** **

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington,D.C. 20549**

 

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# **FORM 10-K**

# ** **

**ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**ý****ANNUAL REPORT PURSUANT TOSECTION 13 OR 15(d) OF**

**THESECURITIES EXCHANGE ACT OF 1934**

 

**For TheFiscal Year Ended December 31, 2005**

**OR**

**TRANSITIONREPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For theTransition Period from                to                   **

 

**CommissionFile Number 0-25507**

 

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**iPARTY CORP.**

(Exact Name ofRegistrant as Specified in Its Charter)

 

| **DELAWARE**                              | ** ** | **76-0547750**       |
|-------------------------------------------|------------|----------------------|
| (State or Other  Jurisdiction of          |       | (IRS Employer        |
| Incorporation or  Organization)           |       | Identification  No.) |
|                                      |       |                 |
| **270  BRIDGE STREET, SUITE 301**         | ** ** | **02026**            |
| **DEDHAM,  MASSACHUSETTS**                |       | (Zip Code)           |
| (Address of  Principal Executive Offices) |       |                 |

 

**(781)329-3952**

(Registrant’sTelephone Number, Including Area Code)

 

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SecuritiesRegistered pursuant to Section 12(b) of the Act:

 

| **Title of Each Class** | ** ** | **Name of Each Exchange on Which Registered** |
|----------------------------------------|------------|-----------------------------------------------------------------------------|
| **COMMON  STOCK, $.001 PAR VALUE**     | ** ** | **AMERICAN  STOCK EXCHANGE**                                                |

 

SecuritiesRegistered pursuant to Section 12(g) of the Act: None

 

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes oNo ý

 

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 orSection 15(d) of the Act. Yes oNo ý

 

Indicate by check markwhether the registrant:  (1) has filedall reports required to be filed by Section 13 or 15(d) of the Securities ExchangeAct of 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes ýNo o

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form 10-K. o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act (Check one).

Large accelerated filer o     Accelerated filer o      Non-accelerated filer ý

 

Indicate by check markwhether the registrant is a shell company as defined in Rule 12b-2 of theExchange Act. Yes o No ý

 

On June 25, 2005, theaggregate market value of the voting common equity of the registrant(consisting of common stock, $.001 par value (the “common stock”)) held bynonaffiliates of the registrant was approximately $10,836,467 based on theclosing price for such common stock on said date as reported by the AmericanStock Exchange. On March 30, 2006 there were 22,545,738 shares of common stock,$.001 par value, issued and outstanding.

 

**DOCUMENTSINCORPORATED BY REFERENCE**

 

Portions of the proxystatement for the annual stockholders’ meeting scheduled to be held June 7,2006, which we plan to file with the SEC no later than 120 days after the endof our fiscal year ended December 31, 2005, are incorporated by reference intoPart III.

 

 

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**PART I**

 

**ITEM1. BUSINESS**

** **

**General**

** **

We believe we are aleading brand in the party industry in the markets we serve and a leadingresource in those markets for consumers seeking party goods, party planningadvice and relevant information. We are a party goods retailer operating storesthroughout New England, where 45 of our 50 retail stores are located. We alsolicense the name iParty.com (at www.iparty.com) to a third party in exchangefor royalties, which to date have not been significant. We generated $72.5million in total revenues and $0.3 million of net loss in fiscal 2005.

 

Our 50 retail stores arelocated predominantly in New England with 25 stores in Massachusetts, 7 inConnecticut, 6 in New Hampshire, 3 in Rhode Island, 3 in Maine and 1 inVermont. We also operate 5 stores in Florida. Our stores range in size fromapproximately 8,000 square feet to 20,300 square feet and average approximately9,800 square feet in size. We lease our properties, typically for 10 years andusually with options from our landlords to renew our leases for an additional 5or 10 years.

 

Our stores feature over20,000 products ranging from paper party goods, Halloween costumes, greetingcards and balloons to more unique merchandise such as piñatas, tiny toys,masquerade and Hawaiian Luau items. Our sales are driven by the followingholiday and party events:  Halloween,Christmas, Easter, Valentine’s Day, New Year’s, Independence Day, St. Patrick’sDay, Thanksgiving and Chanukah. We also focus our business closely on lifetimeevents such as anniversaries, graduations, birthdays, and bridal and babyshowers.

 

Our business has aseasonal pattern. In the past three years we have realized approximately 37.4%of our annual revenues in our fourth quarter, which includes Halloween andChristmas, and approximately 23.6% of our revenues in the second quarter, whichincludes school graduations. Also, during these past three years, we have hadnet income in our second and fourth quarters and generated losses in our firstand third quarters.

 

Our executive offices arelocated at 270 Bridge Street, Suite 301, Dedham, Massachusetts, 02026. Ourphone number is (781) 329-3952. Our licensed website is located atwww.iparty.com. The information contained on our licensed website does notconstitute a part of this Annual Report.

 

Where a reference is madein this Annual Report to a particular year or years, it is a reference to ourfiscal year, unless the context indicates otherwise. For example, “2005” refersto our 53-week fiscal year ended December 31, 2005, “2004” refers to our52-week fiscal year ended December 25, 2004 and “2003” refers to our 52-weekfiscal year ended December 27, 2003.

 

**Organization**

 

While we are presently aparty goods retail chain operating 50 stores, when we were first incorporatedas iParty Corp. (“iParty”) on March 12, 1998 we were an Internet-based merchantof party goods and services. On July 2, 1998, iParty Corp. merged into WSIAcquisitions, Corp. and began trading on the OTC Bulletin Board under tickersymbol “IPTY”. On January 2, 2000, iParty Corp. was listed on the AmericanStock Exchange under ticker symbol “IPT”.

 

On August 3, 2000, iPartyRetail Stores Corp. (“iParty Retail”) was incorporated as a wholly-ownedsubsidiary of iParty Corp. to operate a chain of retail stores selling partygoods. On August 15, 2000, iParty Retail acquired inventory, fixed assets andthe leases of 33 retail stores from The Big Party Corporation (“The Big Party”),a privately-held company which was operating under bankruptcy protection, inexchange for cash and the assumption of certain liabilities. This acquisitionwas approved on August 16, 2000 by the United States Bankruptcy Court for theDistrict of Delaware. We have subsequently opened an additional 17 storesthrough December 31, 2005.

 

On July 8, 2003, wesigned an agreement with Taymark, Inc. (“Taymark”) to license the iParty.comname to Taymark. In return, Taymark pays us a 15% royalty on all net salesrealized through its operation of www.iparty.com. The term of this agreementwas for a period of two (2) years, unless sooner terminated. If this

 

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agreement is notterminated, it is automatically renewed for successive one-year periods.Accordingly, on July 8, 2005, we entered into a one-year renewal period.

 

**CapitalStructure**

** **

Our capital structurecurrently consists of common stock and five outstanding series of convertiblepreferred stock. We have also issued warrants and have a stock option plan.

 

Our common stock has apar value of $0.001 per share. We have 150,000,000 shares of common stockauthorized, 22,536,637 of which were issued and outstanding as of December 31,2005. These shares are listed on the American Stock Exchange and trade underthe symbol “IPT”.

 

We currently have fiveoutstanding series of convertible preferred stock, Series B-F. On January 13,2004 all 1,000,000 shares of our Series A convertible preferred stock wereconverted into 1,000,000 shares of common stock. Each share of Series Bconvertible preferred stock is presently convertible into 12.870 shares of commonstock. Each share of Series C convertible preferred stock is presentlyconvertible into 13.106 shares of common stock. Each share of Series Dconvertible preferred stock is presently convertible into 14.055 shares ofcommon stock. Each share of Series E convertible preferred stock is presentlyconvertible into 10.359 shares of common stock. Each share of Series Fconvertible preferred stock is presently convertible into 10.367 shares ofcommon stock. We had a total of 1,235,355 shares of convertible preferred stockoutstanding as of December 31, 2005, which were convertible into 15,187,880shares of common stock at that date. Our convertible preferred stock ispresented on our balance sheet at its carrying value, which was $13,816,101 atDecember 31, 2005.

 

We also have astockholder rights plan (the “rights plan”). The rights plan associates rightsto our capital stock, such that each share of our common stock is entitled toone right and each share of our preferred stock is entitled to such number ofrights equal to the number of common shares into which it is convertible. Therights will become exercisable only in the event that, with certain exceptions,an acquiring party accumulates 10 percent or more of our voting stock or if aparty announces an offer to acquire 15 percent or more of our voting stock.When exercisable, each right entitles the holder to purchase from us oneone-hundredth of a share of a new series of Series G junior preferred stock atan initial purchase price of $2.00, subject to adjustment. In addition, uponthe occurrence of certain events, holders of the rights would be entitled topurchase either iParty Corp. stock or shares in an “acquiring entity” at halfof market value.

 

The holders of ourconvertible preferred stock have a liquidation preference senior to the holdersof our common stock. In the event of liquidation, which is defined to include amerger, acquisition, or similar transaction involving the acquisition of ourcompany, our convertible preferred stockholders would be entitled to aliquidation value, which was $18,100,539 at December 31, 2005. This amount isin excess of the carrying value of the preferred stock due to amounts allocatedto warrants, which were issued in connection with certain issuances of ourconvertible preferred stock. The difference of approximately $4.3 million willbe accreted when and if a liquidation event occurs. The holders of our SeriesB-F convertible preferred stock are also entitled to anti-dilution protectionin the event we issue common stock, or certain rights, including optionactivity in excess of certain amounts, to purchase or convert into commonstock, at a price below their conversion prices.

 

The Series B-F preferredstockholders are entitled to participate in dividends when and if declared byour Board of Directors.

 

We have also issuedwarrants in connection with the issuance of certain convertible preferred stockand certain licensing and marketing arrangements. At December 31, 2005 we had528,210 warrants outstanding with a weighted average exercise price of $3.79,which were exercisable for 528,210 shares of our common stock. During 2005,warrants granted in conjunction with various series of our convertiblepreferred stock and exercisable for 12,483,005 shares of our common stockexpired without being exercised.

 

Under our stock optionplan we are authorized to grant options to purchase up to 11,000,000 shares ofour common stock. At December 31, 2005, we had options outstanding that wereexercisable for the purchase of 10,340,841 shares of common stock. OnSeptember 21, 2005, our board of directors approved the full accelerationof the vesting of each otherwise unvested stock option that had an exerciseprice of $0.69 or greater that was

 

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currently held by any ofour employees and officers.  As a result, options to purchaseapproximately 1.0 million shares, including approximately 615,000 options heldby our executive officers, became immediately exercisable.

 

The following chartsummarizes our capital structure at December 31, 2005.

 
| ** **                           | ** ** | **Number of  Shares/  Warrants/  Options  Outstanding** | ** ** | **Conversion/  Exercise  Ratios** | ** ** | **Total  Common  Shares  Issued  and  Issuable (1)** | ** ** | **Weighted  Average  Exercise  Price per  Common   Share  Issuable** | ** ** | **Liquidation  Value** | ** ** |
|--------------------------------------|------------|---------------------------------------------------------|------------|-----------------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------------------------|------------|------------------------|------------|
| Common stock                         |       | 22,536,637                                              |       |                              |       | 22,536,637                                           |       |                                                                 |       | $                      | —     |   |
|                                 |       |                                                    |       |                              |       |                                                 |       |                                                                 |       |                   |       |
| Series B convertible preferred stock |       | 474,402                                                 |       | 12.870                            |       | 6,105,559                                            |       |                                                                 |       | 9,488,039              |       |
| Series C convertible preferred stock |       | 100,000                                                 |       | 13.106                            |       | 1,310,600                                            |       |                                                                 |       | 2,000,000              |       |
| Series D convertible preferred stock |       | 250,000                                                 |       | 14.055                            |       | 3,513,750                                            |       |                                                                 |       | 5,000,000              |       |
| Series E convertible preferred stock |       | 296,667                                                 |       | 10.359                            |       | 3,073,168                                            |       |                                                                 |       | 1,112,500              |       |
| Series F convertible preferred stock |       | 114,286                                                 |       | 10.367                            |       | 1,184,803                                            |       |                                                                 |       | 500,000                |       |
| Total convertible preferred stock    |       | 1,235,355                                               |       |                              |       | 15,187,880                                           |       |                                                                 |       | 18,100,539             |       |
|                                 |       |                                                    |       |                              |       |                                                 |       |                                                                 |       |                   |       |
| Warrants                             |       | 528,210                                                 |       | 1.000                             |       | 528,210                                              |       | $                                                                    | 3.79       |                   | —     |   |
|                                 |       |                                                    |       |                              |       |                                                 |       |                                                                 |       |                   |       |
| Stock options                        |       | 10,340,841                                              |       | 1.000                             |       | 10,340,841                                           |       | $                                                                    | 0.95       |                   | —     |   |
|                                 |       |                                                    |       |                              |       |                                                 |       |                                                                 |       |                   |       |
| Total                                |       |                                                    |       |                              |       | 48,593,568                                           |       |                                                                 |       | $                      | 18,100,539 |   |
|                                      |            |                                                         |            |                                   |            |                                                      |            |                                                                      |            |                        |            |  |  |  |

 

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(1)   Includes common stock outstanding and common stock issuable upon conversion ofconvertible preferred stock and exercise of outstanding warrants and stockoptions.

 

**Competition**

** **

The party supplies retailing business ishighly competitive. We compete with a variety of smaller and larger retailers,including single owner-operated party supplies stores, specialty party suppliesretailers, discount department stores, general mass merchants and supermarkets,as well as catalog and Internet merchants.

 

Barriers to entry areminimal. New competitors can open new stores and/or launch new Internet sitesat a relatively low cost. However, we believe that the costs to remaincompetitive in the party supplies retailing business can be significant. Thesecosts include the hiring of human resources with industry knowledge and themarketing costs associated with building a widely recognized brand.

 

**Suppliersand Inventory**

** **

The following representssuppliers from whom we purchased at least 5% of our merchandise:

 

| **Supplier**            | ** ** | **Products supplied** | ** ** | **Fiscal 2005** | ** ** | **Fiscal 2004** | ** ** |
|-------------------------|------------|-----------------------|------------|-----------------|------------|-----------------|------------|
| Amscan, Inc.            |       | Paper party goods     |       | 17.4            | %          | 17.4            | %          |
| Fun World               |       | Halloween costumes    |       | 7.1             | %          | 7.4             | %          |
| Unique Industries, Inc. |       | Paper party goods     |       | 5.6             | %          | 6.1             | %          |
| Total                   |       |                  |       | 30.1            | %          | 30.9            | %          |

 

The loss of any of thesesuppliers could materially adversely affect our business, results ofoperations, financial condition and cash flow. We consider numerous factors insupplier selection, including, but not limited to,

 

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price, credit terms,product offerings and quality. As is customary in our industry, we generally donot have long-term contracts with any supplier, and any supplier maydiscontinue selling to us at any time.

 

**IntellectualProperty**

** **

We hold trademarks for “iParty”and “iParty.com” issued by the U.S. Patent and Trademark Office. Trademarkregistrations for “iParty” were issued on February 19, 2002 and August 26, 2003under U.S. registration No. 2,541,025 and No. 2,756,735. The trademark registrationfor “iParty.com” was issued on November 12, 2002 under U.S. registration No.2,649,801.

 

**Employees**

** **

As of March 1, 2006 wehad 280 full-time employees and 607 part-time employees. None of theseemployees are represented by a labor union, and we consider our relationshipwith our employees to be good.

 

**AvailableInformation**

** **

Our licensed Internetwebsite address is www.iparty.com. Our Annual Reports on Form 10-K, QuarterlyReports on Form 10-Q, Current Reports on Form 8-K and amendments to those reportsfiled or furnished pursuant to Section 13(a) or 15(d) of the SecuritiesExchange Act of 1934 are available through our licensed Internet website assoon as reasonably practicable after we electronically file such material with,or furnish it to, the SEC. Our licensed Internet website and the informationcontained therein or connected thereto are not intended to be incorporated intothis Annual Report on Form 10-K.

 

The public may read andcopy any materials that we file with the SEC at the SEC’s website, www.sec.gov,which contains reports, proxy and information statements and other informationthat public companies are required to file with the SEC. In addition, thepublic may read and copy any materials we file with the SEC at the SEC’s PublicReference Room at 450 Fifth Street, N.W., Washington, D.C., 20549. The publicmay obtain information about the SEC’s Public Reference Room by calling1-800-SEC-0330.

 

**ITEM 1A.    RISKFACTORS**

** **

Our business issubject to certain risks that could materially affect our financial condition,results of operations, and the value of our common stock. These risks include,but are not limited to, the ones described below. Additional risks anduncertainties that we are unaware of, or that we may currently deem immaterial,may become important factors that harm our business, financial condition,results of operations, or the value of our common stock.

 

***Our success depends on economic and other external factors,particularly in the New England region and during the Halloween season, thataffect consumer decisions about whether and when to purchase party goods andsupplies.***

 

Our businesssuccess depends in large measure on consumer decisions to buy party goods andsupplies and seek party planning advice, particularly in the New Englandregion, where 45 of our 50 stores are located, and particularly during theHalloween season, which is our single most important season. Demand for ourproducts and our business results are sensitive to external factors that,directly or indirectly, affect consumer confidence, consumer spending patterns,levels of disposable consumer income, or otherwise lead consumers to host ornot host parties or purchase party goods and supplies. Examples of suchexternal factors include: unseasonable weather, especially in New England; thetiming, duration and effects of adverse changes in overall economic conditions,including rates of job loss or growth, energy prices, and increases ordecreases in interest rates, nationally or more locally in the markets we serve;and the competitive success or failure of local sports teams, such as the NewEngland Patriots or Boston Red Sox, particularly in post-season play. Theprecise impact of any of these external factors on consumer spending patternsfor party goods and supplies is difficult to predict in advance, but one ormore of these factors could adversely affect our business or our operatingresults, particularly with respect to any given fiscal period, to the extentthey adversely impacted the consumer spending patterns most important to ourbusiness success.

 

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***We face intense competition from many sources.***

 

The industry weserve is highly competitive and fragmented. We face intense competition fromother party supply stores and stores that merchandise and market partysupplies, including big discount retailers, such as Wal-Mart, retail drug storechains, like CVS and Walgreen, dollar store chains, and temporary Halloweenstores. Our success thus depends on our ability to be competitive against manydifferent competitors in each local market area we serve. If we fail toanticipate evolving innovations and product offerings from our competitors andfail to offer products that appeal to the changing needs and preferences of ourcustomers in the various markets we serve, demand for our products coulddecline and our operating results would be adversely affected. While thecompetitive importance of product quality, price, service and innovation variesfrom product to product, price is a factor, and we experience pricing pressuresfrom competitors in our markets.

 

***We face new competitive threats as a result of consolidationin our industry following Amscan’s acquisition of Party City Corporation.***

 

The industry inwhich we operate faces the prospect of increased competition as a result ofconsolidation. In December 2005, Amscan Holdings, Inc., our largest supplierand the largest supplier in our industry, reported that it had completed theacquisition of Party City Corporation. Party City Corporation, which operatesapproximately 500 stores nationwide, is the largest party store chain in thenation, followed by Party America, which operates approximately 280 storesnationwide. Neither Party City nor Party America currently have any significantstore presence in the New England area. An important part of our long-rangebusiness plan for 2007 and beyond is to increase our number of stores and enternew geographic markets. Any further geographic expansion by either Party Cityor Party America into the New England market, or any further geographicexpansion by us outside of the New England market, could result in greaterdirect competition with one or both of these party store chains. If so, Amscan’sacquisition of Party City and its status as our largest supplier and thelargest supplier in our industry could adversely affect our ability to competefavorably or operate successfully in a changed marketplace. Price pressuresfrom such new sources of competition, particularly in the event of a strain orrupture in our relationship with Amscan, could erode our margins and cause ourfinancial results of operations to suffer. Our success depends on our abilityto evaluate and respond to the threats arising from growing consolidation andchanging marketplaces and identify ways in which we can competitively operateand strategically grow our store base.

 

***A major failure of our information systems would harm ourbusiness.***

 

The failure of anyof our systems, including, without limitation, the new point-of-sale system weinstalled beginning in 2004, and our existing merchandise management system,the latter of which was developed by a vendor who is no longer in business andis thus currently unsupported by a third-party, would have a material adverseeffect on our business and financial results of operations. We depend on theseinformation systems to operate our retail stores, process transactions, respondto customer inquiries, manage inventory, purchase and sell goods on a timelybasis, and maintain cost-efficient operations. We may experience operationalproblems with our information systems as a result of system failures or anyinability on our part to find qualified personnel to monitor, maintain, andupgrade these systems, particularly with respect to our merchandise managementsystem, or other causes.

 

We currently areplanning to replace our existing merchandising system beginning in 2007. We canprovide no assurance that the new system we are proposing to install willsuccessfully meet our operational and financial requirements or that thetransition from our existing system to the new one will occur without anymaterial disruptions in our business or financial results of operations. Wecannot assure you that our systems will be adequate to support future growth,either as currently configured or as we plan to update them. Any materialdisruption or slowdown of our systems, as currently existing or as proposed tobe replaced, would severely interfere with the normal operation of our retailstore operations and would have a materially negative impact on our businessoperations and financial results. In particular, our total borrowing base underour line of credit depends, among other things, on our inventory levels, creditcard receivables, customer deposits, and merchandise credits. Accordingly, anymaterial disruption or problem affecting our point-of-sale or merchandisemanagement systems could materially and adversely affect our borrowing level,our compliance with various covenants under our bank agreement, and ourliquidity and cash resources.

 

***Our quarterly operating results are subject to significantfluctuation.***

 

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Our operatingresults have fluctuated from quarter to quarter in the past, and we expect thatthey will continue to do so in the future. Factors that could cause thesequarterly fluctuations, both sequentially and on a year-over-year basis,include the following: extreme weather-related disruptions, particularly in NewEngland; the timing of movable holidays, such as Easter, which typically fallsin the second quarter but on occasion falls in the first quarter; thecompetitive success or failure of local sports teams, such as the New EnglandPatriots or Boston Red Sox, particularly in post-season play, which may resultin fluctuations from one year to the next in our sales in the first and fourthquarters; the extent to which sales in new stores result in the loss of salesin existing stores; the mix of products sold; pricing and marketing actions ofcompetitors; the level of advertising and promotional expenses; andseasonality, primarily because the sales and profitability of our stores aretypically lower in the first and third quarters, when we have often operated ata loss, and are typically higher in the second quarter, which includes schoolgraduations, and the fourth quarter, which includes Halloween, our single mostimportant selling season, as well as the Christmas holiday season. Most of ouroperating expenses, such as rent expense, advertising expense and employeesalaries, do not vary directly with the amount of sales and are difficult toadjust in the short term. As a result, if sales in a particular quarter arebelow expectations for that quarter, we may not proportionately reduceoperating expenses for that quarter, and therefore such a sales shortfall wouldhave a disproportionate effect on our net income (or loss) for the quarter.

