed in the
73rd Judicial District Court of Bexar County, Texas on or
about September 25, 2001 (after a similar lawsuit was filed
and later withdrawn in Harris County, Texas) against
Schlotzskys, Inc., John Wooley, Schlotzskys
Franchising Limited Partnership, and Schlotzskys
NAMF, Inc. (Defendants). Plaintiffs are, or
claim to be, franchisees in Houston and San Antonio Texas,
and Plaintiff Kim was an area developer for those markets.
Plaintiffs bring causes of action for breach of contract, breach
of fiduciary duty, breach of the duty of good faith and fair
dealing, civil conspiracy, tortious interference with contract,
tortious interference with prospective business relationship,
violation of the Texas Deceptive Trade Practices and Consumer
Protection Act, restraint of trade, detrimental reliance-fraud
in the inducement, and defamation-business disparagement. They
seek an unspecified amount of money damages plus exemplary
damages, attorneys fees, pre-judgment interest, costs, and
a jury trial. Defendants, except for Mr. Wooley, who was
previously dismissed from the case, answered and asserted
counterclaims alleging breach of contract and that
Plaintiffs claim under the Texas Deceptive Trade Practices
Act is groundless in fact or in law and brought in bad faith or
for the purpose of harassment, and seeks money damages, costs of
court, penalty fees, costs incurred in performing the
accounting, attorneys fees, and pre- and post-judgment
interest. Defendants (except for Mr. Wooley) removed the
case to federal court. The case was remanded to state court on
April 17, 2003. The case is not yet set for trial.

F-29



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##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)


U.S. Restaurant Properties Operating
L.P. v.
Schlotzskys, Inc.(Cause
No. 03-01758) was filed on February 27, 2003, in the
District Court of Dallas County, B-44th Judicial District.
Plaintiff is a real estate investment company that owns certain
Schlotzskys restaurants and leases them to franchisees. It
alleges that in 1997 and 1998 we entered into several agreements
where we agreed to guarantee certain lease agreements. Plaintiff
claims that in 1998 the parties entered into an agreement
whereby Plaintiff agreed to release Schlotzskys from its
guaranty obligations pertaining to six properties in which the
tenants had defaulted, in exchange for Schlotzskys
agreement to purchase six other properties. Plaintiffs are
seeking an order requiring us to purchase six properties for a
total purchase price of over $4.5 million. In the
alternative, Plaintiff is seeking damages or an order
reinstating the previously released guaranties. Plaintiffs
claims include breach of contract and a request for
attorneys fees. The trial date has been scheduled for
September 20, 2004.

In addition to the matters discussed above, we
are defendants in various other legal proceedings arising from
our business. The ultimate outcome of these pending proceedings
cannot be projected with certainty. However, based on our
experience to date, we believe any such proceeding will not have
a material effect on our business or financial condition.



|    |         
|--- | --------
|16. | Segments

The Company and its subsidiaries are principally
engaged in franchising and operating fast-casual restaurants
that feature up-scale made-to-order sandwiches with unique
sourdough buns and pizzas. At December 31, 2003, the
Schlotzskys system included Company-operated and
franchised restaurants in 37 states, the District of
Columbia and six foreign countries.

The Company identifies segments based on
management responsibility within the corporate structure. The
Restaurant Operations segment includes restaurants operated for
the purposes of market leadership and redevelopment of certain
markets, demonstrating profit potential and key operating
metrics, operational leadership of the franchise system, product
development, concept refinement, product and process testing,
training and building brand awareness and restaurants available
for sale. The Franchise Operations segment encompasses the
franchising of restaurants, assisting franchisees in the
development of restaurants, providing franchisee training and
operating the national training center, communicating with
franchisees, conducting regional and national franchisee
meetings, developing and monitoring supplier and distributor
relationships, planning and coordinating advertising and
marketing programs, and the licensing of brand products for sale
to the franchise system and retailers. The Company measures
segment profit as operating profit, which is defined as income
before interest and income taxes. The accounting policies of the
segments are the same as those described in the summary of
significant accounting policies (see Note 1). Segment
information and a reconciliation to income, before interest and
income taxes are as follows:

