** **

**UNITEDSTATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington,D.C. 20549**

 

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# **FORM 10-K**

# ** **

**x ANNUAL REPORTPURSUANT TO SECTION 13 OR 15(d) OF**

**THESECURITIES EXCHANGE ACT OF 1934**

** **

**For TheFiscal Year Ended December 29, 2007**

**OR**

** **

**TRANSITIONREPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

** **

**For theTransition Period from               to**

** **

**CommissionFile Number 0-25507**

 

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** **

**iPARTY CORP.**

(Exact Name of Registrant as Specified in Its Charter)

 

| **DELAWARE**                                                     | ** ** | **76-0547750**                     |
|------------------------------------------------------------------|------------|------------------------------------|
| (State or Other  Jurisdiction of  Incorporation or Organization) |       | (IRS Employer  Identification No.) |

 

| **270  BRIDGE STREET, SUITE 301**         | ** ** |       |
|-------------------------------------------|------------|------------|
| **DEDHAM,  MASSACHUSETTS**                | ** ** | **02026**  |
| (Address of  Principal Executive Offices) |       | (Zip Code) |
|                                      |       |       |

 

**(781)329-3952**

(Registrant’s Telephone Number, Including Area Code)

 

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Securities Registered pursuant to Section 12(b) ofthe 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 o No x

 

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act.Yes o No x

 

Indicate by check markwhether the registrant:  (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. Yes x No 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.x

 

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

 

Large accelerated filer o      Accelerated filer o       Non-accelerated filer o   (Do not checkif a smaller reporting company) Smaller reporting company  x

 

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

 

On June 30, 2007,the aggregate 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 $9,727,815 based on theclosing price for such common stock on said date as reported by the AmericanStock Exchange. On February 29, 2008 there were 22,717,400 shares ofcommon stock, $.001 par value, issued and outstanding.

 

**DOCUMENTSINCORPORATED BY REFERENCE**

 

Portions of the proxystatement for the annual stockholders’ meeting scheduled to be held June 4,2008, which we plan to file with the SEC no later than 120 days after the endof our fiscal year ended December 29, 2007, are incorporated by referenceinto Part III.

 

 

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**PART I**

 

**ITEM1.  BUSINESS**

** **

**General**

** **

We believe we are a leading brand in the partyindustry in the markets we serve and a leading resource in those markets forconsumers seeking party goods, party planning advice and relevantinformation.  We are a party goodsretailer operating stores throughout New England, where 45 of our 50 retailstores are located.  We also license thename iParty.com (at www.iparty.com) to a third party in exchange for royalties,which to date have not been significant. We generated $81.8 million in total revenues and $0.6 million of netincome in fiscal 2007.

 

As of December 29,2007 we operated 26 stores in Massachusetts, 7 in Connecticut, 6 in NewHampshire, 2 in Rhode Island, 3 in Maine and 1 in Vermont.  We also operated 5 stores in Florida.  In January 2008, we acquired twoadditional stores and closed one existing store in Rhode Island, and closed onestore in Massachusetts. We now operate 50 stores located predominately in NewEngland.  Our stores range in size fromapproximately 8,000 square feet to 20,300 square feet and average approximately10,200 square feet in size.  We lease ourproperties, typically for 10 years and usually with options from our landlordsto renew our leases for an additional 5 or 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.  Oursales are primarily driven by the following holiday and party events:  Halloween, Christmas, Easter, Valentine’sDay, New Year’s, Independence Day, St. Patrick’s Day, Thanksgiving andChanukah.  We also focus our businessclosely on lifetime events such as anniversaries, graduations, birthdays, andbridal and baby showers.

 

Our business has aseasonal pattern.  In the past threeyears, we have realized an average of approximately 36.5% of our annualrevenues in our fourth quarter, which includes Halloween and Christmas, and anaverage of approximately 23.8% of our revenues in the second quarter, whichincludes school graduations.  Also,during these past three years, we have had net income in our second and fourthquarters and generated losses in our first and third quarters.

 

Our executive offices arelocated at 270 Bridge Street, Suite 301, Dedham, Massachusetts,02026.  Our phone number is (781) 329-3952.  Our licensed website is located atwww.iparty.com.  The informationcontained on our licensed website does not constitute a part of this AnnualReport, or any other report we file with or furnish to the SEC.

 

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, “2007” refers to our 52-weekfiscal year ended December 29, 2007, “2006” refers to our 52-week fiscalyear ended December 30, 2006, and “2005” refers to our 53-week fiscal yearended December 31, 2005.

 

**Organization**

 

While we are currently a party goods retailchain operating 50 stores, when we were first incorporated as iParty Corp. (“iParty”)on March 12, 1998 we were an Internet-based merchant of party goods andservices.  On January 2, 2000,iParty Corp. was listed on the American Stock Exchange under ticker symbol “IPT”.

 

On August 3, 2000,iParty Retail 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, iPartyRetail acquired inventory, fixed assets and the leases of 33 retail stores fromThe Big Party Corporation (“The Big Party”), a privately-held company, whichwas operating under bankruptcy protection, in exchange for cash and theassumption of certain liabilities.  Thisacquisition was approved on August 16, 2000 by the United StatesBankruptcy Court for the District of Delaware. We have subsequently opened anadditional seventeen stores, acquired three stores, and closed three stores.

 

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**CapitalStructure**

** **

Our capital structurecurrently consists of common stock and five outstanding series of convertiblepreferred stock.  We have also issuedwarrants convertible into common stock and have a stock option plan that offersboth qualified and nonqualified options to purchase common stock.

 

Our common stock has apar value of $0.001 per share.  We have150,000,000 shares of common stock authorized, 22,700,655 of which were issuedand outstanding as of December 29, 2007. 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 through F (“convertible preferred stock”).  On January 13, 2004, all 1,000,000shares of our Series A convertible preferred stock were converted into1,000,000 shares of common stock.  As of December 29,2007, we had a total of 1,226,353 shares of convertible preferred stockoutstanding which were convertible into 15,509,928 shares of common stock onthat date based on the following conversion rates.  As of December 29, 2007, each share of Series Bconvertible preferred stock is presently convertible into 13.396 shares ofcommon stock; each share of Series C convertible preferred stock ispresently convertible into 13.652 shares of common stock; each share of Series Dconvertible preferred stock is presently convertible into 14.609 shares ofcommon stock; each share of Series E convertible preferred stock ispresently convertible into 10.359 shares of common stock; and each share of Series Fconvertible preferred stock is presently convertible into 10.367 shares ofcommon stock.  Our convertible preferredstock is presented on our balance sheet at its carrying value, which was$13,682,167 at December 29, 2007.

 

We also have astockholder rights plan (the “rights plan”). The rights plan associates rights to our capital stock, 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 ofcommon shares into which it is convertible. The rights will become exercisableonly in the event that, with certain exceptions, an acquiring party accumulates10 percent or more of our voting stock or if a party announces an offer toacquire 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 preferredstock at an initial purchase price of $2.00, subject to adjustment. Inaddition, upon the occurrence of certain events, holders of the rights would beentitled to purchase either iParty Corp. stock or shares in an “acquiringentity” at half of 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 $17,920,521 at December 29, 2007.  This amount is in excess of the carryingvalue of the preferred stock due to amounts allocated to warrants, which wereissued in connection with certain issuances of our convertible preferred stock.The difference of approximately $4.2 million will be accreted when and if aliquidation event occurs. The holders of our convertible preferred stock arealso entitled to anti-dilution protection in the event we issue common stock,or certain rights, including option activity in excess of certain amounts, topurchase or convert into common stock, at a price below the applicableconversion prices for the convertible preferred stock.

 

The convertible preferredstockholders are entitled to participate in dividends when and if declared byour Board of Directors.

 

We had also issuedwarrants in connection with the issuance of certain convertible preferred stockand certain licensing, marketing and financing arrangements, including thewarrant issued to an accredited institutional investor on September 15,2006.  At December 29, 2007, we hada warrant outstanding with an exercise price of $0.475, which was exercisablefor 2,083,334 shares of our common stock and warrants outstanding with aweighted average exercise price of $3.79, which were exercisable for 528,210shares of our common stock. During 2005, warrants exercisable for 12,483,005shares of our common stock that had been granted in conjunction with variousseries of our convertible preferred stock expired 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 29,2007, we had options outstanding that were exercisable for the purchase of 

 

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8,799,073 shares of common stock. In addition, at December 29, 2007, we had options outstanding thatwere not yet exercisable for the purchase of 1,331,521 shares of our commonstock.  On September 21,2005, our board of directors approved the full acceleration of the vesting ofeach otherwise unvested stock option that had an exercise price of $0.69 orgreater that was currently held by any of our 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.  On December 8, 2006, we entered intooption cancellation agreements with three of our executive officers pursuant towhich options that had been exercisable for a combined aggregate of 1,324,730shares of our common stock at exercise prices of $2.00 per share or greaterwere cancelled effective as of such date.

 

Thefollowing chart summarizes our capital structure at December 29, 2007.

** **
| ** **                           | ** ** | **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                         |       | 22,700,655                                                   |       |                              |       | 22,700,655                                                |       |                                                                     |       | $                      | —     |   |
|                                 |       |                                                         |       |                              |       |                                                      |       |                                                                     |       |                   |       |
| Series B convertible preferred stock |       | 465,401                                                      |       | 13.396                            |       | 6,234,512                                                 |       |                                                                     |       | 9,308,024              |       |
| Series C convertible preferred stock |       | 100,000                                                      |       | 13.652                            |       | 1,365,200                                                 |       |                                                                     |       | 2,000,000              |       |
| Series D convertible preferred stock |       | 250,000                                                      |       | 14.609                            |       | 3,652,250                                                 |       |                                                                     |       | 5,000,000              |       |
| Series E convertible preferred stock |       | 296,666                                                      |       | 10.359                            |       | 3,073,163                                                 |       |                                                                     |       | 1,112,497              |       |
| Series F convertible preferred stock |       | 114,286                                                      |       | 10.367                            |       | 1,184,803                                                 |       |                                                                     |       | 500,000                |       |
| Total convertible preferred stock    |       | 1,226,353                                                    |       |                              |       | 15,509,928                                                |       |                                                                     |       | 17,920,521             |       |
|                                 |       |                                                         |       |                              |       |                                                      |       |                                                                     |       |                   |       |
| Warrant                              |       | 2,083,334                                                    |       | 1.000                             |       | 2,083,334                                                 |       | $                                                                        | 0.48       |                   | —     |   |
| Warrants                             |       | 528,210                                                      |       | 1.000                             |       | 528,210                                                   |       | $                                                                        | 3.79       |                   | —     |   |
|                                 |       |                                                         |       |                              |       |                                                      |       |                                                                     |       |                   |       |
| Stock options                        |       | 10,130,594                                                   |       | 1.000                             |       | 10,130,594                                                |       | $                                                                        | 0.59       |                   | —     |   |
|                                 |       |                                                         |       |                              |       |                                                      |       |                                                                     |       |                   |       |   |
| Totals                               |       |                                                         |       |                              |       | 50,952,721                                                |       |                                                                     |       | $                      | 17,920,521 |   |
|                                      |            |                                                              |            |                                   |            |                                                           |            |                                                                          |            |                        |            |  |  |  |

 

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(1) Includes common stock outstanding andcommon stock issuable upon conversion of convertible preferred

stock and exercise of outstanding warrantsand stock options.

 

**Competition**

 

The party supplies retailingbusiness is highly competitive and fragmented. We compete with a variety of smaller and larger retailers, includingsingle owner-operated party supply stores, specialty party supplies retailers,discount department stores, retail drug store chains, general mass merchantsand supermarkets, as well as catalog, Internet merchants and temporary seasonalstores, especially Halloween stores.

 

Our success thus depends on ourability to be competitive against many different competitors in each localmarket 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.

 

Barriers to entry are minimal.  New competitors can open new stores andlaunch new Internet sites at a relatively low cost. However, we believe thatthe costs to remain competitive over the longer term in the party 

 

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suppliesretailing business can be significant. These costs include the hiring of humanresources with industry knowledge and the marketing costs associated withbuilding a widely recognized brand.

 

**Seasonality**

 

Our business has a seasonal pattern.  In the past three years, we have realized anaverage of approximately 36.5% of our annual revenues in our fourth quarter,which includes Halloween and Christmas, and an average of approximately 23.8%of our revenues in the second quarter, which includes school graduations.  Also, during these past three years, we havehad net income in our second and fourth quarters and generated losses in ourfirst and third quarters.

 

**Suppliers and Inventory**

** **

Theproducts we sell are sourced from a wide variety of third-party vendors.  Many of the products that we offer for sale,such as paper-based party goods, Halloween masks, and costumes, aremanufactured overseas in foreign countries such as China.  Global sourcing of many of the products wesell is thus an important factor in our financial performance.

 

Thefollowing represents suppliers from whom we purchased at least 5% of ourmerchandise:

 
| **Supplier**                  | ** ** | **Products supplied** | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------|------------|----------------------------|------------|----------|------------|----------|------------|
| Amscan, Inc.             |       | Paper party goods          |       | 18.4     | %          | 16.0     | %          |
| Fun World                     |       | Halloween costumes         |       | 5.8      | %          | 6.0      | %          |
| Unique Industries, Inc.  |       | Paper party goods          |       | 5.7      | %          | 6.0      | %          |
| Hallmark Marketing Corp.      |       | Paper party goods          |       | 5.9      | %          | 5.6      | %          |
| Kendall Confectionery Company |       | Candy                      |       | 4.7      | %          | 5.3      | %          |
| Lagasse Inc.                  |       | Paper party goods          |       | 5.5      | %          | 5.2      | %          |
| Total                         |       |                       |       | 46.0     | %          | 44.1     | %          |

 

In August 2006, weentered into a Supply Agreement with Amscan, Inc. (“Amscan”) which extendsto 2012 and obligates us to purchase increased levels of merchandise fromAmscan, our largest supplier, in exchange for, among other things, the right toreceive certain additional rebates and more favorable pricing terms over thelife of the agreement than were generally available to us under our previousterms with Amscan.

 

The loss of any of thesesuppliers could materially adversely affect our business, results ofoperations, financial condition and cash flow. We consider numerous factors in supplier selection, including, but notlimited to, price, credit terms, product offerings and quality.  As is customary in our industry, we generallydo not have long-term contracts with our suppliers, and any supplier may discontinueselling to us at any time.

 

**IntellectualProperty**

** **

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

 

**Employees**

** **

As of December 29, 2007, we had 269full-time employees and 717 part-time employees.  None of these employees is represented by alabor union, and we consider our relationship with our employees to be good.

 

**AvailableInformation**

** **

Our licensed Internetwebsite address is www.iparty.com.  OurAnnual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed orfurnished pursuant to 

 

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Section 13(a) or 15(d) of the Securities Exchange Act of1934 are available through our licensed Internet website as soon as reasonablypracticable after we electronically file such material with, or furnish it to,the SEC.  Our licensed Internet websiteand the information contained therein or connected thereto are not incorporatedinto or a part of this Annual Report on Form 10-K or any other report wefile or furnish to the SEC.

 

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 or furnish with the SEC.  In addition, the public may read and copy anymaterials we file or furnish with the SEC at the SEC’s Public Reference Room at450 Fifth Street, N.W., Washington, D.C., 20549. The public may obtaininformation about the SEC’s Public Reference Room by calling 1-800-SEC-0330.

 

**ITEM 1A.       RISKFACTORS**

** **

Our business is subject to certain risks thatcould materially affect our financial condition, results of operations, and thevalue of our common stock.  These risksinclude, 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 may harm our business, financial condition,results of operations, or the value of our common stock.

 

***Our success depends on economicand other external factors, particularly in the New England region and duringthe Halloween season, that affect consumer decisions about whether and when topurchase party goods and supplies.***

 

Our business success depends in large measure onconsumer decisions to buy party goods and supplies and seek party planningadvice, particularly in the New England region, where 45 of our 50 stores arelocated, and particularly during the Halloween season, which is our single mostimportant season. Demand for our products and our business results aresensitive to external factors that, directly or indirectly, affect consumerconfidence, consumer spending patterns, levels of disposable consumer income,or otherwise lead consumers to host or not host parties or purchase party goodsand supplies.  Examples of such externalfactors include: unseasonable weather, especially in New England; the timing,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 weserve; and the competitive success or failure of local sports teams, such asthe New England Patriots or Boston Red Sox, particularly in post-seasonplay.  The precise impact of any of theseexternal factors on consumer spending patterns for party goods and supplies is difficultto predict in advance, but one or more of these factors could adversely affectour business or our operating results, particularly with respect to any givenfiscal period, to the extent they adversely impact the consumer spendingpatterns most important to our business success.

 

***We face intense competition frommany sources.***

 

The industry we serve is highly competitive andfragmented. We face intense competition from other party supply stores andstores that merchandise and market party supplies, including big discountretailers, such as Wal-Mart, retail drug store chains, like CVS and Walgreen,dollar store chains, and temporary Halloween stores.  Our success thus depends on our ability to becompetitive against many different competitors in each local market area weserve.  If we fail to anticipate evolvinginnovations and product offerings from our competitors and fail to offerproducts that appeal to the changing needs and preferences of our customers inthe various markets we serve, demand for our products could decline and our operatingresults would be adversely affected. While the competitive importance ofproduct quality, price, service and innovation varies from product to product,price is a factor, and we experience pricing pressures from competitors in ourmarkets.

 

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***We face new competitive threatsas a result of consolidation in our industry following Amscan Holdings, Inc.’sacquisitions of Party City Corporation and Party America.***

 

In a series of transactions in December 2005,September 2006 and November 2007, Amscan Holdings, Inc. (“AHI”),the parent company of Amscan, Inc. (“Amscan”) our largest supplier and thelargest supplier in our industry, or AHI’s parent, AAH Holdings Corporation (“AAH”),acquired Party City Corporation, Party America and Factory Card &Party Outlet Corp. (“Factory Card”). With the acquisitions of these party goods companies, AHI and AAH own atotal of approximately 965 corporate and franchise party supply storesnationwide. Neither of these companies currently has a significant presence inthe New England region.

 

In August 2006, we announced that we hadentered into a Supply Agreement with Amscan which extends to 2012 and obligatesus to purchase increased levels of merchandise from Amscan, in exchange for,among other things, the right to receive certain additional rebates and morefavorable pricing terms over the life of the agreement than were generallyavailable to us under our previous terms with Amscan.  On that same date, we announced that we hadentered into a $2.45 million agreement with Party City pursuant to which weacquired Party City’s retail store in Peabody, Massachusetts and received afive-year non-competition agreement from Party City and its affiliates thatcovers Massachusetts, Maine, New Hampshire, Vermont, Rhode Island, and Windsorand New London counties in Connecticut.

 

Any further geographic expansion by us outsideof the New England market could result in greater direct competition with oneor all of Party City, Party America and Factory Card.  If so, AAH and AHI’s acquisitions of PartyCity, Party America and Factory Card, and its status as our largest supplierand the largest supplier in our industry could adversely affect our ability tocompete favorably or operate successfully in a changed marketplace.  Price pressures from such new sources ofcompetition, particularly in the event of a strain or rupture in ourrelationship with Amscan, could erode our margins and cause our financial resultsof operations to suffer.  Our successdepends on our ability to evaluate and respond to the threats arising fromgrowing consolidation and changing marketplaces and identify ways in which wecan competitively operate and strategically grow our store base.

 

***A major failure of our informationsystems would harm our business.***

 

The failure of any of our systems, including,without limitation, our point-of-sale system and our existing merchandisemanagement system, the latter of which was developed by a vendor who is nolonger in business and is thus currently unsupported by a third-party, wouldhave a material adverse effect on our business and financial results ofoperations.  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 operational problems with our information systems as aresult of system failures or any inability on our part to find and retain qualifiedpersonnel to monitor, maintain, and upgrade these systems, particularly withrespect to our merchandise management system, or other causes.

 

We cannot assure you that our systems will beadequate to support future growth, either as currently configured or as we planto possibly update them.  Any materialdisruption or slowdown of our systems would severely interfere with the normaloperation of our retail store operations and could have a materially negativeimpact on our business operations 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, any material disruption orproblem affecting our point-of-sale or merchandise management systems couldmaterially and adversely affect our borrowing level, our compliance withvarious covenants under our bank agreement, and our liquidity and cashresources.

 

***Our quarterly operating resultsare subject to significant fluctuation.***

 

Our operating resultshave fluctuated from quarter to quarter in the past, and we expect that theywill continue to do so in the future. Factors that could cause these quarterly fluctuations, both sequentiallyand on a year-over-year basis, include the following: extreme weather-relateddisruptions, particularly in New England; the timing of movable holidays, suchas Easter, which typically falls in the second quarter but on occasion falls inthe first quarter; 

 

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the competitive successor failure of local sports teams, such as the New England Patriots or BostonRed Sox, particularly in post-season play, which may result in fluctuationsfrom one year to the next in our sales in the first and fourth quarters; theextent to which sales in new stores result in the loss of sales in existingstores; the mix of products sold; pricing and marketing actions of competitors;the level of advertising and promotional expenses; and seasonality, primarilybecause the sales and profitability of our stores are typically lower in thefirst and third quarters, when we have often operated at a loss, and aretypically higher in the second quarter, which includes school graduations, andthe fourth quarter, which includes Halloween, our single most important sellingseason, as well as the Christmas holiday season.  Most of our operating expenses, such as rentexpense, advertising expense and employee salaries, do not vary directly withthe amount of sales and are difficult to adjust in the short term.  As a result, if sales in a particular quarterare below expectations for that quarter, we may not be able to proportionatelyreduce operating expenses for that quarter, and therefore such a sales shortfallwould have a disproportionate effect on our net income (or loss) for thequarter.

 

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

 

Our success depends in large part on the effortsand abilities of our senior management team. Their skills, experience and industry contacts significantly benefit ouroperations and administration.  Thefailure to attract, retain, and properly motivate the members of our seniormanagement team and other key employees, or to find suitable replacements forthem in the event of death, ill health, or their desire to pursue otherprofessional opportunities, could have a negative effect on our operatingresults.