 

***Risks associated with recent and possible future new storeopenings could adversely affect our business.***

 

An important partof our long-range business plan is to increase our number of stores and, overtime, enter new geographic markets. We have opened 15 new stores over the pastthree years, bringing our total number of stores from 35 at the beginning of2003 to 50 at the end of 2005. While we have no current plans for new storeopenings in 2006, our current growth goals for 2007 and beyond envision newstore openings. For our growth strategy to be successful, we must identify andlease favorable store sites, hire and train associates and store managers, andadapt management and operational systems to meet the needs of our expandedoperations. These tasks may be difficult to accomplish successfully. If we areunable to open new stores in locations and on terms acceptable to us as quicklyas planned, our future sales and profits may be adversely affected. Even if wesucceed in opening new stores, these new stores may not achieve the same salesor profit levels as our existing stores. Also, our expansion strategy includesopening new stores in markets where we already have a presence so we can takeadvantage of economies of scale in marketing, distribution and supervisioncosts. However, these new stores may result in the loss of sales in existing storesin nearby areas, which could adversely affect our business and financialperformance. In addition, future store openings could cause us, among otherthings, to incur additional debt, increased interest expense, as well asexperience dilution in earnings, if any, per share. Impairment losses couldalso occur as a result of new store openings in the event that new storeopenings prove unsuccessful.

 

***Our business may be adversely affected by the actions of andrisks associated with our third-party vendors.***

 

The products wesell are sourced from a wide variety of third-party vendors. We cannot controlthe supply, design, function or cost of most of the products that we offer forsale and are dependent on the availability and pricing of various products, including,without limitation, paper-based party goods, Halloween masks, and costumes,many of which are manufactured overseas in foreign countries such as China.Global sourcing of many of the products we sell is thus an important factor inour financial performance. Our ability to find qualified vendors and accessproducts in a timely and efficient manner is a significant challenge,especially with respect to goods sourced outside the United States. Disruptionsin the availability of raw materials used in production of these products mayadversely affect our sales and result in customer dissatisfaction. Politicalinstability, the financial instability of suppliers, merchandise qualityissues, trade restrictions, tariffs, currency exchange rates, transport capacityand costs, inflation and other factors relating to foreign trade are beyond ourcontrol. In particular, rising oil and gas prices impact prices ofpetroleum-based/plastic products, which are a key raw material in much of ourmerchandise, affect our freight costs, and affect consumer confidence andspending patterns. These and other issues directly or indirectly affecting ourvendors could adversely affect our business and financial performance.

 

***Our failure to generate sufficient cash to meet our liquidityneeds may affect our ability to service our indebtedness and grow our business.***

 

Our businessrequires access to capital to support growth, improve our infrastructure,respond to economic conditions, and meet contractual commitments. In the eventthat our operating plan changes or proves inaccurate

 

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due tolower-than-expected revenues, unanticipated expenses, increased competition,unfavorable economic conditions, other factors discussed in this Item 1A, “RiskFactors,” or other unforeseen circumstances, our liquidity may be negativelyimpacted. Our ability to make payments on and to refinance our indebtedness,principally the amounts borrowed under our line of credit, and to fund plannedcapital expenditures for systems upgrades and new store openings, if any, wemay make in the future will depend in large part on our current and futureability to generate cash. This, to a certain extent, is subject to generaleconomic, financial, competitive and other factors that are beyond our control.We cannot assure you that our business will generate sufficient cash flow fromoperations in the future, that our currently anticipated growth in revenues andcash flow will be realized on schedule, or that future borrowings will beavailable to us under our line of credit in an amount sufficient to enable usto service indebtedness, undertake store openings and replace and upgrade ourtechnology systems to grow our business, or to fund other liquidity needs. Ifwe need to refinance all or a portion of our indebtedness, we cannot assure youthat we will be able to do so on commercially reasonable terms or at all. Inaddition, there can be no assurance, that, should we seek or require additionalfinancing in the form of debt, subordinated debt, equity, convertiblesecurities, or some combination of the above, such financing will be available,if at all, on terms and conditions acceptable to us. If so, our ability, amongother things, to proceed with our store expansion plans for 2007 and beyondwould be negatively affected.

 

***Our ownership structure includes large investors who ownpreferred stock and whose interests and rights in our company differ inimportant respects from those of our common stock investors.***

 

Our capitalstructure includes various series of convertible preferred stock and a numberof investors who own large concentrations of our shares on anas-converted-into-common basis. The ownership rights of these holders of ourpreferred stock impacts the trading liquidity of our common shares, ourcorporate governance, and the relative economic stake that our common stock andpreferred stock investors have in the enterprise value of our business.

 

The largeconcentration of share ownership that some of our investors have generally hasthe effect of making our shares more illiquid than if our ownership structurewas more widely diffused. Our corporate governance is affected by our ownershipstructure to the extent that certain of our preferred stock investors currentlyenjoy, among other things, contractual rights to nominate and elect two of themembers of our board of directors. These rights and the concentration of shareownership enjoyed by certain of our preferred stock investors means that ourlargest investors can influence our strategic direction and that of our seniormanagement in ways that are different than most of our common stock investors.Our preferred stock investors also enjoy certain economic rights thatdifferentiate their ownership rights and interests from those of our commonstock investors. For instance, upon the occurrence of merger, acquisition orsimilar transaction involving the acquisition of our company, the holders ofour preferred stock would generally be entitled to a “liquidation preference”that would entitle them, collectively, to the first $18.1 million of netproceeds, unless they decide to convert their shares of preferred stock intocommon stock. This feature of our preferred stock investors’ rights could makethe attractiveness of our company as an acquisition target differ materiallyfrom what it would be without it. In addition, our preferred stock investorsenjoy certain “anti-dilution” protections not afforded to our common stockinvestors, which generally means that investors in shares of our common stockcould be adversely affected by subsequent dilutive financings, if any, in waysthat are different from some or all of our preferred stock investors.

 

***Our common stock is thinly traded, may fluctuate based onrelatively small levels of trading activity, and may be adversely affected byour capital structure, which makes it more difficult for investors to value ourbusiness.***

 

Investing inshares of our common stock entails a high degree of risk. Public trading of ourcommon stock on the American Stock Exchange typically occurs at relatively lowsales volumes and very few, if any, security analysts regularly follow ourstock. Moreover, our common stock price has traded below $1.00 for significantperiods of time. In addition, our capital structure, which includes variousseries of convertible preferred stock with various contractual rights,generally makes it more difficult for investors, or prospective acquirers ofour company, to value our business on an aggregate basis or to value our sharesof common stock on a trading basis. As a result of these factors, speculativeinvestors may have a greater effect on our common stock price than would be thecase for a company with a simpler ownership structure, a larger marketcapitalization, or common shares that are more diffusely held or heavilytraded. Accordingly, our common stock price could be subject to considerablespeculative volatility and may not necessarily follow market expectationsregarding our business prospects or financial

 

7

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performance. Inparticular, our common stock price may be sensitive to non-financialdevelopments involving our company as well as market rumors disseminated on theInternet or other forms of media regarding our company or our industry. If ourquarterly financial performance does not meet the expectations of investorsthat trade in shares of our common stock, our stock price would likely decline.If so, the decrease in the stock price may be disproportionate to theshortfall, real or perceived, in our financial performance.

 

***Our failure to attract, retain, and motivate qualifiedpersonnel would adversely affect our business.***

 

Our successdepends in large part on the efforts and abilities of our senior managementteam. Their skills, experience and industry contacts significantly benefit ouroperations and administration. The failure to attract, retain, and properlymotivate the members of our senior management team and other key employees, orto find suitable replacements for them in the event of death, ill health, ortheir desire to pursue other professional opportunities, could have a negativeeffect on our operating results.

 

Our performance isalso largely dependent on attracting and retaining quality associates that areable to make the consumer shopping experience at our stores a fun andinformative experience. We face intense competition for qualified associates,and many of our associates are in entry-level or part-time positions withhistorically high rates of turnover. Our ability to meet our labor needsgenerally while controlling our labor costs is subject to numerous externalfactors, including the availability of a sufficient number of qualified personsin the work force, unemployment levels, prevailing wage rates, changingdemographics, health and other insurance costs and changes in employmentlegislation, particularly in the New England region. If we are unable toattract and retain qualified associates or our labor costs increasesignificantly, our business and financial performance may be adverselyaffected.

 

***Compliance with changing regulation of corporate governance,public disclosure, and accounting standards may result in additional expensesand risks.***

 

Changing laws,regulations and standards relating to corporate governance, public disclosureand changes to accounting standards and practices, including the Sarbanes-OxleyAct of 2002, new SEC regulations, corporate law developments in Delaware, andevolving rules applicable to publicly-traded companies on the American StockExchange, are creating uncertainty, and hence risks, for companies such asours. These new or changed laws, regulations and standards are subject tovarying interpretations due to the fact that they are new and there has not yetemerged a well-developed body of interpretation. As a result, their applicationin practice may evolve over time as new guidance is provided by regulatory andgoverning bodies. This development could result in continuing uncertaintyregarding compliance matters and higher costs necessitated by ongoing revisionsto disclosure, governance and accounting practices.

 

Our efforts tocomply with evolving laws, regulations and standards have resulted in, and arelikely to continue to result in, increased general and administrative expensesand a diversion of management time and attention from revenue-generatingactivities to compliance activities. In particular, we are applying significantmanagement and financial resources to document, test, monitor and enhance ourinternal control over financial reporting in order to meet the various currentrequirements of the Sarbanes-Oxley Act of 2002. We cannot be certain that thesemeasures will ensure that our controls will be adequate or effective inpreventing fraud or human error. Any failure in the effectiveness of ourinternal control over financial reporting could have a material effect on ourfinancial reporting or cause us to fail to meet reporting obligations, whichupon disclosure, could negatively impact the market price of our common stock.Our efforts to comply with these types of new regulatory requirements regardingour required assessment of our internal controls over financial reporting andour external auditors’ audit of our financial statements has required thecommitment of increasing levels of financial and managerial resources. If ourefforts to comply with new or changed laws, regulations and standards differfrom the activities intended by regulatory or governing bodies, we could facevarious material and adverse consequences, including, a decline in our commonstock price or a possible delisting of our common stock.

 

**ForwardLooking Statements**

 

Certain statementsin this Annual Report, particularly statements contained in Item 7, “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”constitute “forward-looking statements” within the meaning of Section 27A ofthe Securities Act of 1933, as amended, and Section 21E of the Securities

 

8

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Exchange Act of1934, as amended. The words “anticipate”, “believe”, “estimate”, “expect”, “plan”,“intend” and other similar expressions are intended to identify theseforward-looking statements, but are not the exclusive means of identifyingthem. Forward-looking statements included in this Annual Report or hereafterincluded in other publicly available documents filed with the SEC, reports toour stockholders and other publicly available statements issued or released byus involve known and unknown risks, uncertainties, and other factors whichcould cause our actual results, performance (financial or operating) orachievements to differ from the future results, performance (financial oroperating) or achievements expressed or implied by such forward lookingstatements. Such future results are based upon our best estimates based uponcurrent conditions and the most recent results of operations.

 

Various risks,uncertainties and contingencies could cause our actual results, performance or achievementsto differ materially from those expressed in, or implied by, theforward-looking statements contained in this Annual Report. These include, butare not limited to, those listed above in this Item 1A, “Risk Factors.”

 

**ITEM1B. UNRESOLVED STAFF COMMENTS**

** **

Not applicable.

 

**ITEM2. PROPERTIES**

** **

The following tableidentifies the number of our stores operating as of December 31, 2005, December25, 2004, and December 27, 2003, by state:

 
| **States**    | ** **          | **Number of Stores, for the fiscal year ended** | ** **       |
|---------------|---------------------|-------------------------------------------------|------------------|
| ** **    | **Dec 31, 2005**    | ** **                                      | **Dec 25, 2004** | ** ** | **Dec 27, 2003** | ** ** |
| ** **    | **End  of  Period** | ** **                                      | **Closings**     | ** ** | **Openings** | ** ** | **End  of  Period** | ** ** | **Closings** | ** ** | **Openings** | ** ** | **End  of  Period** | ** ** | **Closings** | ** ** | **Openings** | ** ** |
| Connecticut   |                | 7                                               |             | — |   | 1 |   | 6 |   | — |   | — |   | 6 |   | — |   | 1 |   |
| Florida       |                | 5                                               |             | — |   | 1 |   | 4 |   | — |   | 1 |   | 3 |   | — |   | — |   |
| Maine         |                | 3                                               |             | — |   | 1 |   | 2 |   | — |   | 1 |   | 1 |   | — |   | — |   |
| Massachusetts |                | 25                                              |             | — |   | 2 |   | 23 |   | — |   | 2 |   | 21 |   | — |   | 2 |   |
| New Hampshire |                | 6                                               |             | — |   | 1 |   | 5 |   | — |   | 1 |   | 4 |   | — |   | — |   |
| Rhode Island  |                | 3                                               |             | — |   | — |   | 3 |   | — |   | — |   | 3 |   | — |   | — |   |
| Vermont       |                | 1                                               |             | — |   | — |   | 1 |   | — |   | 1 |   | — |   | — |   | — |   |
| Total         |                | 50                                              |             | — |   | 6 |   | 44 |   | — |   | 6 |   | 38 |   | — |   | 3 |   |

 

Our stores range in sizefrom approximately 8,000 square feet to approximately 20,300 square feet andaverage approximately 9,800 square feet. We lease all of our retail stores. Theleases generally provide for fixed minimum rentals, which typically increaseperiodically during the life of the lease, and, in some instances, contingentrentals based on a percentage of sales in excess of specified minimum saleslevels, as well as related occupancy costs, such as property taxes and commonarea maintenance. We lease our properties, typically for 10 years and usuallywith options from our landlords to renew our leases for an additional 5 or 10years.

 

In addition to our 50stores, we lease office space at 270 Bridge Street, Suite 301, Dedham,Massachusetts, 02026. The lease, which expires November 30, 2011, is for 10,600square feet of space and the monthly rent is $17,500. We also lease office andretail space at 1457 VFW Parkway, West Roxbury, Massachusetts, 02132. Thislease, which expires December 31, 2012, is for 20,000 square feet of space. Theretail store at our West Roxbury location uses 10,688 square feet and theremainder is used primarily for our corporate training center. The totalmonthly rent for the retail store and corporate training center space is$17,100, subject to certain Consumer Price Index escalation clauses. We believethat these spaces are adequate for our immediate needs.

 

We believe that allproperties are adequately covered by insurance.

 

9

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**ITEM3. LEGAL PROCEEDINGS**

** **

We are not a party to any material pendinglegal proceedings other than ordinary routine matters incidental to ourbusiness.

 

**ITEM4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

** **

No matters were submittedto a vote of our security holders during the fourth quarter of fiscal 2005.

 

**PART II**

** **

**ITEM5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS ANDISSUER PURCHASES OF EQUITY SECURITIES**

** **

**MarketInformation**

** **

The American StockExchange is the principal market for our common stock, where our shares are tradedunder the symbol “IPT”. Our common stock began trading on the American StockExchange under the name iParty Corp., symbol “IPT”, on January 2, 2000. Ourcommon stock was quoted previously on the OTC Electronic Bulletin Board underthe name iParty Corp., symbol “IPTY”, commencing July 1998. Prior to that time,from February 1998 until July 1998, our common stock was quoted on the OTCBulletin Board under the name of WSI Acquisitions, Inc., symbol “WSIA”.

 

The following table setsforth the range of high and low sales prices on the American Stock Exchange forour common stock for each of the fiscal quarters of 2005 and 2004:

 

**MARKET PRICE OF COMMON STOCK**

 

| **Period**             | ** ** | **High** | ** ** | **Low** | ** ** |
|------------------------|------------|----------|------------|---------|------------|
| **2005**               |       |     |       |    |       |
| Fourth fiscal  quarter |       | $        | 0.54       |    | $          | 0.37 |   |
| Third fiscal  quarter  |       | 0.59     |       | 0.41    |       |
| Second fiscal  quarter |       | 0.83     |       | 0.45    |       |
| First fiscal  quarter  |       | 1.00     |       | 0.63    |       |
| **2004**               |       |     |       |    |       |
| Fourth fiscal  quarter |       | $        | 0.89       |    | $          | 0.65 |   |
| Third fiscal  quarter  |       | 0.97     |       | 0.58    |       |
| Second fiscal  quarter |       | 1.32     |       | 0.81    |       |
| First fiscal  quarter  |       | 1.63     |       | 0.78    |       |

 

 

**Holders**

** **

The approximate number ofrecord holders of our common stock as of March 30, 2006 was 218. The number ofrecord owners was determined from our stockholder records, and does not includebeneficial owners of our common stock whose shares are held in the names ofvarious security holders, dealers and clearing agencies. We believe that thenumber of beneficial owners of our common stock held by others as or in nomineenames exceeds 500 in number.

 

**Dividends**

** **

We have never paid a cashdividend on our shares of common stock and have no expectation of doing so forthe foreseeable future. Our existing line of credit agreement with Wells FargoRetail Finance II, LLC generally prohibits the payment of any dividends orother distributions to any of our classes of capital stock.

 

10

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**Recent Sales of UnregisteredSecurities**

 

None.

 

**Purchasesof Equity Securities by the Issuer and Affiliated Purchasers**

** **

There were no stockrepurchases made during the fiscal quarter ended December 31, 2005.

 

**EquityCompensation Plan Information**

** **

See Item 12 “SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters” below.

 

11

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**ITEM 6. SELECTED FINANCIAL DATA**

 
| ** **                                                       | ** ** | **2005(1)  53 weeks**      | ** ** | **2004  52 weeks**         | ** ** | **2003  52 weeks**         | ** ** | **2002  52 weeks**         | ** ** | **2001  52 weeks**         | ** ** |
|------------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|
| **Statement of Operations Data:**                                |       |                       |       |                       |       |                       |       |                       |       |                       |       |
| Revenues                                                         |       | $                          | 72,537,998 |                       | $          | 64,276,225                 |       | $                          | 56,697,246 |                       | $          | 52,177,923 |   | $ | 47,983,404 |   |
| Operating costs:                                                 |       |                       |       |                       |       |                       |       |                       |       |                       |       |
| Cost of products  sold                                           |       | 41,395,193                 |       | 35,826,820                 |       | 31,758,625                 |       | 30,420,475                 |       | 28,966,573                 |       |
| Marketing and  sales                                             |       | 24,116,050                 |       | 21,176,925                 |       | 18,363,193                 |       | 16,527,832                 |       | 15,345,744                 |       |
| General and  administrative                                      |       | 6,762,583                  |       | 6,335,067                  |       | 5,516,273                  |       | 5,245,867                  |       | 5,522,688                  |       |
| Special charge                                                   |       | —                     |       | —                     |       | —                     |       | 396,465                    |       | —                     |       |
| Stock option  compensation expense                               |       | —                     |       | —                     |       | —                     |       | —                     |       | 320,373                    |       |
|                                                             |       |                       |       |                       |       |                       |       |                       |       |                       |       |
| Operating income (loss)                                          |       | 264,172                    |       | 937,413                    |       | 1,059,155                  |       | (412,716                   | )          | (2,171,974                 | )          |
|                                                             |       |                       |       |                       |       |                       |       |                       |       |                       |       |
| Other income                                                     |       | —                     |       | 382,500                    |       | —                     |       | —                     |       | —                     |       |
|                                                             |       |                       |       |                       |       |                       |       |                       |       |                       |       |
| Income (loss) before interest and taxes                          |       | 264,172                    |       | 1,319,913                  |       | 1,059,155                  |       | (412,716                   | )          | (2,171,974                 | )          |
|                                                             |       |                       |       |                       |       |                       |       |                       |       |                       |       |
| Interest income                                                  |       | 801                        |       | 1,354                      |       | 1,262                      |       | 9,045                      |       | 117,431                    |       |
| Interest expense                                                 |       | (532,649                   | )          | (225,074                   | )          | (212,227                   | )          | (280,898                   | )          | (381,763                   | )          |
|                                                             |       |                       |       |                       |       |                       |       |                       |       |                       |       |
| Income (loss) before taxes                                       |       | (267,676                   | )          | 1,096,193                  |       | 848,190                    |       | (684,569                   | )          | (2,436,306                 | )          |
|                                                             |       |                       |       |                       |       |                       |       |                       |       |                       |       |
| Income taxes                                                     |       | —                     |       | 105,000                    |       | 97,233                     |       | —                     |       | —                     |       |
|                                                             |       |                       |       |                       |       |                       |       |                       |       |                       |       |
| Net income (loss)                                                |       | $                          | (267,676   | )                          | $          | 991,193                    |       | $                          | 750,957    |                       | $          | (684,569 | ) | $ | (2,436,306 | ) |
|                                                             |       |                       |       |                       |       |                       |       |                       |       |                       |       |
| Net income (loss) available to common stockholders               |       | $                          | (267,676   | )                          | $          | 991,193                    |       | $                          | 750,957    |                       | $          | (774,719 | ) | $ | (2,436,306 | ) |
|                                                             |       |                       |       |                       |       |                       |       |                       |       |                       |       |
| Income (loss) per share:                                         |       |                       |       |                       |       |                       |       |                       |       |                       |       |
| Basic                                                            |       | $                          | (0.01      | )                          | $          | 0.03                       |       | $                          | 0.02       |                       | $          | (0.04 | ) | $ | (0.18 | ) |
| Diluted                                                          |       | $                          | (0.01      | )                          | $          | 0.02                       |       | $                          | 0.02       |                       | $          | (0.04 | ) | $ | (0.18 | ) |
|                                                             |       |                       |       |                       |       |                       |       |                       |       |                       |       |
| Net income  (loss) per share available to common stockholders    |       |                       |       |                       |       |                       |       |                       |       |                       |       |
| Basic                                                            |       | $                          | (0.01      | )                          | $          | 0.03                       |       | $                          | 0.02       |                       | $          | (0.05 | ) | $ | (0.18 | ) |
| Diluted                                                          |       | $                          | (0.01      | )                          | $          | 0.02                       |       | $                          | 0.02       |                       | $          | (0.05 | ) | $ | (0.18 | ) |
|                                                             |       |                       |       |                       |       |                       |       |                       |       |                       |       |
| Weighted-average shares outstanding:                             |       |                       |       |                       |       |                       |       |                       |       |                       |       |
| Basic                                                            |       | 22,186,581                 |       | 37,649,400                 |       | 36,683,142                 |       | 16,219,436                 |       | 13,411,866                 |       |
| Diluted                                                          |       | 22,186,581                 |       | 41,517,036                 |       | 38,868,484                 |       | 16,219,436                 |       | 13,411,866                 |       |
|                                                             |       |                       |       |                       |       |                       |       |                       |       |                       |       |
| **Other Data:**                                                  |       |                       |       |                       |       |                       |       |                       |       |                       |       |
| Net cash provided by (used in) operating activities              |       | $                          | (259,907   | )                          | $          | 129,690                    |       | $                          | 1,368,798  |                       | $          | 581,930 |   | $ | (2,616,844 | ) |
| Net cash used in investing activities                            |       | (1,663,647                 | )          | (2,121,134                 | )          | (1,166,258                 | )          | (775,147                   | )          | (210,738                   | )          |
| Net cash provided by (used in) financing activities              |       | 865,591                    |       | 1,306,130                  |       | (86,412                    | )          | 120,476                    |       | 224,412                    |       |
| Capital expenditures (2)                                         |       | 1,663,647                  |       | 2,121,134                  |       | 1,166,258                  |       | 775,147                    |       | 210,738                    |       |
|                                                             |       |                       |       |                       |       |                       |       |                       |       |                       |       |
| ** **                                                       | ** ** | **Dec 31, 2005** | ** ** | **Dec 25, 2004** | ** ** | **Dec 27, 2003** | ** ** | **Dec 28, 2002** | ** ** | **Dec 29, 2001** | ** ** |
| **Balance Sheet Data:**                                          |       |                       |       |                       |       |                       |       |                       |       |                       |       |
| Working capital                                                  |       | $                          | 2,091,213  |                       | $          | 3,236,148                  |       | $                          | 4,178,436  |                       | $          | 4,021,692 |   | $ | 4,841,696 |   |
| Total assets                                                     |       | 21,717,076                 |       | 19,479,937                 |       | 15,151,980                 |       | 13,815,883                 |       | 14,533,218                 |       |
| Total long-term  liabilities and convertible preferred stock (3) |       | 1,095,998                  |       | 1,268,452                  |       | 406,469                    |       | 19,266,414                 |       | 20,929,419                 |       |
|                                                                  |            |                            |            |                            |            |                            |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |

 

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(1) Fiscal year 2005 refers to a 53-week fiscal year, while fiscalyears 2004, 2003, 2002 and 2001 refer to 52-week fiscal years.