|                                                   |  |            |            |            |  |              |            |   |  |   |             |  
|-------------------------------------------------- |  | ---------- | ---------- | ---------- |  | ------------ | ---------- | - |  | - | ----------- | -
|                                                   |  | Restaurant |            | Franchise  |  |             
|Year Ended December 31, 2003                       |  | Operations |            | Operations |  | Consolidated
|                                                   |  |            |            |            |  |             
|Revenue from external customers                    |  | $          | 32,010,566 |            |  | $            | 24,167,173 |   |  | $ | 56,177,739  |  
|Depreciation and amortization                      |  |            | 2,418,071  |            |  |              | 2,761,336  |   |  |   | 5,179,407   |  
|Operating income (loss)                            |  |            | (1,303,817 | )          |  |              | (5,598,964 | ) |  |   | (6,902,781  | )
|Significant non-cash items-bad debt and impairment |  |            | 11,334     |            |  |              | 3,688,970  |   |  |   | 3,700,304   |  
|Capital expenditures                               |  |            | 3,562,444  |            |  |              | 60,633     |   |  |   | 3,623,077   |  
|Total assets                                       |  |            | 40,106,196 |            |  |              | 85,679,658 |   |  |   | 125,785,554 |  

F-30



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##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)


|                                                   |  |            |            |            |  |              |            |  |  |   |             | 
|-------------------------------------------------- |  | ---------- | ---------- | ---------- |  | ------------ | ---------- |  |  | - | ----------- | 
|                                                   |  | Restaurant |            | Franchise  |  |             
|Year Ended December 31, 2002                       |  | Operations |            | Operations |  | Consolidated
|                                                   |  |            |            |            |  |             
|Revenue from external customers                    |  | $          | 31,723,161 |            |  | $            | 28,823,332 |  |  | $ | 60,546,493  | 
|Depreciation and amortization                      |  |            | 2,520,273  |            |  |              | 2,500,197  |  |  |   | 5,020,470   | 
|Operating income (loss)                            |  |            | (286,737   | )          |  |              | 2,611,981  |  |  |   | 2,325,244   | 
|Significant non-cash items-bad debt and impairment |  |            |           |            |  |              | 1,569,077  |  |  |   | 1,569,077   | 
|Capital expenditures                               |  |            | 2,040,561  |            |  |              | 156,178    |  |  |   | 2,196,739   | 
|Total assets                                       |  | $          | 41,519,280 |            |  | $            | 96,007,202 |  |  | $ | 137,526,482 | 

|                                                   |  |            |            |            |  |              |            |  |  |   |             | 
|-------------------------------------------------- |  | ---------- | ---------- | ---------- |  | ------------ | ---------- |  |  | - | ----------- | 
|                                                   |  | Restaurant |            | Franchise  |  |             
|Year Ended December 31, 2001                       |  | Operations |            | Operations |  | Consolidated
|                                                   |  |            |            |            |  |             
|Revenue from external customers                    |  | $          | 29,905,593 |            |  | $            | 31,945,122 |  |  | $ | 61,850,715  | 
|Depreciation and amortization                      |  |            | 1,856,927  |            |  |              | 2,367,490  |  |  |   | 4,224,417   | 
|Operating income (loss)                            |  |            | 225,201    |            |  |              | 5,855,298  |  |  |   | 6,080,499   | 
|Significant non-cash items-bad debt and impairment |  |            |           |            |  |              | 1,852,374  |  |  |   | 1,852,374   | 
|Capital expenditures                               |  |            | 5,446,194  |            |  |              | 2,442,676  |  |  |   | 7,888,870   | 
|Total assets                                       |  | $          | 36,071,905 |            |  | $            | 78,077,355 |  |  | $ | 114,149,260 | 

Included in revenue from external customers for
the Franchise Operations segment are royalties and fees from
international sources of $86,933, $201,782 and $149,363 for
2003, 2002 and 2001, respectively.



|    |                   
|--- | ------------------
|17. | Earnings Per Share

Basic and diluted earnings per share computations
for the years ended December 31, 2003, 2002 and 2001 are as
follows:

|                           |                                                                                                   |                     |   |             |   |      |   |           |   |  |   |           | 
|-------------------------- | ------------------------------------------------------------------------------------------------- | ------------------- | - | ----------- | - | ---- | - | --------- | - |  | - | --------- | 
|                           |                                                                                                   |                    
|                           |                                                                                                   | For the Years Ended
|                           |                                                                                                   | December 31,       
|                           |                                                                                                   |                    
|                           |                                                                                                   | 2003                |   | 2002        |   | 2001
|                           |                                                                                                   |                     |   |             |   |     
|Basic earnings per share   |                                                                                                   |                     |   |             |   |      |   |           |   |  |   |          
|                           | Net income (loss)                                                                                 |                     | $ | (11,748,595 | ) |      | $ | (199,048  | ) |  | $ | 2,489,139 | 
|                           |                                                                                                   |                     |   |             |   |      |   |           |   |  |   |          
|                           | Weighted average common shares outstanding                                                        |                     |   | 7,325,943   |   |      |   | 7,296,272 |   |  |   | 7,303,455 | 
|                           |                                                                                                   |                     |   |             |   |      |   |           |   |  |   |          
|                           | Basic earnings (loss) per share                                                                   |                     | $ | (1.60       | ) |      | $ | (0.03     | ) |  | $ | 0.34      | 
|                           |                                                                                                   |                     |   |             |   |      |   |           |   |  |   |          
|Diluted earnings per share |                                                                                                   |                     |   |             |   |      |   |           |   |  |   |          
|                           | Net income (loss)                                                                                 |                     | $ | (11,748,595 | ) |      | $ | (199,048  | ) |  |   | 2,489,139 | 
|                           |                                                                                                   |                     |   |             |   |      |   |           |   |  |   |          
|                           | Weighted average common shares outstanding                                                        |                     |   | 7,325,943   |   |      |   | 7,296,272 |   |  |   | 7,303,455 | 
|                           | Assumed conversion of common shares issuable
    under stock option plan and exercise of warrants |                     |   |            |   |      |   |          |   |  |   | 169,991   | 
|                           |                                                                                                   |                     |   |             |   |      |   |           |   |  |   |          
|                           | Weighted average common shares
    outstanding  assuming dilution                                |                     |   | 7,325,943   |   |      |   | 7,296,272 |   |  |   | 7,473,446 | 
|                           |                                                                                                   |                     |   |             |   |      |   |           |   |  |   |          
|                           | Diluted earnings (loss) per share                                                                 |                     | $ | (1.60       | ) |      | $ | (0.03     | ) |  | $ | 0.33      | 
|                           |                                                                                                   |                     |   |             |   |      |   |           |   |  |   |          

Outstanding options that were not included in the
diluted calculation because their effect would be anti-dilutive
totaled 910,000, 1,133,000 and 672,000 in 2003, 2002 and 2001,
respectively.

F-31



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##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|    |                              
|--- | -----------------------------
|18. | New Accounting Pronouncements

The FASB has issued Interpretation No. 46,
Consolidation of Variable Interest Entities.
FIN 46 addresses the consolidation by business enterprises
of variable interest entities whose equity holders have not
provided sufficient equity to allow the entity to finance its
own activities or whose equity holders lack the essential
characteristics of a controlling financial interest. FIN 46
requires a variable interest entity to be consolidated by a
company if that company is subject to a majority of the risk of
loss from the entitys activities or entitled to receive a
majority of the entitys residual returns, or both. There
are multiple effective dates for applying FIN 46®, and
the Company will adopt the guidance by the end of its next
reporting period, March 31, 2004. The Company continues to
evaluate the impact of FIN 46, but preliminarily does not
anticipate any material change to the Company financial results
or balance sheet that will result from the adoption of
FIN 46.

F-32



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##### Table of Contents



REPORT OF INDEPENDENT CERTIFIED PUBLIC
ACCOUNTANTS

To the Board of Directors and Stockholders,

Schlotzskys, Inc.:


In connection with our audit of the consolidated
financial statements of Schlotzskys, Inc. and
Subsidiaries referred to in our report dated March 6, 2004,
which is included in Part IV of this Form 10-K, we
have also audited Schedule II for each of the three years
in the period ended December 31, 2003. In our opinion, this
schedule when considered in relation to the basic financial
statements taken as a whole, presents fairly, in all material
respects, the information set forth therein.