 

Our performance is also largely dependent onattracting and retaining quality associates that are able to make the consumershopping experience at our stores a fun and informative experience.  We face intense competition for qualifiedassociates, and many of our associates are in entry-level or part-timepositions with historically high rates of turnover.  Our ability to meet our labor needs generallywhile controlling our labor costs is subject to numerous external factors,including the availability of a sufficient number of qualified persons in thework force, unemployment levels, prevailing wage rates, changing demographics,health and other insurance costs and changes in employment legislation,particularly in the New England region. If we are unable to attract and retain qualified associates or our laborcosts increase significantly, our business and financial performance may beadversely affected.

 

***Risks associated with recent andpossible future new store openings could adversely affect our business.***

 

An important part of our long-range businessplan is to increase our number of stores and, over time, enter new geographicmarkets.  We have opened 15 new stores,acquired one store and closed one store over the past five years, bringing ourtotal number of stores from 35 at the beginning of 2003 to 50 at the end of2007.  Our growth goals envision openingor acquiring additional stores in 2008 and 2009.  For our growth strategy to be successful, wemust identify and lease or acquire favorable store sites, hire and trainassociates and store managers, and adapt management and operational systems tomeet the needs of our expanded operations. These tasks may be difficult to accomplish successfully.  If we are unable to open or acquire newstores in locations and on terms acceptable to us as quickly as planned, our futuresales and profits may be adversely affected. Even if we succeed in opening or acquiring new stores, these new storesmay not achieve the same sales or profit levels as our existing stores.  Also, our expansion strategy includes openingnew stores in markets where we already have a presence so we can take advantageof economies of scale in marketing, distribution and supervision costs.  However, these new stores may result in theloss of sales in existing stores in nearby areas, which could adversely affectour business and financial performance. In addition, future store openingscould cause us, among other things, to incur additional debt, increasedinterest expense, as well as experience dilution in earnings, if any, pershare.  Impairment losses could alsooccur as a result of new store openings in the event that new store openingsprove unsuccessful.

 

***Our business may be adverselyaffected by the actions of and risks associated with our third-party vendors.***

 

The products we sell are sourced from a widevariety of third-party vendors.  Wecannot control the supply, design, function or cost of most of the productsthat we offer for sale and are dependent on the availability and pricing ofvarious products, including, without limitation, paper-based party goods,Halloween masks, and costumes, many of which are manufactured overseas inforeign countries such as China.  Globalsourcing of many of the products we sell is thus an important factor in ourfinancial performance.  Our ability tofind qualified vendors and 

 

7

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accessproducts in a timely and efficient manner is a significant challenge,especially with respect to goods sourced outside the United States.  Disruptions in the availability of raw materialsused in production of these products may adversely affect our sales and resultin customer dissatisfaction.  Politicalinstability, the financial instability of suppliers, merchandise qualityissues, trade restrictions, tariffs, currency exchange rates, transportcapacity and costs, inflation and other factors relating to foreign trade arebeyond our control.  In particular,volatile oil and gasoline prices impact prices of petroleum-based/plasticproducts, which are a key raw material in much of our merchandise, affect ourfreight costs, and affect consumer confidence and spending patterns.  Additionally, we have seen shortages inhelium supplies affecting the pricing of certain popular products, such asballoons. These and other issues directly or indirectly affecting our vendorscould adversely affect our business and financial performance.

 

***Ourfailure to generate sufficient cash to meet our liquidity needs may affect ourability to service our indebtedness and grow our business.***

 

Our business requiresaccess to capital to support growth, improve our infrastructure, respond toeconomic conditions, and meet contractual commitments.  In the event that our current operating planor long term goals change due to changes in our strategic plans, lower-than-expectedrevenues, unanticipated expenses, increased competition, unfavorable economicconditions, other risk factors discussed in this report, or other unforeseencircumstances, our liquidity may be negatively impacted.  Our ability to make payments on and torefinance our indebtedness, principally the amounts borrowed under our bankline of credit and notes payable, and to fund any capital expenditures forsystems upgrades and new store openings, if any, we may make in the future willdepend in large part on our current and future ability to generate cash.  This, to a certain extent, is subject togeneral economic, financial, competitive and other factors that are beyond ourcontrol.  We cannot assure you that ourbusiness will generate sufficient cash flow from operations in the future, thatour currently anticipated growth in revenues and cash flow will be realized onschedule, or that future borrowings will be available to us under our line ofcredit in an amount sufficient to enable us to service indebtedness, undertakestore openings and replace and upgrade our technology systems to grow ourbusiness, or to fund other liquidity needs. If we need to refinance all or a portion of our indebtedness, we cannotassure you that we will be able to do so on commercially reasonable terms or atall.  In addition, there can be noassurance, that, should we seek or require additional financing in the form ofdebt, subordinated debt, equity, convertible securities, or some combination ofthe above, such financing will be available, if at all, on terms and conditionsacceptable to us.  If so, our ability,among other things, to proceed with our store expansion plans for 2008 andbeyond would be negatively affected.

 

Our existing bank line of credit with WellsFargo allows us to borrow up to $12,500,000 with an option to increase thatlimit up to $15 million and matures on January 2, 2010.  As of December 29, 2007, there was $2,613,511outstanding under the Wells Fargo line.

 

We currently have three notes payable outstandingwith principal balances totaling $4,233,255 at December 29, 2007. Theprincipal amount of one of these notes is paid monthly in installments. Theprincipal amounts of the other two notes are due in full in the amounts of$2,500,000 and $600,000 on September 15, 2009 and August 7, 2010,respectively.  If we need to refinanceall or a portion of our indebtedness, we cannot assure you that we will be ableto do so on commercially reasonable terms or at all.

 

***Our ownership structure includeslarge investors who own preferred stock and whose interests and rights in ourcompany******may******differ in important respects from those of our common stock investors.***

 

 As of December 29,2007, there were 22,700,655 shares of common stock outstanding, and 28,252,066potential additional common share equivalents outstanding that may be issuedupon the conversion of outstanding convertible preferred stock, warrants andoptions to purchase our common stock. The average weekly trading volumes in our common stock as reported on theAmerican Stock Exchange for the fifty two week periods ending December 29,2007 and December 30, 2006 were 188,408 shares and 142,229 shares,respectively.  Additionally, a number ofinvestors in the company own large concentrations of our common and convertiblepreferred stock making our shares more illiquid than if our ownership structurewere more widely distributed. The ownership rights of these holders of ourconvertible preferred stock impact the trading liquidity of our common shares,our corporate governance, and the relative economic stake that our common stockand convertible preferred stock investors have 

 

8

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inthe enterprise value of our business. Although a more active trading market may develop in the future, thelimited market liquidity for our stock may affect your ability to sell at aprice that is satisfactory to you.

 

Our corporate governance is affected by ourownership structure to the extent that certain of our convertible preferred stockinvestors currently enjoy, among other things, contractual rights to nominateand elect two of the members of our board of directors, although only one ofthese board seats is currently filled. These rights and the concentration of share ownership enjoyed by certainof our preferred stock investors mean that our largest investors can influenceour strategic direction and that of our senior management in ways that aredifferent from most of our common stock investors.  Our preferred stock investors also enjoycertain economic rights that differentiate their ownership rights and interestsfrom those of our common stock investors. For instance, upon the occurrence of merger, acquisition or similartransaction involving the acquisition of our company, the holders of ourpreferred stock would generally be entitled to a “liquidation preference” thatwould entitle them, collectively, to the first $17.9 million of net proceeds,unless they decide to convert their shares of preferred stock into commonstock.  This feature of our preferredstock investors’ rights could make the attractiveness of our company as anacquisition target differ materially from 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.

 

****Shares that may be********resold********pursuantto our prospectus on Form S-********3by the selling stockholder named therein********declaredeffective by the SEC on April 4, 2007********,********oreligible for sale in the future could negatively affect our stock price.****

 

Certain securities maybe sold in the future pursuant to registration statements filed with the SEC orwithout registration under the Securities Act, to the extent permitted by Rule 144or other exemptions under the Securities Act. We may issue additional shares in the future in connection withacquisitions, compensation or otherwise, although we cannot ensure that we willbe able to identify or complete any acquisition in the future. The market priceof our common stock could decline as a result of sales of a large number ofshares of our common stock or the perception that these sales could occur.  This may also make it more difficult for usto raise funds through the issuance of debt or the sale of equity securities.

 

As of December 29, 2007, there were28,252,066 potential additional common share equivalents outstanding.  These included 15,509,928 shares issuableupon the conversion of immediately convertible preferred stock, 2,083,334shares issuable upon the exercise of a warrant with an exercise price of$0.475, 528,210 shares issuable upon the exercise of warrants with a weightedaverage exercise price of $3.79 and 10,130,594 shares issuable upon theexercise of stock options with a weighted average exercise price of $0.59.

 

***Our common stock is thinlytraded, may fluctuate based on relatively small levels of trading activity, andmay be adversely affected by our capital structure, which makes it moredifficult for investors to value our business.***

 

Investing in shares of our common stock entailsa high degree of risk.  Public trading ofour common stock on the American Stock Exchange typically occurs at relativelylow sales volumes and very few, if any, security analysts regularly follow ourstock.  Moreover, our common stock pricehas traded below $1.00 for significant periods of time.  In addition, our capital structure, whichincludes various series of convertible preferred stock with various contractualrights, generally makes it more difficult for investors, or prospective acquirersof our company, to value our business on an aggregate basis or to value ourshares of common stock on a trading basis. As a result of these factors, speculative investors may have a greatereffect on our common stock price than would be the case for a company with asimpler ownership structure, a larger market capitalization, or common sharesthat are more diffusely held or heavily traded. Accordingly, our common stock price could be subject to considerablespeculative volatility and may not necessarily follow market expectationsregarding our business prospects or financial performance.  In particular, our common stock price may besensitive to non-financial developments involving our company as well as marketrumors disseminated on the Internet or other forms of media regarding our companyor our industry. If our quarterly financial performance does not meet theexpectations of investors that trade in shares 

 

9

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ofour common stock, our stock price would likely decline.  If so, the decrease in the stock price may bedisproportionate to the shortfall, real or perceived, in our financialperformance.

 

***Compliance with changingregulation of corporate governance, public disclosure, and accounting standardsmay result in additional expenses and risks.***

 

Changing laws, regulations and standardsrelating to corporate governance, public disclosure and changes to accountingstandards and practices, including the Sarbanes-Oxley Act of 2002, new SECregulations, corporate law developments in Delaware, and evolving rules applicableto publicly-traded companies on the American Stock Exchange, are creatinguncertainty, and hence risks, for companies such as ours.  These new or changed laws, regulations andstandards are subject to varying interpretations due to the fact that they arenew and there has not yet emerged a well-developed body of interpretation.  As a result, their application in practicemay evolve over time as new guidance is provided by regulatory and governingbodies.  This development could result incontinuing uncertainty regarding compliance matters and higher costsnecessitated by ongoing revisions to disclosure, governance and accountingpractices.

 

Our efforts to comply with evolving laws,regulations and standards have resulted in, and are likely to continue toresult in, increased general and administrative expenses and a diversion ofmanagement time and attention from revenue-generating activities to complianceactivities.  In particular, we haveapplied significant management and financial resources to document, test,monitor and enhance our internal control over financial reporting in order tomeet the various current requirements of the Sarbanes-Oxley Act of 2002.  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 commonstock.  Our efforts to comply with thesetypes of new regulatory requirements regarding our required assessment of ourinternal controls over financial reporting and our external auditors’ audit ofour financial statements have required the commitment of increasing levels offinancial and managerial resources. If our efforts to comply with new orchanged laws, regulations and standards differ from the activities intended byregulatory or governing bodies, we could face various material and adverseconsequences, including, a decline in our common stock price or a possibledelisting of our common stock.

 

**Forward Looking Statements**

 

Certain statements in this Annual Report,particularly statements contained in Item 7, “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” constitute “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of1933, as amended, and Section 21E of the Securities Exchange Act of 1934,as amended.  The words “anticipate”, “believe”,“estimate”, “expect”, “plan”, “intend” and other similar expressions areintended to identify these forward-looking statements, but are not theexclusive means of identifying them. 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) 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. Our forward-looking statements speak only as of the date of thisdocument, and we do not intend to update these statements to reflect events orcircumstances that occur after that date.

 

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

 

**ITEM 1B. UNRESOLVED STAFF COMMENTS**

** **

Not applicable.

 

10

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** **

**ITEM 2. PROPERTIES**

** **

The following tableidentifies the number of our stores operating as of December 29, 2007, December 30,2006 and December 31, 2005, by state:

 
| **States**                 | ** ** | **Number of Stores, for the fiscal year ended** | ** ** |
|----------------------------|------------|------------------------------------------------------------------------------------|------------|
| **Dec 29, 2007** | ** ** | **Dec 30, 2006**                                                         | ** ** | **Dec 31, 2005** | ** ** |
| **End  of  Period**        | ** ** | **Closings**                                                                       | ** ** | **Acquired/  Openings** | ** ** | **End  of  Period** | ** ** | **Closings** | ** ** | **Acquired/  Openings** | ** ** | **End  of  Period** | ** ** | **Closings** | ** ** | **Openings** | ** ** |
| Connecticut                |       | 7                                                                                  |       | — |   | — |   | 7 |   | — |   | — |   | 7 |   | — |   | 1 |   |
| Florida                    |       | 5                                                                                  |       | — |   | — |   | 5 |   | — |   | — |   | 5 |   | — |   | 1 |   |
| Maine                      |       | 3                                                                                  |       | — |   | — |   | 3 |   | — |   | — |   | 3 |   | — |   | 1 |   |
| Massachusetts              |       | 26                                                                                 |       | — |   | — |   | 26 |   | — |   | 1 |   | 25 |   | — |   | 2 |   |
| New Hampshire              |       | 6                                                                                  |       | — |   | — |   | 6 |   | — |   | — |   | 6 |   | — |   | 1 |   |
| Rhode Island               |       | 2                                                                                  |       | — |   | — |   | 2 |   | 1 |   | — |   | 3 |   | — |   | — |   |
| Vermont                    |       | 1                                                                                  |       | — |   | — |   | 1 |   | — |   | — |   | 1 |   | — |   | — |   |
| Total                      |       | 50                                                                                 |       | — |   | — |   | 50 |   | 1 |   | 1 |   | 50 |   | — |   | 6 |   |

 

In early January 2008, we acquired twoadditional stores in Rhode Island and closed one store in Rhode Island and onestore in Massachusetts whose leases were expiring.

 

Our stores rangein size from approximately 8,000 square feet to approximately 20,500 squarefeet and average approximately 10,200 square feet. We lease all of our retailstores. The leases generally provide for fixed minimum rentals, which typicallyincrease periodically during the life of the lease, and, in some instances,contingent rentals based on a percentage of sales in excess of specifiedminimum sales levels, as well as related occupancy costs, such as propertytaxes and common area maintenance. We lease our properties typically for 10years and usually with options from our landlords to renew our leases for anadditional 5 or 10 years.

 

In addition to our50 stores, we lease office space at 270 Bridge Street, Suite 301, Dedham,Massachusetts, 02026. The lease, which expires November 30, 2011, is for10,600 square feet of space and the monthly rent is $17,917. We also leaseoffice and retail space at 1457 VFW Parkway, West Roxbury, Massachusetts,02132. This lease, which expires December 31, 2012, is for 20,500 squarefeet of space. The retail store at our West Roxbury location uses 10,688 squarefeet and the remainder is used primarily for our corporate training center. Thetotal monthly rent for the retail store and corporate training center space is$19,435, subject to certain Consumer Price Index escalation clauses. We believethat these spaces are adequate for our immediate needs.

 

We believe thatall properties are adequately covered by insurance.

 

**ITEM 3. LEGAL PROCEEDINGS**

** **

We are not a party to anymaterial pending legal proceedings other than ordinary routine mattersincidental to our business, which we do not expect, individually or in theaggregate, to have a material adverse effect on the Company.

 

**ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

** **

No matters were submittedto a vote of our security holders during the fourth quarter of fiscal 2007.

 

11

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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 aretraded under the symbol “IPT”.

 

The following table sets forth the range of high and low sales priceson the American Stock Exchange for our common stock for each of the fiscalquarters of 2007 and 2006:

 
| **MARKET  PRICE OF COMMON STOCK** |
|-----------------------------------|

 
| **Period**            | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------------------|------------|----------|------------|---------|------------|
| **2007**              |       |     |       |    |       |
| Fourth fiscal quarter |       | $        | 0.46       |    | $          | 0.15 |   |
| Third fiscal quarter  |       | 0.46     |       | 0.33    |       |
| Second fiscal quarter |       | 0.51     |       | 0.36    |       |
| First fiscal quarter  |       | 0.58     |       | 0.40    |       |
| **2006**              |       |     |       |    |       |
| Fourth fiscal quarter |       | $        | 0.88       |    | $          | 0.33 |   |
| Third fiscal quarter  |       | 0.47     |       | 0.27    |       |
| Second fiscal quarter |       | 0.49     |       | 0.30    |       |
| First fiscal quarter  |       | 0.60     |       | 0.37    |       |

 

**Holders**

** **

Theapproximate number of record holders of our common stock as of February 29,2008 was 116. The number of record owners was determined from our stockholderrecords, and does not include beneficial owners of our common stock whoseshares are held in the names of various security holders, dealers and clearingagencies. We believe that the number of beneficial owners of our common stockheld by others as or in nominee names exceeds 500 in number.

 

**Dividends**

** **

We have never paid a cash dividend on ourshares of common stock and have no expectation of doing so for the foreseeablefuture. Our existing line of credit agreement with Wells Fargo Retail FinanceII, LLC generally prohibits the payment of any dividends or other distributionsto any of our classes of capital stock.

 

**RecentSales of Unregistered Securities**

** **

There were no sales ofunregistered securities made during the fourth quarter of 2007.

 

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

** **

There were no stockrepurchases made during the fourth quarter of 2007.

 

12

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**Stock Performance Graph**

 

**COMPARISON OF CUMULATIVE TOTALRETURN AMONG iPARTY (“IPT”), RUSSELL 2000 INDEX (“RUSSELL 2000”) AND S&P RETAIL INDEX**

 

The following graphcompares the cumulative total stockholder return of our common stock during thefive fiscal years ended December 29, 2007 with the cumulative return ofthe Russell 2000 Index and the Standard & Poor’s Retail Index.

 

This graph is not deemedto be “filed” with the SEC or subject to the liabilities of Section 18 ofthe Securities Exchange Act of 1934, and the graph shall not be deemedincorporated by reference into any prior or subsequent filings by us under theSecurities Act or the Exchange Act.

 

 
| ** **               | ** ** | **12/28/02** | ** ** | **12/27/03** | ** ** | **12/25/04** | ** ** | **12/31/05** | ** ** | **12/30/06** | ** ** | **12/29/07** | ** ** |
|--------------------------|------------|--------------|------------|--------------|------------|--------------|------------|--------------|------------|--------------|------------|--------------|------------|
| IPT                      |       | $            | 100.00     |         | $          | 468.42       |       | $            | 363.16     |         | $          | 205.26       |       | $ | 210.53 |   | $ | 115.79 |   |
| Russell 2000             |       | $            | 100.00     |         | $          | 144.45       |       | $            | 169.04     |         | $          | 175.24       |       | $ | 205.03 |   | $ | 200.90 |   |
| S&P Retail Index-Rlx |       | $            | 100.00     |         | $          | 142.91       |       | $            | 174.03     |         | $          | 174.80       |       | $ | 191.16 |   | $ | 157.05 |   |

 

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(1)                      Assumes $100 invested on December 28,2002 in our common stock, the Russell 2000 Index and the S&P Retail Index,including reinvestment of any dividends paid on the investment. The Russell2000 Index is an index of 2,000 “small cap” domestic equities that rank incapitalization below the 1,000 largest public companies in terms of marketcapitalization. The S&P Retail Index is a capitalization-weighted index ofdomestic equities that consist of the retail sector stocks contained in theS&P 500 Index.