 

(2) Capital expenditures exclude assets acquired under capital leases.

 

(3) The holders of our Series A-F convertible preferred stock have theright to a liquidation preference, which was not considered under our controlin 2002 and 2001.  Therefore theircarrying values have been excluded from stockholders' equity for theseperiods.  Their carrying values areincluded in stockholders' equity in 2005, 2004 and 2003 as redemption is deemedto be solely within our control.

 

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**ITEM7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS**

** **

*Thefollowing discussion should be read in conjunction with our ConsolidatedFinancial Statements and the related Notes included below.*

 

*Certainstatements in this Annual Report, particularly statements contained in thisItem 7, “Management’s Discussion and Analysis of Financial Condition andResults of Operations” constitute “forward-looking statements” within themeaning of Section 27A of the Securities Act of 1933, as amended, and Section21E of the Securities Exchange Act of 1934, as amended. The words “anticipate”,“believe”, “estimate”, “expect”, “plan”, “intend” and other similar expressionsare intended to identify these forward-looking statements, but are not theexclusive means of identifying them. Forward-looking statements included inthis Annual Report or hereafter included in other publicly available documentsfiled with the Securities and Exchange Commission (“SEC”), reports to ourstockholders and other publicly available statements issued or released by usinvolve known and unknown risks, uncertainties, and other factors which couldcause our actual results, performance (financial or operating) or achievementsto differ from the future results, performance (financial or operating) orachievements expressed or implied by such forward looking statements. Suchfuture results are based upon our best estimates based upon current conditionsand the most recent results of operations. Various risks, uncertainties andcontingencies could cause our actual results, performance or achievements todiffer materially from those expressed in, or implied by, the forward-lookingstatements contained in this Annual Report. These include, but are not limitedto, those described above under Item 1A, “Risk Factors.”*

 

**Overview**

** **

At the end of 2005 weoperated 50 retail stores, including 45 in New England and five in Florida, andfor the year we generated approximately $72.5 million in sales and had a netloss of approximately $0.3 million. We opened six new stores in 2005, five ofwhich opened in the third quarter. In 2005 we also achieved a 0.6% increase incomparable stores sales for the comparable 52-week period. Comparable storesales are defined as sales from those stores open for at least one full year.This marks our fourth consecutive year of comparable store sales growth. Totalsales for fiscal year 2005 included sales from a 53rd week.

 

Total sales for fiscalyear 2005 increased 12.9% over fiscal year 2004. Excluding sales from the 53rdweek of 2005, total sales for the comparable 52-week period increased 10.3%over 2004. The following table shows the sales percentage increase (decrease)for each quarter of 2005 compared to the same period for 2004 for comparablestores, non-comparable stores which include sales from six new stores thatopened in 2005 and sales from six new stores that opened in 2004 which were notincluded in comparable store sales in 2005 until they had been open for onefull year and the 53rd week:

 

**QUARTERLY FINANCIAL DATA**

 

| ** **                                   | ** ** | **Mar 26** | ** ** | **Jun 25** | ** ** | **Sep 24** | ** ** | **Dec 31** | ** ** | **Fiscal Year** | ** ** |
|----------------------------------------------|------------|-----------------|------------|-----------------|------------|-----------------|------------|-----------------|------------|----------------------|------------|
| Comparable store sales % increase (decrease) |       | (0.7            | )%         | (0.5            | )%         | 2.5             | %          | 0.8             | %          | 0.6                  | %          |
| Non-comp stores sales % increase (decrease)  |       | 10.0            | %          | 8.0             | %          | 10.3            | %          | 10.2            | %          | 9.7                  | %          |
| 53rd week sales % increase                   |       | n/a             |       | n/a             |       | n/a             |       | 7.1             | %          | 2.6                  | %          |
| Total sales % increase (decrease)            |       | 9.3             | %          | 7.5             | %          | 12.8            | %          | 18.1            | %          | 12.9                 | %          |

 

The year began with a0.7% decrease in comparable store sales in the first quarter of 2005 due tosevere weather that impacted our New England stores, partially offset by anincrease in sales related to the earlier-than-normal Easter season as well asthe post-season success of the New England Patriots in winning the Super Bowl.In the second quarter, comparable stores sales decrease 0.5% largely related tothe Easter shift. Comparable stores sales increased by 2.5% in the thirdquarter mostly driven by higher sales of Boston Red Sox related merchandisewhich we feel was due to increased exposure for our brand through our Red Sox sponsorshipprogram as well as better inventory levels. The year ended, with a 0.8%increase in comparable store sales in the fourth quarter despite a 1.1%decrease in comparable store sales for the Halloween season. We believe thatthe decrease for the Halloween season was partially related to the shift to aMonday Halloween whereas Halloween fell on a weekend in 2004 and partiallyrelated to, although to a lesser extent, more competition from temporaryHalloween stores than we had experienced in the past. Overall, our comparablestores sales increase of 0.6% for 2005 did not meet our

 

13

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expectation consideringwe realized a 4.6% increase in 2004 and a 4.8% increase in 2003. In 2005, salesfrom our new stores contributed significantly to our total sales increase.

 

Throughout theyear, our gross profit margin was negatively affected by increases in ourproduct costs charged to us by certain key vendors primarily due to rising oilprices. We adjusted our prices to reflect most of these increases, but givencompetitive pressure we were not able to pass on all of the increases to ourcustomers. We also experienced certain delays in implementing our priceincreases from the time that we were first notified of cost increases from ourvendors due to the sheer number of these increases and certain technologylimitations in our merchandising system. By the fourth quarter, our grossprofit margin had stabilized and was only slightly lower than the same periodin 2004. Overall, the effect of the increase in our product costs was higherthan originally anticipated.

 

Additionally, thecosts associated with opening the six new stores in 2005 put pressure on ouroccupancy costs and marketing and sales expense. Our new stores operate at ahigher cost to sales ratio until they reach maturity which typically occurs 18to 24 months after opening.

 

As a result of thelower than expected comparable store sales, lower gross profit margin and thecosts associated with opening six new stores in 2005, we had an operatingincome in fiscal 2005 of $0.3 and a loss of approximately $0.3 million. Thisloss is disappointing considering that it follows two years of profitability.Despite having a net loss for the year, we are pleased to report operatingincome for a third consecutive year.

 

In April 2005, weincreased the limit on our bank line-of-credit from $7,500,000, to $10,000,000.In September 2005, we again increased the limit on our bank line-of-credit from$10,000,000, to $12,500,000. The increases to our bank line-of-credit were usedto fund the costs associated with opening the six new stores. Our inventory andaccounts receivable secure our line of credit.

 

Subsequent to theend of fiscal 2005, on January 17, 2006, we amended our agreement to allow fora $500,000 term loan which increases our borrowing base, but does not increasethe $12.5 million credit limit. We borrowed the full $500,000 on that date. Theinterest rate on the term loan is the bank’s base rate plus 125 basis points. Duringthe time in which the term loan remains outstanding, the interest rate on theline of credit is the bank’s base rate plus 75 basis points. The term loan iscurrently outstanding and is due and payable in full on October 31, 2006. Theamendment also waived a default as a consequence of the fact that the principalbalance of the line of credit exceeded availability on January 12, 2006. As ofMarch 30, 2006, we are in compliance with the covenants under our line ofcredit.

 

Among our primarygoals in 2006 are to increase our comparable store sales, increase our grossprofit margin percentage and leverage our occupancy costs, marketing and salesexpense and general and administrative expense as the 12 stores we opened overthe past two years reach maturity. We do not currently plan to open any newstores in 2006.

 

**Fiscal2005 Compared to Fiscal 2004**

** **

*Revenues*

 

Our consolidatedrevenues for fiscal 2005, a 53 week year, were $72,537,998, an increase of$8,261,773, or 12.9% from the prior fiscal year, a 52 week year. Revenuesinclude the selling price of party goods sold, net of returns and discounts,and are recognized at the point of sale.

 

Sales for fiscal2005 included an increase of 0.6% in comparable store sales, sales from six newstores that opened in 2005 and sales from six new stores that opened in 2004which were not included in comparable stores sales in 2005 until they had beenopen for one full year. Comparable store sales for fiscal 2005 were negativelyaffected by the severe weather that impacted our New England region storesduring the first quarter and lower than expected comparable store sales duringthe Halloween season in the fourth quarter. This shortfall was partially offsetby positive comparable sales in the third quarter mostly driven by higher salesof Boston Red Sox related merchandise which we feel was due to increasedexposure for our brand through our Red Sox sponsorship program as well asbetter inventory levels.

 

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*Costof goods sold and occupancy costs*

 

Our cost of products soldand occupancy costs for fiscal 2005 was $41,395,193, or 57.1% of revenues, anincrease of $5,568,373 and an increase of 1.3 percentage points, as apercentage of revenues, from the prior fiscal year. Cost of products sold andoccupancy costs consists of the cost of merchandise sold to customers and theoccupancy costs for our stores.

 

As a percentage ofrevenues, the increase in cost of products sold was primarily attributable toincreases in our product costs charged to us by certain key vendors primarilydue to rising oil prices. We adjusted our prices to reflect most of thesesincreases, but given competitive pressure we were not able to pass on all ofthe increases to our customers. We also experienced certain delays inimplementing our price increases from the time that we were first notified ofcost increases from our vendors due to the sheer number of these increases andcertain technology limitations in our merchandising system. By the fourthquarter, our gross profit margin had stabilized and was only slightly lowerthan the same period in 2004. Additionally, occupancy costs, as a percentage torevenue, was negatively affected by our new stores, which operate at a higheroccupancy to sales ratio until they reach maturity.

 

*Marketingand sales expense*

 

Our consolidatedmarketing and sales expense for fiscal 2005 was $24,116,050, or 33.2% ofrevenues, an increase of $2,939,125 and an increase of 0.3 percentage points,as a percentage of revenues, from the prior fiscal year. Marketing and salesexpense consists primarily of advertising and promotional expenditures, allstore payroll and related expenses for personnel engaged in marketing andselling activities and other non-payroll expenses associated with operating ourstores.

 

As a percentage ofrevenues, the increase in marketing expense was primarily due to increasedadvertising, which included our sponsorship program with the Boston Red Sox andthe costs associated with supporting our new stores. Additionally, the increasein sales expense, as a percentage of revenues, was negatively affected by ournew stores, which operate at a higher store payroll to sales ratio until theyreach maturity as well as higher depreciation expenses related to the acquisitionof fixed assets for new stores.

 

*Generaland administrative expense*

 

Our consolidatedgeneral and administrative (“G&A”) expense for fiscal 2005 was $6,762,583,or 9.3% of revenues, an increase of $427,516 and a decrease of 0.5 percentagepoints, as a percentage of revenues, from the prior fiscal year. G&Aexpense consists of payroll and related expenses for executive, merchandising,finance and administrative personnel, as well as information technology,professional fees and other general corporate expenses.

 

The increase inG&A expense is largely attributable to professional fees related to ourcompliance work for Section 404 of Sarbanes-Oxley Act and consultant costsassociated with the selection of a new merchandise system that we are currentlyplanning to install in the first quarter of 2007.

 

*Operatingincome*

 

Our operatingincome for fiscal 2005 was $264,172, or 0.4% of revenues, compared to anoperating income of $937,413, or 1.5% of revenues in fiscal 2004.

 

*Otherincome*

 

In fiscal 2004 wereached a settlement with a third party in connection with the special chargepertaining to our preferred stock previously recorded in fiscal 2002. Werecorded the net settlement of $382,500 as other income during fiscal 2004.

 

*Interestexpense*

 

Our interest expensein fiscal 2005 was $532,649, an increase of $307,575 from fiscal 2004. Theincrease during fiscal 2005 was due to an increase in interest rates, a higheraverage loan balance and additional interest expense resulting from capitalleases associated with our new point-of-sale system. Our average loan balancewas

 

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approximately$6,208,700 during fiscal 2005 compared to $3,435,578 in fiscal 2004, whichincreased interest expense by approximately $186,233. The effective interestrate on our borrowings under our line of credit increased to 6.8% during fiscal2005 compared to 5.1% in fiscal 2004, which increased interest expense byapproximately $60,680. The interest rate was based on the bank’s base rate plus50 basis points. Additionally, interest expense from capital leases in 2005increased by $51,983 over 2004.

 

*Income taxes*

 

In 2005, due to our netloss for the year, we did not provide for federal or state income taxes. Additionally, we did not utilize any net operating loss carryforwards forfederal income tax purposes in 2005.

 

In 2004 our provision forincome taxes was $105,000, which included $20,000 for federal alternativeminimum taxes and $85,000 for state income taxes. We were able to utilize approximately$900,000 of net operating loss carryforwards for federal income tax purposes in2004, which were fully reserved for in the prior year due to the uncertainty offuture taxable income.

 

At the end of 2005 we hadestimated net operating loss carryforwards of approximately $23.7 million,which begin to expire in 2018. In accordance with Section 382 of the InternalRevenue Code, the use of these carryforwards may be subject to annuallimitations based upon certain ownership changes of our stock that may haveoccurred or that may occur.

 

*NetLoss*

 

Our net loss in fiscal2005 was $267,676 or $0.01 per basic and diluted share, compared to net incomeof $991,193, or $0.03 per basic and $0.02 per diluted share, in fiscal 2004.

 

**Fiscal2004 Compared to Fiscal 2003**

** **

*Revenues*

 

Our consolidated revenuesfor 2004 were $64,276,225, an increase of $7,578,979, or 13.4% from the prioryear. Revenues include the selling price of party goods sold, net of returnsand discounts, and are recognized at the point of sale.

 

This increase was due toan increase of 4.6% in comparable stores sales, sales from six new stores thatopened in 2004 and sales from three new stores that opened in 2003 which werenot included in comparable stores sales in 2004 until they had been open forone full year. The increase in comparable stores sales was largely attributableto a stronger Halloween season compared to the prior year.

 

*Costof products sold*

 

In 2004 our consolidatedcost of products sold was 55.7% of revenues, a decrease of 0.3 percentagepoints from the prior year. Cost of products sold consisted of the cost ofmerchandise sold to customers and the occupancy costs for our stores. Thisdecrease was primarily attributable to the elimination of costs of productssold for our Internet business, which was licensed to a third party in 2003 inexchange for royalties under a license agreement.

 

*Marketingand sales expense*

 

Our consolidatedmarketing and sales expense for 2004 was $21,176,925 or 32.9% of revenues, anincrease of $2,813,732, or 0.5 percentage points, as a percentage of revenues,from the prior year. Marketing and sales expense consisted primarily of allstore payroll and related expenses for personnel engaged in marketing andselling activities, as well as advertising, public relations and promotionalexpenditures.

 

This increase, as apercentage of revenues, was due to store payroll and other expenses related tomarketing and sales in our new stores, which run at a higher than normal rateuntil they reach maturity. Our experience has been that it usually takes about18 to 24 months after opening for a store to reach maturity.

 

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*Generaland administrative expense*

 

Our consolidated G&Aexpense for 2004 was $6,335,067 or 9.9% of revenue, an increase of $818,794, or0.1 percentage points, as a percentage of revenues, from the prior year.G&A expense consisted of payroll and related expenses for executive,merchandising, finance and administrative personnel, as well as information technology,professional fees and other general corporate expenses.

 

The increase in G&Acosts was attributable to rate increases in payroll-related costs, such asunemployment insurance, health insurance and workers’ compensation insurance,and start-up costs associated with implementing our new point-of-sale system.

 

*Operatingincome*

 

Our operating income forfiscal 2004 was $937,413, or 1.5% of revenues, compared to an operating incomeof $1,059,155, or 1.9% of revenues in fiscal 2003.

 

*Otherincome*

 

In2004 we reached a settlement with a third party in connection with the specialcharge previously recorded in fiscal year 2002. We recorded the net settlementof $382,500 as other income during fiscal 2004.

 

*Interestexpense*

 

Our interest expense was$225,074 in 2004, an increase of $12,847 from the prior year. This increase wasdue to higher average borrowings that were largely offset by lower interestrates.

 

*Incometaxes*

 

In 2004 our provision forincome taxes was $105,000, which included $20,000 for federal alternativeminimum taxes and $85,000 for state income taxes. We were able to utilizeapproximately $923,000 of net operating loss carryforwards for federal incometax purposes in 2004, which were fully reserved for in the prior year due tothe uncertainty of future taxable income.

 

At the end of 2004 we hadestimated net operating loss carryforwards of approximately $23.0 million,which begin to expire in 2018. In accordance with Section 382 of the InternalRevenue Code, the use of these carryforwards may be subject to annuallimitations based upon certain ownership changes of our stock that may haveoccurred or that may occur.

 

*NetIncome*

 

Our net income for 2004was $991,193 or $0.03 per basic and $0.02 per diluted share, compared to netincome of $750,957, or $0.02 per basic and diluted share for 2003.

 

**CriticalAccounting Policies**

** **

Our financial statementsare based on the application of significant accounting policies, many of whichrequire our management to make significant estimates and assumptions (see Note2 to our consolidated financial statements). We believe the followingaccounting policies to be those most important to the portrayal of ourfinancial condition and those that require the most subjective judgment. Ifactual results differ significantly from management’s estimates andprojections, there could be a material effect on our financial statements.

 

*Inventoryand Related Allowance for Obsolete and Excess Inventory*

 

Our inventory consists ofparty supplies and is valued at the lower of moving weighted-average cost ormarket. We record vendor rebates, discounts and certain other adjustments toinventory, including freight costs, and we recognize these amounts in theincome statement as the related goods are sold.

 

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During each interimreporting period we estimate the impact on cost of products sold associatedwith inventory shortage. The actual inventory shortage is determined uponreconciliation of the annual physical inventory, which occurs shortly beforeand after our year end, and an adjustment to cost of products sold is recordedat the end of the fourth quarter to recognize the difference between theestimated and actual inventory shortage for the full year. The adjustment inthe fourth quarter of 2005 included an estimated reduction of $175,884 to thecost of products sold during the previous three quarters. The adjustment in thefourth quarter of 2004 included an estimated reduction of $149,316 to the costof products sold during the previous three quarters. The adjustment in thefourth quarter of 2003 included an estimated reduction of $145,983 to the costof products sold during the previous three quarters.

 

We also make adjustmentsto reduce the value of our inventory for an allowance for obsolete and excessinventory, which is based on our review of inventories on hand compared toestimated future sales. We conduct reviews periodically throughout the year oneach stock keeping unit (“SKU”). As we identify obsolete and excess inventory,we take immediate measures to reduce our inventory risk on these items and weadjust our allowance accordingly. Thus, actual results could differ from ourestimates.

 

In 2003, we refined ourmethodology for accounting for vendor rebates, discounts and freight and forestimating an appropriate allowance for obsolete and excess inventory. The netimpact of these adjustments increased pre-tax income by $141,757 and net incomeby $125,455 in 2003 but had no impact on basic and diluted earnings per share.

 

*RevenueRecognition*

 

Revenues include theselling price of party goods sold, net of returns and discounts, and arerecognized at the point of sale. We estimate returns based upon historicalreturn rates and such amounts have not been significant.