GRANT THORNTON LLP

Dallas, Texas

March 6, 2004


S-1



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##### Table of Contents



SCHLOTZSKYS, INC. AND
SUBSIDIARIES

SCHEDULE II  VALUATION AND
QUALIFYING ACCOUNTS

For the Years Ended December 31, 2003,
2002 and 2001


|                             |           |           |           |            |  |            |           |            |  |            |        |   |  |   |            |            |   |   |           |           | 
|---------------------------- | --------- | --------- | --------- | ---------- |  | ---------- | --------- | ---------- |  | ---------- | ------ | - |  | - | ---------- | ---------- | - | - | --------- | --------- | 
|                             |           |           |           |            |  |            |           |           
|Col. A                       |           | Col. B    |           | Col. C     |  | Col. D     |           | Col. E    
|                             |           |           |           |            |  |            |           |           
|                             |           |           |           |            |  |            |           |           
|                             |           |           |           | Additions  |  |            |           |           
|                             |           | Balance   |           |            |  |            |           |           
|                             |           | at        |           | Charged to |  | Charged to |           |            |  | Balance at
|                             |           | Beginning |           | Costs and  |  | Other      |           |            |  | End of    
|Description                  |           | of Period |           | Expenses   |  | Accounts   |           | Deductions |  | Period    
|                             |           |           |           |            |  |            |           |            |  |           
|Year ended December 31, 2003 |           |           |           |            |  |            |           |            |  |            |        |   |  |   |            |            |   |   |           |          
|Accounts receivable:         |           |           |           |            |  |            |           |            |  |            |        |   |  |   |            |            |   |   |           |          
|                             | Royalties |           | $         | 425,935    |  |            | $         | 847,194    |  |            | $      |  |  |   | $          | (21,015    | ) |   | $         | 1,252,114 | 
|                             | Other     |           |           | 576,254    |  |            |           | 435,258    |  |            |        |  |  |   |            |           |   |   |           | 1,011,512 | 
|Notes receivable             |           |           | 1,924,743 |            |  |            | 2,417,851 |            |  |            | 13,896 |   |  |   |           |            |   |   | 4,356,490 |          
|                             |           |           |           |            |  |            |           |            |  |            |        |   |  |   |            |            |   |   |           |          
|                             |           | $         | 2,926,932 |            |  | $          | 3,700,304 |            |  | $          | 13,896 |   |  | $ | (21,015    | )          |   | $ | 6,620,116 |          
|                             |           |           |           |            |  |            |           |            |  |            |        |   |  |   |            |            |   |   |           |          
|Year ended December 31, 2002 |           |           |           |            |  |            |           |            |  |            |        |   |  |   |            |            |   |   |           |          
|Accounts receivable:         |           |           |           |            |  |            |           |            |  |            |        |   |  |   |            |            |   |   |           |          
|                             | Royalties |           | $         | 240,379    |  |            | $         | 522,692    |  |            | $      |  |  |   | $          | (337,136   | ) |   | $         | 425,935   | 
|                             | Other     |           |           | 771,848    |  |            |           | 215,241    |  |            |        |  |  |   |            | (410,835   | ) |   |           | 576,254   | 
|Notes receivable             |           |           | 1,787,571 |            |  |            | 831,144   |            |  |            |       |   |  |   | (693,972   | )          |   |   | 1,924,743 |          
|                             |           |           |           |            |  |            |           |            |  |            |        |   |  |   |            |            |   |   |           |          
|                             |           | $         | 2,799,798 |            |  | $          | 1,569,077 |            |  | $          |       |   |  | $ | (1,441,943 | )          |   | $ | 2,926,932 |          
|                             |           |           |           |            |  |            |           |            |  |            |        |   |  |   |            |            |   |   |           |          
|Year ended December 31, 2001 |           |           |           |            |  |            |           |            |  |            |        |   |  |   |            |            |   |   |           |          
|Accounts receivable:         |           |           |           |            |  |            |           |            |  |            |        |   |  |   |            |            |   |   |           |          
|                             | Royalties |           | $         | 821,601    |  |            | $         | 689,171    |  |            | $      |  |  |   | $          | (1,270,393 | ) |   | $         | 240,379   | 
|                             | Other     |           |           | 1,018,570  |  |            |           | 79,041     |  |            |        |  |  |   |            | (325,763   | ) |   |           | 771,848   | 
|Notes receivable             |           |           | 1,886,689 |            |  |            | 604,007   |            |  |            |       |   |  |   | (703,125   | )          |   |   | 1,787,571 |          
|                             |           |           |           |            |  |            |           |            |  |            |        |   |  |   |            |            |   |   |           |          
|                             |           | $         | 3,726,860 |            |  | $          | 1,372,219 |            |  | $          |       |   |  | $ | (2,299,281 | )          |   | $ | 2,799,798 |          
|                             |           |           |           |            |  |            |           |            |  |            |        |   |  |   |            |            |   |   |           |          

S-2