 

13

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**ITEM 6. SELECTEDFINANCIAL DATA**

 

The following selectedconsolidated financial data is derived from our audited consolidated financialstatements and should be read in conjunction with our audited consolidatedfinancial statements and related notes, which are included in item 8 “FinancialStatements and Supplementary Data” below, and “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” included in item 7below.

 
| ** **                                                   | ** ** | **2007  52 weeks** | ** ** | **2006  52 weeks** | ** ** | **2005 (1)  53 weeks** | ** ** | **2004  52 weeks** | ** ** | **2003  52 weeks** | ** ** |
|--------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|----------------------------------|------------|-------------------------|------------|-------------------------|------------|
| **Statement of Operations Data:**                            |       |                    |       |                    |       |                             |       |                    |       |                    |       |
| Revenues                                                     |       | $                       | 81,798,634 |                    | $          | 78,458,329                       |       | $                       | 72,537,998 |                    | $          | 64,276,225 |   | $ | 56,697,246 |   |
| Operating costs:                                             |       |                    |       |                    |       |                             |       |                    |       |                    |       |
| Cost of products sold                                        |       | 46,465,441              |       | 44,942,542              |       | 41,395,193                       |       | 35,826,820              |       | 31,758,625              |       |
| Marketing and sales                                          |       | 26,181,504              |       | 25,625,547              |       | 24,116,050                       |       | 21,176,925              |       | 18,363,193              |       |
| General and administrative                                   |       | 7,553,869               |       | 6,736,197               |       | 6,762,583                        |       | 6,335,067               |       | 5,516,273               |       |
|                                                         |       |                    |       |                    |       |                             |       |                    |       |                    |       |
| Operating income                                             |       | 1,597,820               |       | 1,154,043               |       | 264,172                          |       | 937,413                 |       | 1,059,155               |       |
|                                                         |       |                    |       |                    |       |                             |       |                    |       |                    |       |
| Other income                                                 |       | —                  |       | —                  |       | —                           |       | 382,500                 |       | —                  |       |
|                                                         |       |                    |       |                    |       |                             |       |                    |       |                    |       |
| Income before interest and taxes                             |       | 1,597,820               |       | 1,154,043               |       | 264,172                          |       | 1,319,913               |       | 1,059,155               |       |
|                                                         |       |                    |       |                    |       |                             |       |                    |       |                    |       |
| Interest income                                              |       | 17,806                  |       | 10,217                  |       | 801                              |       | 1,354                   |       | 1,262                   |       |
| Interest expense                                             |       | (857,612                | )          | (772,334                | )          | (532,649                         | )          | (225,074                | )          | (212,227                | )          |
|                                                         |       |                    |       |                    |       |                             |       |                    |       |                    |       |
| Income (loss) before taxes                                   |       | 758,014                 |       | 391,926                 |       | (267,676                         | )          | 1,096,193               |       | 848,190                 |       |
|                                                         |       |                    |       |                    |       |                             |       |                    |       |                    |       |
| Income taxes                                                 |       | 146,323                 |       | 17,279                  |       | —                           |       | 105,000                 |       | 97,233                  |       |
|                                                         |       |                    |       |                    |       |                             |       |                    |       |                    |       |
| Net income (loss)                                            |       | $                       | 611,691    |                    | $          | 374,647                          |       | $                       | (267,676   | )                       | $          | 991,193 |   | $ | 750,957 |   |
|                                                         |       |                    |       |                    |       |                             |       |                    |       |                    |       |
| Net income (loss) available to common stockholders           |       | $                       | 611,691    |                    | $          | 374,647                          |       | $                       | (267,676   | )                       | $          | 991,193 |   | $ | 750,957 |   |
|                                                         |       |                    |       |                    |       |                             |       |                    |       |                    |       |
| Income (loss) per share:                                     |       |                    |       |                    |       |                             |       |                    |       |                    |       |
| Basic                                                        |       | $                       | 0.02       |                    | $          | 0.01                             |       | $                       | (0.01      | )                       | $          | 0.03 |   | $ | 0.02 |   |
| Diluted                                                      |       | $                       | 0.02       |                    | $          | 0.01                             |       | $                       | (0.01      | )                       | $          | 0.02 |   | $ | 0.02 |   |
|                                                         |       |                    |       |                    |       |                             |       |                    |       |                    |       |
| Net income (loss) per share available to common stockholders |       |                    |       |                    |       |                             |       |                    |       |                    |       |
| Basic                                                        |       | $                       | 0.02       |                    | $          | 0.01                             |       | $                       | (0.01      | )                       | $          | 0.03 |   | $ | 0.02 |   |
| Diluted                                                      |       | $                       | 0.02       |                    | $          | 0.01                             |       | $                       | (0.01      | )                       | $          | 0.02 |   | $ | 0.02 |   |
|                                                         |       |                    |       |                    |       |                             |       |                    |       |                    |       |
| Weighted-average shares outstanding:                         |       |                    |       |                    |       |                             |       |                    |       |                    |       |
| Basic                                                        |       | 38,204,374              |       | 37,862,928              |       | 22,186,581                       |       | 37,649,400              |       | 36,683,142              |       |
| Diluted                                                      |       | 39,913,274              |       | 39,535,874              |       | 22,186,581                       |       | 41,517,036              |       | 38,868,484              |       |
|                                                         |       |                    |       |                    |       |                             |       |                    |       |                    |       |
| **Other Data:**                                              |       |                    |       |                    |       |                             |       |                    |       |                    |       |
| Net cash provided by (used in) operating activities          |       | $                       | (239,008   | )                       | $          | 4,412,036                        |       | $                       | (259,907   | )                       | $          | 129,690 |   | $ | 1,368,798 |   |
| Net cash used in investing activities                        |       | (802,174                | )          | (2,579,007              | )          | (1,663,647                       | )          | (2,121,134              | )          | (1,166,258              | )          |
| Net cash provided by (used in) financing activities          |       | 352,338                 |       | (1,771,847              | )          | 865,591                          |       | 1,306,130               |       | (86,412                 | )          |
| Capital expenditures (2)                                     |       | 802,174                 |       | 709,892                 |       | 1,663,647                        |       | 2,121,134               |       | 1,166,258               |       |

 
| ** **                  | ** ** | **Dec 29, 2007** | ** ** | **Dec 30, 2006** | ** ** | **Dec 31, 2005** | ** ** | **Dec 25, 2004** | ** ** | **Dec 27, 2003** | ** ** |
|-----------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|
| **Balance Sheet Data:**     |       |                       |       |                       |       |                       |       |                       |       |                       |       |
| Working capital             |       | $                          | 6,184,373  |                       | $          | 4,954,989                  |       | $                          | 2,091,213  |                       | $          | 3,236,148 |   | $ | 4,178,436 |   |
| Total assets                |       | 22,977,086                 |       | 22,697,373                 |       | 21,717,076                 |       | 19,479,937                 |       | 15,151,980                 |       |
| Total long-term liabilities |       | 4,394,367                  |       | 4,707,964                  |       | 1,095,998                  |       | 1,268,452                  |       | 406,469                    |       |
|                             |            |                            |            |                            |            |                            |            |                            |            |                            |            |  |  |  |  |  |

 

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(1)  Fiscal year2005 refers to a 53-week fiscal year, while fiscal years 2007, 2006, 2004 and2003 refer to 52-week fiscal years.

 

(2) Capitalexpenditures exclude assets acquired under capital leases.

 

14

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**ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

** **

*The followingdiscussion should be read in conjunction with our Consolidated FinancialStatements and the related Notes included below.*

 

*Certain statements in this Annual Report,particularly statements contained in this Item 7, “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” constitute “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of1933, as amended, and Section 21E of the Securities Exchange Act of 1934,as amended. The words “anticipate”, “believe”, “estimate”, “expect”, “plan”, “intend”and other similar expressions are intended to identify these forward-lookingstatements, but are not the exclusive means of identifying them. Forward-lookingstatements included in this Annual Report or hereafter included in otherpublicly available documents filed with the Securities and Exchange Commission(“SEC”), reports to our stockholders and other publicly available statementsissued or released by us involve known and unknown risks, uncertainties, andother factors which could cause our actual results, performance (financial oroperating) or achievements to differ from the future results, performance(financial or operating) or achievements expressed or implied by such forwardlooking statements. Such future results are based upon our best estimates basedupon current conditions and the most recent results of operations. Variousrisks, uncertainties and contingencies could cause our actual results,performance or achievements to differ materially from those expressed in, orimplied by, the forward-looking statements contained in this Annual Report. Theseinclude, but are not limited to, those described above under Item 1A, “RiskFactors.”**Ourforward-looking statements speak only as of the date of this document, and wedo not intend to update these statements to reflect events or circumstancesthat occur after that date.*

 

**Overview**

** **

At the end of 2007, weoperated 50 retail stores, including 45 in New England and five in Florida, andfor the year we generated approximately $81.8 million in sales and had netincome of approximately $0.6 million. Total sales for fiscal 2007 (a 52-weekperiod) increased 4.3% over fiscal 2006 (also a 52-week period). Comparablestore sales in 2007 increased 2.6% over sales in 2006. Comparable store salesare defined as sales from those stores open for at least one full year. Thismarks our sixth consecutive year of positive comparable store sales growth.

 

The year began with an11.3% increase in comparable store sales in the first quarter of 2007. Totalsales for the first quarter of 2007 increased 15.2% compared to the firstquarter of 2006. This performance was partly due to the inclusion ofapproximately $494,000 in sales from December 31, traditionally a strongsales day, which was not included in the first quarter of 2006. Our comparablestore sales were also positively affected by the exit of a significantcompetitor from our Boston market. In addition, increased sales in our maturestores and in stores opened during 2005 contributed to the first quarter 2007comparable store sales results. The increase in comparable store and totalsales allowed us to better leverage our occupancy, marketing and general andadministrative expenses for the first quarter of 2007 as compared to our firstquarter of 2006.

 

In the second quarter,comparable stores sales increased 5.9% compared to the same period in 2006.During this quarter, our comparable store sales continued to benefit from theexit of our Boston market competitor, as well as from sales gains from ourstores opened in 2004 and 2005. Total sales increased 9.8% in the secondquarter of 2007 compared to the same period in 2006. Because of these salesresults, we were able to better leverage our occupancy and marketing costs duringthe second quarter as compared to the second quarter of 2006. General andadministrative costs during the second quarter increased both in total dollarsand as a percentage of sales, largely because of increases in executiverecruitment costs and professional fees associated with our complianceactivities related to Section 404 of the Sarbanes-Oxley Act of 2002. Netincome significantly increased to $512,000 compared to net income of $122,000in the second quarter of 2006.

 

In the third quarter, ourcomparable stores sales increased by 4.5% compared to the third quarter of2006. Total sales increased 5.6% compared to third quarter 2006. The effect ofthe exit of our Boston competitor, while present, was less in the third quarterthan in the first two quarters of the year. As a result of the increased sales,

 

15

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product and occupancy costs and marketing and sales costs continued todecrease as a percentage of sales compared to the third quarter of 2006. Ourgeneral and administrative expenses in the third quarter of 2007 increased as apercentage of sales compared to the third quarter of 2006, mainly due to costsassociated with executive recruitment and Sarbanes-Oxley Act compliance. Ourloss for the third quarter of 2007 was $1.1 million compared to a net loss inthe third quarter of 2006 of $1.5 million.

 

The year ended with a4.8% decrease in comparable store sales in the fourth quarter, which included a2.9% decrease in comparable store sales in the calendar month of October. Totalcompany sales decreased 5.2% in the fourth quarter as compared to the fourthquarter of 2006. This decrease included a 3.6% decrease in total company salesfor the calendar month of October. Comparable store and total company sales forthe quarter were negatively affected by several episodes of inclement weatherin the New England region, where we predominantly operate, during the month ofDecember, and to a lesser extent by increased temporary Halloween storecompetition in the company’s markets during the Halloween season. Cost ofproducts sold and occupancy costs increased as a percentage of sales during thefourth quarter, partly as a result of additional markdowns taken to avoidexcessive inventory levels, and partly because of the decreased leverage onlower sales. Marketing and sales expenses increased both in total dollars andas a percentage of sales during the fourth quarter compared to the prior yearfourth quarter. On the other hand, general and administrative expensesdecreased both in total dollars and as a percentage of sales, mostly related toa smaller bonus accrual for employees in our support office. For the quarter,our net income was $2.7 million, compared to $3.9 million in the fourth quarterof 2006.

 

Overall, our comparablestores sales increase for 2007 was 2.6% which follows a 3.8% increase for 2006and a 0.6% increase in 2005. Our net income for 2007 was $0.6 million comparedto $0.4 million in 2006.

 

For 2008, we plan tocontinue to leverage our occupancy costs, marketing and sales expenses andgeneral and administrative expenses by increasing sales in our comparablestores, by opening or acquiring additional retail stores, by closingunder-performing stores as their lease terms expire, and/or by opening temporaryHalloween stores.

 

**Fiscal2007 Compared to Fiscal 2006**

** **

*Revenues*

 

Our consolidated revenuesfor 2007 were $81,798,634, an increase of $3,340,305, or 4.3% from 2006. Revenuesinclude the selling price of party goods sold, net of returns and discounts,and are recognized at the point of sale.

 
| ** **                           | ** ** | **For the year ended** | ** ** |
|--------------------------------------|------------|---------------------------------------|------------|
| ** **                           | ** ** | **Dec 29, 2007**            | ** ** | **Dec 30, 2006** | ** ** |
| Revenues                             |       | $                                     | 81,798,634 |   | $ | 78,458,329 |   |
|                                 |       |                                  |       |   |   |
| Increase in revenues from prior year |       | 4.3                                   | %          | 8.2 | % |
|                                      |            |                                       |            |  |  |  |  |

 

Sales for 2007 includedan increase of 2.6% in comparable store sales, and sales from one store that weacquired in the third quarter of 2006, but was not included in the comparablestores sales calculation until the third quarter of 2007, the store’s one yearanniversary.

 

16

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*Cost ofgoods sold and occupancy costs*

 

Our cost of products soldand occupancy costs for 2007 was $46,465,441, or 56.8% of revenues, an increaseof $1,522,899 and a decrease of 0.5 percentage points, as a percentage ofrevenues, from 2006. Cost of products sold and occupancy costs consist of thecost of merchandise sold to customers and the occupancy costs for our stores.

 
| ** **                              | ** ** | **For the year ended** | ** ** |
|-----------------------------------------|------------|---------------------------------------|------------|
| ** **                              | ** ** | **Dec 29, 2007**            | ** ** | **Dec 30, 2006** | ** ** |
| Cost of goods  sold and occupancy costs |       | $                                     | 46,465,441 |   | $ | 44,942,542 |   |
|                                    |       |                                  |       |   |   |
| Percentage of  revenues                 |       | 56.8                                  | %          | 57.3 | % |
|                                         |            |                                       |            |  |  |  |  |

 

As a percentage ofrevenues, the decrease in cost of products sold was primarily attributable toimproved leveraging of occupancy costs and increased sales in our comparablestores.

 

*Marketingand sales expense*

 

Our consolidatedmarketing and sales expense for 2007 was $26,181,504 or 32.0% of revenues, anincrease of $555,957 and a decrease of 0.7 percentage points, as a percentageof revenues, from 2006. Marketing and sales expenses consist primarily ofadvertising and promotional expenditures, all store payroll and relatedexpenses for personnel engaged in marketing and selling activities and othernon-payroll expenses associated with operating our stores.

 
| ** **             | ** ** | **For the year ended** | ** ** |
|------------------------|------------|---------------------------------------|------------|
| ** **             | ** ** | **Dec 29, 2007**            | ** ** | **Dec 30, 2006** | ** ** |
| Marketing and sales    |       | $                                     | 26,181,504 |   | $ | 25,625,547 |   |
|                   |       |                                  |       |   |   |
| Percentage of revenues |       | 32.0                                  | %          | 32.7 | % |
|                        |            |                                       |            |  |  |  |  |

 

As a percentage ofrevenues, the decrease in marketing expenses was primarily due to improvedleveraging of advertising and store operating costs from increased sales in ourcomparable stores.

 

*Generaland administrative expense*

 

Our consolidated generaland administrative (“G&A”) expenses for 2007 were $7,553,869, or 9.2% ofrevenues, an increase of $817,672, or 0.6 percentage points as a percentage ofrevenues, from 2006. G&A expenses consist of payroll and related expensesfor executive, merchandising, finance and administrative personnel, as well asinformation technology, professional fees and other general corporate expenses.

 
| ** **                 | ** ** | **For the year ended** | ** ** |
|----------------------------|------------|---------------------------------------|------------|
| ** **                 | ** ** | **Dec 29, 2007**            | ** ** | **Dec 30, 2006** | ** ** |
| General and administrative |       | $                                     | 7,553,869  |   | $ | 6,736,197 |   |
|                       |       |                                  |       |   |   |
| Percentage of revenues     |       | 9.2                                   | %          | 8.6 | % |
|                            |            |                                       |            |  |  |  |  |

 

The increase in generaland administrative expenses was primarily due to increases in executive payrolland recruitment costs, and to increases in professional fees associated withour compliance activities related to the Sarbanes-Oxley Act.

 

17

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*Operating income*

 

Our operating income for2007 was $1,597,820, or 2.0% of revenues, compared to an operating income of$1,154,043, or 1.5% of revenues in 2006.

 

### *Interest expense*

### * *

Our interest expense in 2007 was $857,612, anincrease of $85,278 from 2006. The increase during 2007 was due primarily tointerest expense and warrant expense related to notes payable. The effectiveinterest rate on our borrowings under our line of credit decreased to 8.2%during 2007 compared to 8.6% in 2006, which decreased interest expense byapproximately $7,201. The interest rate was based on the bank’s base rate. Ouraverage revolving loan balance was approximately $2,071,953 during 2007compared to $5,385,117 in 2006, which decreased interest expense byapproximately $318,988. Interest expense and warrant expense related to notespayable in 2007 were $463,862 and $204,550, respectively, compared to interestand warrant expense in 2006 of $129,498 and $68,184, respectively. Theseincreases were due to the Amscan, Party City and Highbridge notes beingoutstanding the full fiscal year 2007, while being outstanding only part of thefiscal year 2006. Our average notes payable balance was approximately$4,079,132 during 2007, compared to $1,367,544 in 2006, which increasedinterest by approximately $391,967. The effective interest rate on our notespayable increased to 16.3% in 2007, compared to 14.5% in 2006, which increasedinterest expense by $78,763. Additionally, interest expense from capital leasesand other sources in 2007 decreased by $59,263 from 2006. Interest expense in2007 was also slightly offset by interest income of $17,806.

 

*Income taxes*

 

In 2007, our provisionfor income taxes was $146,323, which included $19,215 for federal alternativeminimum taxes and $127,108 for state income taxes. Our provision for statetaxes exceeds the average statutory rate net of federal tax benefit because ofpermanent and temporary differences between taxable and book income, includingamounts associated with stock based compensation expense, depreciation, andnote payable amortization. We were able to utilize approximately $1,436,844 ofnet operating loss carryforwards for federal income tax purposes in 2007, whichwere fully reserved for in the prior year due to the uncertainty of futuretaxable income.

 

In 2006, our provisionfor income taxes was $17,279, which included $5,717 for federal alternativeminimum taxes and $11,562 for state income taxes. Our provision for state taxeswas less than the average statutory rate net of federal tax benefit because wewere able to use state tax loss carryforwards to reduce state taxes payable.Those state tax loss carryforwards were fully exhausted in 2006 and weretherefore not available to reduce state taxes payable in 2007. We were able toutilize approximately $621,692 of net operating loss carryforwards for federalincome tax purposes in 2006, which were fully reserved for in the prior yeardue to the uncertainty of future taxable income.

 

At the end of 2007, wehad estimated net operating loss carryforwards of approximately $21.2 million,which begin to expire in 2018. In accordance with Section 382 of theInternal Revenue 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.

 

*Net income (loss)*

 

Our net income in 2007 was $611,691 or$0.02 per basic and diluted share, compared to net income of $374,647, or $0.01per basic and diluted share, in 2006.

 

18

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**Fiscal2006 Compared to Fiscal 2005**

** **

*Revenues*

 

Our consolidated revenuesfor 2006, a 52 week year, were $78,458,329, an increase of $5,920,331, or 8.2%from 2005, a 53 week year. Revenues include the selling price of party goodssold, net of returns and discounts, and are recognized at the point of sale.

 
| ** **                           | ** ** | **For the year ended** | ** ** |
|--------------------------------------|------------|---------------------------------------|------------|
| ** **                           | ** ** | **Dec 30, 2006**            | ** ** | **Dec 31, 2005** | ** ** |
| Revenues                             |       | $                                     | 78,458,329 |   | $ | 72,537,998 |   |
|                                 |       |                                  |       |   |   |
| Increase in revenues from prior year |       | 8.2                                   | %          | 12.9 | % |
|                                      |            |                                       |            |  |  |  |  |

 

Sales for 2006 includedan increase of 3.8% in comparable store sales, sales from six new stores thatopened in 2005 which were not included in comparable stores sales in 2006 untilthey had been open for one full year and sales from one store that we acquiredin the third quarter of 2006.

 

*Cost ofgoods sold and occupancy costs*

 

Our cost of products soldand occupancy costs for 2006 was $44,942,542, or 57.3% of revenues, an increaseof $3,547,349 and an increase of 0.2 percentage points, as a percentage ofrevenues, from 2005. Cost of products sold and occupancy costs consists of thecost of merchandise sold to customers and the occupancy costs for our stores.

 
| ** **                             | ** ** | **For the year ended** | ** ** |
|----------------------------------------|------------|---------------------------------------|------------|
| ** **                             | ** ** | **Dec 30, 2006**            | ** ** | **Dec 31, 2005** | ** ** |
| Cost of goods sold and occupancy costs |       | $                                     | 44,942,542 |   | $ | 41,395,193 |   |
|                                   |       |                                  |       |   |   |
| Percentage of revenues                 |       | 57.3                                  | %          | 57.1% |   |
|                                        |            |                                       |            |  |  |  |  |

 

As a percentage ofrevenues, the increase in cost of products sold was primarily attributable toincreases in common area maintenance expenses and real estate tax expensescharged to us by our landlords.

 

### *Marketing and sales expense*

### * *

Our consolidatedmarketing and sales expense for 2006 was $25,625,547, or 32.7% of revenues, anincrease of $1,509,497 and a decrease of 0.5 percentage points, as a percentageof revenues, from 2005. Marketing and sales expense consists primarily ofadvertising and promotional expenditures, all store payroll and relatedexpenses for personnel engaged in marketing and selling activities and othernon-payroll expenses associated with operating our stores.

 
| ** **             | ** ** | **For the year ended** | ** ** |
|------------------------|------------|---------------------------------------|------------|
| ** **             | ** ** | **Dec 30, 2006**            | ** ** | **Dec 31, 2005** | ** ** |
| Marketing and sales    |       | $                                     | 25,625,547 |   | $ | 24,116,050 |   |
|                   |       |                                  |       |   |   |
| Percentage of revenues |       | 32.7                                  | %          | 33.2 | % |
|                        |            |                                       |            |  |  |  |  |

 

As a percentage ofrevenues, the decrease in marketing expense was primarily due to reduction inpre-opening expenses associated with the six new stores opened in 2005.

 

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*Generaland administrative expense*

 

Our consolidated generaland administrative (“G&A”) expense for 2006 was $6,736,197, or 8.6% ofrevenues, a decrease of $26,386 and a decrease of 0.7 percentage points, as apercentage of revenues, from 2005. G&A expense consists of payroll andrelated expenses for executive, merchandising, finance and administrativepersonnel, as well as information technology, professional fees and othergeneral corporate expenses.

 
| ** **                 | ** ** | **For the year ended** | ** ** |
|----------------------------|------------|---------------------------------------|------------|
| ** **                 | ** ** | **Dec 30, 2006**            | ** ** | **Dec 31, 2005** | ** ** |
| General and administrative |       | $                                     | 6,736,197  |   | $ | 6,762,583 |   |
|                       |       |                                  |       |   |   |
| Percentage of revenues     |       | 8.6                                   | %          | 9.3 | % |
|                            |            |                                       |            |  |  |  |  |

 

As a percentage ofrevenues, the decrease in general and administrative expense was primarilyattributable to improved leveraging of those costs from increased sales in ourstores.