 

*Propertyand Equipment*

 

Property and equipmentare stated at cost less accumulated depreciation and are depreciated on thestraight-line method over the estimated useful lives of the assets. At thebeginning of fiscal 2004 we adopted a new policy for estimating the useful lifeof fixed assets which extended the useful life of equipment and furniture andfixtures. Changing the estimated life of the assets in these categories as ofthe beginning of 2004 reduced depreciation expense by approximately $130,885 infiscal 2004. Net income in 2004 would have been $0.02 per basic and dilutedshare (as opposed to $0.03 per basic and $0.02 per diluted share) if thischange in estimating the useful life of fixed assets had not been adopted.Expenditures for maintenance and repairs are charged to operations as incurred.

 

*Impairmentof Long-Lived Assets*

 

In accordance with SFASNo. 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets*, we perform a review of each store for impairmentindicators whenever events and changes in circumstances suggest that thecarrying amounts may not be recoverable from estimated future store cash flows.Our review considers store operating results, future sales growth and cashflows. The conclusion regarding impairment may differ from current estimates ifunderlying assumptions or business strategies change. We are not aware of anyimpairment indicators for any of our stores at December 31, 2005.

 

*IncomeTaxes*

 

Historically, we have notrecognized an income tax benefit for our losses. Accordingly we record avaluation allowance against our deferred tax assets because of the uncertaintyof future taxable income and the realizability of the deferred tax assets. Indetermining if a valuation allowance against our deferred tax asset is appropriate,we consider both positive and negative evidence. The positive evidence that weconsidered included (1) we were profitable in 2004 and 2003 due to the successof our Halloween seasons, (2) we have achieved positive comparable store salesgrowth for the last three years and (3) improved merchandise margins in 2004and 2003. The negative evidence that we considered included (1) after two yearsof profitability we realized a net loss in 2005, (2) our merchandise marginsdecreased in 2005, (3) our future profitability is vulnerable to certain risks,including (a) the risk that we may not be able to generate significant taxableincome to fully utilize our net operating loss

 

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carryforwards ofapproximately $23.7 million, (b) the risk of unseasonable weather and otherfactors in a single geographic region, New England, where our stores areconcentrated, (c) the risk of being so dependent upon a single season,Halloween, for a significant amount of annual sales and profitability and (d)the risk of rising prices for petroleum products, which are a key raw materialfor much of our merchandise and which affect our freight costs, (4) the coststhat opening new stores will put pressure on our profit margins until thesestores reach maturity, (5) the investment in infrastructure required in fiscal2006 to support our store expansion plan in fiscal 2007 will increase our costsand (6) the expected costs of increased regulatory compliance, including,without limitation, those associated with Section 404 of the  Sarbanes-Oxley Act, will likely have anegative impact on our profitability.

 

The negative evidence isstrong enough for us to conclude that the level of our future profitability isuncertain at this time. We believe that it is prudent for us to maintain avaluation allowance until we have a longer track record of profitability and wecan reduce our exposure to the risks described above. Should we determine thatwe will be able to realize our deferred tax assets in the future, an adjustmentto our deferred tax assets would increase income in the period we made such adetermination.

 

*PreviousRestatement of Financial Information and Balance Sheet Presentation of SeriesA-F Convertible Preferred Stock*

 

The holders of ourvarious series of convertible preferred stock have the right to a liquidationpreference, which previously could have been exercised under certain events notwithin our control. In accordance with EITF Topic D-98, we have included therespective equity securities outside of permanent stockholders’ deficit in ouraccompanying table of selected financial data as of December 28, 2002 andDecember 29, 2001 at their respective carrying values.

 

During the fourth quarterof 2003, the composition of our board of directors changed such that holders ofour convertible preferred stock or the designates of our preferred stockholdersno longer constituted a majority of our board members. This change in thecomposition of our board of directors has permitted us to present ourconvertible preferred stock in equity in the accompanying balance sheets as ofDecember 31, 2005 and December 25, 2004, at their respective carrying values asthe redemption is deemed to be solely within our control.

 

We will continue toreview and consider the criteria in EITF Topic D-98 at the reporting of eachbalance sheet.

 

*StockOption Compensation Expense*

 

We account for our stockoption compensation agreements with employees under the provisions ofAccounting Principles Board (“APB”) Opinion No. 25, *Accountingfor Stock Issued to Employees*. We have adopted the disclosure-onlyprovisions of SFAS No. 123, *Accounting for Stock-BasedCompensation*, as amended by SFAS No. 148, *Accountingfor Stock-Based Compensation – Transition and Disclosure, an amendment ofFinancial Accounting Standards Board (“FASB”) Statement No. 123*.

 

*Useof Estimates*

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States requires us to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenue and expenses during the reporting period. Ouractual results could differ from our estimates.

 

**New Accounting Pronouncements**

 

OnDecember 16, 2004, the Financial Accounting Standards Board (“FASB”) issuedFASB Statement No. 123 (revised 2004), *Share-BasedPayment*, which is a revision of FASB Statement No. 123, *Accounting for Stock-Based Compensation*.Statement 123(R) supersedes APB Opinion No. 25, *Accounting for Stock Issued to Employees*, and amends FASBStatement No. 95, *Statement of Cash Flows*.Generally, the approach in Statement 123(R) is similar to the approach describedin Statement 123. However, Statement 123(R) requires all share-based paymentsto employees, including grants of employee stock options, to be recognized inthe income statement based

 

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ontheir fair values. Pro forma disclosure is no longer an alternative. We wererequired to adopt Statement 123(R) on January 1, 2006. Early adoption waspermitted for periods in which financial statements had not yet been issued.

 

Inresponse to FAS No. 123R, on September 21, 2005, our board of directorsapproved an acceleration of the vesting of certain unvested and “out-of-the-money”stock options previously awarded to our employees and officers with exerciseprices equal to or greater than $0.69 per share. As a result, options topurchase approximately 1.0 million shares of our common stock becameexercisable immediately. Based upon our closing stock price of $0.45 onSeptember 21, 2005, none of these options had any intrinsic value on the dateof acceleration.

 

In making the decision toaccelerate these options, our board of directors considered the interest of ourstockholders as this acceleration will reduce our reported compensation expensein future periods following the effectiveness of FAS No. 123R. The future stockoption expense that was eliminated was approximately $508,000 on a pre-taxbasis and is reflected in the pro forma footnote disclosure for the year endedDecember 31, 2005.

 

Statement123(R) permits public companies to adopt its requirements using one of twomethods:

 

•      A “modified prospective” method in whichcompensation cost is recognized beginning with the effective date (a) based onthe requirements of Statement 123(R) for all share-based payments granted afterthe effective date and (b) based on the requirements of Statement 123 for allawards granted to employees prior to the effective date of Statement 123(R)that remain unvested on the effective date.

 

•      A “modified retrospective” method which includesthe requirements of the modified prospective method described above, but alsopermits entities to restate based on the amounts previously recognized underStatement 123 for purposes of pro forma disclosures either (a) all priorperiods presented or (b) prior interim periods of the year of adoption.

 

We adopted Statement 123(R) on January 1, 2006 andwill use the modified prospective method.

 

As permitted by Statement 123, as of December 31,2005 we accounted for share-based payments to employees using Opinion 25’sintrinsic value method and, as such, generally recognized no compensation costfor employee stock options. Accordingly, we believe that the adoption ofStatement 123(R)’s fair value method will have a significant impact on ourresults of operations, although it will have no impact on our overall financialposition. The precise impact of adoption of Statement 123(R) cannot bepredicted at this time because it will depend on levels of share-based paymentsgranted in the future. However, had we adopted Statement 123(R) in priorperiods, the impact of that standard would have approximated the impact ofStatement 123 as described in the disclosure of pro forma net loss and net lossper share discussed in Note 2 to our consolidated financial statements.

 

In February 2005, the Chief Accountant of the SECissued a letter clarifying his staff’s interpretation of certain accountingissues and their application under generally accepted accounting principles (“GAAP”)relating to operating leases. In summary, the staff’s interpretation is that(1) leasehold improvements should be amortized by the lessee over the shorterof their economic lives or the lease term, which could include lease renewalterms when the renewals are “reasonably assured,” (2) free or reduced rentsshould be recognized by the lessee on a straight-line basis over the lease term(including any free or reduced rent period) and (3) the statement of cash flowsshould reflect cash received from the lessor that is accounted for as a leaseincentive within operating activities and the acquisition of leaseholdimprovements for cash within investing activities. These positions are basedupon existing accounting literature. We believe that our present accountingpolicies are consistent with the positions described by the Chief Accountantand his staff in this letter. Our policy is to amortize leasehold improvementsfor 10 years or the life of the lease, whichever period is shorter. Our policyis to amortize free or reduced rent on a straight-line basis over the leaseterm (including any free or reduced rent periods). We generally do not enterinto agreements that involve receiving cash from lessors/landlords.

 

**Liquidityand Capital Resources**

** **

Our operating activitiesused $259,907 in fiscal 2005 compared to providing $129,690 in fiscal 2004, avariance of $389,597. The additional cash used in operating activities wasprimarily due to the net loss in fiscal 2005 compared net income in fiscal 2004. The variance due to the net loss in2005 was partially offset by the increases in depreciation expense, decreasesin cash used for inventory and increases in cash provided by accounts

 

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payable. The increase in cash provided by accountspayable was primarily due to the extended payment terms related to theinventory purchased for the five new stores opened in the third quarter of2005. These payables became due in the first quarter of 2006.

 

We used $1,663,647 ininvesting activities in fiscal 2005 compared to $2,121,134 in 2004. The cashinvested in 2005 was primarily for fixed assets associated with new stores, anexisting store expansion and point-of-sale system enhancements. The cashinvested in fiscal 2004 was predominantly for fixed assets associated with newstores and the new point-of-sale system.

 

We provided $865,591 byfinancing activities in 2005 compared to $1,306,130 in 2004, a decrease of$440,539. This decrease was largely due to an increase in our payments oncapital lease obligations by $256,188 over 2004. Additionally, we increased ourborrowings under our line of credit by $1,378,184 in 2005 (to $6.6 million)compared to an increase of $1,497,019 in 2004 (to $5.3 million). The borrowingsunder our line of credit in 2005 was higher than 2004 primarily due to capitalexpenditures related to new store openings, enhancements to our point-of-salesystem, and to support our net loss.

 

During 2005 we alsoacquired assets under capital leases totaling $132,968 for new copiers for oursupport office. The capital lease obligations outstanding at December 31, 2005were $869,353.

 

At December 31, 2005 wehad a line of credit (the “line”) with Wells Fargo Retail Finance II, LLC,which had been amended on January 2, 2004. The amendment extended the maturitydate of the line to January 2, 2007, eliminated the minimum interest rate of6.5%, established a new interest rate at the bank’s base rate plus 50 basispoints and added the option to increase the line in increments of $2,500,000beyond the previous limit of $7,500,000, to a limit of $12,500,000, upon 15days written notice, as long as we were in compliance with all debt covenantsand the other provisions of the loan agreement. Our inventory and accountsreceivable secure our line of credit. We borrow against these assets at agreedupon advance rates, which may vary at different times of the year.

 

On September 12, 2005, weincreased our line of credit to $12,500,000 to help finance our operations and2005 store openings.

 

Our inventory consists ofparty supplies which are valued at the lower of weighted-average cost or marketand are reduced by an allowance for obsolete and excess inventory and otheradjustments, including vendor rebates, discounts and freight costs. Our line ofcredit availability calculation allows us to borrow against “acceptable inventoryat cost,” which takes our inventory at cost and reflects adjustments that ourlender has approved which may be different than adjustments we use for valuingour inventory in our financial statements, such as the adjustment to reservefor inventory shortage. The amount of “acceptable inventory at cost” wasapproximately $15,201,074 at December 31, 2005.

 

Our accounts receivableconsists primarily of vendor rebates receivables and credit card receivables.Our line of credit availability calculation allows us to borrow against “eligiblecredit card receivables,” which are the credit card receivables for theprevious three days of business. The amount of “eligible credit cardreceivables” was approximately $404,252 at December 31, 2005.

 

The total borrowing baseis then determined by adding the “acceptable inventory at cost” times an agreedupon advance rate plus the “eligible credit card receivables” times an agreedupon advance rate but not to exceed our established credit limit. The totalborrowing base at December 31, 2005 was limited to our credit limit of$12,500,000. Under the terms of our line of credit, the credit limit amount of$12,500,000 was then further reduced by (1) a minimum availability block, (2)customer deposits, (3) gift certificates, (4) merchandise credits and (5)outstanding letters of credit. Therefore, our additional availability atDecember 31, 2005 was approximately $386,681.

 

The amounts outstandingunder our line were $6,635,874 as of December 31, 2005 and $5,257,690 as ofDecember 25, 2004. The outstanding balances under our line are classified ascurrent liabilities in the accompanying consolidated balance sheets since weare required to apply daily lock-box receipts to reduce the amount outstanding.

 

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On April 27, 2005,we amended our agreement to allow for a “special subline” that would increaseour borrowing base by $500,000. Upon activation of the “special subline”, theinterest rate on the line of credit would have been the bank’s base rate plus75 basis points through the “special subline” termination date. We did notactivate the “special subline” and the “special subline” terminated on November1, 2005.

 

Subsequent to theend of fiscal 2005, on January 17, 2006, we amended our agreement to allow fora $500,000 term loan which increases our borrowing base, but does not increasethe $12.5 million credit limit. We borrowed the full $500,000 on that date. Theinterest rate on the term loan is the bank’s base rate plus 125 basis points.During the time the term loan remains outstanding, the interest rate on theline of credit will be the bank’s base rate plus 75 basis points. The term loanis currently outstanding and is due and payable in full on October 31, 2006.The amendment also waived a default as a consequence of the fact that theprincipal balance of the line of credit exceeded availability on January 12,2006. As of March 30, 2006, we are in compliance with the covenants under theline of credit.

 

Our prospectivecash flows are subject to certain trends, events and uncertainties, includingdemands for capital to support growth, improve our infrastructure, respond toeconomic conditions, and meet contractual commitments. We expect our capitalexpenditures for 2006 to be primarily related to store improvements,enhancement of our point-of-sale system, and the replacement of ourmerchandising system which we plan to begin in 2006 with an installation in thefirst quarter of 2007. We believe, based on our current operating plan, thatanticipated revenues from operations and borrowings available under theexisting line of credit, which we anticipate extending, will be sufficient tofund our operations and working capital requirements through the next twelvemonths, but that we will need to raise additional cash through debt, equity, ora combination of both to continue to fund our growth goals in 2007and beyond****.****Inthe event that our operating plan changes or proves inaccurate due tolower-than-expected revenues, unanticipated expenses, increased competition,unfavorable economic conditions or other unforeseen circumstances, ourliquidity may be negatively impacted. If so, we would be required to adjust ourexpenditures in 2006 to conserve working capital or raise additional capital tofund operations. Our current operating plan includes opening no additional newstores in 2006.

 

In recognition ofthe need to raise additional cash to fund our growth in 2007 and beyond, wehave been exploring various financing alternatives. In February 2006, weexecuted a non-binding term sheet to enter discussions and negotiations with aninstitutional accredited investor regarding a proposed financing that wouldraise approximately $2.5 million through a combination of subordinated debt andwarrants. In the event that we are unable to reach a definitive agreement withthis third party on terms that are acceptable to us, we expect to continue toexplore other financing alternatives. There can be no assurance, that, shouldwe seek or require additional financing, such financing will be available, ifat all, on terms and conditions acceptable to us, in which case we wouldreconsider our current growth goals for 2007 and beyond.

 

Contractualobligations at December 31, 2005 were as follows:

 
| ** **                                        | ** ** | **Payments Due By Period** | ** ** |
|---------------------------------------------------|------------|----------------------------|------------|
| ** **                                        | ** ** | **Within  1Year**          | ** ** | **Within  2 - 3  Years** | ** ** | **Within  4 - 5  Years** | ** ** | **After 5  Years** | ** ** | **Total** | ** ** |
| Line of credit                                    |       | $                          | 6,635,874  |   | $ | — |   | $ | — |   | $ | — |   | $ | 6,635,874 |   |
| Capital lease  obligations                        |       | 442,358                    |       | 426,995 |   | — |   | — |   | 869,353 |   |
| Operating leases  (including retail space leases) |       | 8,176,327                  |       | 13,273,981 |   | 10,923,604 |   | 14,824,929 |   | 47,198,840 |   |
| Total  contractual obligations                    |       | $                          | 15,254,559 |   | $ | 13,700,976 |   | $ | 10,923,604 |   | $ | 14,824,929 |   | $ | 54,704,067 |   |

 

In addition, at December31, 2005, we had outstanding purchase orders totaling approximately $1,136,178for the acquisition of inventory that was scheduled for delivery after December31, 2005.

 

**Acquisitions**

 

We operate in a largelyun-branded business arena that has many small players. As a result, we mayconsider growing our business through acquisitions of other entities. Anydetermination to make an acquisition will be based upon a variety of factors,including, without limitation, the purchase price and other financial terms ofthe transaction, the business prospects, geographical location and the extentto which any acquisition would enhance our

 

22

----

 

prospects. We presentlyhave no plans, agreements, understandings, or arrangements with respect to anyacquisitions.

 

**StockholderRights Plan**

** **

On November 9, 2001, weannounced that our board of directors adopted a stockholder rights plan (the “rightsplan”). Under the rights plan each share of our capital stock outstanding atthe close of business on November 9, 2001 and each share of our capital stockissued subsequent to that date has a right associated with it, such that eachshare of our common stock is entitled to one right and each share of ourpreferred stock is entitled to such number of rights equal to the number of commonshares into which it is convertible. The rights will become exercisable only inthe event that, with certain exceptions, an acquiring party accumulates 10percent or more of our voting stock or if a party announces an offer to acquire15 percent or more of our voting stock. The rights expire on November 9, 2011.When exercisable, each right entitles the holder to purchase from us oneone-hundredth of a share of a new series of Series G junior preferred stock atan initial purchase price of $2.00, subject to adjustment. In addition, uponthe occurrence of certain events, holders of the rights will be entitled topurchase either iParty Corp. stock or shares in an “acquiring entity” at halfof market value. We generally will be entitled to redeem the rights at $0.001per right at any time until the date on which a 10 percent position in ourvoting stock is acquired by any person or group. Until a right is exercised,the holder of a right will have no rights as a stockholder of iParty solely byvirtue of being a rights holder, including, without limitation, the right tovote or receive dividends.

 

**Seasonality**

** **

**Due tothe seasonality of our business, sales and operating income are typicallyhigher in our second and fourth quarters. Our business is highly dependent uponsales of Easter, graduation and summer merchandise in the second quarter andsales of Halloween and Christmas merchandise in the fourth quarter. We havetypically operated at a loss during the first and third quarters.**

** **

**Geographic Concentration**

** **

**As ofDecember 31, 2005 we operated a total of 50 stores, 45 of which are located inNew England. As a result, a severe or prolonged regional recession or regionalchanges in demographics, employment levels, population, weather patterns, realestate market conditions or other factors specific to the New England regionmay adversely affect us more than a company that is more geographicallydiverse.**

** **

**Effectsof Inflation**

** **

While we do notview the effects of inflation as having a direct material effect upon ourbusiness, we believe that rising oil and gas prices impact prices ofpetroleum-based/plastic products, which are a key raw material in much of ourmerchandise, affect our freight costs, and affect consumer confidence andspending patterns. These and other issues directly or indirectly affecting ourvendors could adversely affect our business and financial performance.

 

**Off-Balance Sheet Arrangements**

 

We do not have anyoff-balance sheet arrangements that have or are reasonably likely to have acurrent or future effect on our financial condition, changes in financialcondition, revenues or expenses, results of operations, liquidity, capitalexpenditures or capital resources that is material to investors.

 

**ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK**

 

We are exposed to marketrisk from changes in interest rates and, indirectly, foreign exchange rates andcommodity price risk with respect to fluctuating oil prices as more fullydescribed in Item 1A, “Risk Factors.”  Ingeneral, however, we do not believe we have the various market or price risksthat require the quantitative and qualitative disclosures set forth in Item 305of Regulation S-K. We have interest rate risk on our line of credit debtobligation to the extent that if interest rates were to rise our rate ofinterest under our line of credit would also increase. We do not believe thatthis interest rate risk is material and we have not entered into any hedging or

 

23

----

 

similar contractual arrangements with respect to suchrisk or with respect to the indirect market risks we face from changes inforeign exchange rates and oil prices. We do not enter into contracts fortrading purposes.

 

**ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**

 

The response to this itemis included in a separate section of this report. See “Index to ConsolidatedFinancial Statements” on page F-1.

 

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

 

None.

 

**ITEM 9A. CONTROLS AND PROCEDURES**

 

(a)           *Evaluation ofDisclosure Controls and Procedures.*Our management, with the participation of our ChiefExecutive Officer, or CEO, and Chief Financial Officer, or CFO, evaluated theeffectiveness of our disclosure controls and procedures (as defined in Rules13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended)as of December 31, 2005. In designing and evaluating our disclosure controlsand procedures, our management recognized that any controls and procedures, nomatter how well designed and operated, can provide only reasonable assurance ofachieving their objectives, and our management necessarily applied its judgmentin evaluating the cost-benefit relationship of possible controls andprocedures. Based on this evaluation, our CEO and CFO concluded that, as ofDecember 31, 2005, our disclosure controls and procedures were (1) designed toensure that material information relating to us, including our consolidatedsubsidiaries, is made known to our CEO and CFO by others within those entities,particularly during the period in which this report was being prepared and (2)effective, in that they provide reasonable assurance that information requiredto be disclosed by us in the reports that we file or submit under theSecurities Exchange Act is recorded, processed, summarized, communicated tomanagement, including our CEO and CFO, and reported within the time periodsspecified in the SEC’s rules and forms.

 

(b)           *Attestation Report of theRegistered Public Accounting Firm*. We are not an accelerated filer, as such term isdefined in Rule 12b-2 under the Securities Exchange Act. Accordingly, theattestation report of our independent registered public accounting firm on ourmanagement’s assessment of our internal control over financial reporting is notrequired to be included in this Annual Report on Form 10-K.

 

(c)           *Changes in InternalControls.*Nochange in our internal control over financial reporting (as defined in Rules13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended)occurred during the fiscal quarter ended December 31, 2005 that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

 

**ITEM 9B. OTHER INFORMATION**

 

None.

 

**PART III**

** **

**ITEM 10. DIRECTORS AND EXECUTIVEOFFICERS OF THE REGISTRANT**

 

The information required by this Item is containedin our proxy statement for the annual meeting of stockholders scheduled to beheld on June 7, 2006, which we plan to file with the SEC no later than 120 daysafter the end of our fiscal year ended December 31, 2005. Such information ishereby incorporated by reference.

 

We have adopted awritten code of business conduct and ethics that applies to all our directors,officers and employees, a copy of which is located on the Investor Relationspage of our website which is located at www.iparty.com. We intend to discloseany amendments to, or waivers from, our code of business conduct and ethics onthat same page of our website*.*

 

24

----

 

**ITEM 11. EXECUTIVE COMPENSATION**

 

The information required by this Item is contained in our proxystatement for the annual meeting of stockholders scheduled to be held on June7, 2006, which we plan to file with the SEC no later than 120 days after the endof our fiscal year ended December 31, 2005. Such information is hereby incorporated by reference.

 

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

**RELATED STOCKHOLDER MATTERS**

 

Certain of the information required by this Item is contained in ourproxy statement for the annual meeting of stockholders scheduled to be held onJune 7, 2006, which we plan to file with the SEC no later than 120 days afterthe end of our fiscal year ended December 31, 2005.  Such information is hereby incorporated byreference.

 

Securities authorizedunder equity compensation plans as of December 31, 2005, were as follows:

 
| **Plan Category**                                           | ** ** | **Number of Securities  to be Issued  upon Exercise of****Outstanding  Options** | ** ** | **Weighted Average  Exercise Price of  Outstanding Options** | ** ** | **Number of Securities  Remaining Available  for Future Issuances  under Equity  Compensation Plans  (Excluding Securities  Reflected in Column a)** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by security holders     |       | 10,340,841                                                                       |       | $                                                            | 0.95       |                                                                                                                                                 | 267,615    |   |
| Equity compensation  plans not approved by security holders |       | —                                                                           |       | —                                                       |       | —                                                                                                                                               |       |
| Total                                                       |       | 10,340,841                                                                       |       | $                                                            | 0.95       |                                                                                                                                                 | 267,615    |   |

 

Under the iParty Corp.Amended and Restated 1998 Incentive and Nonqualified Stock Option Plan we areauthorized to grant options for the purchase of up to 11,000,000 shares of ourcommon stock.  As of December 31, 2005,391,544 shares had been issued pursuant to the exercise of previously issuedstock options.  As of December 31, 2005,there were options outstanding to purchase 10,340,841 shares of our commonstock.  Consequently, as of December 31,2005, options for the purchase of up to 267,615 common shares remain availablefor future grants.

 

**ITEM 13.  CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS**

 

The information required by this Item is contained in our proxystatement for the annual meeting of stockholders scheduled to be held on June7, 2006, which we plan to file with the SEC no later than 120 days after theend of our fiscal year ended December 31, 2005. Such information is hereby incorporated by reference.

 

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

 

The information required by this Item is contained in our proxystatement for the annual meeting of stockholders scheduled to be held on June7, 2006, which we plan to file with the SEC no later than 120 days after theend of our fiscal year ended December 31, 2005. Such information is hereby incorporated by reference.

 

**PART IV**

 

**ITEM 15. EXHIBITS AND FINANCIAL STATEMENTSCHEDULES**

 

(a)                      1. Financialstatements:

 

For a listing of consolidated financial statementswhich are included in this document, see page F-1.

 

2. Financial Statement Schedules:

 

All schedules for which provision is made under Item15(a)(2) are inapplicable and, therefore, have been omitted.

 

25

----

 

3. Exhibits:

 

The exhibits listed in the Exhibit Index immediatelypreceding the exhibits are filed as part of this Annual Report on Form 10-K andare incorporated herein by reference.

 

(b)                     Exhibits:

 

The exhibits listed in the Exhibit Index immediatelypreceding the exhibits are filed as part of this Annual Report on Form 10-K andare incorporated herein by reference.

 

(c)                      FinancialStatement Schedules:

 

Included in Item 15(a)(2) above.

 

26

----

 

**SIGNATURES**

 

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

 
|     | iPARTY CORP. |
|----------|--------------|
|     |         |   |
|     | By:          | /s/ SAL PERISANO |
|     |         |   |   |
|     |         | Sal Perisano |
| * * | * *     | *Chairman  of the Board and* |
| * * | * *     | *Chief  Executive Officer* |
|          |              |  |  |  |

 

Dated:  March 30, 2006

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.

 
| **SIGNATURE**              | ** **                            | **TITLE**                                  | ** ** | **DATE** |
|----------------------------|---------------------------------------|--------------------------------------------|------------|----------|
|                       |                                  |                                       |
| /s/ SAL PERISANO           | Chairman of the Board and             | March 30, 2006                             |
|                       |                                  | Chief Executive Officer                    |       |
| Sal Perisano               | (Principal Executive Officer)         |                                       |
|                       |                                  |                                       |       |
| /s/ PATRICK FARRELL        | President and Chief Financial Officer | March 30, 2006                             |
|                       |                                  | (Principal Financial Officer and Principal |       |
| Patrick Farrell            | Accounting Officer)                   |                                       |
|                       |                                  |                                       |       |
| /s/ DANIEL DE WOLF         | Director                              | March 30, 2006                             |
|                       |                                  |                                       |       |
| Daniel De Wolf             |                                  |                                       |
|                       |                                  |                                       |
| /s/ FRANK HAYDU            | Director                              | March 30, 2006                             |
|                       |                                  |                                       |       |
| Frank Haydu                |                                  |                                       |
|                       |                                  |                                       |
| /s/ ROBERT JEVON           | Director                              | March 30, 2006                             |
|                       |                                  |                                       |       |
| Robert Jevon               |                                  |                                       |
|                       |                                  |                                       |
| /s/ ERIC SCHINDLER         | Director                              | March 30, 2006                             |
|                       |                                  |                                       |       |
| Eric Schindler             |                                  |                                       |
|                       |                                  |                                       |
| /s/ JOSEPH VASSALLUZZO     | Director                              | March 30, 2006                             |
|                       |                                  |                                       |       |
| Joseph Vassalluzzo         |                                  |                                       |
|                       |                                  |                                       |
| /s/ CHRISTINA  WEAVER-VEST | Director                              | March 30, 2006                             |
|                       |                                  |                                       |       |
| Christina Weaver-Vest      |                                  |                                       |
|                            |                                       |                                            |            |          |  |

 

 

27

----

 

**i****PARTY CORP.**

 

**INDEX TO CONSOLIDATED FINANCIAL STATEMENTS**

 

 
| ** **                                                                                      | ** ** |
|-------------------------------------------------------------------------------------------------|------------|
|                                                                                            |       |
| Report  of Independent Registered Public Accounting Firm                                        |       |
|                                                                                            |       |
| Consolidated  Balance Sheets                                                                    |       |
|                                                                                            |       |
| Consolidated  Statements of Operations                                                          |       |
|                                                                                            |       |
| Consolidated  Statements of Convertible Preferred Stock and Stockholders’ Equity (Deficit) |       |
|                                                                                            |       |
| Consolidated  Statements of Cash Flows                                                          |       |
|                                                                                            |       |
| Notes  to Consolidated Financial Statements                                                     |       |

 

The accompanying notesare an integral part of these Consolidated Financial Statements.

 

F-1

----

 

**Reportof Independent Registered Public Accounting Firm**

 

Board of Directors and Stockholders

iParty Corp.

 

We have audited theaccompanying consolidated balance sheets of iParty Corp. and subsidiaries as ofDecember 31, 2005 and December 25, 2004, and the related consolidated statementsof operations, convertible preferred stock and stockholders’ equity (deficit),and cash flows for each of the three years in the period ended December 31,2005.  These financial statements are the responsibility of the Company’smanagement.  Our responsibility is to express an opinion on thesefinancial statements based on our audits.

 

We conducted our auditsin accordance with the standards of the Public Company Accounting OversightBoard (United States). Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether the financial statements arefree of material misstatement.  We were not engaged to perform an audit ofthe Company’s internal control over financial reporting.  Our auditincluded consideration of internal control over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management,and evaluating the overall financial statement presentation.  We believethat our audits provide a reasonable basis for our opinion.

 

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the consolidated financial position of iParty Corp. and subsidiariesat December 31, 2005 and December 25, 2004, and the consolidated results oftheir operations and their cash flows for each of the three years in the periodended December 31, 2005, in conformity with U.S. generally accepted accountingprinciples.

 
|   |   |   |   |   | /s/ Ernst &  Young LLP |   |
|--------|--------|--------|--------|--------|----------------------------|--------|

 

 

Boston, Massachusetts

February 17, 2006

 

The accompanyingnotes are an integral part of these Consolidated Financial Statements.

 

F-2

----

 

**iPARTY CORP.**

**CONSOLIDATEDBALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                                          | ** ** | **Dec 31, 2005** | ** ** | **Dec 25, 2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| **ASSETS**                                                                                                                                                                                                                                          |       |                       |       |                       |       |
| Current assets:                                                                                                                                                                                                                                     |       |                       |       |                       |       |
| Cash and cash  equivalents                                                                                                                                                                                                                          |       | $                          | 699,194    |                       | $          | 1,757,157 |   |
| Restricted cash                                                                                                                                                                                                                                     |       | 651,617                    |       | 561,407                    |       |
| Accounts  receivable                                                                                                                                                                                                                                |       | 1,246,545                  |       | 700,961                    |       |
| Inventory, net                                                                                                                                                                                                                                      |       | 13,251,307                 |       | 11,400,971                 |       |
| Prepaid expenses  and other assets                                                                                                                                                                                                                  |       | 548,114                    |       | 476,046                    |       |
| Total current  assets                                                                                                                                                                                                                               |       | 16,396,777                 |       | 14,896,542                 |       |
| Property and  equipment, net                                                                                                                                                                                                                        |       | 5,187,099                  |       | 4,483,705                  |       |
| Other assets                                                                                                                                                                                                                                        |       | 133,200                    |       | 99,690                     |       |
| Total assets                                                                                                                                                                                                                                        |       | $                          | 21,717,076 |                       | $          | 19,479,937 |   |
|                                                                                                                                                                                                                                                |       |                       |       |                       |       |
| **LIABILITIES AND STOCK AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                             |       |                       |       |                       |       |
| Current  liabilities:                                                                                                                                                                                                                               |       |                       |       |                       |       |
| Accounts payable                                                                                                                                                                                                                                    |       | $                          | 4,695,094  |                       | $          | 3,421,195 |   |
| Accrued expenses                                                                                                                                                                                                                                    |       | 2,532,238                  |       | 2,615,835                  |       |
| Current portion  of capital lease obligations                                                                                                                                                                                                       |       | 442,358                    |       | 365,674                    |       |
| Borrowings under  line of credit                                                                                                                                                                                                                    |       | 6,635,874                  |       | 5,257,690                  |       |
| Total current  liabilities                                                                                                                                                                                                                          |       | 14,305,564                 |       | 11,660,394                 |       |
|                                                                                                                                                                                                                                                |       |                       |       |                       |       |
| Long-term liabilities:                                                                                                                                                                                                                              |       |                       |       |                       |       |
| Capital lease  obligations, net of current portion                                                                                                                                                                                                  |       | 426,995                    |       | 796,693                    |       |
| Other liabilities                                                                                                                                                                                                                                   |       | 669,003                    |       | 471,759                    |       |
| Total long-term liabilities                                                                                                                                                                                                                         |       | 1,095,998                  |       | 1,268,452                  |       |
|                                                                                                                                                                                                                                                |       |                       |       |                       |       |
| Commitments and  contingencies                                                                                                                                                                                                                      |       |                       |       |                       |       |
|                                                                                                                                                                                                                                                |       |                       |       |                       |       |
| Stockholders’  equity:                                                                                                                                                                                                                         |       |                       |       |                       |       |
| Convertible  preferred stock - $.001 par value; 10,000,000 shares authorized,                                                                                                                                                                       |       |                       |       |                       |       |
| Series B  convertible preferred stock - 1,150,000 shares authorized; 474,402 and  507,460 shares issued and outstanding at December 31, 2005 and December 25,  2004, respectively (aggregate liquidation value of $9,488,039 at December 31,  2005) |       | 7,059,101                  |       | 7,551,002                  |       |
| Series C  convertible preferred stock - 100,000 shares authorized, issued and  outstanding (aggregate liquidation value of $2,000,000 at December 31, 2005)                                                                                         |       | 1,492,000                  |       | 1,492,000                  |       |
| Series D  convertible preferred stock - 250,000 shares authorized, issued and  outstanding (aggregate liquidation value of $5,000,000 at December 31, 2005)                                                                                         |       | 3,652,500                  |       | 3,652,500                  |       |
| Series E  convertible preferred stock - 533,333 shares authorized; 296,667 shares  issued and outstanding (aggregate liquidation value of $1,112,500 at December  31, 2005)                                                                         |       | 1,112,500                  |       | 1,112,500                  |       |
| Series F  convertible preferred stock - 114,286 shares authorized, issued and  outstanding (aggregate liquidation value of $500,000 at December 31, 2005)                                                                                           |       | 500,000                    |       | 500,000                    |       |
| Total  convertible preferred stock                                                                                                                                                                                                                  |       | 13,816,101                 |       | 14,308,002                 |       |
|                                                                                                                                                                                                                                                |       |                       |       |                       |       |
| Common stock -  $.001 par value; 150,000,000 shares authorized; 22,536,637 and 22,092,717 shares  issued and outstanding at December 31, 2005 and December 25, 2004,  respectively                                                                  |       | 22,537                     |       | 22,093                     |       |
|                                                                                                                                                                                                                                                |       |                       |       |                       |       |
| Additional  paid-in capital                                                                                                                                                                                                                         |       | 50,971,656                 |       | 50,448,100                 |       |
| Accumulated  deficit                                                                                                                                                                                                                                |       | (58,494,780                | )          | (58,227,104                | )          |
| Total  stockholders’ equity                                                                                                                                                                                                                    |       | 6,315,514                  |       | 6,551,091                  |       |
|                                                                                                                                                                                                                                                |       |                       |       |                       |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                                                                    |       | $                          | 21,717,076 |                       | $          | 19,479,937 |   |

 

The accompanyingnotes are an integral part of these Consolidated Financial Statements.

 

F-3

----

 

**iPARTY CORP.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                            | ** ** | **For the periods ended**  | ** ** |
|---------------------------------------|------------|-------------------------------------------|------------|
| ** **                            | ** ** | **Dec 31, 2005  53 weeks** | ** ** | **Dec 25, 2004  52 weeks** | ** ** | **Dec 27, 2003  52 weeks** | ** ** |
| Revenues                              |       | $                                         | 72,537,998 |   | $ | 64,276,225 |   | $ | 56,697,246 |   |
| Operating costs:                      |       |                                      |       |   |   |   |   |
| Cost of products  sold                |       | 41,395,193                                |       | 35,826,820 |   | 31,758,625 |   |
| Marketing and  sales                  |       | 24,116,050                                |       | 21,176,925 |   | 18,363,193 |   |
| General and  administrative           |       | 6,762,583                                 |       | 6,335,067 |   | 5,516,273 |   |
|                                  |       |                                      |       |   |   |   |   |
| Operating income                      |       | 264,172                                   |       | 937,413 |   | 1,059,155 |   |
|                                  |       |                                      |       |   |   |   |   |
| Other income                          |       | —                                    |       | 382,500 |   | — |   |
|                                  |       |                                      |       |   |   |   |   |
| Income before  income taxes           |       | 264,172                                   |       | 1,319,913 |   | 1,059,155 |   |
|                                  |       |                                      |       |   |   |   |   |
| Interest income                       |       | 801                                       |       | 1,354 |   | 1,262 |   |
| Interest expense                      |       | (532,649                                  | )          | (225,074 | ) | (212,227 | ) |
|                                  |       |                                      |       |   |   |   |   |
| Income (loss)  before income taxes    |       | (267,676                                  | )          | 1,096,193 |   | 848,190 |   |
|                                  |       |                                      |       |   |   |   |   |
| Income taxes                          |       | —                                    |       | 105,000 |   | 97,233 |   |
|                                  |       |                                      |       |   |   |   |   |
| Net income  (loss)                    |       | $                                         | (267,676   | ) | $ | 991,193 |   | $ | 750,957 |   |
|                                  |       |                                      |       |   |   |   |   |
| Income (loss)  per share:             |       |                                      |       |   |   |   |   |
| Basic                                 |       | $                                         | (0.01      | ) | $ | 0.03 |   | $ | 0.02 |   |
| Diluted                               |       | $                                         | (0.01      | ) | $ | 0.02 |   | $ | 0.02 |   |
|                                  |       |                                      |       |   |   |   |   |
| Weighted-average  shares outstanding: |       |                                      |       |   |   |   |   |
| Basic                                 |       | 22,186,581                                |       | 37,649,400 |   | 36,683,142 |   |
| Diluted                               |       | 22,186,581                                |       | 41,517,036 |   | 38,868,484 |   |

 

The accompanyingnotes are an integral part of these Consolidated Financial Statements.

 

F-4

----

 

**IPARTY CORP.**

**CONSOLIDATED STATEMENTS OF CONVERTIBLE PREFERRED STOCK ANDSTOCKHOLDERS’ EQUITY(DEFICIT)**

 
| ** **                                                                        | ** ** | ** **               | ** ** | ** **               | ** ** | **Stockholders’ Equity (Deficit)** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------|------------|--------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                        | ** ** | **Convertible**          | ** ** | **Convertible**          | ** ** | ** **                                        | ** ** | ** ** | ** ** | **Additional** | ** ** | ** ** | ** ** | **Total** | ** ** |
| ** **                                                                        | ** ** | **Preferred Stock** | ** ** | **Preferred Stock** | ** ** | **Common Stock**                             | ** ** | **Paid-In** | ** ** | **Accumulated** | ** ** | **Stockholders’** | ** ** |
| ** **                                                                        | ** ** | **Shares**               | ** ** | **Amount**               | ** ** | **Shares**                                        | ** ** | **Amount** | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Capital** | ** ** | **Deficit** | ** ** | **Equity (Deficit)** | ** ** |
| Balance December  28, 2002                                                        |       | 2,615,752                |       | $                        | 18,584,309 |                                              | —     |   | $ | — |   | 16,996,570 |   | $ | 16,997 |   | $ | 46,168,101 |   | $ | (59,969,254 | ) | $ | (13,784,156 | ) |
|                                                                              |       |                     |       |                     |       |                                              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Issuance of  common stock upon conversion of Series B convertible preferred stock |       | (73,719                  | )          | (1,096,939               | )          |                                              |       |   |   | 948,690 |   | 948 |   | 1,095,991 |   | — |   | 1,096,939 |   |
| Issuance of  common stock upon conversion of Series E convertible preferred stock |       | (77,228                  | )          | (289,604                 | )          |                                              |       |   |   | 823,944 |   | 824 |   | 288,780 |   | — |   | 289,604 |   |
| Reclassification  of Series A convertible preferred stock (Note 1)                |       | (1,000,000               | )          | (1,000,000               | )          | 1,000,000                                         |       | 1,000,000 |   |   |   |   |   |   |   |   |   | 1,000,000 |   |
| Reclassification  of Series B convertible preferred stock (Note 1)                |       | (611,080                 | )          | (9,092,870               | )          | 611,080                                           |       | 9,092,870 |   |   |   |   |   |   |   |   |   | 9,092,870 |   |
| Reclassification  of Series C convertible preferred stock (Note 1)                |       | (100,000                 | )          | (1,492,000               | )          | 100,000                                           |       | 1,492,000 |   |   |   |   |   |   |   |   |   | 1,492,000 |   |
| Reclassification  of Series D convertible preferred stock (Note 1)                |       | (250,000                 | )          | (3,652,500               | )          | 250,000                                           |       | 3,652,500 |   |   |   |   |   |   |   |   |   | 3,652,500 |   |
| Reclassification  of Series E convertible preferred stock (Note 1)                |       | (389,439                 | )          | (1,460,396               | )          | 389,439                                           |       | 1,460,396 |   |   |   |   |   |   |   |   |   | 1,460,396 |   |
| Reclassification  of Series F convertible preferred stock (Note 1)                |       | (114,286                 | )          | (500,000                 | )          | 114,286                                           |       | 500,000 |   |   |   |   |   |   |   |   |   | 500,000 |   |
| Exercise of stock  options                                                        |       | —                   |       | —                   |       | —                                            |       | — |   | 11,000 |   | 11 |   | 1,749 |   | — |   | 1,760 |   |
| Net income                                                                        |       | —                   |       | —                   |       | —                                            |       | — |   | — |   | — |   | — |   | 750,957 |   | 750,957 |   |
| Balance December  27, 2003                                                        |       | —                   |       | —                   |       | 2,464,805                                         |       | 17,197,766 |   | 18,780,204 |   | 18,780 |   | 47,554,621 |   | (59,218,297 | ) | 5,552,870 |   |
|                                                                              |       |                     |       |                     |       |                                              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Issuance of  common stock upon conversion of Series A convertible preferred stock |       | —                   |       | —                   |       | (1,000,000                                        | )          | (1,000,000 | ) | 1,000,000 |   | 1,000 |   | 999,000 |   |   |   | — |   |
| Issuance of  common stock upon conversion of Series B convertible preferred stock |       | —                   |       | —                   |       | (103,620                                          | )          | (1,541,869 | ) | 1,333,693 |   | 1,333 |   | 1,540,536 |   |   |   | — |   |
| Issuance of  common stock upon conversion of Series E convertible preferred stock |       | —                   |       | —                   |       | (92,772                                           | )          | (347,895 | ) | 961,025 |   | 961 |   | 346,934 |   |   |   | — |   |
| Exercise of stock  options                                                        |       | —                   |       | —                   |       | —                                            |       | — |   | 17,795 |   | 19 |   | 7,009 |   |   |   | 7,028 |   |
| Net income                                                                        |       | —                   |       | —                   |       | —                                            |       | — |   | — |   | — |   | — |   | 991,193 |   | 991,193 |   |
| Balance December  25, 2004                                                        |       | —                   |       | —                   |       | 1,268,413                                         |       | 14,308,002 |   | 22,092,717 |   | 22,093 |   | 50,448,100 |   | (58,227,104 | ) | 6,551,091 |   |
|                                                                              |       |                     |       |                     |       |                                              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Issuance of  common stock upon conversion of Series B convertible preferred stock |       | —                   |       | —                   |       | (33,058                                           | )          | (491,901 | ) | 425,546 |   | 426 |   | 491,475 |   |   |   | — |   |
| Non-cash stock  compensation                                                      |       | —                   |       | —                   |       | —                                            |       | — |   | — |   | — |   | 28,500 |   | — |   | 28,500 |   |
| Exercise of stock  options                                                        |       | —                   |       | —                   |       | —                                            |       | — |   | 18,374 |   | 18 |   | 3,581 |   | — |   | 3,599 |   |
| Net loss                                                                          |       | —                   |       | —                   |       | —                                            |       | — |   | — |   | — |   | — |   | (267,676 | ) | (267,676 | ) |
| Balance December  31, 2005                                                        |       | —                   |       | $                        | —     |                                              | 1,235,355  |   | $ | 13,816,101 |   | 22,536,637 |   | $ | 22,537 |   | $ | 50,971,656 |   | $ | (58,494,780 | ) | $ | 6,315,514 |   |

 

The accompanyingnotes are an integral part of these Consolidated Financial Statements.