 

*Operating income*

 

Our operating income for2006 was $1,154,043, or 1.5% of revenues, compared to an operating income of$264,172, or 0.4% of revenues in 2005.

 

*Interestexpense*

 

Our interest expense in 2006 was $772,334, anincrease of $239,685 from 2005. The increase during 2006 was due to an increasein interest rates, interest expense and warrant expense related to notespayable. The effective interest rate on our borrowings increased to 9.9% during2006 compared to 6.8% in 2005, which increased interest expense byapproximately $190,302. The interest rate on our line of credit was based onthe bank’s base rate plus 75 basis points. Interest expense and warrant expenserelated to notes payable in 2006 was $129,498 and $68,184, respectively. Theseincreases were partially offset by a reduction in interest expense related to alower average loan balance on our line of credit and a reduction in interestexpense related to capital leases associated with our point-of-sale system. Ouraverage loan balance was approximately $5,385,117 during 2006 compared to$6,208,700 in 2005, which decreased interest expense by approximately $116,737.Additionally, interest expense from capital leases in 2006 decreased by $39,167from 2005. Interest expense in 2006 was also slightly offset by interest incomeof $10,217.

 

*Income taxes*

 

In 2006, our provisionfor income taxes was $17,279, which included $5,717 for federal alternativeminimum taxes and $11,562 for state income taxes. We were able to utilizeapproximately $621,692 of net operating loss carryforwards for federal incometax purposes in 2006, which were fully reserved for in the prior year due tothe uncertainty of future taxable income.

 

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.

 

At the end of 2006, wehad estimated net operating loss carryforwards of approximately $23.0 million,which begin to expire in 2018. In accordance with Section 382 of theInternal Revenue 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.

 

20

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*Net income (loss)*

 

Our net income in 2006 was $374,647 or$0.01 per basic and diluted share, compared to a net loss of $267,676, or $0.01per basic and diluted share, in 2005.

 

**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.

 

*Inventory and Related Allowance for Obsolete andExcess Inventory*

 

Our inventory consists of party supplies and isvalued at the lower of moving weighted-average cost or market. We record vendorrebates, discounts and certain other adjustments to inventory, includingfreight costs, and we recognize these amounts in the income statement as therelated goods are sold.

 

During each interim reporting period, weestimate the impact on cost of products sold associated with inventoryshortage. The actual inventory shortage is determined upon reconciliation ofthe annual physical inventory, which occurs shortly before and after our yearend, and an adjustment to cost of products sold is recorded at the end of thefourth quarter to recognize the difference between the estimated and actualinventory shortage for the full year. The adjustment in the fourth quarter of2007 included an estimated reduction of $123,249 to the cost of products soldduring the previous three quarters. The adjustment in the fourth quarter of2006 included an estimated reduction of $251,806 to the cost of products soldduring the previous three quarters. The adjustment in the fourth quarter of2005 included an estimated reduction of $175,884 to the cost of products soldduring the previous three quarters.

 

We also make adjustments to reduce the value ofour inventory for an allowance for obsolete and excess inventory, which isbased on our review of inventories on hand compared to estimated future sales.We conduct reviews periodically throughout the year on each stock keeping unit(“SKU”). As we identify obsolete and excess inventory, we take immediatemeasures to reduce our inventory risk on these items and we adjust ourallowance accordingly. Thus, actual results could differ from our estimates.

 

*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.

 

*Property and Equipment*

 

Propertyand equipment are stated at cost less accumulated depreciation and aredepreciated on the straight-line method over the estimated useful lives of theassets. Expenditures for maintenance and repairs are charged to operations asincurred.

 

*IntangibleAssets*

 

Intangible assetsconsist primarily of the value of a five-year non-compete agreement from PartyCity Corporation (“Party City”) and its affiliates that covers Massachusetts,Maine, New Hampshire, Vermont, Rhode Island, and Windsor and New Londoncounties in Connecticut which expires in 2011. This asset has an estimated lifeof 60 months. Also included is the value related to the retail store lease thatwe acquired from Party City in Peabody, Massachusetts. This asset has anestimated life of 90 months, which includes 30 months on the initial term ofthe store lease plus 60 months on an existing lease renewal option.  Also, intangible assets includes legal andother transaction costs incurred before the end of our 2007 fiscal year relatedto the purchase of two Party City

21

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franchise storeslocated in Rhode Island. The Rhode Island stores transaction was completed on January 2,2008, shortly after the period covered by this report.

 

*Impairmentof Long-Lived Assets*

 

In accordance with SFAS No. 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 cashflows.  Our review considers storeoperating results, future sales growth and cash flows.  The conclusion regarding impairment maydiffer from current estimates if underlying assumptions or business strategieschange.  On November 4, 2006, weclosed our store in East Providence, Rhode Island due to underperformingsales.  As a result of this closing, werecorded a charge of approximately $140,000 related to remaining lease paymentsand other closing costs during the year ended December 30, 2006. The termof the lease expired on August 31, 2007. At December 29, 2007, the accrual has been reduced to zero. As of December 29,2007, we planned to close two stores in early January 2008, at the end oftheir lease terms.  These two stores wereclosed as planned. No impairment charges were required for these stores, as theassets related to them have been fully amortized, except for immaterialamounts, and no liability existed for future lease costs. We are not aware ofany impairment indicators for any of our remaining stores at December 29,2007.

 

*Income Taxes*

 

Historically, we have not recognized an incometax benefit for our losses. Accordingly, we record a valuation allowanceagainst our deferred tax assets because of the uncertainty of future taxableincome and the realizability of the deferred tax assets.  In determining if a valuation allowanceagainst our deferred tax asset is appropriate, we consider both positive andnegative evidence.  The positive evidencethat we considered included (1) we were profitable in 2007 and 2006, (2) wehave achieved positive comparable store sales growth for the last six years and(3) we had improved merchandise margins in 2007.  The negative evidence that we consideredincluded (1) we realized a net loss in 2005, (2) our merchandisemargins decreased in 2006 and 2005, (3) our future profitability isvulnerable to certain risks, including (a) the risk that we may not beable to generate significant taxable income to fully utilize our net operatingloss carryforwards of approximately $21.2 million, (b) the risk ofunseasonable weather and other factors in a single geographic region, NewEngland, where our stores are concentrated, (c) the risk of being sodependent upon a single season, Halloween, for a significant amount of annualsales and profitability and (d) the risk of fluctuating prices forpetroleum products, which are a key raw material for much of our merchandiseand which affect our freight costs and those of our suppliers and affect ourcustomers’ spending levels and patterns, (4) the costs that opening oracquiring new stores will put pressure on our profit margins until these storesreach maturity, (5) the expected costs of increased regulatory compliance,including, without limitation, those associated with Section 404 of theSarbanes-Oxley Act, will likely have a negative impact on our profitability.

 

The negative evidence is strong enough for us toconclude that the level of our future profitability is uncertain at this time.We believe that it is prudent for us to maintain a valuation allowance until wehave a longer track record of profitability and we can reduce our exposure tothe risks described above.  Should wedetermine that we will be able to realize our deferred tax assets in thefuture, an adjustment to our deferred tax assets would increase income in theperiod we made such a determination.

 

*Stock Option Compensation Expense*

 

On January 1, 2006,we adopted Statement No. 123(R) using the modified prospective methodin which compensation cost is recognized beginning with the effective date (a) basedon the requirements of Statement No. 123(R) for all share-basedpayments granted after the effective date and (b) based on therequirements of Statement No. 123 for all awards granted to employeesprior to the effective date of Statement No. 123(R) that remainunvested on the effective date.  Prior toJanuary 1, 2006, we accounted for our stock option compensation agreementswith employees under the provisions of Accounting Principles Board (“APB”)Opinion No. 25, *Accounting for StockIssued to Employees* and the disclosure-only provisions of Statement No. 123,*Accounting for Stock-Based Compensation*,as amended by SFAS No. 148, *Accounting for Stock-BasedCompensation – Transition and Disclosure, an amendment of Financial AccountingStandards Board (“FASB”) Statement No. 123*.

 

22

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*Use ofEstimates*

 

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.  Our actual results could differ from ourestimates.

 

**New Accounting Pronouncements**

 

InSeptember 2006, the FASB issued SFAS No. 157, *Fair ValueMeasurements* (“SFAS 157”). SFAS 157 defines fair value, establishesa framework for measuring fair value in accordance with generally acceptedaccounting principles and expands disclosures about fair value measurements.SFAS 157 emphasizes that fair value is a market-based measurement which shouldbe evaluated based on applicable assumptions for pricing an asset or liabilityas well as consideration of ongoing performance. The provisions of SFAS 157are effective for the fiscal year beginning after November 15, 2007 or forus the year ending December 27, 2008, and should be applied prospectivelyas of the beginning of the fiscal year in which the statement is adopted. In February 2008,the FASB decided to defer the effective date of SFAS 157 for all nonfinancialassets and nonfinancial liabilities, except those that are recognized ordisclosed at fair value in the financial statements on a recurring basis (atleast annually). We will adopt SFAS 157 for our fiscal year ending December 27,2008. We believe that SFAS 157 will not have a material effect on our financialposition or results of operations.

 

InFebruary 2007, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 159, *The Fair Value Option forFinancial Assets – including an amendment of FASB Statement No. 115 (“SFAS159”)*. SFAS  159 permitsentities to measure certain eligible financial instruments and certain otheritems at fair value. Unrealized gains and losses in items for which the fairvalue option has been elected must be reported in earnings in periodssubsequent to adoption.

 

SFAS159 will be effective as of the beginning of an entity’s first fiscal year thatbegins after November 15, 2007, or for us the fiscal year ending December 27,2008. We do not expect the adoption of SFAS No. 159 to have a materialeffect on our financial statements.

 

InDecember 2007, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 160, *Non-controlling Interestsin Consolidated Financial Statements – an amendment of ARB No. 51 (“SFAS160”).*SFAS 160 establishes accounting and reporting standardsrelated to minority interests held in consolidated subsidiaries. Among otherthings, it requires that:

 

·                  Theownership interests in subsidiaries held by parties other than the parent beidentified separately within the equity section of the statement of financialposition.

 

·                  Theamount of net income attributable to the minority interest be presented on theface of the consolidated statement of income.

 

·                  Entitiesprovide sufficient disclosures that clearly identify and distinguish betweenthe interests of the parent and the interests of the minority owners.

 

SFAS160 will be effective for fiscal years beginning on or after December 15,2008, or for us the fiscal year ending December 26, 2009. We do not haveany minority interests and do not expect the adoption of SFAS 160 to have amaterial effect on our financial statements.

 

InDecember 2007, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 141 (Revised 2007), *Business Combinations (“SFAS141(R)”).*SFAS 141(R) restates the requirement of SFAS No. 141that the purchase method of accounting be used for business combinationsachieved through the transfer of consideration, and extends that requirement tobusiness combinations that previously used the pooling of interests method ofaccounting, such as those achieved by contract alone or through the lapse ofminority rights. SFAS 141(R) applies 

 

23

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prospectively tobusiness combinations with acquisition dates on or after the beginning of thefirst annual reporting period beginning on or after December 15, 2008, orfor us the fiscal year ending December 26, 2009. We do not expect theadoption of SFAS 141(R) to have a material effect on our financialstatements.

 

In December 2007,the U.S. Securities and Exchange Commission (“SEC”) issued Staff AccountingBulletin No. 110 (“SAB 110”). SAB 110 authorizes the continued use ofthe “simplified” method, as discussed in SAB No. 107, in developing anestimate of expected term of “plain vanilla” share options in accordance withStatement of Financial Accounting Standards No. 123(R), *Share Based Payment.*SAB 110 is effective January 1,2008. We do not expect its adoption to have a material effect on our financialstatements.

 

**Liquidity and Capital Resources**

** **
|   |   | Our primary uses  of cash are:                                                                                       |
|--------|--------|----------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                 |
| · |   | purchases of  inventory, including purchases under our Supply Agreement with Amscan, as  described more fully below; |
| · |   | occupancy  expenses of our stores;                                                                                   |
| · |   | employee  salaries; and                                                                                              |
| · |   | new store  openings, including acquisitions.                                                                         |
|   |   |                                                                                                                 |
|   |   | Our primary  sources of cash are:                                                                                    |
|   |   |                                                                                                                 |
| · |   | cash from  operating activities; and                                                                                 |
| · |   | debt, including  our line of credit and notes payable.                                                               |

 

Our prospective cashflows 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 capital expenditures for 2008to include amounts for asset purchases related to our strategic plans toacquire new stores, as well as amounts related to opening new stores and improvingexisting stores.  We believe, based onour current operating plan, that anticipated revenues from operations andborrowings available under our existing line of credit will be sufficient tofund our operations and working capital requirements through the next twelvemonths.  In the event that our operatingplan changes due to changes in our strategic plans, lower-than-expectedrevenues, unanticipated expenses, increased competition, unfavorable economicconditions or other unforeseen circumstances, our liquidity may be negativelyimpacted.  If so, we would be required toadjust our expenditures in 2008 to conserve working capital or raise additionalcapital, possibly including debt or equity financing, to fund operations andour growth strategy.  There can be noassurance, that, should we seek or require additional financing, such financingwill be available, if at all, on terms and conditions acceptable to us,effecting our ability to effectuate our acquisition strategy.

 

Our operating activitiesused $239,008 in 2007 compared to providing $4,412,036 in 2006, an increase useof $4,651,044. The additional cash used by operating activities was primarilydue to higher purchases of inventory and reductions in accounts payable andaccrued expenses, as compared to increases in those liabilities in the prioryear.

 

We used $802,174 in investing activities in 2007compared to $2,579,007 in 2006.  The cashinvested in 2007 was primarily for fixed assets associated with improvements inour existing stores. The cash invested in 2006 was primarily for theacquisition in August 2006 of one retail store and a five-year non-competeagreement with Party City. Additional cash invested in 2006 was for fixedassets associated with improvements to our existing stores.  If we achieve our acquisition strategy in2008, we expect to see a further increase in investing activities.

 

We provided $352,338 incash from financing activities in 2007 compared to using $1,771,847 infinancing activities in 2006, an increase of $2,124,185.  We increased borrowings under our line ofcredit (see below) by $1,450,792 in 2007 (to $2.6 million) compared to adecrease of $5,473,155 in 2006 (to $1.2 million).  The borrowings under our line of credit in2007 were higher than 2006 primarily due to increased inventory purchases,increased payments of accounts payable and accrued expenses, and the absence ofnotes payable proceeds. In 2006, pursuant to our Supply Agreement with Amscan,we elected to convert $1,143,896 of extended payables originally 

 

24

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due to Amscan as of August 8, 2006 as well as an additional$675,477 of payables due to Amscan as of September 28, 2006 into a singlesubordinated promissory note in the total principal amount of $1,819,373.

 

We have a line of credit(the “line”) with Wells Fargo Retail Finance II, LLC, which expires on January 2,2010.  The maximum loan amount availableunder the line of credit with Wells Fargo is $12,500,000, which may beincreased up to a maximum level of $15,000,000, upon 15 days written notice, aslong as we are in compliance with all debt covenants and the other provisionsof the loan agreement.   The agreementpermits us, at our option, to use the London Interbank Offered Rate (“LIBOR”)for certain of our borrowings ratherthan the bank’s base rate. Borrowings under our line of credit are secured by our inventory andaccounts receivable. We borrow against these assets at agreed upon advancerates, which vary at different times of the year.

 

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 of credit availability calculationallows us to borrow against “acceptable inventory at cost,” which takes ourinventory at cost and reflects adjustments that our lender has approved whichmay be different than adjustments we use for valuing our inventory in ourfinancial statements, such as the adjustment to reserve for inventoryshortage.  The amount of “acceptableinventory at cost” was approximately $13,661,269 at December 29, 2007.

 

Our accounts receivableconsists primarily of vendor rebates receivables and credit cardreceivables.  Our line of creditavailability calculation allows us to borrow against “eligible credit cardreceivables,” which are the credit card receivables for the previous two tothree days of business.  The amount of “eligiblecredit card receivables” was approximately $218,615 at December 29, 2007.

 

Our total borrowing baseis determined by adding the “acceptable inventory at cost” times an agreed uponadvance rate plus the “eligible credit card receivables” times an agreed uponadvance rate but not to exceed our established credit limit, which was $12.5million at December 29, 2007.  Underthe terms of our line of credit, our $12,500,000 credit limit was furtherreduced by (1) a minimum availability block, (2) customer deposits, (3) giftcertificates, (4) merchandise credits and (5) outstanding letters ofcredit.  Therefore, our additionalavailability was $4,354,468 at December 29, 2007 and $5,657,200 at December 30,2006.

 

The amounts outstandingunder our line were $2,613,511 at December 29, 2007 and $1,162,719 as of December 30,2006.  The outstanding balances under ourline are classified as current liabilities in the accompanying consolidatedbalance sheets since we are required to apply daily lock-box receipts to reducethe amount outstanding.

 

Our line of creditincludes a number of covenants, including a financial covenant requiring us tomaintain a minimum availability under the line of 5% of the credit limit.  At December 29, 2007, we were incompliance with this financial covenant. The amended agreement also has acovenant that requires us to limit our capital expenditures to within 110% ofthose amounts included in our business plan, which may be updated from time totime. Actual capital expenditures for our fiscal year 2007 totaled $802,174, or116% of our business plan amount. On December 28, 2007, Wells Fargo waivedcompliance with the capital expenditure covenant for 2007. With this waiver, asof December 29, 2007, we believe we were in compliance with all of thecovenants under our line of credit.

 

On January 17, 2006,we amended our line to allow for a $500,000 term loan, which increased ourborrowing base, but was contained within the $12.5 million credit limit.  The interest rate on the term loan was thebank’s prime rate plus 125 basis points. During the time the term loan remainedoutstanding, the interest rate on the line of credit was the bank’s base rateplus 75 basis points.  The term loan hadan amended maturity date of October 31, 2007.  We repaid the term loan on March 2,2007.

 

On August 7, 2006,we amended our agreement with Wells Fargo to permit us to enter into a SupplyAgreement with Amscan and an Asset Purchase Agreement with Party City.  The amendment also allows for us to incur theindebtedness represented by the Amscan Note, defined below, and the Party CityNote, defined below, and to incur other unsecured subordinated indebtednessconsented to by Wells Fargo.

 

25

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Our Supply Agreement withAmscan gives us the right to receive certain additional rebates and morefavorable pricing terms over the term of the agreement than generally wereavailable to us under our previous terms with Amscan.  The right to receive additional rebates, andthe amount of such rebates, are subject to our achievement of increased levelsof purchases and other factors provided for in the Supply Agreement.  In exchange, the Supply Agreement obligatesus to purchase increased levels of merchandise from Amscan until 2012.  The Supply Agreement provided for a ramp-upperiod during 2006 and 2007 and, for five years beginning with calendar year2008, requires us to purchase on an annual basis merchandise equal to the totalnumber of our stores open during such calendar year, multiplied by $180,000.  The Supply Agreement provides for penaltiesin the event we fail to attain the annual purchase commitment that wouldrequire us to pay to Amscan the difference between the purchases for that yearand the annual purchase commitment for that year. Although we do not expect toincur any penalties under this supply agreement, if they were to occur, therecould be a material adverse effect on our uses and sources of cash.

 

The Supply Agreement alsoprovided for Amscan to extend, until October 31, 2006, approximately$1,150,000 of certain currently due Amscan payables owed by us to Amscan whichwould otherwise have been payable by us on August 8, 2006 (the “extendedpayables”) and gave us the right, at our option, to convert the extendedpayables into a subordinated promissory note.

 

As discussed above, on October 24,2006, we elected to convert $1,143,896 of extended payables originally due toAmscan as of August 8, 2006 as well as an additional $675,477 of payablesdue to Amscan as of September 28, 2006 into a single subordinatedpromissory note in the total principal amount of $1,819,373 (“the Amscan Note”).  The Amscan Note  bears interest at the rate of 11.0% per annumand is payable in thirty-six (36) equal monthly installments of principal andinterest of $59,562.48 commencing on November 1, 2006, and on the firstday of each month thereafter until October 1, 2009, when the entireremaining principal balance and all accrued interest is due and payable.

 

On August 7, 2006,we also entered into and simultaneously closed an Asset Purchase Agreement withParty City, an affiliate of Amscan, pursuant to which we acquired a Party Cityretail party goods store in Peabody, Massachusetts and received a five-yearnon-competition covenant from Party City, for aggregate consideration of$2,450,000, payable by a subordinated note in the principal amount of $600,000,which will bear interest at the rate of 12.25% per annum (the “Party City Note”)and $1,850,000 in cash.  The Party CityNote is payable by quarterly interest-only payments over four years, with thefull principal amount due at the note’s maturity on August 7, 2010.

 

On September 15,2006, we entered into a Securities Purchase Agreement pursuant to which weraised $2.5 million through a combination of subordinated debt and warrantsissued to Highbridge International LLC (“Highbridge”), an institutionalaccredited investor.

 

Under the terms of thefinancing, we issued Highbridge a three-year $2.5 million subordinated note(the “Highbridge Note”) that bears interest at an interest rate of prime plusone percent.  The Highbridge Note matureson September 15, 2009.  In addition,we issued Highbridge a warrant (the “Highbridge Warrant”) exercisable for2,083,334 shares of our common stock at an exercise price of $0.475 per share,or 125% of the closing price of our common stock on the day immediately priorto the closing of the transaction.  Weallocated approximately $613,651 of value to the Highbridge Warrant using theBlack-Scholes model with volatility of 108%, interest of 4.73% and expectedlife of five years.  The HighbridgeWarrant is being amortized using the effective interest method over the life ofthe Highbridge Note.  The agreementsentered into in connection with the financing provide for certain restrictionsand covenants consistent with Highbridge’s status as a subordinated lender, andalso grant Highbridge resale registration rights with respect to the shares ofcommon stock underlying the Highbridge Warrant.

 

The issuance of theHighbridge Warrant triggered certain anti-dilution provisions of our Series B,C, and D convertible preferred stock.  Asa result, the outstanding shares of these three series of preferred stock arenow convertible into an aggregate of 442,354 additional shares of common stock.  The issuance of the Highbridge Warrant,however, did not trigger the anti-dilution provisions of our Series E or Fconvertible preferred stock or any of our other outstanding warrants.