 

F-5

----

 

**iPARTYCORP.**

**CONSOLIDATED STATEMENTS OF CASHFLOWS**

 
| ** **                                                                                           | ** ** | **For the periods ended**  | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                           | ** ** | **Dec 31, 2005  53 weeks** | ** ** | **Dec 25, 2004  52 weeks** | ** ** | **Dec 27, 2003  52 weeks** | ** ** |
| **Operating  activities:**                                                                           |       |                                      |       |   |   |   |   |
|                                                                                                 |       |                                      |       |   |   |   |   |
| Net income  (loss)                                                                                   |       | $                                         | (267,676   | ) | $ | 991,193 |   | $ | 750,957 |   |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                                      |       |   |   |   |   |
| Depreciation and  amortization                                                                       |       | 1,093,221                                 |       | 634,250 |   | 601,015 |   |
| Deferred rent                                                                                        |       | 197,244                                   |       | 65,550 |   | (22,723 | ) |
| Changes in  operating assets and liabilities:                                                        |       |                                      |       |   |   |   |   |
| Accounts  receivable                                                                                 |       | (545,584                                  | )          | (213,027 | ) | (41,946 | ) |
| Inventory                                                                                            |       | (1,850,336                                | )          | (1,977,508 | ) | (506,799 | ) |
| Prepaid expenses  and other assets                                                                   |       | 120,637                                   |       | 191,345 |   | 55,351 |   |
| Accounts payable                                                                                     |       | 1,273,899                                 |       | 325,347 |   | 343,537 |   |
| Accrued expenses  and other liabilities                                                              |       | (281,312                                  | )          | 112,540 |   | 189,406 |   |
| Net cash  provided by (used in) operating activities                                                 |       | (259,907                                  | )          | 129,690 |   | 1,368,798 |   |
|                                                                                                 |       |                                      |       |   |   |   |   |
| **Investing  activities:**                                                                           |       |                                      |       |   |   |   |   |
|                                                                                                 |       |                                      |       |   |   |   |   |
| Purchase of  property and equipment                                                                  |       | (1,663,647                                | )          | (2,121,134 | ) | (1,166,258 | ) |
| Net cash used in  investing activities                                                               |       | (1,663,647                                | )          | (2,121,134 | ) | (1,166,258 | ) |
|                                                                                                 |       |                                      |       |   |   |   |   |
| **Financing  activities:**                                                                           |       |                                      |       |   |   |   |   |
|                                                                                                 |       |                                      |       |   |   |   |   |
| Net borrowings  under line of credit                                                                 |       | 1,378,184                                 |       | 1,497,019 |   | 283,933 |   |
| Decrease  (increase) in restricted cash                                                              |       | (90,210                                   | )          | (28,123 | ) | (161,332 | ) |
| Principal  payments on capital lease obligations                                                     |       | (425,982                                  | )          | (169,794 | ) | (210,773 | ) |
| Proceeds from exercise  of stock options                                                             |       | 3,599                                     |       | 7,028 |   | 1,760 |   |
| Net cash  provided by (used in) financing activities                                                 |       | 865,591                                   |       | 1,306,130 |   | (86,412 | ) |
|                                                                                                 |       |                                      |       |   |   |   |   |
| **Net  increase (decrease) in cash and cash equivalents**                                            |       | (1,057,963                                | )          | (685,314 | ) | 116,128 |   |
|                                                                                                 |       |                                      |       |   |   |   |   |
| **Cash  and cash equivalents, beginning of year**                                                    |       | 1,757,157                                 |       | 2,442,471 |   | 2,326,343 |   |
|                                                                                                 |       |                                      |       |   |   |   |   |
| **Cash  and cash equivalents, end of year**                                                          |       | $                                         | 699,194    |   | $ | 1,757,157 |   | $ | 2,442,471 |   |
|                                                                                                 |       |                                      |       |   |   |   |   |
| Supplemental  disclosure of non-cash financing activities:                                           |       |                                      |       |   |   |   |   |
|                                                                                                 |       |                                      |       |   |   |   |   |
| Conversion of  Series A convertible preferred stock to common stock                                  |       | $                                         | —     |   | $ | 1,000,000 |   | $ | — |   |
| Conversion of  Series B convertible preferred stock to common stock                                  |       | 491,901                                   |       | 1,541,869 |   | 1,096,939 |   |
| Conversion of  Series E convertible preferred stock to common stock                                  |       | —                                    |       | 347,895 |   | 289,604 |   |
| Total conversion  of convertible preferred stock to common stock                                     |       | $                                         | 491,901    |   | $ | 2,889,764 |   | $ | 1,386,543 |   |
|                                                                                                 |       |                                      |       |   |   |   |   |
| Acquisition of  assets under capital lease                                                           |       | $                                         | 132,968    |   | $ | 1,302,681 |   | $ | — |   |

 

The accompanyingnotes are an integral part of these Consolidated Financial Statements.

 

F-6

----

 

**iPARTYCORP.**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**December31, 2005**

 

**1. THE COMPANY**

 

*Background*

 

The Company’s efforts aredevoted to the sale of party goods and services through its retail stores.  At the end of fiscal 2005 the Company had 45 retailstores located throughout New England, with five additional stores located inFlorida.  In 2003, the Company licensedits Internet business to a third party in exchange for royalties under alicense agreement, which to date have not been significant.  Previously, the Company operated the Internetbusiness with the same party under a fulfillment agreement.

 

The stores feature over 20,000products ranging from greeting cards and balloons to more unique merchandisesuch as piñatas, gag gifts, masquerade and Hawaiian Luau items.  The Company’s sales are driven by thefollowing events:  Halloween, Christmas,Easter, Valentine’s Day, New Year’s, Independence Day, St. Patrick’s Day,Thanksgiving, and Chanukah.  The Companyalso focuses its business closely on lifetime events such as anniversaries,graduations, birthdays, and bridal or baby showers.  The Company’s business has a seasonal patternwith higher revenues in the second and fourth quarters, reflecting schoolgraduations and Halloween, respectively.

 

The Company’s fiscal yearended December 31, 2005 consisted of 53 weeks while fiscal years ended December25, 2004 and December 27, 2003 consisted of 52 weeks.

 

*Management’s Plans*

 

The Company believes,based on its current operating plan, that anticipated revenues from operationsand borrowings available under the existing line of credit will be sufficientto fund its operations and working capital requirements through the next twelvemonths, but that it will need to raise additional cash through debt, equity, ora combination of both to continue to fund its growth goals in 2007and beyond****.****  In the event that the Company’s operatingplan changes or proves inaccurate due to decreased revenues, unanticipatedexpenses, increased competition, unfavorable economic conditions or otherunforeseen circumstances, the Company’s liquidity may be negativelyimpacted.  Accordingly, the Company wouldbe required to adjust its expenditures in 2006 to conserve working capital orraise additional capital to fund operations. The Company’s current operating plan includes opening no additional newstores in 2006.

 

In recognition of theneed to raise additional cash to fund its growth in 2007 and beyond, theCompany has been exploring financing alternatives.  In February 2006, the Company executed anon-binding term sheet to enter discussions and negotiations with aninstitutional accredited investor regarding a proposed financing that wouldraise approximately $2.5 million through a combination of subordinated debt andwarrants.  In the event that the Companyis unable to reach a definitive agreement with this third party on terms thatare acceptable to it, the Company expects to continue to explore otherfinancing alternatives.  There can be noassurance, that, should the Company seek or require additional financing, suchfinancing will be available, if at all, on terms and conditions acceptable toit, in which case the Company would reconsider its current growth goals for2007 and beyond.

 

**2.  SIGNIFICANTACCOUNTING POLICIES:**

 

*Principlesof Consolidation*

 

The consolidatedfinancial statements include the accounts of the Company and its wholly-ownedsubsidiaries after elimination of all significant intercompany transactions andbalances.

 

F-7

----

 

*Revenue Recognition*

 

Revenues include theselling price of party goods sold, net of returns and discounts, and arerecognized at the point of sale.  TheCompany estimates returns based upon historical return rates and such amountshave not been significant.

 

*Concentrations*

 

The Company purchases itsinventory from a diverse group of vendors and is not overly dependent upon anysingle source for its merchandise, often using more than one vendor for similarkinds of products.

 

Accounts receivableprimarily represent amounts due from credit card companies and vendors forinventory rebates.  Management does notprovide for doubtful accounts as such amounts have not been significant todate; the Company does not require collateral.

 

*Use ofEstimates*

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenue and expenses during thereporting period.  Actual results coulddiffer from these estimates.

 

*Cashand Cash Equivalents, Outstanding Checks and Restricted Cash*

 

The Company considers allhighly liquid investments with an original maturity date of three months orless to be cash equivalents.  Cashequivalents consist primarily of money market accounts and are carried at costplus accrued interest, which approximates fair value.

 

TheCompany uses controlled disbursement banking arrangements as part of its cashmanagement program.  Outstanding checks,which were included in accounts payable, totaled $627,269 at December 31, 2005and $950,156 at December 25, 2004.  TheCompany had sufficient funds available to fund the outstanding checks when theywere presented for payment.

 

Restrictedcash represents money deposited in blocked accounts established for the benefitof and under the control of Wells Fargo Retail Finance II, LLC, the Company’slender under its line of credit, and constitutes collateral for amountsoutstanding under the Company’s line of credit.

 

*Fair Value of Financial Instruments*

 

The carrying values of cash and cash equivalents,accounts receivable and accounts payable approximate fair value because of theshort-term nature of these instruments.  Thefair value of borrowings under its line of credit approximates carrying valuebecause the debt bears interest at a variable market rate.  The fair value of the capital leaseobligations approximates the carrying value.

 

*Inventories*

 

Inventories consist ofparty supplies and are valued at the lower of moving weighted-average cost ormarket.  Inventory has been reduced by anallowance for obsolete and excess inventory, which is based on management’sreview of inventories on hand compared to estimated future sales.  The Company records vendor rebates, discountsand certain other adjustments to inventory, including freight costs, and theseamounts are recognized in the income statement as the related goods are sold.

 

The Company also makesadjustments to reduce the value of its inventory for an allowance for obsoleteand excess inventory, which is based on its review of inventories on handcompared to estimated future sales.

 

F-8

----

 

In2003, the Company refined its methodology for accounting for vendor rebates,discounts and freight.  The net impact ofthese adjustments increased pre-tax income by $141,757, net income by $125,455and had no impact on net income per basic and diluted share.

 

*Advertising*

 

Advertising costs areexpensed upon first showing.  Advertisingcosts amounted to $3,439,403, $3,174,446, and $2,706,596 for the years ended December31, 2005, December 25, 2004 and December 27, 2003, respectively.

 

*Deferred Rent*

 

Certain operating leaseagreements contain scheduled rent increases, which are being amortized over theterms of the agreements using the straight-line method, and are included inother liabilities in the accompanying consolidated balance sheet.  Deferred rent was $669,003 at December 31,2005 and $471,759 at December 25, 2004.

 

*Net Income(Loss) per Share*

 

Net income (loss) perbasic share is computed by dividing net income by the weighted-average numberof common shares outstanding plus the common share equivalents of Series B-Fpreferred stock.  The common shareequivalents of Series B-F are included in the calculation of net income (loss) perbasic share in accordance with EITF Topic D-95, *Effect ofParticipating Convertible Securities on the Computation of Basic Earnings PerShare*, since the preferred stockholders are entitled to participatein dividends when and if declared by the Board of Directors.  For the periods with net losses, the Companyexcludes those common share equivalents since their impact would beanti-dilutive.

 

Net income (loss) perdiluted share is computed by dividing net income (loss) by the weighted averagenumber of common shares outstanding, plus the common share equivalents ofSeries A-F preferred stock, plus the common share equivalents of the “in the money”stock options and warrants as computed by the treasury method.  For the periods with net losses, the Companyexcludes those common share equivalents since their impact would beanti-dilutive.

 

The following table setsforth the computation of net income (loss) per basic and diluted share availableto common stockholders:

 
| ** **                                                          | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|---------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Net income  (loss)                                                  |       | $          | (267,676   | )          | $          | 991,193    |       | $ | 750,957 |   |
|                                                                |       |       |       |       |       |       |       |
| Net income  (loss) per share                                        |       |       |       |       |       |       |       |
| Basic                                                               |       | $          | (0.01      | )          | $          | 0.03       |       | $ | 0.02 |   |
| Diluted                                                             |       | $          | (0.01      | )          | $          | 0.02       |       | $ | 0.02 |   |
|                                                                |       |       |       |       |       |       |       |
| Weighted-average  shares outstanding:                               |       |       |       |       |       |       |       |
| Common shares                                                       |       | 22,186,581 |       | 21,364,673 |       | 17,652,805 |       |
| Common share  equivalents of Series B-F convertible preferred stock |       | —     |       | 16,284,727 |       | 19,030,337 |       |
| Basic weighted-average  shares outstanding                          |       | 22,186,581 |       | 37,649,400 |       | 36,683,142 |       |
|                                                                |       |       |       |       |       |       |       |
| Common share  equivalents of Series A convertible preferred stock   |       | —     |       | 48,077     |       | 1,000,000  |       |
| Common share  equivalents of “in the money” stock options |       | —     |       | 3,819,559  |       | 1,185,342  |       |
| Common share  equivalents of “in the money” warrants      |       | —     |       | —     |       | —     |       |
| Diluted weighted-average  shares outstanding                        |       | 22,186,581 |       | 41,517,036 |       | 38,868,484 |       |

 

The common shareequivalents of “out of the money” stock options and warrants which wereexcluded from the computation of net income (loss) per diluted share availableto common stockholders were 10,340,841 and 528,210 in 2005, respectively and 3,309,630and 13,011,215 in 2004, respectively.

 

F-9

----

 

*StockOption Compensation Expense*

 

The Companyaccounts for its stock option compensation agreements with employees under theprovisions of Accounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees*.  The Company has adopted the disclosure-onlyprovisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, *Accounting for Stock-Based Compensation*, as amended by SFASNo. 148, *Accounting for Stock-Based Compensation –Transition and Disclosure, an amendment of Financial Accounting Standards Board(“FASB”) Statement No. 123*.

 

The Company has computedthe value of options using the Black-Scholes option pricing model prescribed bySFAS No. 123.  The weighted-average fairvalue of the options granted was $0.43 per share in 2005, $0.73 per share in2004 and $0.38 per share during 2003, using the Black-Scholes option-pricingmodel with the following assumptions:  nodividend yield, volatility of 109% to 116% in 2005, 116% to 119% in 2004 and 119%to 125% in 2003, a risk-free interest rate of 3.69% to 4.16% in 2005, 2.71% to 4.00%in 2004 and 2.13% to 3.51% in 2003, and an expected life of five years fromdate of the grant.  Had compensation costfor the Company’s stock option plan been determined based upon the fair valueat the grant date for awards under the plan consistent with the methodologyprescribed under SFAS 123, the Company’s net income (loss) and net income (loss)per share would have been the following pro forma amounts:

 
| ** **                            | ** ** | **2005**   | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------|------------|------------|------------|----------|------------|----------|------------|
| Net income  (loss):                   |       |       |       |     |       |     |       |
| Reported                              |       | $          | (267,676   | )        | $          | 991,193  |       | $ | 750,957 |   |
| Stock option  compensation expense    |       | (1,033,342 | )          | (668,223 | )          | (480,268 | )          |
| Pro forma                             |       | $          | (1,301,018 | )        | $          | 322,970  |       | $ | 270,689 |   |
|                                  |       |       |       |     |       |     |       |
| Net income  (loss) per basic share:   |       |       |       |     |       |     |       |
| Reported                              |       | $          | (0.01      | )        | $          | 0.03     |       | $ | 0.02 |   |
| Pro forma                             |       | $          | (0.06      | )        | $          | 0.01     |       | $ | 0.01 |   |
|                                  |       |       |       |     |       |     |       |
| Net income  (loss) per diluted share: |       |       |       |     |       |     |       |
| Reported                              |       | $          | (0.01      | )        | $          | 0.02     |       | $ | 0.02 |   |
| Pro forma                             |       | $          | (0.06      | )        | $          | 0.01     |       | $ | 0.01 |   |

 

*Propertyand Equipment*

 

Property andequipment are stated at cost less accumulated depreciation and are depreciatedon the straight-line method over the estimated useful lives of the assets.  At the beginning of fiscal 2004 the Companyadopted a new policy for estimating the useful life of fixed assets whichextended the useful life of equipment and furniture and fixtures.  Changing the estimated life of the assets inthese categories as of the beginning of the year reduced depreciation expenseby approximately $130,885.  Net income in2004 would have been $0.02 per basic and diluted share if this change inestimating the useful life of fixed assets had not been adopted.  Expenditures for maintenance and repairs arecharged to operations as incurred.  Alisting of the estimated useful life of the various categories of property andequipment is as follows:

 

| **Asset Classification**   | ** ** | **Estimated Useful Life** |
|---------------------------------|------------|-------------------------------------|
| Leasehold  improvements         |       | Lesser of term of lease or 10 years |
| Furniture and  fixtures         |       | 7 years                             |
| Equipment                       |       | 5 years                             |
| Computer  hardware and software |       | 3 years                             |

 

*Accountingfor the Impairment of Long-Lived Assets*

 

The Companyadopted SFAS No. 144, *Accounting for theImpairment or Disposal of Long-Lived Assets*,**in fiscal 2002,which requires that long-lived assets be measured at the lower of carryingamount or fair value less cost

 

F-10

----

 

to sell.  The adoption of SFASNo. 144 did not have a material impact on the Company’s consolidated results ofoperations.  As of December 31, 2005, theCompany does not believe that any of its assets are impaired.

 

*New AccountingPronouncements*

 

On December 16, 2004, the Financial AccountingStandards Board (“FASB”) issued FASB Statement No. 123 (revised 2004), *Share-Based Payment*, which is a revisionof FASB Statement No. 123, *Accounting forStock-Based Compensation*.  Statement123(R) supersedes APB Opinion No. 25, *Accountingfor Stock Issued to Employees*, and amends FASB Statement No. 95, *Statement of Cash Flows*.  Generally, the approach in Statement 123(R)is similar to the approach described in Statement 123.  However, Statement 123(R) requires allshare-based payments to employees, including grants of employee stock options,to be recognized in the income statement based on their fair values.  Pro forma disclosure is no longer analternative.  The Company was required toadopt Statement 123(R) on January 1, 2006. Early adoption was permitted in periods in which financial statementshad not yet been issued.

 

In response to FASNo. 123R, on September 21, 2005, the Company’s Board of Directors approved anacceleration of the vesting of certain unvested and “out-of-the-money” stockoptions previously awarded to employees and officers with exercise prices equalto or greater than $0.69 per share.  As aresult, options to purchase approximately 1.0 million shares of the Company’scommon stock became exercisable immediately. Based upon the Company’s closing stock price of $0.46 on September 21,2005, none of these options had economic value on the date of acceleration.

 

In making thedecision to accelerate these options, the Company’s Board of Directorsconsidered the interest of the stockholders as this acceleration will reducethe company’s reported compensation expense in future periods following theeffectiveness of FAS No. 123R. The future stock option expense that was eliminatedwas approximately $508,000 on a pre-tax basis and is reflected in the pro formafootnote disclosure for the year ended December 31, 2005.

 

Statement 123(R) permits public companies to adoptits requirements using one of two methods:

 

•                  A “modified prospective” method in whichcompensation cost is recognized beginning with the effective date (a) based onthe requirements of Statement 123(R) for all share-based payments granted afterthe effective date and (b) based on the requirements of Statement 123 for allawards granted to employees prior to the effective date of Statement 123(R)that remain unvested on the effective date.

 

•                  A “modified retrospective” method which includesthe requirements of the modified prospective method described above, but alsopermits entities to restate based on the amounts previously recognized underStatement 123 for purposes of pro forma disclosures either (a) all priorperiods presented or (b) prior interim periods of the year of adoption.

 

The Company adopted Statement 123(R) on January 1,2006 and will use the modified prospective method.

 

As permitted by Statement 123, as of December 31,2005 the Company accounts for share-based payments to employees using Opinion25’s intrinsic value method and, as such, generally recognizes no compensationcost for employee stock options. Accordingly, the adoption of Statement 123(R)’s fair value method willhave a significant impact on the Company’s results of operations, although itwill have no impact on its overall financial position.  The impact of adoption of Statement 123(R)cannot be predicted at this time because it will depend on levels ofshare-based payments granted in the future. However, had the Company adopted Statement 123(R) in prior periods, theimpact of that standard would have approximated the impact of Statement 123 asdescribed in the disclosure of pro forma net loss and net loss per sharediscussed above.