 

26

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Contractualobligations at December 29, 2007 were as follows:

 
| ** **                                       | ** ** | **Payments Due By Period** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------|------------|
| **Within  1 Year**                          | ** ** | **Within  2 - 3  Years**        | ** ** | **Within  4 - 5  Years** | ** ** | **After  5 Years** | ** ** | **Total** | ** ** |
| Line of credit                                   |       | $                                         | 2,613,511  |   | $ | — |   | $ | — |   | $ | — |   | $ | 2,613,511 |   |
| Capital lease obligations                        |       | 30,473                                    |       | 9,213 |   | — |   | — |   | 39,686 |   |
| Notes payable                                    |       | 620,706                                   |       | 3,612,549 |   | — |   | — |   | 4,233,255 |   |
| Supply agreement                                 |       | 9,000,000                                 |       | 18,000,000 |   | 18,000,000 |   | — |   | 45,000,000 |   |
| Operating leases (including retail space leases) |       | 8,551,099                                 |       | 15,594,039 |   | 11,443,556 |   | 9,278,427 |   | 44,867,121 |   |
| Total contractual obligations                    |       | $                                         | 20,815,789 |   | $ | 37,215,801 |   | $ | 29,443,556 |   | $ | 9,278,427 |   | $ | 96,753,573 |   |

 

In addition, at December 29,2007, we had outstanding purchase orders totaling approximately $3,324,914 forthe acquisition of inventory and non-inventory items that were scheduled fordelivery after December 29, 2007.

 

**Acquisitions**

 

We operate in a largelyun-branded market that has many small businesses.  As a result, we have considered, and maycontinue to consider, growing our business through acquisitions of otherentities.  Any determination to make anacquisition will be based upon a variety of factors, including, withoutlimitation, the purchase price and other financial terms of the transaction,the business prospects, geographical location and the extent to which anyacquisition would enhance our prospects.

 

On August 15, 2007,we entered into an Asset Purchase Agreement to purchase two franchised PartyCity Corporation retail stores in Lincoln, Rhode Island and Warwick, Rhode Island,in exchange for aggregate consideration of $1,350,000 plus up to $400,000 forassociated inventory. On January 2, 2008, we completed the purchase of thetwo stores. The aggregate consideration paid was $1,350,000 plus approximately$195,000 for associated inventory. The stores were converted into iParty storesimmediately following the closing of the transaction.

 

**StockholderRights Plan**

** **

On November 9, 2001,we announced that our board of directors adopted a stockholder rights plan (the“rights plan”).  Under the rights planeach share of our capital stock outstanding at the close of business on November 9,2001 and each share of our capital stock issued subsequent to that date has aright associated with it, such that each share of our common stock is entitledto one right and each share of our preferred stock is entitled to such numberof rights equal to the number of common shares into which it isconvertible.  The rights will becomeexercisable only in the event that, with certain exceptions, an acquiring partyaccumulates 10 percent or more of our voting stock or if a party announces anoffer to acquire 15 percent or more of our voting stock.  The rights expire on November 9,2011.  When exercisable, each rightentitles the holder to purchase from us one one-hundredth of a share of a newseries of Series G junior preferred stock at an initial purchase price of$2.00, subject to adjustment.  Inaddition, upon the occurrence of certain events, holders of the rights will beentitled to purchase either iParty Corp. stock or shares in an “acquiringentity” at half of market value.  Wegenerally will be entitled to redeem the rights at $0.001 per right at any timeuntil the date on which a 10 percent position in our voting stock is acquiredby any person or group.  Until a right isexercised, the holder of a right will have no rights as a stockholder of iPartysolely by virtue of being a rights holder, including, without limitation, theright to vote or receive dividends.

 

On September 15,2006, we amended the rights plan to clarify that the issuance of the HighbridgeWarrant did not constitute a triggering event under the rights plan.

 

27

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**Seasonality**

** **

**Due tothe seasonality of our business, sales and operating income are typicallyhigher in our second and fourth quarters. Our business is highly dependent upon sales of Easter, graduation andsummer merchandise in the second quarter and sales of Halloween and Christmas merchandisein the fourth quarter.  We have typicallyoperated at a loss during the first and third quarters.**

** **

**GeographicConcentration**

** **

**As of December 29,2007, we operated a total of 50 stores, 45 of which are located in NewEngland.  As a result, a severe orprolonged regional recession or regional changes in demographics, employmentlevels, population, weather patterns, real estate market conditions or otherfactors specific to the New England region may adversely affect us more than acompany that is more geographically diverse.**

** **

**Effectsof Inflation**

** **

While we do not view theeffects of inflation as having a direct material effect upon our business, webelieve that volatility in oil and gasoline prices impact the cost of producingpetroleum-based/plastic products, which are a key raw material in much of ourmerchandise, and also impact prices of shipping products made overseas inforeign countries, such as China, which includes much of our merchandise.  Volatile oil and gasoline prices also impactour freight costs, consumer confidence and spending patterns.  These and other issues directly or indirectlyaffecting our vendors and us could adversely affect our business and financialperformance.

 

**Off-Balance Sheet Arrangements**

 

We do not have any off-balance sheetarrangements that have or are reasonably likely to have a current or futureeffect on our financial condition, changes in financial condition, revenues orexpenses, results of operations, liquidity, capital expenditures or capitalresources that is material to investors.

 

**ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

We are exposed to market risk from changes ininterest rates and, indirectly, foreign exchange rates and commodity price riskwith respect to fluctuating oil prices as more fully described in Item 1A, “RiskFactors.”  In general, however, we do notbelieve we have the various market or price risks that require the quantitativeand qualitative disclosures set forth in Item 305 of Regulation S-K.  We have interest rate risk on our line ofcredit debt obligation to the extent that if interest rates were to rise ourrate of interest under our line of credit would also increase.  We do not believe that this interest raterisk is material and we have not entered into any hedging or similarcontractual arrangements with respect to such risk or with respect to theindirect market risks we face from changes in foreign exchange rates and oilprices.  We do not enter into contractsfor trading purposes.

 

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

 

The response to this item is included in aseparate section of this report. See “Index to Consolidated FinancialStatements” on page F–1.

 

**ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTSON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

None.

 

28

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**ITEM 9A. CONTROLS AND PROCEDURES**

 

(a)       *Evaluation of DisclosureControls and Procedures.*  TheChief Executive Officer and the Chief Financial Officer of iParty (itsprincipal executive officer and principal financial officer, respectively) haveconcluded, based on their evaluation as of December 29, 2007, the end ofthe fiscal year to which this report relates, that iParty’sdisclosure controls and procedures: are effective to ensure that informationrequired to be disclosed by iParty in the reports filed or submitted by itunder the Securities Exchange Act of 1934, as amended, is recorded, processed,summarized and reported within the time periods specified in the SEC’s rules andforms; and include controls and procedures designed to ensure that informationrequired to be disclosed by iParty in such reports is accumulated andcommunicated to iParty’s management, including the Chief Executive Officerand the Chief Financial Officer, to allow timely decisions regarding requireddisclosure.  iParty’s disclosure controlsand procedures were designed to provide a reasonable level of assurance ofreaching iParty’s disclosure requirements and are effective in reaching thatlevel of assurance.

 

(b)       *Management’s Report onInternal Control Over Financial Reporting.*Our management isresponsible for establishing and maintaining adequate internal control overfinancial reporting, as defined in Rules 13a-15(f) and 15d-15(f) underthe Securities Exchange Act of 1934, as amended.

 

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to risk that controls may become inadequate becauseof changes in conditions, or the degree of compliance with the policies andprocedures may deteriorate.

 

Our management hasassessed the effectiveness of its internal control over financial reporting asof December 29, 2007. This evaluation was based on the framework in *Internal Control-Integrated Framework* issued by theCommittee of Sponsoring Organizations (“COSO”). Based on its assessment, ourmanagement concluded that our internal control over financial reporting waseffective as of December 29, 2007 to provide reasonable assuranceregarding the reliability of financial reporting and the preparation offinancial statements for external purposes in accordance with generallyaccepted accounting principles.

 

*Thisreport shall not be deemed to be filed for purposes of Section 18 of theSecurities Exchange Act of 1934 or otherwise subject to the liability of that Section norincorporated by reference into a filing under the Securities Act of 1933 orSecurities Exchange Act of 1934.*

 

(c)       *Attestation Report of theRegistered Public Accounting Firm*. We are not an accelerated filer, as such term is defined in Rule 12b-2under the Securities Exchange Act of 1934, as amended.  Accordingly, this annual report does notinclude an attestation report of our independent registered public accountingfirm regarding internal control over financial reporting as management’s reportwas not subject to attestation by the Company’s registered public accountingfirm pursuant to temporary rules of the SEC that permit the Company toprovide only management’s report in this annual report.

 

** **(d)      *Changes in InternalControls.*  No change in ourinternal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Securities Exchange Act of 1934, as amended) occurredduring the fiscal quarter ended December 29, 2007 that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

 

ITEM 9A(T). CONTROLS AND PROCEDURES

 

The information requiredby this Item is included in Item 9A of this report.

 

ITEM9B.  OTHER INFORMATION

 

None.

 

29

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**PART III**

** **

**ITEM 10.  DIRECTORS, EXECUTIVE OFFICERS AND CORPORATEGOVERNANCE**

 

The information required by this Item is contained inour proxy statement for the annual meeting of stockholders scheduled to be heldon June 4, 2008, which we plan to file with the SEC no later than 120 daysafter the end of our fiscal year ended December 29, 2007.  Such information is hereby incorporated byreference.

 

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 Relations page ofour website which is located at www.iparty.com. We intend to disclose any amendments to, or waivers from, our code ofbusiness conduct and ethics on that same page of our website*.*

 

**ITEM 11.  EXECUTIVE COMPENSATION**

 

The information required by this Item is contained inour proxy statement for the annual meeting of stockholders scheduled to be heldon June 4, 2008, which we plan to file with the SEC no later than 120 daysafter the end of our fiscal year ended December 29, 2007.  Such information is hereby incorporated byreference.

 

**ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIALOWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS**

 

Certain of the information required by this Item iscontained in our proxy statement for the annual meeting of stockholdersscheduled to be held on June 4, 2008, which we plan to file with the SEC nolater than 120 days after the end of our fiscal year ended December 29,2007.  Such information is herebyincorporated by reference.

 

Securities authorized under equity compensation plans as of December 29,2007, were as follows:

 

 
| **EQUITY  COMPENSATION PLAN INFORMATION**                  |
|------------------------------------------------------------|
| **Plan Category**                                     | ** ** | **(A)  Number of Securities**

**to be Issued**

**upon Exercise of**

**Outstanding Options** | ** ** | **(B)  Weighted Average**

**Exercise Price of**

**Outstanding Options** | ** ** | **(C)  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     |   | 10,130,594 |   | $ | 0.59 |   | 434,145 |   |
| Equity compensation plans not approved by security holders |   | — |   | — |   | — |   |
| Total                                                      |   | 10,130,594 |   | $ | 0.59 |   | 434,145 |   |

 

Under the iPartyCorp. Amended and Restated 1998 Incentive and Nonqualified Stock Option Plan weare authorized to grant options for the purchase of up to 11,000,000 shares ofour common stock.  As of December 29,2007, 435,261 shares had been issued pursuant to the exercise of previouslyissued stock options.  As of December 29,2007, there were options outstanding to purchase 10,130,594 shares of ourcommon stock.  Consequently, as of December 29,2007, options for the purchase of up to 434,145 common shares remain availablefor future grants.

 

**ITEM 13.  CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS**

 

The information required by this Item is contained inour proxy statement for the annual meeting of stockholders scheduled to be heldon June 4, 2008, which we plan to file with the SEC no later than 120 daysafter the end of our fiscal year ended December 29, 2007.  Such information is hereby incorporated byreference.

 

30

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

 

The information required by this Item is contained inour proxy statement for the annual meeting of stockholders scheduled to be heldon June 4, 2008, which we plan to file with the SEC no later than 120 daysafter the end of our fiscal year ended December 29, 2007.  Such information is hereby incorporated byreference.

 

**PART IV**

 

**ITEM 15. EXHIBITS AND FINANCIALSTATEMENT SCHEDULES**

 
| (a)    |                            | 1. Financial  statements:                                                                                                                                                               |
|--------|---------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                            |                                                                                                                                                                                    |
|   |                            | For a listing of  consolidated financial statements which are included in this document, see  page F–1.                                                                       |
|   |                            |                                                                                                                                                                                    |
|   |                            | 2. Financial Statement  Schedules:                                                                                                                                                      |
|   |                            |                                                                                                                                                                                    |
|   |                            | All schedules for which  provision is made under Item 15(a)(2) are inapplicable and, therefore,  have been omitted.                                                                |
|   |                            |                                                                                                                                                                                    |
|   |                            | 3. Exhibits:                                                                                                                                                                            |
|   |                            |                                                                                                                                                                                    |
|   |                            | The exhibits listed in  the Exhibit Index immediately preceding the exhibits are filed as part  of this Annual Report on Form 10-K and are incorporated herein by  reference. |
|   |                            |                                                                                                                                                                                    |
| (b)    | Exhibits:                       |
|   |                            |                                                                                                                                                                                    |
|   |                            | The exhibits listed in  the Exhibit Index immediately preceding the exhibits are filed as part  of this Annual Report on Form 10-K and are incorporated herein by  reference. |
|   |                            |                                                                                                                                                                                    |
| (c)    | Financial Statement  Schedules: |
|   |                            |                                                                                                                                                                                    |
|   |                            | Included in Item  15(a)(2) above.                                                                                                                                                  |

 

31

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**SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

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

 

Dated:  March 13, 2008

 

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 13, 2008 |
| Sal Perisano            |       | Chief Executive Officer  (Principal Executive Officer)           |       |                |
|                    |       |                                                             |       |                |
| /s/ DAVID  ROBERTSON    |       | Chief Financial Officer                                          |       | March 13, 2008 |
| David Robertson         |       | (Principal Financial  Officer and Principal  Accounting Officer) |       |                |
|                    |       |                                                             |       |                |
| /s/ DANIEL DE  WOLF     |       | Director                                                         |       | March 13, 2008 |
|                    |       |                                                             |       |                |
| Daniel De Wolf          |       |                                                             |       |                |
|                    |       |                                                             |       |                |
| /s/ FRANK HAYDU         |       | Director                                                         |       | March 13, 2008 |
|                    |       |                                                             |       |                |
| Frank Haydu             |       |                                                             |       |                |
|                    |       |                                                             |       |                |
| /s/ ROBERT JEVON        |       | Director                                                         |       | March 13, 2008 |
|                    |       |                                                             |       |                |
| Robert Jevon            |       |                                                             |       |                |
|                    |       |                                                             |       |                |
| /s/ ERIC  SCHINDLER     |       | Director                                                         |       | March 13, 2008 |
|                    |       |                                                             |       |                |
| Eric Schindler          |       |                                                             |       |                |
|                    |       |                                                             |       |                |
| /s/ JOSEPH  VASSALLUZZO |       | Director                                                         |       | March 13, 2008 |
|                    |       |                                                             |       |                |
| Joseph  Vassalluzzo     |       |                                                             |       |                |

 

32

----

 

**iPARTY CORP.**

 

**INDEX TO CONSOLIDATED FINANCIAL STATEMENTS**

 
| ** **                                                                                      | **Page** |
|-------------------------------------------------------------------------------------------------|----------|
|                                                                                            |     |
| Report  of Independent Registered Public Accounting Firm                                        | F-2      |
|                                                                                            |     |
| Consolidated  Balance Sheets                                                                    | F-3      |
|                                                                                            |     |
| Consolidated  Statements of Operations                                                          | F-4      |
|                                                                                            |     |
| Consolidated  Statements of Convertible Preferred Stock and Stockholders’ Equity (Deficit) | F-5      |
|                                                                                            |     |
| Consolidated  Statements of Cash Flows                                                          | F-6      |
|                                                                                            |     |
| Notes to Consolidated Financial Statements                                                      | F-7      |

 

Theaccompanying notes are an integral part of these Consolidated FinancialStatements.

 

F-1

----

 

**Report of IndependentRegistered Public Accounting Firm**

 

Boardof Directors and Stockholders

iPartyCorp.

 

We have audited the accompanying consolidatedbalance sheets of iParty Corp. and subsidiaries as of December 29, 2007 andDecember 30, 2006, and the related consolidated statements of operations,convertible preferred stock and stockholders’ equity (deficit), and cash flowsfor each of the three years in the period ended December 29, 2007. 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 audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement.  We were not engaged to perform an audit of the Company’sinternal control over financial reporting.  Our audit includedconsideration of internal control over financial reporting as a basis fordesigning audit procedures that are appropriate in the circumstances, but notfor the purpose of expressing an opinion on the effectiveness of the Company’sinternal control over financial reporting. Accordingly, we express no suchopinion. An audit also includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements, assessing theaccounting principles used and significant estimates made by management, andevaluating the overall financial statement presentation.  We believe thatour audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of iParty Corp. and subsidiaries at December 29, 2007 and December 30,2006, and the consolidated results of their operations and their cash flows foreach of the three years in the period ended December 29, 2007, inconformity with U.S. generally accepted accounting principles.

 

On January 1, 2006, the Company adopted SFAS No. 123(Revised 2004), *Share Based Payments*. On December 31,2006, the Company adopted Financial Accounting Standards Board (FASB)Interpretation No. 48, *Accounting for Uncertaintyin Income Taxes*, an interpretation of FASB Statement No. 109.

 
|                   | /s/  Ernst & Young LLP |
|------------------------|---------------------------------|
|                   |                            |
|                   |                            |
| Boston,  Massachusetts |                            |
| March 7,  2008    |                            |

 

Theaccompanying notes are an integral part of these Consolidated FinancialStatements.

 

F-2

----

 

**iPARTY CORP.**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                                                             | ** ** | **Dec 29, 2007** | ** ** | **Dec 30, 2006** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| **ASSETS**                                                                                                                                                                                                                                                             |       |                       |       |                       |       |
| Current assets:                                                                                                                                                                                                                                                        |       |                       |       |                       |       |
| Cash and cash equivalents                                                                                                                                                                                                                                              |       | $                          | 71,532     |                       | $          | 760,376 |   |
| Restricted cash                                                                                                                                                                                                                                                        |       | 862,536                    |       | 706,066                    |       |
| Accounts receivable                                                                                                                                                                                                                                                    |       | 1,105,807                  |       | 1,116,042                  |       |
| Inventory, net                                                                                                                                                                                                                                                         |       | 13,639,531                 |       | 12,264,737                 |       |
| Prepaid expenses and other assets                                                                                                                                                                                                                                      |       | 996,779                    |       | 752,172                    |       |
| Total current assets                                                                                                                                                                                                                                                   |       | 16,676,185                 |       | 15,599,393                 |       |
| Property and equipment, net                                                                                                                                                                                                                                            |       | 4,360,123                  |       | 4,817,993                  |       |
| Intangible assets, net                                                                                                                                                                                                                                                 |       | 1,756,800                  |       | 2,015,750                  |       |
| Other assets                                                                                                                                                                                                                                                           |       | 183,978                    |       | 264,237                    |       |
| Total assets                                                                                                                                                                                                                                                           |       | $                          | 22,977,086 |                       | $          | 22,697,373 |   |
|                                                                                                                                                                                                                                                                   |       |                       |       |                       |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                                                                                                         |       |                       |       |                       |       |
| Current liabilities:                                                                                                                                                                                                                                                   |       |                       |       |                       |       |
| Accounts payable                                                                                                                                                                                                                                                       |       | $                          | 4,723,370  |                       | $          | 5,516,406 |   |
| Accrued expenses                                                                                                                                                                                                                                                       |       | 2,503,752                  |       | 3,070,003                  |       |
| Current portion of capital lease obligations                                                                                                                                                                                                                           |       | 30,473                     |       | 343,761                    |       |
| Current notes payable                                                                                                                                                                                                                                                  |       | 620,706                    |       | 551,515                    |       |
| Borrowings under line of credit                                                                                                                                                                                                                                        |       | 2,613,511                  |       | 1,162,719                  |       |
| Total current liabilities                                                                                                                                                                                                                                              |       | 10,491,812                 |       | 10,644,404                 |       |
|                                                                                                                                                                                                                                                                   |       |                       |       |                       |       |
| Long-term liabilities:                                                                                                                                                                                                                                                 |       |                       |       |                       |       |
| Capital lease obligations, net of current portion                                                                                                                                                                                                                      |       | 9,213                      |       | 42,456                     |       |
| Notes payable, net of discount of $340,917                                                                                                                                                                                                                             |       | 3,271,632                  |       | 3,736,309                  |       |
| Other liabilities                                                                                                                                                                                                                                                      |       | 1,113,522                  |       | 929,199                    |       |
| Total long-term liabilities                                                                                                                                                                                                                                            |       | 4,394,367                  |       | 4,707,964                  |       |
|                                                                                                                                                                                                                                                                   |       |                       |       |                       |       |
| 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; 465,401 and 471,401 shares issued and outstanding at  December 29, 2007 and December 30, 2006, respectively (aggregate  liquidation value of $9,308,024 at December 29, 2007) |       | 6,925,170                  |       | 7,014,450                  |       |
| Series C convertible preferred stock - 100,000 shares  authorized, issued and outstanding (aggregate liquidation value of $2,000,000  at December 29, 2007)                                                                                                  |       | 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 29, 2007)                                                                                                  |       | 3,652,500                  |       | 3,652,500                  |       |
| Series E convertible preferred stock - 533,333 shares  authorized; 296,666 shares issued and outstanding (aggregate liquidation  value of $1,112,497 at December 29, 2007)                                                                                   |       | 1,112,497                  |       | 1,112,497                  |       |
| Series F convertible preferred stock - 114,286 shares  authorized, issued and outstanding (aggregate liquidation value of $500,000  at December 29, 2007)                                                                                                    |       | 500,000                    |       | 500,000                    |       |
| Total convertible preferred stock                                                                                                                                                                                                                                      |       | 13,682,167                 |       | 13,771,447                 |       |
|                                                                                                                                                                                                                                                                   |       |                       |       |                       |       |
| Common stock - $.001 par value; 150,000,000 shares authorized;  22,700,655 and 22,603,877 shares issued and outstanding at December 29,  2007 and December 30, 2006, respectively                                                                            |       | 22,701                     |       | 22,604                     |       |
|                                                                                                                                                                                                                                                                   |       |                       |       |                       |       |
| Additional paid-in capital                                                                                                                                                                                                                                             |       | 51,894,481                 |       | 51,671,087                 |       |
| Accumulated deficit                                                                                                                                                                                                                                                    |       | (57,508,442                | )          | (58,120,133                | )          |
| Total stockholders’ equity                                                                                                                                                                                                                                        |       | 8,090,907                  |       | 7,345,005                  |       |
|                                                                                                                                                                                                                                                                   |       |                       |       |                       |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                                        |       | $                          | 22,977,086 |                       | $          | 22,697,373 |   |

 

Theaccompanying notes are an integral part of these Consolidated FinancialStatements.

 

F-3

----

 

**iPARTY CORP.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                        | ** ** | **For the periods ended** | ** ** |
|-----------------------------------|------------|------------------------------------------|------------|
| ** **                        | ** ** | **Dec 29, 2007**               | ** ** | **Dec 30, 2006** | ** ** | **Dec 31, 2005** | ** ** |
| ** **                        | ** ** | **(52 weeks)**                      | ** ** | **(52 weeks)** | ** ** | **(53 weeks)** | ** ** |
| Revenues                          |       | $                                        | 81,798,634 |   | $ | 78,458,329 |   | $ | 72,537,998 |   |
| Operating costs:                  |       |                                     |       |   |   |   |   |
| Cost of products sold             |       | 46,465,441                               |       | 44,942,542 |   | 41,395,193 |   |
| Marketing and sales               |       | 26,181,504                               |       | 25,625,547 |   | 24,116,050 |   |
| General and administrative        |       | 7,553,869                                |       | 6,736,197 |   | 6,762,583 |   |
|                              |       |                                     |       |   |   |   |   |
| Operating income                  |       | 1,597,820                                |       | 1,154,043 |   | 264,172 |   |
|                              |       |                                     |       |   |   |   |   |
| Other income                      |       | —                                   |       | — |   | — |   |
|                              |       |                                     |       |   |   |   |   |
| Income before income taxes        |       | 1,597,820                                |       | 1,154,043 |   | 264,172 |   |
|                              |       |                                     |       |   |   |   |   |
| Interest income                   |       | 17,806                                   |       | 10,217 |   | 801 |   |
| Interest expense                  |       | (857,612                                 | )          | (772,334 | ) | (532,649 | ) |
|                              |       |                                     |       |   |   |   |   |
| Income (loss) before income taxes |       | 758,014                                  |       | 391,926 |   | (267,676 | ) |
|                              |       |                                     |       |   |   |   |   |
| Income taxes                      |       | 146,323                                  |       | 17,279 |   | — |   |
|                              |       |                                     |       |   |   |   |   |
| Net income (loss)                 |       | $                                        | 611,691    |   | $ | 374,647 |   | $ | (267,676 | ) |
|                              |       |                                     |       |   |   |   |   |
| Income (loss) per share:          |       |                                     |       |   |   |   |   |
| Basic                             |       | $                                        | 0.02       |   | $ | 0.01 |   | $ | (0.01 | ) |
| Diluted                           |       | $                                        | 0.02       |   | $ | 0.01 |   | $ | (0.01 | ) |

 

Theaccompanying notes are an integral part of these Consolidated FinancialStatements.

 

F-4

----

 

**IPARTY CORP.**

**CONSOLIDATED STATEMENTS OF CONVERTIBLE PREFERRED STOCKAND STOCKHOLDERS’ EQUITY (DEFICIT)**

 
| ** **                                                                             | ** ** | **Stockholders’ Equity (Deficit)** | ** ** |
|----------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                             | ** ** | **Convertible**                                   | ** ** | ** ** | ** ** | ** ** | ** ** | **Additional** | ** ** | ** ** | ** ** | **Total** | ** ** |
| ** **                                                                             | ** ** | **Preferred Stock**                          | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Accumulated** | ** ** | **Stockholders’** | ** ** |
| ** **                                                                             | ** ** | **Shares**                                        | ** ** | **Amount** | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Capital** | ** ** | **Deficit** | ** ** | **Equity (Deficit)** | ** ** |
| Balance  December 25, 2004                                                        |       | 1,268,411                                         |       | $ | 14,307,999 |   | 22,092,717 |   | $ | 22,093 |   | $ | 50,448,103 |   | $ | (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 |   | — |   | — |   |
| Stock based  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                                                        |       | 1,235,353                                         |       | 13,816,098 |   | 22,536,637 |   | 22,537 |   | 50,971,659 |   | (58,494,780 | ) | 6,315,514 |   |
|                                                                                   |       |                                              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Issuance of  common stock upon conversion of Series B convertible preferred stock |       | (3,000                                            | )          | (44,651 | ) | 39,925 |   | 40 |   | 44,611 |   |   |   | — |   |
| Stock based  compensation                                                              |       | —                                            |       | — |   | — |   | — |   | 35,592 |   | — |   | 35,592 |   |
| Exercise of stock  options                                                             |       | —                                            |       | — |   | 27,315 |   | 27 |   | 5,574 |   | — |   | 5,601 |   |
| Issuance of  warrants                                                                  |       | —                                            |       | — |   | — |   | — |   | 613,651 |   | — |   | 613,651 |   |
| Net income                                                                             |       | —                                            |       | — |   | — |   | — |   | — |   | 374,647 |   | 374,647 |   |
| Balance  December 30, 2006                                                        |       | 1,232,353                                         |       | 13,771,447 |   | 22,603,877 |   | 22,604 |   | 51,671,087 |   | (58,120,133 | ) | 7,345,005 |   |
|                                                                                   |       |                                              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Issuance of  common stock upon conversion of Series B convertible preferred stock |       | (6,000                                            | )          | (89,280 | ) | 80,376 |   | 81 |   | 89,199 |   | — |   | — |   |
| Stock based  compensation                                                              |       | —                                            |       | — |   | — |   | — |   | 129,628 |   | — |   | 129,628 |   |
| Exercise of stock  options                                                             |       | —                                            |       | — |   | 16,402 |   | 16 |   | 4,567 |   | — |   | 4,583 |   |
| Net income                                                                             |       | —                                            |       | — |   | — |   | — |   | — |   | 611,691 |   | 611,691 |   |
| Balance  December 29, 2007                                                        |       | 1,226,353                                         |       | $ | 13,682,167 |   | 22,700,655 |   | $ | 22,701 |   | $ | 51,894,481 |   | $ | (57,508,442 | ) | $ | 8,090,907 |   |

 

Theaccompanying notes are an integral part of these Consolidated FinancialStatements.

 

F-5

----

 

**iPARTY CORP.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                                          | ** ** | **For the periods ended** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                          | ** ** | **Dec 29, 2007**               | ** ** | **Dec 30, 2006** | ** ** | **Dec 31, 2005** | ** ** |
| ** **                                                                                          | ** ** | **(52 weeks)**                      | ** ** | **(52 weeks)** | ** ** | **(53 weeks)** | ** ** |
| **Operating activities:**                                                                           |       |                                     |       | — |   |   |   |
|                                                                                                |       |                                     |       |   |   |   |   |
| Net income (loss)                                                                                   |       | $                                        | 611,691    |   | $ | 374,647 |   | $ | (267,676 | ) |
| Adjustments to reconcile net income (loss)  to net cash provided by (used in) operating activities: |       |                                     |       |   |   |   |   |
| Depreciation and amortization                                                                       |       | 1,705,948                                |       | 1,343,857 |   | 1,093,221 |   |
| Deferred rent                                                                                       |       | 184,323                                  |       | 260,196 |   | 197,244 |   |
| Non cash stock based compensation expense                                                           |       | 129,628                                  |       | 35,592 |   | — |   |
| Non cash warrant expense                                                                            |       | 204,550                                  |       | 68,183 |   | — |   |
| Changes in operating assets and  liabilities:                                                       |       |                                     |       |   |   |   |   |
| Accounts receivable                                                                                 |       | 10,235                                   |       | 130,503 |   | (545,584 | ) |
| Inventory                                                                                           |       | (1,374,794                               | )          | 1,283,983 |   | (1,850,336 | ) |
| Prepaid expenses and other assets                                                                   |       | (351,302                                 | )          | (149,766 | ) | 120,637 |   |
| Accounts payable                                                                                    |       | (793,036                                 | )          | 821,312 |   | 1,273,899 |   |
| Accrued expenses and other liabilities                                                              |       | (566,251                                 | )          | 243,529 |   | (281,312 | ) |
| Net cash provided by (used in) operating  activities                                                |       | (239,008                                 | )          | 4,412,036 |   | (259,907 | ) |
|                                                                                                |       |                                     |       |   |   |   |   |
| **Investing activities:**                                                                           |       |                                     |       |   |   |   |   |
|                                                                                                |       |                                     |       |   |   |   |   |
| Acquisition of retail store and non-compete  agreement                                              |       | —                                   |       | (1,869,115 | ) | — |   |
| Purchase of property and equipment                                                                  |       | (802,174                                 | )          | (709,892 | ) | (1,663,647 | ) |
| Net cash used in investing activities                                                               |       | (802,174                                 | )          | (2,579,007 | ) | (1,663,647 | ) |
|                                                                                                |       |                                     |       |   |   |   |   |
| **Financing activities:**                                                                           |       |                                     |       |   |   |   |   |
|                                                                                                |       |                                     |       |   |   |   |   |
| Net borrowings (repayments) under line of  credit                                                   |       | 1,450,792                                |       | (5,473,155 | ) | 1,378,184 |   |
| Proceeds from notes payable                                                                         |       | —                                   |       | 4,319,373 |   | — |   |
| Principal payments on notes payable                                                                 |       | (600,036                                 | )          | (86,081 | ) | — |   |
| Increase in restricted cash                                                                         |       | (156,470                                 | )          | (54,449 | ) | (90,210 | ) |
| Principal payments on capital lease  obligations                                                    |       | (346,531                                 | )          | (483,136 | ) | (425,982 | ) |
| Proceeds from exercise of stock options                                                             |       | 4,583                                    |       | 5,601 |   | 3,599 |   |
| Net cash provided by (used in) financing  activities                                                |       | 352,338                                  |       | (1,771,847 | ) | 865,591 |   |
|                                                                                                |       |                                     |       |   |   |   |   |
| **Net increase (decrease) in cash and cash  equivalents**                                           |       | (688,844                                 | )          | 61,182 |   | (1,057,963 | ) |
|                                                                                                |       |                                     |       |   |   |   |   |
| **Cash and cash equivalents, beginning of  year**                                                   |       | 760,376                                  |       | 699,194 |   | 1,757,157 |   |
|                                                                                                |       |                                     |       |   |   |   |   |
| **Cash and cash equivalents, end of year**                                                          |       | $                                        | 71,532     |   | $ | 760,376 |   | $ | 699,194 |   |
|                                                                                                |       |                                     |       |   |   |   |   |
| Supplemental disclosure of non-cash  financing activities:                                          |       |                                     |       |   |   |   |   |
|                                                                                                |       |                                     |       |   |   |   |   |
| Conversion of Series B convertible  preferred stock to common stock                            |       | $                                        | 89,280     |   | $ | 44,651 |   | $ | 491,901 |   |
|                                                                                                |       |                                     |       |   |   |   |   |
| Conversion of accounts payable to notes  payable                                                    |       | $                                        | —     |   | $ | 1,819,373 |   | $ | — |   |
|                                                                                                |       |                                     |       |   |   |   |   |
| Acquisition of assets under capital lease                                                           |       | $                                        | —     |   | $ | — |   | $ | 132,968 |   |

 

Theaccompanying notes are an integral part of these Consolidated FinancialStatements.

 

F-6

----

 

**iPARTY CORP.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**December 29, 2007**

 

**1.  THE COMPANY**

 

*Background*

 

TheCompany’s efforts are devoted to the sale of party goods and services throughits retail stores.  At the end of fiscal2007, the Company had 45 retail stores located throughout New England, withfive additional stores located in Florida. The Company licenses its Internetbusiness to a third party in exchange for royalties under a license agreement,which to date have not been significant.

 

Thestores feature over 20,000 products ranging from greeting cards and balloons tomore unique merchandise such as piñatas, gag gifts, masquerade and HawaiianLuau items.  The Company’s sales aredriven by the following events: Halloween, Christmas, Easter, Valentine’s Day, New Year’s, IndependenceDay, St. Patrick’s Day, Thanksgiving, and Chanukah.  The Company also focuses its business closelyon lifetime events such as anniversaries, graduations, birthdays, and bridal orbaby showers.  The Company’s business hasa seasonal pattern with higher revenues in the second and fourth quarters,reflecting school graduations and Halloween, respectively.

 

TheCompany’s fiscal years ended December 29, 2007 and December 30, 2006consisted of 52 weeks while fiscal year December 31, 2005 consisted of 53weeks.

 

*Management’s Plans*

 

TheCompany operates in a largely un-branded market that has many smallbusinesses.  As a result, it may considergrowing its business through acquisitions of other entities.  Any determination to make an acquisition willbe based upon a variety of factors, including, without limitation, the purchaseprice and other financial terms of the transaction, the business prospects,geographical location and the extent to which any acquisition by iParty would enhancethe target entity’s prospects.

 

OnAugust 15, 2007, the Company entered into an Asset Purchase Agreement topurchase two franchised Party City Corporation retail stores in Lincoln, RhodeIsland and Warwick, Rhode Island. The purchase was completed on January 2,2008. The aggregate consideration paid was $1,350,000 plus approximately$195,000 for associated inventory. Funding for the purchase was obtained fromthe Company’s existing line of credit with Wells Fargo Retail Finance. Thestores were converted into iParty stores immediately following the closing ofthe transaction.

 

TheCompany believes, based on its current operating plan, that anticipatedrevenues from operations and borrowings available under the existing line ofcredit will be sufficient to fund its operations and working capitalrequirements through the next twelve months****.****  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 2008 to conserve working capital orraise additional capital to fund operations. There can be no assurance that, should the Company seek or requireadditional financing, such financing will be available, if at all, on terms andconditions acceptable to it

 

**2.  SIGNIFICANTACCOUNTING POLICIES:**

 

*Principles of Consolidation*

 

Theconsolidated financial statements include the accounts of the Company and itswholly-owned subsidiaries after elimination of all significant intercompanytransactions and balances.

 

F-7

----

 

*Revenue Recognition*

 

Revenuesinclude the selling price of party goods sold, net of returns and discounts,and are recognized at the point of sale. The Company estimates returns basedupon historical return rates and such amounts have not been significant todate.

 

*Concentrations*

 

The Company purchases itsinventory from a diverse group of vendors. Six suppliers account for approximately 46% of the Company’s purchasesof merchandise, but the Company does not believe that it is overly dependentupon any single source for its merchandise, often using more than one vendorfor similar kinds of products.  TheCompany entered into a Supply Agreement with its largest supplier on August 7,2006, which obligates the Company to purchase increased levels of merchandiseuntil 2012.  The Supply Agreementprovides for a ramp-up period during 2006 and 2007 and, for five yearsbeginning with calendar year 2008, requires the Company to purchase on anannual basis merchandise equal to the total number of stores open during suchcalendar year, multiplied by $180,000. The Supply Agreement provides for penalties in the event the Companyfails to attain the annual purchase commitment that would require the Companyto pay the difference between the purchases for that year and the annualpurchase commitment for that year. The Company is not aware of any reason orcircumstance that would prevent the minimum purchase amount commitments underthe Supply Agreement from being met.

 

Accounts receivable primarily represent amountsdue from credit card companies and from vendors for inventory rebates.  Management does not provide for doubtfulaccounts as such amounts have not been significant to date; the Company doesnot require collateral.

 

### *Use of Estimates*

### * *

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States requires management to make estimatesand assumptions 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 revenues and expenses during thereporting period.  Actual results coulddiffer from these estimates.

 

*Cash and Cash Equivalents and Restricted Cash*

 

TheCompany considers all highly liquid investments with an original maturity dateof three months or less to be cash equivalents. Cash equivalents consist primarily of store cash funds and daily storereceipts in transit to our concentration bank and are carried at cost.

 

The Company uses controlled disbursement bankingarrangements as part of its cash management program.  Outstanding checks, which were included inaccounts payable, totaled $329,756 at December 29, 2007 and $2,316,026 at December 30,2006.  The decrease in outstanding checksas of December 29, 2007 is due to the timing of store lease payments.

 

Restricted cash represents funds on depositestablished for the benefit of and under the control of Wells Fargo RetailFinance II, LLC, the Company’s lender under its line of credit, and constitutescollateral for amounts outstanding under this line.

 

*Fair Value of FinancialInstruments*

 

The carrying values of cash and cashequivalents, accounts receivable and accounts payable approximate fair valuebecause of the short-term nature of these instruments.  The fair value of borrowings under theCompany’s line of credit approximates carrying value because the debt bearsinterest at a variable market rate.  Thefair value of the capital lease obligations approximates the carrying value.   The fair value of the notes payableapproximates the

 

F-8

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carryingvalue.   The fair value of the commonstock warrant issued in 2006 was determined by using the Black-Scholes model(volatility of 108%, interest of 4.73% and expected life of five years).

 

*Inventories*

 

Inventoriesconsist of party supplies and are valued at the lower of movingweighted-average cost or market. Inventory has been reduced by an allowance for obsolete and excessinventory, which is based on management’s review of inventories on handcompared to estimated future sales.  TheCompany records vendor rebates, discounts and certain other adjustments toinventory, including freight costs, and these amounts are recognized in theincome statement as the related goods are sold.

 

Theactivity in the allowance for obsolete and excess inventory is as follows:

 
| ** **                 | ** ** | **2007** | ** ** | **2006** | ** ** |
|----------------------------|------------|----------|------------|----------|------------|
| Beginning balance          |       | $        | 1,079,814  |     | $          | 1,098,972 |   |
| Increases to reserve       |       | 263,847  |       | 524,550  |       |
| Write-offs against reserve |       | (373,802 | )          | (543,708 | )          |
| Ending balance             |       | $        | 969,859    |     | $          | 1,079,814 |   |

 

### *Advertising*

### * *

Advertisingcosts are expensed upon first showing. Advertising costs amounted to $3,721,516, $3,659,743, and $3,439,403 forthe years ended December 29, 2007, December 30, 2006, and December 31,2005, respectively.

 

*Deferred Rent*

 

Certainoperating lease agreements contain scheduled rent increases, which are beingamortized over the terms of the agreements using the straight-line method, andare included in other liabilities in the accompanying consolidated balancesheet.  Deferred rent was $1,113,522 at December 29,2007 and $929,199 at December 30, 2006.

 

*Net Income (Loss) per Share*

 

Netincome (loss) per basic share is computed by dividing net income available tocommon shareholders by the weighted-average number of common sharesoutstanding.  The common shareequivalents of Series B-F are required to be excluded in the calculationof net income (loss) per basic share in accordance with EITF Consensus 03-6, *Participating**Securities and the Two-Class Methodunder SFAS No. 128*, which supersedes EITF Topic D-95, *Effect of Participating Convertible Securities on the Computation ofBasic Earnings Per Share.* Since the preferred stockholders areentitled to participate in dividends when and if declared by the Board ofDirectors on the same basis as if the shares of Series B-F were convertedto common stock, the application of EITF 03-6 has no effect on the amount ofincome (loss) per basic share of common stock. For periods with net losses, the Company does not allocate losses to Series B-Fpreferred stock.

 

Netincome (loss) per diluted share under EITF 03-6 is computed by dividing netincome (loss) by the weighted average number of common shares outstanding, plusthe common share equivalents of Series B-F preferred stock on anif-converted basis, 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.

 

F-9

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Thefollowing table sets forth the computation of net income (loss) per basic anddiluted share available to common stockholders:

 
| ** **                                                               | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|--------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Common shares                                                            |       | $          | 362,525    |       | $          | 223,203    |       | $ | (267,676 | ) |
| Convertible preferred Series B-F                                    |       | 249,166    |       | 151,444    |       | —     |       |
| Net income (loss)                                                        |       | $          | 611,691    |       | $          | 374,647    |       | $ | (267,676 | ) |
|                                                                     |       |       |       |       |       |       |       |
| Net income (loss) per share                                              |       |       |       |       |       |       |       |
| Basic                                                                    |       | $          | 0.02       |       | $          | 0.01       |       | $ | (0.01 | ) |
| Diluted                                                                  |       | $          | 0.02       |       | $          | 0.01       |       | $ | (0.01 | ) |
|                                                                     |       |       |       |       |       |       |       |
| Weighted-average shares outstanding:                                     |       |       |       |       |       |       |       |
| Common shares—basic                                                 |       | 22,642,564 |       | 22,557,436 |       | 22,186,581 |       |
| Common share equivalents of Series B-F  convertible preferred stock |       | 15,561,810 |       | 15,305,492 |       | —     |       |
| If-converted weighted-average shares  outstanding                        |       | 38,204,374 |       | 37,862,928 |       | 22,186,581 |       |
|                                                                     |       |       |       |       |       |       |       |
| Common share equivalents of “in the money”  stock options      |       | 1,708,900  |       | 1,672,946  |       | —     |       |
| Common share equivalents of “in the money”  warrants           |       | —     |       | —     |       | —     |       |
| Diluted weighted-average shares outstanding                              |       | 39,913,274 |       | 39,535,874 |       | 22,186,581 |       |

 

Thecommon share equivalents of “out of the money” stock options and warrants whichwere excluded from the computation of net income (loss) per diluted shareavailable to common stockholders were 4,654,753 and 2,611,544 in 2007,respectively, 3,858,769 and 2,611,544 in 2006, respectively, 10,340,841 and528,210 in 2005, respectively.