 

In February 2005, the Chief Accountant of the SECissued a letter clarifying his staff’s interpretation of certain accountingissues and their application under generally accepted accounting principles (“GAAP”)relating to operating leases.  Insummary, their interpretation is that (1) leasehold improvements should beamortized by the lessee over the shorter of their economic lives or the leaseterm, which could include lease renewal terms when the renewals are “reasonablyassured,” (2) free or reduced rents should be recognized by the lessee on astraight-line

 

F-11

----

 

basis over the lease term (including any free orreduced rent period) and (3) the statement of cash flows should reflect cashreceived from the lessor that is accounted for as a lease incentive withinoperating activities and the acquisition of leasehold improvements for cashwithin investing activities.  Thesepositions are based upon existing accounting literature.  The Company believes that its presentaccounting policies are consistent with the positions described by the ChiefAccountant and his staff in this letter. The Company’s policy is to amortize leasehold improvements for 10 yearsor the life of the lease, whichever period is shorter.  The Company’s policy is to amortize free orreduced rent on a straight-line basis over the lease term (including any freeor reduced rent periods).  The Companygenerally does not enter into agreements that involve receiving cash fromlessors/landlords.

 

*Reclassifications*

 

Certainreclassifications have been made to prior year’s amounts to conform to the currentyear presentation.

 

**3.  PROPERTY AND EQUIPMENT:**

 

Property and equipmentconsist of the following:

 

| ** **                      | ** ** | **Dec 31, 2005** | ** ** | **Dec 25, 2004** | ** ** |
|---------------------------------|------------|----------------------------|------------|----------------------------|------------|
| Leasehold  improvements         |       | $                          | 2,416,015  |                       | $          | 2,017,339 |   |
| Furniture and  fixtures         |       | 2,467,501                  |       | 1,798,389                  |       |
| Equipment under  capital leases |       | 1,454,129                  |       | 1,321,160                  |       |
| Computer  hardware and software |       | 1,224,564                  |       | 728,946                    |       |
| Equipment                       |       | 546,920                    |       | 446,680                    |       |
|                            |       |                       |       |                       |       |
| Property and  equipment         |       | 8,109,129                  |       | 6,312,514                  |       |
| Less accumulated  depreciation  |       | (2,922,030                 | )          | (1,828,809                 | )          |
|                            |       |                       |       |                       |       |
| Property and  equipment, net    |       | $                          | 5,187,099  |                       | $          | 4,483,705 |   |

 

**4.  LEASES:**

 

The Company conducts itsoperations in leased facilities with certain leased equipment accounted for asoperating and capital leases.  Real estateleases generally provide for fixed minimum rentals, which typically increaseperiodically during the life of the lease, and, in some instances, contingentrentals based on a percentage of sales in excess of specified minimum saleslevels, as well as occupancy costs, such as property taxes and common areamaintenance.  The leases are typicallyfor 10 years, usually with options from the Company’s landlords to renew theCompany’s leases for an additional 5 or 10 years.

 

The original cost ofassets under capital leases at December 31, 2005 and December 25, 2004 was $1,454,129and $1,321,161, respectively. The accumulated depreciation of assets undercapital leases at December 31, 2005 and December 25, 2004 was $411,630 and $132,631,respectively.  The amortization relatedto those assets under capital lease is included in depreciation expense.

 

AtDecember 31, 2005 the minimum rental commitments under all non-cancelablecapital and operating leases with initial or remaining terms of more than oneyear were as follows:

 

F-12

----

 

| **Year**                                                 | ** ** | **Capital** | ** **    | **Operating** | ** ** |
|----------------------------------------------------------|------------|-------------|---------------|---------------|------------|
| 2006                                                     |       | $           | 539,532       |          | $          | 8,176,327 |   |
| 2007                                                     |       | 361,470     |          | 7,255,315     |       |
| 2008                                                     |       | 37,636      |          | 6,018,665     |       |
| 2009                                                     |       | 7,295       |          | 5,892,121     |       |
| 2010                                                     |       | —      |          | 5,031,483     |       |
| Thereafter                                               |       | —      |          | 14,824,929    |       |
| Total future minimum lease payments                      |       | 945,934     |          | $             | 47,198,840 |   |
|                                                     |       |        |          |          |       |
| Less amount representing interest                        |       | 76,581      |          |          |       |
|                                                     |       |        |          |          |       |
| Present value of minimum lease payments                  |       | 869,353     |          |          |       |
| Less current portion of obligation under capital  leases |       | 442,358     |          |          |       |
|                                                     |       |        |          |          |       |
| Long-term obligation under capital leases                |       | $           |  426,995 |          |       |   |
|                                                          |            |             |               |               |            |  |  |  |  |

 

The Company’s rental expense under operating leasesamounted to $7,710,542 in 2005, $6,492,212 in 2004 and $5,295,696 in 2003.  Included in these amounts are contingentrentals totaling $25,482 in 2005, $39,949 in 2004 and $32,958 in 2003.

 

**5.  INCOME TAXES:**

 

A reconciliation of theeffective rate with the federal statutory rate is as follows:

 
| ** **                                 | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Federal statutory rate                     |       | -34.0    | %          | 34.0     | %          | 34.0     | %          |
| State income taxes, net of federal benefit |       | 0.0      | %          | 5.1      | %          | 5.2      | %          |
| Permanent differences                      |       | 4.8      | %          | 1.7      | %          | 1.1      | %          |
| Change in valuation allowance              |       | 0.0      | %          | -31.2    | %          | -28.8    | %          |
| State losses not benefited                 |       | 29.2     | %          | -31.2    | %          | -28.8    | %          |
| Effective tax rate                         |       | 0.0      | %          | 9.6      | %          | 11.5     | %          |

 

Deferredtax assets consist of the following:

 
| ** **                                         | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|----------------------------------------------------|------------|------------|------------|------------|------------|
| Net operating loss carryforwards                   |       | $          | 8,162,000  |       | $          | 8,732,000 |   |
| Inventory reserves                                 |       | 436,000    |       | `          |       |
| Deferred rent                                      |       | 266,000    |       | 186,000    |       |
| Accrued vacation                                   |       | 101,000    |       | 103,000    |       |
| Other                                              |       | 4,000      |       | 91,000     |       |
| Excess book over tax depreciation and amortization |       | (23,000    | )          | 60,000     |       |
|                                               |       | 8,946,000  |       | 9,675,000  |       |
| Less valuation allowance                           |       | (8,946,000 | )          | (9,675,000 | )          |
| Net deferred tax asset                             |       | $          | —     |       | $          | — |   |

 

The Company has recorded a valuation allowance againstits deferred tax assets because of the uncertainty regarding the realizabilityof these assets against future taxable income.

 

The Company used approximately $0 and $900,000 of netoperating loss carryforwards in 2005 and 2004, respectively.

 

F-13

----

 

As of December 31, 2005, the Company has estimated netoperating loss carryforwards of approximately $23.7 million, which begin toexpire in 2018.  In accordance withSection 382 of the Internal Revenue Code, the use of some of thesecarryforwards will be subject to annual limitations based upon ownershipchanges of the Company’s stock which may have occurred or that may occur.

 

The Company made cash payments for state income taxesof $73,005 in 2005, $157,952 in 2004 and $77,279 in 2003.  The Company made cash payments for federalincome taxes of $0 in 2005, $35,000 in 2004 and $0 in 2003.

 

**6.  CONTRACTUALARRANGEMENTS:**

 

*LicenseArrangement*

 

On July 8, 1999, the Company entered into a productfulfillment agreement with Taymark, a direct marketer of party supplies, toutilize the direct marketer’s inventory and fulfillment services to delivermerchandise ordered on the Company’s website, or directly through a toll-freetelephone number, to consumers.

 

On July 8, 2003 the Company signed a new agreementwith Taymark to license the iParty.com name to Taymark, which now operates thewebsite at www.iparty.com.  In return,Taymark pays the Company a 15% royalty on all net sales realized through itsoperation of www.iparty.com.  The term ofthis agreement is for a period of two (2) years, unless sooner terminated.  If this agreement is not terminated, it shallbe automatically renewed for successive one-year periods.  On July 8, 2005, the Company entered into aone-year renewal period.

 

*Earn-outagreement*

 

The Company purchased from The Big Party, Debtor andDebtor-in-Possession (the “sellers”) in 2000 inventory, fixed assets and theleases of 33 retail stores in consideration of cash and assumption of certainliabilities.  In addition, the Companyagreed to pay the sellers, no later than March 31, 2004, an amount equivalentto the greater of $250,000, or a percentage of the aggregate operating resultsof the 33 acquired locations.  Inconnection with the Company’s purchase accounting in 2000, the Company accruedthe guaranteed amount of $250,000, which based on actual results is the minimumand final amount due as of December 27, 2003, and paid this amount during thefirst quarter of 2004.

** **

**7.  RELATED PARTY TRANSACTIONS:**

 

On September 7, 1999, the Company and Mr. StuartMoldaw, who served as a Director of the Company from 1999 to 2003, entered intoa consulting agreement that had a term of three years.  Upon the expiration of this agreement, theCompany and Mr. Moldaw entered into an oral agreement that Mr. Moldawwould continue to provide consulting services to the Company.  On November 6, 2003 the CompensationCommittee of the Company’s Board of Directors approved a stock option grant toMr. Moldaw, vesting immediately, with the strike price set at the closing priceof the Company’s common stock on that day, to purchase 50,000 shares of commonstock, for consulting services performed by Mr. Moldaw in 2003.  The fair value of the options granted to Mr. Moldawon November 6, 2003 was $25,000.  OnJanuary 31, 2005 the Compensation Committee of the Company’s Board of Directorsapproved a stock option grant to Mr. Moldaw, vesting immediately, with thestrike price set at the closing price of the Company’s common stock on thatday, to purchase 50,000 shares of common stock, for consulting servicesperformed by Mr. Moldaw in 2004.  Thefair value of the options granted on January 31, 2005 was $28,500.  The committee approved this grant, but notedthat Mr. Moldaw would not receive any additional stock option grants forconsulting services in the future.

 

On June 8, 2005, the Company’s Board of Directorsapproved the payment of $10,000 to Frank Haydu for serving as the Chairman ofthe Company’s Audit Committee for a one-year period until the next AnnualShareholder meeting.  As of December 31,2005, approximately $5,000 had been earned and paid.  Also on June 8, 2005, the Company’s Board ofDirectors approved the payment of up to $60,000 to Joseph Vassalluzzo, aDirector of the Company, for services as a part-time consultant for a one-yearperiod.  As of December 31, 2005, feesfor approximately $30,000 had been earned, but not paid.

 

F-14

----

 

**8.  LINE OF CREDIT:**

 

On January 2, 2004 the Company amended its existingline of credit (“the line”) with Wells Fargo Retail Finance II, LLC.  The amendment extended the maturity date ofthe line to January 2, 2007, eliminated the minimum interest rate of 6.5%,established a new interest rate at the bank’s base rate plus 50 basis pointsand added the option to increase the line in increments of $2,500,000 beyondthe previous limit of $7,500,000, to a limit of $12,500,000, upon 15 dayswritten notice, as long as the Company is in compliance of all debt covenantsand the provisions of the loan agreement. Inventory and accounts receivable secure the Company’s line.

 

The amended agreement includes a financial covenantrequiring the Company to maintain a minimum availability under the line of 5%of the credit limit.  At the currentcredit limit of $12,500,000, the minimum availability is $625,000.  The amended agreement also has a covenantthat requires the Company to limit its capital expenditures to within 110% ofthose amounts included in its business plan, which may be updated from time totime. At December 31, 2005, the Company was in compliance with these financialcovenants.  The line generally prohibitsthe payment of any dividends or other distributions to any of the Company’sclasses of capital stock.

 

On April 27, 2005, the Company amended its agreementto allow for a “special subline” that would increase its borrowing base by$500,000.  Upon activation of the“special subline”, the interest rate on the line of credit would have been thebank’s base rate plus 75 basis points through the “special subline” terminationdate.  The Company did not activate the“special subline” and it terminated on November 1, 2005.

 

On September 12, 2005, the Company increased its lineof credit to $12,500,000 to help finance its present operations and currentyear new store expansion plans.

 

The amounts outstanding under the line as of December31, 2005 and December 25, 2004 were $6,635,874 and $5,257,690,respectively.  The interest rate on theseborrowings was 7.75% at December 31, 2005 and 5.75% at December 25, 2004.  The outstanding balances under the line areclassified as current liabilities in the accompanying consolidated balancesheets since the Company is required to apply daily lock box receipts to reducethe amount outstanding.  At December 31,2005, the Company had approximately $386,681 of additional availability underthe line.  In the third quarter of fiscal2004, the Company established a letter of credit for $356,000 with Wells FargoBank, N.A. associated with the leasing of its new point-of-sale system.  This $356,000 letter of credit was outstandingat December 31, 2005.

 

The Company made cash payments for interest of$501,826 in 2005, $208,631 in 2004 and $215,847 in 2003.

 

On January 17, 2006, the Company amended its agreementto allow for a $500,000 term loan which increases its borrowing base, but doesnot increase the $12.5 million credit limit. The Company borrowed the full $500,000 on that date.  The interest rate on the term loan is thebank’s base rate plus 125 basis points. During the time in which the term loan remains outstanding, the interestrate on the line of credit is the bank’s base rate plus 75 basis points.  The term loan is currently outstanding and isdue and payable in full on October 31, 2006. The amendment also waived a default as a consequence of the fact thatthe principal balance of the line of credit exceeded availability on January12, 2006.  As of March 30, 2006, theCompany was in compliance with the covenants under the line of credit.

 

**9.  PREFERRED STOCK:**

 

The following tablesummarizes the changes in the number of shares of convertible preferred stockduring the past two years.

 

F-15

----

 
| ** **                           | ** ** | **Shares  Issued  and  Outstanding  as of 12/31/05** | ** ** | **Conversions  to  Common  Stock** | ** ** | **Shares  Issued  and  Outstanding  as of 12/25/04** | ** ** | **Conversions  to  Common  Stock** | ** ** | **Shares   Issued  and  Outstanding  as of 12/27/03** | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|------------------------------------|------------|------------------------------------------------------|------------|------------------------------------|------------|-------------------------------------------------------|------------|
| Series A convertible preferred stock |       | —                                               |       | —                             |       | —                                               |       | (1,000,000                         | )          | 1,000,000                                             |       |
| Series B convertible preferred stock |       | 474,402                                              |       | (33,058                            | )          | 507,460                                              |       | (103,620                           | )          | 611,080                                               |       |
| Series C convertible preferred stock |       | 100,000                                              |       | —                             |       | 100,000                                              |       | —                             |       | 100,000                                               |       |
| Series D convertible preferred stock |       | 250,000                                              |       | —                             |       | 250,000                                              |       | —                             |       | 250,000                                               |       |
| Series E convertible preferred stock |       | 296,667                                              |       | —                             |       | 296,667                                              |       | (92,772                            | )          | 389,439                                               |       |
| Series F convertible preferred stock |       | 114,286                                              |       | —                             |       | 114,286                                              |       | —                             |       | 114,286                                               |       |
| Total                                |       | 1,235,355                                            |       | (33,058                            | )          | 1,268,413                                            |       | (1,196,392                         | )          | 2,464,805                                             |       |

 

*SeriesA Convertible Preferred Stock*

 

On January 13, 2004, all shares of Series Aconvertible preferred stock were converted into 1,000,000 shares of commonstock on a 1.00 to 1.00 ratio.  Holdersof Series A convertible preferred stock had a liquidation preference senior tothe Company’s common stockholders, and were *pari passu* withthe Company’s Series B, C, D, E and F convertible preferred stock.  Until their shares of Series A convertiblepreferred stock were converted into shares of common stock, holders of Series Aconvertible preferred stock were not entitled to any dividends or to vote onmatters submitted to a vote of the Company’s stockholders, except to the extentotherwise expressly provided by the General Corporation Law of Delaware.

 

*SeriesB Convertible Preferred Stock*

 

The shares of Series B convertible preferred stock areimmediately convertible into 6,105,559 shares of common stock on a 1.000 to12.870 ratio at December 31, 2005, and carry an aggregate liquidation value of$9,488,039 ($1.55 per common share issuable upon conversion) at December 31,2005.  With certain exceptions, theconversion price will be adjusted on a weighted-average basis in the event theCompany issues common stock or certain rights, including option activity inexcess of certain amounts, to purchase or convert into common stock as definedin the Company’s Certificate of Incorporation as amended at a price below theconversion price.  The Series Bconvertible preferred stock will automatically convert into common stock at theconversion price then in effect in the event the Company consummates asecondary public offering resulting in gross proceeds to the Company of atleast $10,000,000.

 

In the event of liquidation, the holders of Series Bconvertible preferred stock have preference to holders of the Company’s commonstock, and are *pari passu* with the Company’sSeries C, D, E and F convertible preferred stock.

 

Holders of Series B convertible preferred stock areentitled to 12 votes per share (i.e., one vote for each whole number of sharesof common stock into which each such share is presently convertible) on allmatters submitted to a vote of the Company’s stockholders and are entitled to participatein dividends when and if declared by the Board of Directors.

 

*SeriesC Convertible Preferred Stock*

 

The shares of Series C convertible preferred stock areimmediately convertible into 1,310,600 shares of common stock on a 1.000 to13.106 ratio at December 31, 2005, and carry an aggregate liquidation value of$2,000,000 ($1.53 per common share issuable upon conversion) at December 31,2005.  With certain exceptions, theconversion price will be adjusted on a weighted-average basis in the event the Companyissues common stock or certain rights, including option activity in excess ofcertain amounts, to purchase or convert into common stock as defined in theCompany’s Preferred Stock Charter at a price below the conversion price.  The Series C convertible preferred stock willautomatically convert into common stock at the conversion price then in effectin the event the 

 

F-16

----

 

Company consummates a secondary public offering resulting in grossproceeds to the Company of at least $10,000,000.

 

In the event of liquidation, the holders of Series Cconvertible preferred stock have preference to holders of the Company’s commonstock, and are *pari passu* with the Company’sSeries B, D, E and F convertible preferred stock.

 

Holders of Series C convertible preferred stock areentitled to 13 votes per share (i.e., one vote for each whole number of sharesof common stock into which each such share is presently convertible) on allmatters submitted to a vote of the Company’s stockholders and are entitled toparticipate in dividends when and if declared by the Board of Directors.

 

*SeriesD Convertible Preferred Stock*

 

The shares of Series D convertible preferred stock areimmediately convertible into 3,513,750 shares of common stock on a 1.000 to14.055 ratio at December 31, 2005, and carry an aggregate liquidation value of$5,000,000 ($1.42 per common share issuable upon conversion) at December 31,2005.  With certain exceptions, theconversion price will be adjusted on a weighted-average basis in the event theCompany issues common stock or certain rights, including option activity inexcess of certain amounts, to purchase or convert into common stock as definedin the Company’s Preferred Stock Charter at a price below the conversionprice.  The Series D convertiblepreferred stock will automatically convert into common stock at the conversionprice then in effect in the event the Company consummates a secondary publicoffering resulting in gross proceeds to the Company of at least $10,000,000.

 

In the event of liquidation, the holders of Series Dconvertible preferred stock have preference to holders of the Company’s commonstock, and are *pari passu* with the Company’sSeries B, C, E and F convertible preferred stock.

 

Holders of Series D convertible preferred stock areentitled to 14 votes per share (i.e., one vote for each whole number of sharesof common stock into which each such share is presently convertible) on allmatters submitted to a vote of the Company’s stockholders and are entitled toparticipate in dividends when and if declared by the Board of Directors.

 

*SeriesE Convertible Preferred Stock*

 

The shares of Series E convertible preferred stock areimmediately convertible into 3,073,168 shares of common stock on a 1.000 to10.359 ratio at December 31, 2005, and carry an aggregate liquidation value of$1,112,500 ($0.36 per common share issuable upon conversion) at December 31,2005.  With certain exceptions, theconversion price will be adjusted on a weighted-average basis in the event theCompany issues common stock or certain rights, including option activity inexcess of certain amounts, to purchase or convert into common stock as definedin the Company’s Preferred Stock Charter at a price below the conversionprice.  The Series E convertiblepreferred stock will automatically convert into common stock at the conversionprice then in effect in the event the average closing bid price of the commonstock equals or exceeds $10.00 per share for 20 days within any 30-day period.

 

In the event of liquidation, the holders of Series Econvertible preferred stock have preference to holders of the Company’s commonstock, and are *pari passu* with the Company’sSeries B, C, D and F convertible preferred stock.

 

Holders of Series E convertible preferred stock areentitled to 10 votes per share (i.e., one vote for each whole number of sharesof common stock into which each such share is presently convertible) on allmatters submitted to a vote of the Company’s stockholders and are entitled toparticipate in dividends when and if declared by the Board of Directors.

 

F-17

----

 

*SeriesF Convertible Preferred Stock*

 

The shares of Series Fconvertible preferred stock are immediately convertible into 1,184,803 sharesof common stock on a 1.000 to 10.367 ratio at December 31, 2005, and carry anaggregate liquidation value of $500,000 ($0.42 per common share issuable uponconversion) at December 31, 2005.  Withcertain exceptions, the conversion price will be adjusted on a weighted-averagebasis in the event the Company issues common stock or certain rights, includingoption activity in excess of certain amounts, to purchase or convert intocommon stock as defined in the Company’s Preferred Stock Charter at a pricebelow the conversion price.  The Series Fconvertible preferred stock will automatically convert into common stock at theconversion price then in effect in the event the average closing bid price ofthe common stock equals or exceeds $10.00 per share for 20 days within any 30-dayperiod.

 

In the event of liquidation, the holders of Series Fconvertible preferred stock have preference to holders of the Company’s commonstock, and are pari passu with the Company’s Series B, C, D and E convertiblepreferred stock.

 

Holders of Series F preferred stock are entitled to 10votes per share (i.e., one vote for each whole number of shares of common stockinto which each such share is presently convertible) on all matters submittedto a vote of the Company’s stockholders and are entitled to participate individends when and if declared by the Board of Directors.

 

*Accretion of Dividends in the Event of Liquidation*

 

The carrying values of Series B-F convertiblepreferred stock have been determined based on their fair market values at theoriginal dates of issuance.  In certaincases, warrants were issued, which the Company allocated value to and includedin additional paid in capital.  Shouldsuch a liquidation event occur, the difference between the carrying value ofthe convertible preferred stock and their liquidation value will beaccreted.  This amount was $4,284,438 onDecember 31, 2005.

 

**10.  WARRANTS:**

 

At December 31, 2005, there were 528,210 warrantsoutstanding for shares of the Company’s common stock.  These warrants were issued in connection withcertain preferred stock financings.

 

On August 26, 2005, a total of 5,723,512 warrantsissued in connection with the issuance of Series B and Series C convertiblepreferred stock which were exercisable for 9,157,619 shares of common stockexpired without being exercised.  OnSeptember 10, 2005, a total of 929,929 warrants issued in connection with theissuance of Series B and Series C convertible preferred stock which wereexercisable for 1,487,886 shares of common stock expired without beingexercised.   On December 20, 2005, atotal of 1,250,000 warrants issued in connection with the issuance of Series Dconvertible preferred stock which were exercisable for 1,837,500 shares ofcommon stock expired without being exercised.

 

The following table summarizes the Company’soutstanding warrants at December 31, 2005:

 

F-18

----

 

| **Number  of  Warrants** | ** ** | **Total  Common  Shares  Issuable** | ** ** | **Exercise  Price per  Common  Share  Issuable** | ** ** | **Expiration  Date** | ** ** |
|--------------------------|------------|-------------------------------------|------------|-------------------------------------------------------|------------|----------------------|------------|
| 146,341                  |       | 146,341                             |       | $                                                     | 5.13       |                 | 04/16/09   |   |
| 121,212                  |       | 121,212                             |       | 4.13                                                  |       | 05/13/09             |       |
| 44,444                   |       | 44,444                              |       | 2.81                                                  |       | 06/15/09             |       |
| 47,619                   |       | 47,619                              |       | 2.63                                                  |       | 06/22/09             |       |
| 40,816                   |       | 40,816                              |       | 3.06                                                  |       | 07/15/09             |       |
| 44,444                   |       | 44,444                              |       | 2.81                                                  |       | 07/22/09             |       |
| 83,334                   |       | 83,334                              |       | 3.00                                                  |       | 08/15/09             |       |
| 528,210                  |       | 528,210                             |       | $                                                     | 3.79       |                 |       |   |
|                          |            |                                     |            |                                                       |            |                      |            |  |  |

 

**11.  STOCK OPTION PLAN:**

 

Under the Company’sAmended and Restated 1998 Incentive and Nonqualified Stock Option Plan (the“1998 Plan”) options to acquire 11,000,000 shares of common stock may be grantedto officers, directors, key employees and consultants.  The exercise price for qualified incentiveoptions cannot be less than the fair market value of the stock on the grantdate and the exercise price of nonqualified options can be fixed by the Board.  Qualified incentive options to purchase theCompany’s common stock under the 1998 Plan have been granted to employees,directors and consultants of the Company at fair market value at the date ofgrant.  Generally, the options becomeexercisable over periods of up to four years, and expire ten years from thedate of grant.

 

In response to FAS No.123R, on September 21, 2005, the Board of Directors approved an acceleration ofthe vesting of certain unvested and “out-of-the-money” stock options previouslyawarded to employees and officers with exercise prices equal to or greater than$0.69 per share.  As a result, options topurchase approximately 1.0 million shares of the Company’s common stock becameexercisable immediately.  Based upon theclosing stock price of $0.45 on September 21, 2005, none of these options hadany intrinsic value on the date of acceleration.

 

In making the decision toaccelerate these options, the Board of Directors considered the interest of thestockholders as the acceleration will reduce the reported compensation expensein future periods following the effectiveness of FAS No. 123R.

 

A summary of theCompany’s stock options is as follows:

 

F-19

----

 

| ** **                              | ** ** | **Number  of  Stock  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Price  Range** | ** ** |
|-----------------------------------------|------------|--------------------------------|------------|----------------------------------------|------------|------------------|------------|
| Outstanding - December 28, 2002         |       | 8,243,184                      |       | $                                      | 1.01       |             | $          | 0.11 | - | $ | 5.38 |   |
| Granted                                 |       | 455,555                        |       | 0.45                                   |       | 0.15             | -          | 1.06 |   |
| Expired/Forfeited                       |       | (170,021                       | )          | 0.29                                   |       | 0.15             | -          | 0.44 |   |
| Exercised                               |       | (11,000                        | )          | 0.16                                   |       | 0.16             | -          | 0.16 |   |
|                                    |       |                           |       |                                   |       |             |       |   |   |
| Outstanding - December 27, 2003         |       | 8,517,718                      |       | 0.99                                   |       | 0.11             | -          | 5.38 |   |
| Granted                                 |       | 1,801,300                      |       | 0.89                                   |       | 0.69             | -          | 1.33 |   |
| Expired/Forfeited                       |       | (286,096                       | )          | 1.50                                   |       | 0.11             | -          | 4.00 |   |
| Exercised                               |       | (17,795                        | )          | 0.39                                   |       | 0.20             | -          | 0.50 |   |
|                                    |       |                           |       |                                   |       |             |       |   |   |
| Outstanding - December 25, 2004         |       | 10,015,127                     |       | 0.96                                   |       | 0.13             | -          | 5.38 |   |
| Granted                                 |       | 495,578                        |       | 0.54                                   |       | 0.45             | -          | 0.70 |   |
| Expired/Forfeited                       |       | (151,490                       | )          | 0.45                                   |       | 0.18             | -          | 1.33 |   |
| Exercised                               |       | (18,374                        | )          | 0.20                                   |       | 0.18             | -          | 0.20 |   |
|                                    |       |                           |       |                                   |       |             |       |   |   |
| Outstanding - December 31, 2005         |       | 10,340,841                     |       | 0.95                                   |       | 0.13             | -          | 5.38 |   |
|                                    |       |                           |       |                                   |       |             |       |   |   |
| Exercisable - December 31, 2005         |       | 10,162,854                     |       | $                                      | 0.96       |             | $          | 0.13 | - | $ | 5.38 |   |
|                                    |       |                           |       |                                   |       |             |       |   |   |
| Available for grant - December 31, 2005 |       | 267,615                        |       |                                   |       |             |       |   |   |

 

The following tablesummarizes information for options outstanding and exercisable at December 31,2005:

 
| **Price Range**                | ** ** | **Outstanding**                                 | ** ** | **Exercisable**                        | ** ** |
|--------------------------------|------------|-------------------------------------------------|------------|----------------------------------------|------------|
| **Number  of  Stock  Options** | ** ** | **Weighted  Average  Remaining  Life  (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  of  Stock  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $                              | 0.11       | -                                               | $          | 0.20                                   |       |   | 170,366 |   | 5.4 |   | $ | 0.18 |   | 161,566 |   | $ | 0.18 |   |
| 0.21                           | -          | 0.30                                            |       |                                   | 3,817,532  |   | 5.2 |   | 0.25 |   | 3,798,162 |   | 0.25 |   |
| 0.31                           | -          | 0.50                                            |       |                                   | 1,120,295  |   | 6.2 |   | 0.36 |   | 1,028,539 |   | 0.37 |   |
| 0.51                           | -          | 1.00                                            |       |                                   | 3,262,518  |   | 7.2 |   | 0.77 |   | 3,204,457 |   | 0.77 |   |
| 1.01                           | -          | 3.50                                            |       |                                   | 980,130    |   | 3.6 |   | 2.18 |   | 980,130 |   | 2.18 |   |
| 3.51                           | -          | 5.38                                            |       |                                   | 990,000    |   | 3.4 |   | 3.82 |   | 990,000 |   | 3.82 |   |
| Total                          |       | 10,340,841                                      |       | 5.6                                    |       | $ | 0.95 |   | 10,162,854 |   | $ | 0.96 |   |

 

The Company has reserved 26,056,931 shares of commonstock for issuance in connection with the conversion of convertible preferredstock (15,157,880 shares), the exercise of warrants (528,210 shares) and theexercise of stock options (10,340,841 shares).

 

**12. STOCKHOLDER RIGHTS PLAN:**

 

The Company has a Stockholder Rights Plan (the “Plan”)effective November 9, 2001.  Under thePlan each share of the Company’s capital stock outstanding at the close ofbusiness on November 9, 2001 and each share of the Company’s capital stockissued subsequent to that date has a right associated with it, such that eachshare of its 

 

F-20

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common stock is entitled to one right and each share of its preferredstock is entitled to such number of rights equal to the number of common sharesinto which it is convertible.

 

The rights areexercisable only in the event, with certain exceptions, an acquiring partyaccumulates 10 percent or more of the Company’s voting stock, or if a partyannounces an offer to acquire 15 percent or more of the Company’s voting stock.  The rights expire on November 9, 2011.

 

When exercisable, eachright entitles the holder to purchase from the Company, one one-hundredth of ashare of a new series of Series G junior preferred stock at an initial purchaseprice of $2.00.  In addition, upon theoccurrence of certain events, holders of the rights will be entitled topurchase either iParty Corp. stock or shares in an “acquiring entity” at halfof market value.  The Company generallywill be entitled to redeem the rights at $0.001 per right at any time until thedate on which a 10 percent position in its voting stock is acquired by anyperson or group.  Until a right isexercised, the holder thereof, as such, will have no rights as a stockholder ofthe Company, including, without limitation, the right to vote or receivedividends.

 

**13.  PROFIT SHARING 401(k) PLAN:**

 

The iParty 401(k) Plan isa qualified profit sharing plan covering substantially all of itsemployees.  Contributions to this planare at the discretion of the Board of Directors.  The Company’s expense, including matchingcontributions and any discretionary amounts was $113,127 in 2005, $111,799 in2004 and $95,405 in 2003.

 

**14.  SEGMENT REPORTING:**

 

SFAS No. 131, *Disclosures about Segmentsof an Enterprise and Related Information*, establishes standards forthe way business enterprises report information about operating segments inannual financial statements and requires that those enterprises report selectedinformation about operating segments in interim financial reports issued tostockholders.  The Company reports oneoperating segment as revenues from the other segment are not material.

 

F-21

----

 

**15.  QUARTERLY FINANCIAL DATA (UNAUDITED):**

 

**QUARTERLY FINANCIAL DATA**

 
| ** **                            | ** ** | **Mar 26, 2005** | ** ** | **Jun 25, 2005** | ** ** | **Sep 24, 2005** | ** ** | **Dec 31, 2005(4)** | ** ** |
|---------------------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|-------------------------------|------------|
| Revenues                              |       | $                          | 13,159,763 |                       | $          | 16,517,522                 |       | $                             | 14,839,051 |   | $ | 28,021,662 |   |
| Cost of products  sold (1),(2)        |       | 8,113,575                  |       | 9,479,347                  |       | 8,983,536                  |       | 14,818,735                    |       |
| Operating income  (loss)              |       | (1,590,609                 | )          | 227,553                    |       | (2,201,072                 | )          | 3,828,300                     |       |
| Net income  (loss)                    |       | (1,692,785                 | )          | 98,149                     |       | (2,352,032                 | )          | 3,678,992                     |       |
|                                  |       |                       |       |                       |       |                       |       |                          |       |
| Net income  (loss) per share          |       |                       |       |                       |       |                       |       |                          |       |
| Basic                                 |       | $                          | (0.08      | )                          | $          | 0.00                       |       | $                             | (0.11      | ) | $ | 0.10 |   |
| Diluted                               |       | $                          | (0.08      | )                          | $          | 0.00                       |       | $                             | (0.11      | ) | $ | 0.09 |   |
|                                  |       |                       |       |                       |       |                       |       |                          |       |
| Weighted-average  shares outstanding: |       |                       |       |                       |       |                       |       |                          |       |
| Basic                                 |       | 22,107,567                 |       | 37,706,143                 |       | 22,147,063                 |       | 37,724,517                    |       |
| Diluted                               |       | 22,107,567                 |       | 39,937,184                 |       | 22,147,063                 |       | 39,337,114                    |       |

 
| ** **                            | ** ** | **Mar 27, 2004** | ** ** | **Jun 26, 2004** | ** ** | **Sep 25, 2004** | ** ** | **Dec 25, 2004** | ** ** |
|---------------------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|
| Revenues                              |       | $                          | 12,036,066 |                       | $          | 15,360,388                 |       | $                          | 13,157,546 |   | $ | 23,722,225 |   |
| Cost of products  sold (1),(3)        |       | 6,973,329                  |       | 8,482,813                  |       | 7,849,135                  |       | 12,521,543                 |       |
| Operating income  (loss)              |       | (810,759                   | )          | 494,417                    |       | (1,477,668                 | )          | 2,731,423                  |       |
| Net income  (loss)                    |       | (838,005                   | )          | 805,852                    |       | (1,526,977                 | )          | 2,550,323                  |       |
|                                  |       |                       |       |                       |       |                       |       |                       |       |
| Net income  (loss) per share          |       |                       |       |                       |       |                       |       |                       |       |
| Basic                                 |       | $                          | (0.04      | )                          | $          | 0.02                       |       | $                          | (0.07      | ) | $ | 0.07 |   |
| Diluted                               |       | $                          | (0.04      | )                          | $          | 0.02                       |       | $                          | (0.07      | ) | $ | 0.06 |   |
|                                  |       |                       |       |                       |       |                       |       |                       |       |
| Weighted-average  shares outstanding: |       |                       |       |                       |       |                       |       |                       |       |
| Basic                                 |       | 20,227,671                 |       | 37,698,128                 |       | 22,019,408                 |       | 37,701,585                 |       |
| Diluted                               |       | 20,227,671                 |       | 41,914,275                 |       | 22,019,408                 |       | 41,119,932                 |       |

 

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(1) Cost of products sold consists of the cost of merchandise sold tocustomers and the occupancy costs for stores.

 

(2) The fourth quarter of 2005 included an estimated reduction of $175,884to the cost of products sold during the previous three

quartersdue to the completion of physical inventories, for which shortage had beenestimated during the year.

 

(3) The fourth quarter of 2004 included an estimated reduction of $149,316to the cost of products sold during the previous three

quartersdue to the completion of physical inventories, for which shortage had beenestimated during the year.

 

(4) The fourth quarter of 2005 consisted of 14 weeks compared to 13 weeksfor the fourth quarter of 2004.

 

F-22

----

 

**EXHIBIT INDEX**

 
| **EXHIBIT  NUMBER** | ** ** | **DESCRIPTION** |
|---------------------|------------|-----------------|
| 3.1                 |       | (1)             |   | Restated Certificate of Incorporation of WSI  Acquisition Corp. and Certificate of Merger by iParty Corp. into WSI  Acquisition Corp. |
| 3.2                 |       | (1)             |   | Certificate of Designation of Series A Preferred  Stock of WSI Acquisitions, Corp. |
| 3.3                 |       | (2)             |   | Certificate of Designation of Series B Preferred  Stock of iParty Corp. |
| 3.4                 |       | (2)             |   | Certificate of Designation of Series C Preferred  Stock of iParty Corp. |
| 3.5                 |       | (4)             |   | Certificate of Designation of Series D Preferred  Stock of iParty Corp. |
| 3.6                 |       | (5)             |   | Certificate of Designation of Series E Preferred  Stock of iParty Corp. |
| 3.7                 |       | (10)            |   | Certificate of Correction to Certificate of  Designation of Series E Preferred Stock of iParty Corp. |
| 3.8                 |       | (6)             |   | Certificate of Designation of Series F Preferred  Stock of iParty Corp. |
| 3.9                 |       | (8)             |   | Certificate of Designation of Series G Junior  Preferred Stock of iParty Corp. |
| 3.10                |       | (1)             |   | By-Laws of WSI Acquisition Corp., as amended. |
| 10.1                |       | (1)             |   | Agreement and Plan of Merger between iParty Corp.  and WSI Acquisitions Corp. |
| 10.2                |       | (1)             | ## | 1998 Incentive and Non-Qualified Stock Option Plan. |
| 10.3                |       | (10)            | ## | Amended and Restated 1998 Incentive and  Non-Qualified Stock Option Plan. |
| 10.4                |       | **              | ## | Form of Non-qualified Stock Option Agreement. |
| 10.5                |       | **              | ## | Form of Incentive Stock Option Agreement. |
| 10.6                |       | (16)            | ## | Form of Stock Option Agreement granted to Messrs.  DeWolf, Haydu, Schindler, and Vassalluzzo. |
| 10.7                |       | (14)            | ## | Amended and Restated Employment Agreement between  iParty Corp. and Sal Perisano, dated May 14, 2004. |
| 10.8                |       | (14)            | ## | Amended and Restated Employment Agreement between  iParty Corp. and Patrick Farrell, dated May 14, 2004. |
| 10.9                |       | (14)            | ## | Amended and Restated Employment Agreement between  iParty Corp. and Dorice Dionne, dated May 14, 2004. |
| 10.10               |       | (16)            | ## | Compensation Arrangements with Messrs. DeWolf,  Haydu, Schindler, and Vassalluzzo. |
| 10.11               |       | (16)            | ## | Written Summary of One-Year Part-time Consulting  Arrangement with Joseph Vassalluzzo. |
| 10.12               |       | (11)            |   | Web Site License Agreement between iParty Corp. and  Taymark, Inc. |
| 10.13               |       | (7)             |   | Rights Agreement between iParty Corp. and  Continental Stock Transfer & Trust, as Rights Agent. |
| 10.14               |       | (10)            |   | Loan and Security Agreement between iParty Retail  Stores Corp. and Paragon Capital LLC. |
| 10.15               |       | (9)             |   | First Amendment to Loan and Security Agreement by  and among iParty Corp., iParty Retail Stores Corp. and Wells Fargo Retail  Finance, LLC. |
| 10.16               |       | (12)            |   | Second Amendment to Loan and Security Agreement by  and among iParty Corp., iParty Retail Stores Corp. and Wells Fargo Retail  Finance II, LLC. |
| 10.17               |       | (13)            |   | Third Amendment to Loan and Security Agreement by  and among iParty Corp., iParty Retail Stores Corp. and Wells Fargo Retail  Finance II, LLC. |
| 10.18               |       | (15)            |   | Fourth Amendment to Loan and Security Agreement by  and among iParty Corp., iParty Retail Stores Corp. and Wells Fargo Retail  Finance II, LLC. |
| 10.19               |       | (10)            |   | Trademark Security Agreement between iParty Retail  Stores Corp. and Paragon Capital LLC. |
| 10.20               |       | (10)            |   | Trademark Security Agreement between iParty Corp.  and Wells Fargo Retail Finance, LLC. |
| 10.21               |       | (5)             |   | Stock Purchase Agreement by and among iParty Corp.,  Ajmal Khan and Robert Lessin. |
| 10.22               |       | (6)             |   | Stock Purchase Agreement between iParty Corp. and  Patriot Capital Ltd. |
| 10.23               |       | (3)             |   | Funding Agreement among iParty Corp., Robert Lessin  and Ajmal Khan. |
| 21.1                |       | **              |   | Subsidiaries of Registrant. |
| 23.1                |       | **              |   | Consent of Ernst & Young LLP, Independent  Registered Public Accounting Firm. |
| 31.1                |       | **              |   | Certification of Chief Executive Officer pursuant to  Section 302 of Sarbanes-Oxley Act. |
| 31.2                |       | **              |   | Certification  of Chief Financial Officer pursuant to Section 302 of Sarbanes-Oxley Act. |
| 32.1                |       | **              |   | Certification  of Chief Executive Officer pursuant to Section 906 of Sarbanes-Oxley Act. |
| 32.2                |       | **              |   | Certification  of Chief Financial Officer pursuant to Section 906 of Sarbanes-Oxley Act. |

 

----

**                      Filed herewith.

##                      Management contract or compensatory plan orarrangement.

 

----

 
| (1)  |   | Filed as an exhibit to  iParty’s Registration Statement on Form 10-SB, Registration No. 0-25507, as  filed with the SEC on March 8, 1999 and incorporated herein by reference.                        |
|------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2)  |   | Filed as an exhibit to  Amendment No. 2 to iParty’s Registration Statement on Form 10-SB,  Registration No. 0-25507, as filed with the SEC on October 19, 1999 and  incorporated herein by reference. |
| (3)  |   | Filed as an exhibit to  Amendment No. 1 to iParty’s Registration Statement on Form 10-SB,  Registration No. 0-25507, as filed with the SEC on July 12, 1999 and  incorporated herein by reference.    |
| (4)  |   | Filed as an exhibit to  iParty’s Annual Report on Form 10-KSB for the year ended December 31, 1999,  as filed with the SEC on April 14, 2000 and incorporated herein by reference.                    |
| (5)  |   | Filed as an exhibit to  iParty’s Current Report on Form 8-K, filed with the SEC on August 30, 2000  and incorporated herein by reference.                                                             |
| (6)  |   | Filed as an exhibit to  iParty’s Current Report on Form 8-K, filed with the SEC on September 15, 2000  and incorporated herein by reference.                                                          |
| (7)  |   | Filed as an exhibit to  iParty’s Current Report on Form 8-K, filed with the SEC on November 16, 2001  and incorporated herein by reference.                                                           |
| (8)  |   | Included as an exhibit  (Exhibit C) to Exhibit 99.2 to iParty’s Current Report on Form 8-K, filed  with the SEC on November 16, 2001 and incorporated herein by reference.                            |
| (9)  |   | Filed as an exhibit to  iParty’s Quarterly Report on Form 10-QSB for the quarterly period ended June  29, 2002, as filed with the SEC on August 13, 2002 and incorporated herein by  reference.       |
| (10) |   | Filed as an exhibit to  iParty’s Annual Report on Form 10-KSB for the year ended December 28, 2002,  filed with the SEC on March 28, 2003 and incorporated herein by reference.                       |
| (11) |   | Filed as an exhibit to  iParty’s Quarterly Report on Form 10-Q, filed with the SEC on August 12, 2003  and incorporated herein by reference.                                                          |
| (12) |   | Filed as an exhibit to  iParty’s Current Report on Form 8-K, filed with the SEC on January 29, 2004  and incorporated herein by reference.                                                            |
| (13) |   | Filed as an exhibit to  iParty’s Quarterly Report on Form 10-Q, filed with the SEC on May 9, 2005 and  incorporated herein by reference.                                                              |
| (14) |   | Filed as an exhibit to  iParty’s Quarterly Report on Form 10-Q, filed with the SEC on August 10, 2004  and incorporated herein by reference.                                                          |
| (15) |   | Filed as an exhibit to  iParty’s Current Report on Form 8-K, filed with the SEC on January 19, 2006  and incorporated herein by reference.                                                            |
| (16) |   | Filed as an exhibit to  iParty’s Current Report on Form 8-K, filed with the SEC on March 30, 2006 and  incorporated herein by reference.                                                              |

 

----