 

*Stock Option Compensation Expense*

 

OnJanuary 1, 2006, the Company adopted the Financial Accounting Standards Board(“FASB”) Statement No. 123(R), *Share-Based Payments*,using the modified prospective method. Under this method, stock based compensation expense is recognized fornew grants beginning in 2006 and any unvested grants prior to the adoption ofStatement No. 123(R).  Prior tofiscal 2006, the Company accounted for share-based payments to employees usingthe Accounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees*, and thedisclosure-only provisions of Statement No. 123, *Accountingfor Stock-Based Compensation*. Because the Company granted stock options to employees at exerciseprices equal to fair market value on the date of grant, no stock basedcompensation cost was recognized for option grants in periods prior to fiscal2006.

 

Inresponse to Statement No. 123(R), on September 21, 2005, the Company’sBoard of Directors approved an acceleration of the vesting of certain unvestedand “out-of-the-money” stock options previously awarded to employees andofficers with exercise prices equal to or greater than $0.69 per share.  Options held by non-employee directors wereexcluded from the vesting acceleration. As a result, options to purchase approximately 1.0 million shares ofiParty stock became exercisable immediately. Based upon the Company’s closing stock price of $0.46 on September 21,2005, none of these options had intrinsic value on the date of acceleration.

 

Inmaking the decision to accelerate these options, the Company’s Board ofDirectors considered the interest of the stockholders as it would reduce theCompany’s reported stock based compensation expense in future periods followingthe effectiveness of Statement No. 123(R). The future stock basedcompensation expense that was eliminated was approximately $508,000 on apre-tax basis and is reflected in the pro forma footnote disclosure for theyear ended December 31, 2005.

 

UnderStatement No. 123(R), the Company uses the Black-Scholes option pricingmodel to determine the fair value of stock based compensation.  The Black-Scholes model requires the Companyto make several subjective

 

F-10

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assumptions, including the estimated lengthof time employees will retain their vested stock options before exercising them(“expected term”), and the estimated volatility of the Company’s common stockprice over the expected term, which is based on historical volatility of theCompany’s common stock over a time period equal to the expected term.  The Black-Scholes model also requires arisk-free interest rate, which is based on the U.S. Treasury yield curve ineffect at the time of the grant, and the dividend yield on the Company’s commonstock, which is assumed to be zero since the Company does not pay dividends andhas no current plans to do so in the future. Changes in these assumptions can materially affect the estimate of fairvalue of stock based compensation and consequently, the related expenserecognized on the consolidated statement of operations.  Under the modified prospective method, stockbased compensation expense is recognized for new grants beginning in the fiscalyear ended December 30, 2006 and any unvested grants prior to the adoptionof Statement No. 123(R). The Company recognizes stock based compensationexpense on a straight-line basis over the vesting period of each grant.

 

Thestock based compensation expense recognized by the Company was:

 
| ** **                       | ** ** | **2007** | ** ** | **2006** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|
| Stock Based Compensation Expense |       | $        | 129,628    |     | $          | 35,592 |   |
|                                  |            |          |            |          |            |  |  |

 

Stockbased compensation expense is included in general and administrativeexpense.  The adoption of Statement No. 123(R) hadno impact on cash flow from operations and cash flow from financing activitiesfor the years ended December 29, 2007 and December 30, 2006.

 

On September 26, 2007, the Board of Directors,acting on the recommendation of the Compensation Committee, extended theexpiration date on options to purchase 970,087 shares of the Company’s commonstock held by a former officer for an additional six months following histermination date, making the expiration date August 15, 2008.  As a result, additional stock basedcompensation of $14,569, representing the change in the fair value of theseoptions immediately before and after this modification, was recorded as of September 26,2007 as required by Statement No. 123(R).

 

Inaccordance with Statement No. 123(R), the results for the year ended December 31,2005 have not been restated.  If thestock based compensation expense for the Company’s stock option plan had beendetermined based upon the fair value at the grant date for awards made prior tofiscal 2006 under the plan consistent with the methodology prescribed underStatement No. 123, the Company’s net loss would have been increased by$1,033,342 for the year ended December 31, 2005.  Basic and diluted loss per share would haveincreased by $0.05 for the year ended December 31, 2005.

 
| ** **                                                                                              | ** ** | **2005**   | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|------------|------------|
| Net income (loss):                                                                                      |       |       |       |
| Reported                                                                                                |       | $          | (267,676   | ) |
| Deduct: Total stock based compensation  expense determined under fair value based method for all awards |       | (1,033,342 | )          |
| Pro forma                                                                                               |       | $          | (1,301,018 | ) |
|                                                                                                    |       |       |       |
| Net income (loss) per basic share:                                                                      |       |       |       |
| Reported                                                                                                |       | $          | (0.01      | ) |
| Pro forma                                                                                               |       | $          | (0.06      | ) |
|                                                                                                    |       |       |       |
| Net income (loss) per diluted share:                                                                    |       |       |       |
| Reported                                                                                                |       | $          | (0.01      | ) |
| Pro forma                                                                                               |       | $          | (0.06      | ) |

 

Under the Company’s Amended and Restated 1998Incentive and Nonqualified Stock Option Plan (the “1998 Plan”) options toacquire 11,000,000 shares of common stock may be granted to officers,directors, key employees and consultants. The exercise price for qualified incentive options cannot be less thanthe fair market value of the

 

F-11

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stock on the grant date andthe exercise price of nonqualified options can be fixed by the Board. Optionsto purchase the Company’s common stock under the 1998 Plan have been granted toemployees, directors and consultants of the Company at fair market value at thedate of grant.  Generally, the optionsbecome exercisable over periods of up to four years, and expire ten years fromthe date of grant.

 

TheCompany granted options for the purchase of 1,350,000 shares of common stock tokey employees and each of the four independent members of the Board ofDirectors on June 6, 2007 at an exercise price of $0.42 per share.  Similarly, the Company granted options forthe purchase of 25,000 shares of common stock to each of the four independentmembers of the Board of Directors on June 7, 2006 at an exercise price of$0.36 per share.  The weighted-averagefair market value using the Black-Scholes option-pricing model of the optionsgranted was $0.33 per share for options granted during the twelve months ended December 29,2007, and was $0.30 per share for options granted during the twelve monthsended December 30, 2006.  The fairmarket value of the stock options at the date of the grant was estimated usingthe Black-Scholes option-pricing model with the following weighted averageassumptions:

 
| ** **                                | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Risk-free interest rate                   |       | 4.94     | %          | 5.18     | %          | 3.76     | %          |
| Expected volatility                       |       | 102.6    | %          | 115.6    | %          | 111.5    | %          |
| Weighted average expected life (in years) |       | 5.0      |       | 5.0      |       | 5.0      |       |
| Expected dividends                        |       | 0.00     | %          | 0.00     | %          | 0.00     | %          |

 

Thetotal fair value of shares vested during 2007 was $2,462.  The remaining unrecognized stock basedcompensation expense related to unvested awards at December 29, 2007, was$360,697 and the period of time over which this expense will be recognized is3.5 years.

 

*Property and Equipment*

 

Propertyand equipment are stated at cost less accumulated depreciation and aredepreciated on the straight-line method over the estimated useful lives of theassets.  Expenditures for maintenance andrepairs are charged to operations as incurred. A listing of the estimated useful life of the various categories ofproperty and equipment 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                              |       |

 

*Intangible Assets*

 

Intangible assets consistprimarily of the value of a five-year non-compete agreement from Party CityCorporation and its affiliates that covers Massachusetts, Maine, New Hampshire,Vermont, Rhode Island, and Windsor and New London counties in Connecticut whichexpires in 2011.  This asset has anestimated life of 60 months.  Alsoincluded is the value related to the retail store lease that the Companyacquired from Party City in Peabody, Massachusetts.  This asset has an estimated life of 90months.   Also, intangible assetsincludes legal and other transaction costs incurred before the end of  our 2007 fiscal year related to the purchaseof two Party City franchise stores located in Rhode Island. The Rhode Islandstores transaction was completed on January 2, 2008, shortly after theperiod covered by this report. These amounts will be included in theconsideration allocated to the value of intangible assets accounted for inconnection with store acquisitions.

 

F-12

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Intangibleassets as of December 29, 2007 and December 30, 2006 were:

 
| ** **                     | ** ** | **Dec 29, 2007** | ** ** | **Dec 30, 2006** | ** ** |
|--------------------------------|------------|----------------------------|------------|----------------------------|------------|
| Non-compete agreement          |       | $                          | 1,688,346  |                       | $          | 1,725,069 |   |
| Lease valuation                |       | 449,716                    |       | 460,000                    |       |
| Other                          |       | 182,049                    |       | —                     |       |
|                           |       |                       |       |                       |       |
| Intangible assets              |       | 2,320,111                  |       | 2,185,069                  |       |
|                           |       |                       |       |                       |       |
| Less: accumulated amortization |       | (563,310                   | )          | (169,319                   | )          |
|                           |       |                       |       |                       |       |
| Intangible assets, net         |       | $                          | 1,756,800  |                       | $          | 2,015,750 |   |

 

Amortizationexpense for these intangible assets was $393,991 in 2007, $169,319 in 2006 and$0 in 2005, respectively.  Thenon-compete agreement amortization expense is included in general andadministrative expense on the Consolidated Statement of Operations.  The lease valuation amortization expense isincluded in cost of goods sold and occupancy costs.

 

Futureamortization expense related to these intangible assets as of December 29,2007:

 
| **Year**   | ** ** | **Amount** | ** ** |
|------------|------------|------------|------------|
| 2008       |       | $          | 434,042    |   |
| 2009       |       | 434,041    |       |
| 2010       |       | 434,041    |       |
| 2011       |       | 293,346    |       |
| Thereafter |       | 161,330    |       |
| Total      |       | $          | 1,756,800  |   |

 

*Accounting for the Impairment of Long-Lived Assets*

 

Inaccordance with SFAS No. 144, *Accounting for theImpairment or Disposal of Long-Lived Assets*, the Company reviewseach store for impairment indicators whenever events and changes incircumstances suggest that the carrying amounts may not be recoverable fromestimated future store cash flows.  The Company’s review considers storeoperating results, future sales growth and cash flows. During the fourthquarter of 2006, the Company decided to close its store in East Providence,Rhode Island effective November 4, 2006 due to underperforming sales.  As a result of this closing, the Companyincurred a charge in the fourth quarter of 2006 of approximately $140,000related to remaining lease payments and other closing costs.  In addition, during the third quarter of2007, the Company decided to close its stores in North Providence, Rhode Islandand Auburn, Massachusetts ** **at the end of their lease terms,which expired on January 31, 2008. No material impairment costs were incurred as a result of thatdecision.  As of December 29, 2007,the Company does not believe that any of its remaining assets are impaired.

 

*New Accounting Pronouncements*

 

InSeptember 2006, the FASB issued SFAS No. 157, *Fair ValueMeasurements* (“SFAS 157”). SFAS 157 defines fair value, establishesa framework for measuring fair value in accordance with generally acceptedaccounting principles and expands disclosures about fair value measurements.SFAS 157 emphasizes that fair value is a market-based measurement which shouldbe evaluated based on applicable assumptions for pricing an asset or liabilityas well as consideration of ongoing performance. The provisions of SFAS 157are effective for the fiscal year beginning after November 15, 2007 or forthe Company the fiscal year ending December 27, 2008, and should beapplied prospectively as of the beginning of the fiscal year in which thestatement is adopted. In February 2008, the FASB decided to defer theeffective date of SFAS 157 for all nonfinancial assets and nonfinancialliabilities, except those that are recognized or disclosed at fair value in thefinancial statements on a recurring basis (at least 

 

F-13

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annually). The Companywill adopt SFAS 157 for its fiscal year ending December 27, 2008. TheCompany believes that SFAS 157 will not have a material effect on its financialposition or results of operations.

 

InFebruary 2007, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 159, *The Fair Value Option forFinancial Assets – including an amendment of FASB Statement No. 115 (“SFSA159”)*. SFAS 159 permits entities to measure certain eligiblefinancial instruments and certain other items at fair value. Unrealized gainsand losses in items for which the fair value option has been elected must bereported in earnings in periods subsequent to adoption.

 

SFAS159 will be effective as of the beginning of an entity’s first fiscal year thatbegins after November 15, 2007, or for the Company the fiscal year ending December 27,2008. The Company does not expect the adoption of SFAS 159 to have a materialeffect on its financial statements.

 

InDecember 2007, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 160, *Non-controlling Interestsin Consolidated Financial Statements – an amendment of ARB No. 51 (“SFSA160”).*SFAS 160 establishes accounting and reporting standardsrelated to minority interests held in consolidated subsidiaries. Among otherthings, it requires that:

 

·                  Theownership interests in subsidiaries held by parties other than the parent beidentified separately within the equity section of the statement of financialposition.

 

·                  Theamount of net income attributable to the minority interest be presented on theface of the consolidated statement of income.

 

·                  Entitiesprovide sufficient disclosures that clearly identify and distinguish betweenthe interests of the parent and the interests of the minority owners.

 

SFAS160 will be effective for fiscal years beginning on or after December 15,2008, or for the Company the fiscal year ending December 26, 2009. TheCompany does not have any minority interests and does not expect the adoptionof SFAS 160 to have a material effect on its financial statements.

 

InDecember 2007, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 141 (Revised 2007), *Business Combinations (“SFAS141(R)”).*SFAS 141(R) restates the requirement of SFAS No. 141that the purchase method of accounting be used for business combinationsachieved through the transfer of consideration, and extends that requirement tobusiness combinations that previously used the pooling of interests method ofaccounting, such as those achieved by contract alone or through the lapse ofminority rights. In addition, SFAS 141(R) requires that acquisitionrelated costs be expensed in the period in which they are incurred. SFAS 141(R) appliesprospectively to business combinations with acquisition dates on or after thebeginning of the first annual reporting period beginning on or after December 15,2008, or for the Company the fiscal year ending December 26, 2009. TheCompany does not expect the adoption of SFAS 141(R) to have a materialeffect on its financial statements.

 

InDecember 2007, the U.S. Securities and Exchange Commission (“SEC”) issuedStaff Accounting Bulletin No. 110 (“SAB 110”). SAB 110 authorizes thecontinued use of the “simplified” method, as discussed in SAB No. 107, indeveloping an estimate of expected term of “plain vanilla” share options inaccordance with Statement of Financial Accounting Standards No. 123(R), *Share Based Payment.*SAB 110 is effective January 1,2008. The Company does not expect its adoption to have a material effect on itsfinancial statements.

 

*Reclassifications*

 

Certain reclassifications have been madeto prior year’s amounts to conform to the current year presentation.

 

F-14

----

 

**3.  PROPERTY AND EQUIPMENT:**

** **

Propertyand equipment consist of the following:

 
| ** **                     | ** ** | **Dec 29, 2007** | ** ** | **Dec 30, 2006** | ** ** |
|--------------------------------|------------|----------------------------|------------|----------------------------|------------|
| Leasehold improvements         |       | $                          | 3,138,079  |                       | $          | 2,755,807 |   |
| Furniture and fixtures         |       | 2,635,838                  |       | 2,531,579                  |       |
| Equipment under capital leases |       | 1,416,334                  |       | 1,454,129                  |       |
| Computer hardware and software |       | 1,841,359                  |       | 1,531,870                  |       |
| Equipment                      |       | 656,445                    |       | 612,496                    |       |
|                           |       |                       |       |                       |       |
| Property and equipment         |       | 9,688,055                  |       | 8,885,881                  |       |
| Less accumulated depreciation  |       | (5,327,932                 | )          | (4,067,888                 | )          |
|                           |       |                       |       |                       |       |
| Property and equipment, net    |       | $                          | 4,360,123  |                       | $          | 4,817,993 |   |

 

**4.  LEASES:**

** **

The Company conducts its operations in leasedfacilities with certain leased equipment accounted for as operating and capitalleases.  Real estate leases generallyprovide for fixed minimum rentals, which typically increase periodically duringthe life of the lease, and, in some instances, contingent rentals based on apercentage of sales in excess of specified minimum sales levels, as well asoccupancy costs, such as property taxes and common area maintenance.  The leases are typically for 10 years,usually with options from the Company’s landlords to renew the Company’s leasesfor an additional 5 or 10 years.

 

The original cost of assets under capital leasesat December 29, 2007 and December 30, 2006 was $1,416,334 and$1,454,129, respectively. The accumulated depreciation of assets under capitalleases at December 29, 2007 and December 30, 2006 was $987,425 and$705,551, respectively.  The amortizationrelated to those assets under capital lease is included in depreciationexpense.

 

At December 29, 2007, the minimum rentalcommitments under all non-cancelable capital and operating leases with initialor remaining terms of more than one year were as follows:

 
| **Year**                                                 | ** ** | **Capital** | ** ** | **Operating** | ** ** |
|----------------------------------------------------------|------------|-------------|------------|---------------|------------|
| 2008                                                     |       | $           | 37,636     |          | $          | 8,551,099 |   |
| 2009                                                     |       | 7,295       |       | 8,240,998     |       |
| 2010                                                     |       | —      |       | 7,353,041     |       |
| 2011                                                     |       | —      |       | 6,519,214     |       |
| 2012                                                     |       | —      |       | 4,924,343     |       |
| Thereafter                                               |       | —      |       | 9,278,426     |       |
| Total future minimum lease payments                      |       | 44,931      |       | $             | 44,867,121 |   |
|                                                     |       |        |       |          |       |
| Less amount representing interest                        |       | 5,245       |       |          |       |
|                                                     |       |        |       |          |       |
| Present value of minimum lease payments                  |       | 39,686      |       |          |       |
| Less current portion of obligation under capital  leases |       | 30,473      |       |          |       |
|                                                     |       |        |       |          |       |
| Long-term obligation under capital leases                |       | $           | 9,213      |          |       |   |

 

F-15

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TheCompany’s rental expense under operating leases amounted to $8,857,650 in 2007,$8,699,501 in 2006, and $7,725,856 in 2005. Included in these amounts are contingent rentals totaling $50,643 in2007, $47,334 in 2006, and $30,695 in 2005.

 

**5.  INCOME TAXES:**

** **

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

 
| ** **                                 | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Federal statutory rate                     |       | 34.0     | %          | 34.0     | %          | -34.0    | %          |
| State income taxes, net of federal benefit |       | 9.5      | %          | 1.9      | %          | 0.0      | %          |
| Permanent differences                      |       | 7.2      | %          | 4.9      | %          | 4.8      | %          |
| Change in valuation allowance              |       | -31.3    | %          | -36.4    | %          | 29.2     | %          |
| Effective tax rate                         |       | 19.4     | %          | 4.4      | %          | 0.0      | %          |

 

The Company’s provision for state taxesexceeds the average statutory rate net of federal tax benefit because ofpermanent and temporary differences between taxable and book income, includingamounts associated with stock based compensation expense, depreciation, andnote payable amortization.

 

Deferred tax assets consist of thefollowing:

 
| ** **                                     | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|------------------------------------------------|------------|------------|------------|------------|------------|
| Net operating loss carryforwards               |       | $          | 7,200,000  |       | $          | 7,829,000 |   |
| Inventory reserves                             |       | 385,000    |       | 428,000    |       |
| Deferred rent                                  |       | 441,000    |       | 368,000    |       |
| Accrued vacation/compensation                  |       | 61,000     |       | 69,000     |       |
| Accrued expenses                               |       | 9,000      |       | 29,000     |       |
| Intangible assets                              |       | 143,000    |       | 43,000     |       |
| Other                                          |       | —     |       | 4,000      |       |
| Book versus tax depreciation and  amortization |       | 99,000     |       | (26,000    | )          |
|                                           |       | 8,338,000  |       | 8,744,000  |       |
| Less valuation allowance                       |       | (8,338,000 | )          | (8,744,000 | )          |
| Net deferred tax asset                         |       | $          | —     |       | $          | — |   |

 

TheCompany has recorded a valuation allowance against its deferred tax assetsbecause of the uncertainty regarding the realizability of these assets againstfuture taxable income.

 

TheCompany used approximately $1,436,844 and $621,692 of net operating losscarryforwards in 2007 and 2006, respectively.

 

Asof December 29, 2007, the Company has estimated net operating losscarryforwards of approximately $21.2 million, which begin to expire in 2018.  In accordance with Section 382 of theInternal Revenue Code, the use of some of these carryforwards may be subject toannual limitations based upon ownership changes of the Company’s stock whichmay have occurred or that may occur.

 

TheCompany made cash payments for state income taxes of $56,478 in 2007, $33,509in 2006 and $73,005 in 2005.  The Companymade cash payments for federal income taxes of $0 in 2007, $0 in 2006 and $0 in2005.

 

TheCompany adopted the provisions of Financial Accounting Standards Board (“FASB”)Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, aninterpretation of FASB Statement No. 109” (“FIN 48”) on December 31,2006. At December 29, 2007, the Company had no material unrecognized taxbenefits and no adjustments to liabilities, retained earnings or operationswere required.

 

TheCompany recognizes interest and penalties related to uncertain tax positions inincome tax expense which were zero for the year ended December 29, 2007.

 

F-16

----

 

Tax years 2004 through2006 are subject to examination by the federal and state taxing authorities.There are no income tax examinations currently in process.

 

**6. CONTRACTUAL ARRANGEMENTS:**

 

*LicenseArrangement*

 

On July 8,2003 the Company signed an agreement with Taymark, a direct marketer of partysupplies, 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 soonerterminated.  If this agreement is notterminated, it automatically renews for successive one-year periods.  On July 8, 2005, July 8, 2006 and July 8,2007, the Company entered into one-year renewal periods.

 

**7.  RELATED PARTY TRANSACTIONS:**

** **

On September 7,1999, the Company and Mr. Stuart Moldaw, who served as a Director of theCompany from 1999 to 2003, entered into a consulting agreement that had a termof three years.  Upon the expiration ofthis agreement, the Company and Mr. Moldaw entered into an oral agreementthat Mr. Moldaw would continue to provide consulting services to theCompany.  On November 6, 2003, theCompensation Committee of the Company’s Board of Directors approved a stockoption grant to Mr. Moldaw, vesting immediately, with an exercise priceset at the closing price of the Company’s common stock on that day, to purchase50,000 shares of common stock, for consulting services performed by Mr. Moldawin 2003.  The fair value of the optionsgranted to Mr. Moldaw on November 6, 2003 was $25,000.  On January 31, 2005, the CompensationCommittee of the Company’s Board of Directors approved a stock option grant to Mr. Moldaw,vesting immediately, with an exercise price set at the closing price of theCompany’s common stock on that day, to purchase 50,000 shares of common stock,for consulting services performed by Mr. Moldaw in 2004.  The fair value of the options granted on January 31,2005 was $28,500.

 

On June 8,2005, the Company’s Board of Directors approved the payment of up to $60,000 toJoseph Vassalluzzo, a Director of the Company, for services as a part-timeconsultant for a one-year period.  As of December 30,2006, this amount had been earned and paid.

 

On June 7, 2006, theCompany’s Board of Directors approved the payment of up to $60,000 to JosephVassalluzzo, a Director of the Company, for services as a part-time consultantfor a one-year period.  As of December 29,2007, this amount had been earned and paid.

 

On June 6, 2007, theCompany’s Board of Directors approved the payment of up to $60,000 to JosephVassalluzzo, a Director of the Company, for services as a part-time consultantfor a one-year period.  As of December 29,2007, $30,000 had been earned and paid.

 

**8.**  **LINE OF CREDIT:**

 

 On December 21, 2006, the Company amendedand restated its existing line of credit (the “line”) with Wells Fargo RetailFinance II, LLC. The amendment continues the line of credit with Wells Fargo at$12,500,000 and extends it for three additional years to January 2,2010.  In addition, the new agreementwith Wells Fargo includes an option whereby the Company may increase its lineof credit up to a maximum level of $15,000,000, upon 15 days written notice, aslong as it is in compliance with all debt covenants and the other provisions ofthe loan agreement.  The new agreementalso adjusts the interest rate applicable to the Company’s borrowings andpermits the Company at its option, to use the London Interbank Offered Rate (“LIBOR”)rate for certain of its borrowings. Inventory and accounts receivable secure the Company’s line.

 

The amended line includesa financial covenant requiring the Company to maintain a minimum availabilityunder the line of 5% of the credit limit. At the current credit limit of $12,500,000, the minimum availability is 

 

F-17

----

 

$625,000.  At December 29, 2007, the Company was incompliance with this financial covenant.  The amended agreement also has a covenant that requires the Company tolimit its capital expenditures to within 110% of those amounts included in itsbusiness plan, which may be updated from time to time.  Actual capital expenditures for our fiscalyear 2007 totaled $802,174, or 116% of our business plan amount. On December 28,2007, Wells Fargo waived compliance with the capital expenditure covenant for2007.   The line generally prohibits thepayment of any dividends or other distributions to any of the Company’s classesof capital stock.

 

On January 17, 2006,the Company amended its prior agreement to allow for a $500,000 term loan whichincreased its borrowing base, but did not increase the $12.5 million creditlimit.  The Company borrowed the full$500,000 on that date.  The interest rateon the term loan was the bank’s base rate plus 125 basis points.  During the time in which the term loanremained outstanding, the interest rate on the line of credit was the bank’sbase rate plus 75 basis points.  On October 30,2006, the Company further amended its agreement to extend the maturity date ofits outstanding term loan in the amount of $500,000 from October 31, 2006to January 2, 2007.  On December 21,2006, the Company further amended its agreement to extend the maturity date of itsoutstanding term loan in the amount of $500,000 to October 31, 2007.  The amendment entered into on January 17,2006 also waived a default as a consequence of the fact that the principalbalance of the line of credit exceeded availability on January 12,2006.  The term loan was paid in full on March 2,2007.

 

On August 7, 2006,the Company further amended its prior agreement with Wells Fargo to permit itto enter into a Supply Agreement with Amscan and an Asset Purchase Agreementwith Party City.  The amendment alsoallows for the Company to incur the indebtedness represented by the Amscan Noteand the Party City Note, and to incur other unsecured subordinated indebtednessconsented to by Wells Fargo.

 

The amounts outstandingunder the line as of December 29, 2007 and December 30, 2006 were$2,613,511 and $1,162,719, respectively. The interest rate on these borrowings was 8.2% at December 29, 2007and 8.6% at December 30, 2006.  Theoutstanding balances under the line are classified as current liabilities inthe accompanying consolidated balance sheets since the Company is required toapply daily lock box receipts to reduce the amount outstanding.  At December 29, 2007, the Company hadapproximately $4,354,468 of additional availability under the line.  In the third quarter of fiscal 2004, theCompany established a letter of credit for $356,000 with Wells Fargo Bank, N.A.associated with the leasing of its new point-of-sale system.  On May 22, 2007, this letter of creditwas released.

 

The Company made cashpayments for interest due under the line of $645,392 in 2007, $748,656 in 2006and $501,826 in 2005.

 

**9.  NOTES PAYABLE:**

** **

Notes payable consist ofthree notes entered into in fiscal 2006.

 

The “Highbridge Note” isa subordinated note in the stated principal amount of $2,500,000 that bearsinterest at the rate of prime plus one percent. The note matures on September 15, 2009.  Interest only is payable quarterly in arrearsand the entire principal balance is due at the maturity date. The originaldiscount associated with the warrant issued in conjunction with the HighbridgeNote (original discount amount $613,651) is being amortized using the effectiveinterest method over the life of the note payable. The note payable balance of$2,159,083 as of December 29, 2007 is presented net of the remainingunamortized discount.

 

The “Amscan Note” is asubordinated promissory note in the original principal amount of $1,819,373,with a balance as of December 29, 2007 of $1,133,255. The note bearsinterest at the rate of 11.0% per annum and is payable in thirty-six (36) equalmonthly installments of principal and interest of $59,562 beginning on November 1,2006, and on the first day of each month thereafter until October 1, 2009,when the entire remaining principal balance and all accrued interest are dueand payable.

 

The “Party City Note” isa subordinated promissory note in the principal amount of $600,000.   The note bears interest at the rate of12.25% per annum and is payable by quarterly interest-only payments over fouryears, with the full principal amount due at the note’s maturity on August 7,2010.

 

F-18

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On August 7, 2006,the Company entered into a Supply Agreement with Amscan Inc. (“Amscan”), thelargest supplier in the party goods industry. The Company purchased approximately 18.4% and 16.0% of its merchandisefrom Amscan in each of fiscal 2007 and 2006, respectively making Amscan itslargest supplier.

 

The Supply Agreement withAmscan gives the Company the right to receive certain additional rebates andmore favorable pricing terms over the term of the agreement than generally wereavailable to the Company under its previous terms with Amscan.  The right to receive additional rebates, andthe amount of such rebates, are subject to the Company’s achievement ofincreased levels of purchases and other factors provided for in the SupplyAgreement.  In exchange, the SupplyAgreement obligates the Company to purchase increased levels of merchandisefrom Amscan until 2012.  The SupplyAgreement provides for a ramp-up period during 2006 and 2007 and, beginningwith calendar year 2008, requires the Company to purchase on an annual basismerchandise equal to the total number of its stores open during such calendaryear, multiplied by $180,000.  The SupplyAgreement provides for penalties in the event the Company fails to attain theannual purchase commitment.

 

The Supply Agreement alsoprovided for Amscan to extend, until October 31, 2006, approximately$1,150,000 of certain currently due Amscan payables owed by the Company toAmscan which would otherwise have been payable on August 8, 2006 (the “extendedpayables”) and gave the Company the right, at its option, to convert theextended payables into a subordinated promissory note.

 

On October 24, 2006,the Company elected to convert $1,143,896 of extended payables originally dueto Amscan as of August 8, 2006 as well as an additional $675,477 ofpayables due to Amscan as of September 28, 2006 into a single subordinatedpromissory note in the total principal amount of $1,819,373 (the “Amscan Note”).

 

On August 7, 2006,the Company also entered into and simultaneously closed an Asset PurchaseAgreement with Party City, an affiliate of Amscan, pursuant to which theCompany acquired a Party City retail party goods store in Peabody,Massachusetts and received a five-year non-competition covenant from PartyCity, for aggregate consideration of $2,450,000, payable by a subordinated notein the principal amount of $600,000 (the “Party City Note”) and $1,850,000 incash.

 

**10.  PREFERRED STOCK:**

** **

Thefollowing table summarizes the changes in the number of shares of convertiblepreferred stock during the past two years:

 
| ** **                                | ** ** | **Shares  Issued  and  Outstanding  as of 12/29/07** | ** ** | **Conversions  to  Common  Stock** | ** ** | **Shares  Issued  and  Outstanding  as of 12/30/06** | ** ** | **Conversions  to  Common  Stock** | ** ** | **Shares  Issued  and  Outstanding  as of 12/31/05** | ** ** |
|-------------------------------------------|------------|----------------------------------------------------------------|------------|------------------------------------|------------|----------------------------------------------------------------|------------|------------------------------------|------------|----------------------------------------------------------------|------------|
| Series B convertible preferred stock |       | 465,401                                                        |       | (6,000                             | )          | 471,401                                                        |       | (3,000                             | )          | 474,401                                                        |       |
| 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 |       | 296,666                                                        |       | —                             |       | 296,666                                                        |       | —                             |       | 296,666                                                        |       |
| Series F convertible preferred stock |       | 114,286                                                        |       | —                             |       | 114,286                                                        |       | —                             |       | 114,286                                                        |       |
| Total                                     |       | 1,226,353                                                      |       | (6,000                             | )          | 1,232,353                                                      |       | (3,000                             | )          | 1,235,353                                                      |       |

 

*Series B ConvertiblePreferred Stock*

* *

The shares of Series Bconvertible preferred stock are immediately convertible into 6,234,512 sharesof common stock on a 1.000 to 13.396 ratio at December 29, 2007, and carryan aggregate liquidation value of $9,308,024 ($1.49 per common share issuableupon conversion) at December 29, 2007. With certain exceptions, the conversion price will be adjusted on aweighted-average basis in the event the Company issues common stock or certainrights, including option activity in excess of certain amounts, to purchase orconvert into common stock as 

 

F-19

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defined in the Company’sCertificate of Incorporation, as amended, at a price below the conversionprice.  The Series B 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.

 

On September 15,2006, the Company entered into a Securities Purchase Agreement pursuant towhich it raised $2.5 million through a combination of subordinated debt andwarrant issued on September 15, 2006 to Highbridge, an institutionalaccredited investor.  The warrant issuedto Highbridge (the “Highbridge Warrant”) is exercisable for 2,083,334 shares ofthe Company’s common stock at an exercise price of $0.475 per share.  The issuance of the Highbridge Warranttriggered certain anti-dilution provisions of the Company’s Series B, C,and D convertible preferred stock.  As aresult, the number of shares of common stock into which the Series Bpreferred stock convert increased by 249,254 additional shares.

 

In the event ofliquidation, the holders of Series B convertible preferred stock havepreference to holders of the Company’s common stock, and are *pari passu* with the Company’s Series C, D, E and Fconvertible preferred stock.

 

Holders of Series B convertiblepreferred stock are entitled to 13 votes per share (i.e., one vote for eachwhole number of shares of common stock into which each such share is presentlyconvertible) on all matters submitted to a vote of the Company’s stockholdersand are entitled to participate in dividends when and if declared by the Boardof Directors.

 

*Series CConvertible Preferred Stock*

 

The shares of Series Cconvertible preferred stock are immediately convertible into 1,365,200 sharesof common stock on a 1.000 to 13.652 ratio at December 29, 2007, and carryan aggregate liquidation value of $2,000,000 ($1.47 per common share issuableupon conversion) at December 29, 2007. With certain exceptions, the conversion price will be adjusted on aweighted-average basis in the event the Company issues common stock or certainrights, including option activity in excess of certain amounts, to purchase orconvert into common stock as defined in the Company’s Certificate ofIncorporation, as amended, at a price below the conversion price.  The Series C convertible preferred stockwill automatically convert into common stock at the conversion price then ineffect in the event the Company consummates a secondary public offeringresulting in gross proceeds to the Company of at least $10,000,000.

 

On September 15,2006, the Company entered into a Securities Purchase Agreement pursuant towhich it raised $2.5 million through a combination of subordinated debt andwarrant issued on September 15, 2006 to Highbridge, an institutionalaccredited investor.  The warrant issuedto Highbridge is exercisable for 2,083,334 shares of the Company’s common stockat an exercise price of $0.475 per share. The issuance of the Highbridge Warrant triggered certain anti-dilutionprovisions of the Company’s Series B, C, and D convertible preferredstock.  As a result, the number of sharesof common stock into which the Series C preferred stock convert increasedby 54,600 additional shares.

 

In the event ofliquidation, the holders of Series C convertible preferred stock havepreference to holders of the Company’s common stock, and are *pari passu* with the Company’s Series B, D, E and Fconvertible preferred stock.

 

Holders of Series Cconvertible preferred stock are entitled to 13 votes per share (i.e., one votefor each whole number of shares of common stock into which each such share ispresently convertible) on all matters submitted to a vote of the Company’sstockholders and are entitled to participate in dividends when and if declaredby the Board of Directors.

 

F-20

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*Series DConvertible Preferred Stock*

 

The shares of Series Dconvertible preferred stock are immediately convertible into 3,652,250 sharesof common stock on a 1.000 to 14.609 ratio at December 29, 2007, and carryan aggregate liquidation value of $5,000,000 ($1.37 per common share issuableupon conversion) at December 29, 2007. With certain exceptions, the conversion price will be adjusted on aweighted-average basis in the event the Company issues common stock or certainrights, including option activity in excess of certain amounts, to purchase orconvert into common stock as defined in the Company’s Certificate ofIncorporation, as amended, at a price below the conversion price.  The Series D convertible preferred stockwill automatically convert into common stock at the conversion price then ineffect in the event the Company consummates a secondary public offeringresulting in gross proceeds to the Company of at least $10,000,000.

 

On September 15,2006, the Company entered into a Securities Purchase Agreement pursuant towhich it raised $2.5 million through a combination of subordinated debt andwarrant issued on September 15, 2006 to Highbridge, an institutionalaccredited investor.  The warrant issuedto Highbridge is exercisable for 2,083,334 shares of the Company’s common stockat an exercise price of $0.475 per share. The issuance of the Highbridge Warrant triggered certain anti-dilutionprovisions of the Company’s Series B, C, and D convertible preferredstock.  As a result, the number of sharesof common stock into which the Series D preferred stock convert increasedby 138,500 additional shares.

 

In the event ofliquidation, the holders of Series D convertible preferred stock havepreference to holders of the Company’s common stock, and are *pari passu* with the Company’s Series B, C, E and Fconvertible preferred stock.

 

Holders of Series Dconvertible preferred stock are entitled to 14 votes per share (i.e., one votefor each whole number of shares of common stock into which each such share ispresently convertible) on all matters submitted to a vote of the Company’sstockholders and are entitled to participate in dividends when and if declaredby the Board of Directors.

 

*Series EConvertible Preferred Stock*

 

The shares of Series Econvertible preferred stock are immediately convertible into 3,073,163 sharesof common stock on a 1.000 to 10.359 ratio at December 29, 2007, and carryan aggregate liquidation value of $1,112,497 ($0.36 per common share issuableupon conversion) at December 29, 2007. With certain exceptions, the conversion price will be adjusted on aweighted-average basis in the event the Company issues common stock or certainrights, including option activity in excess of certain amounts, to purchase orconvert into common stock as defined in the Company’s Certificate ofIncorporation, as amended, at a price below the conversion price.  The Series E convertible preferred stockwill automatically convert into common stock at the conversion price then ineffect in the event the average closing bid price of the common stock equals orexceeds $10.00 per share for 20 days within any 30-day period.

 

In the event ofliquidation, the holders of Series E convertible preferred stock havepreference to holders of the Company’s common stock, and are *pari passu* with the Company’s Series B, C, D and Fconvertible preferred stock.

 

Holders of Series Econvertible preferred stock are entitled to 10 votes per share (i.e., one votefor each whole number of shares of common stock into which each such share ispresently convertible) on all matters submitted to a vote of the Company’sstockholders and are entitled to participate in dividends when and if declaredby the Board of Directors.

 

F-21

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*Series FConvertible 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 29, 2007, and carryan aggregate liquidation value of $500,000 ($0.42 per common share issuableupon conversion) at December 29, 2007. With certain exceptions, the conversion price will be adjusted on aweighted-average basis in the event the Company issues common stock or certainrights, including option activity in excess of certain amounts, to purchase orconvert into common stock as defined in the Company’s Certificate ofIncorporation, as amended, at a price below the conversion price.  The Series F convertible preferred stockwill automatically convert into common stock at the conversion price then ineffect in the event the average closing bid price of the common stock equals orexceeds $10.00 per share for 20 days within any 30-day period.

 

In the event of liquidation,the holders of Series F convertible preferred stock have preference toholders of the Company’s common stock, and are *pari passu*withthe Company’s Series B, C, D and E convertible preferred stock.

 

Holders of Series Fpreferred stock are entitled to 10 votes per share (i.e., one vote for eachwhole number of shares of common stock into which each such share is presentlyconvertible) on all matters submitted to a vote of the Company’s stockholdersand are entitled to participate in dividends when and if declared by the Boardof Directors.

 

*Accretionof Dividends in the Event of Liquidation*

 

The carrying values of Series Bthrough F convertible preferred stock have been determined based on their fairmarket values at the original dates of issuance.  In certain cases, warrants were issued, whichthe Company allocated value to and included in additional paid in capital.  Should such a liquidation event occur, thedifference between the carrying value of the convertible preferred stock andtheir liquidation value will be accreted. This amount was $4,238,354 on December 29, 2007.

 

**11.  WARRANTS:**

** **

On August 26,2005, warrants issued in connection with the issuance of Series B and Series Cconvertible preferred stock which were exercisable for 9,157,619 shares ofcommon stock expired without being exercised. On September 10, 2005, warrants issued in connection with theissuance of Series B and Series C convertible preferred stock whichwere exercisable for 1,487,886 shares of common stock expired without being exercised.   On December 20, 2005, warrants issuedin connection with the issuance of Series D convertible preferred stockwhich were exercisable for 1,837,500 shares of common stock expired withoutbeing exercised.

 

At December 29,2007, there were warrants outstanding which were exercisable for 2,611,544shares of the Company’s common stock. These warrants were issued in connection with certain preferred stockand subordinated debt financings.

 

On September 15,2006, the Company entered into a Securities Purchase Agreement pursuant towhich it raised $2.5 million through a combination of subordinated debt andwarrant issued on September 15, 2006 to Highbridge, an institutionalaccredited investor. Under the terms of the financing, the Company issuedHighbridge a warrant (the “Highbridge Warrant”) exercisable for 2,083,334shares of its common stock at an exercise price of $0.475 per share, or 125% ofthe closing price of our common stock on the day immediately prior to theclosing of the transaction.  The Companyallocated approximately $613,651 of value to the Highbridge Warrant using theBlack-Scholes model with volatility of 108%, interest of 4.73% and expectedlife of five years.  The HighbridgeWarrant is being amortized using the effective interest method over the life ofthe Highbridge Note.  The agreementsentered into in connection with the financing provide for certain restrictionsand covenants consistent with Highbridge’s status as a subordinated lender, andalso grant Highbridge resale registration rights with respect to the shares ofcommon stock underlying the Highbridge Warrant.

 

F-22

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During the period April 1999through August 1999, the Company issued warrants in connection withconvertible debt exercisable for a total of 528,210 shares of its common stock,at exercise prices ranging from $2.81 to $5.13 per share. The weighted averageexercise price of these warrants at December 29, 2007 was $3.79 per share.These warrants expire between April and August 2009.

 

The following table summarizes the Company’soutstanding warrants at December 29, 2007:

 
| **Total  Common  Shares  Issuable** | ** ** | **Exercise  Price per  Common  Share  Issuable** | ** ** | **Expiration  Date** | ** ** |
|-------------------------------------|------------|-------------------------------------------------------|------------|----------------------|------------|
| 146,341                             |       | $                                                     | 5.13       |                 | 04/16/09   |   |
| 121,212                             |       | 4.13                                                  |       | 05/13/09             |       |
| 44,444                              |       | 2.81                                                  |       | 06/15/09             |       |
| 47,619                              |       | 2.63                                                  |       | 06/22/09             |       |
| 40,816                              |       | 3.06                                                  |       | 07/15/09             |       |
| 44,444                              |       | 2.81                                                  |       | 07/22/09             |       |
| 83,334                              |       | 3.00                                                  |       | 08/15/09             |       |
| 2,083,334                           |       | 0.48                                                  |       | 09/15/11             |       |
| 2,611,544                           |       | $                                                     | 1.14       |                 |       |   |

 

**12.  STOCK OPTION PLAN:**

** **

Underthe Company’s Amended and Restated 1998 Incentive and Nonqualified Stock OptionPlan (the “1998 Plan”) options to acquire 11,000,000 shares of common stock maybe granted to 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 theBoard.  Incentive and Nonqualifiedoptions to purchase the Company’s common stock under the 1998 Plan have beengranted to employees, directors and consultants of the Company at fair marketvalue at the date of grant.  Generally,the options become exercisable over periods of up to four years, and expire tenyears from the date of grant.

 

On January 1,2006, the Company adopted the Financial Accounting Standards Board (“FASB”)Statement No. 123(R), *Share-Based Payments*,using the modified prospective method. Under this method, stock based compensation expense is recognized fornew grants beginning in fiscal 2006 and any unvested grants prior to theadoption of Statement No. 123(R). Prior to fiscal 2006, the Company accounted for share-based payments toemployees using the Accounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees*, and the disclosure-onlyprovisions of Statement No. 123, *Accounting for Stock-BasedCompensation*.  Because theCompany granted stock options to employees at exercise prices equal to fairmarket value on the date of grant, no stock based compensation cost wasrecognized for option grants in periods prior to fiscal 2006.

 

F-23

----

 

Asummary of the Company’s stock options is as follows:

 
| ** **                           | ** ** | **Number of  Shares of  Common Stock  Underlying  Stock Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Price Range** | ** ** |
|--------------------------------------|------------|---------------------------------------------------------------------------------------|------------|----------------------------------------|------------|----------------------|------------|
| 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 |   |
| Granted                              |       | 100,000                                                                               |       | 0.36                                   |       | 0.36                 |       | — |   | 0.36 |   |
| Expired/Forfeited                    |       | (1,491,086                                                                            | )          | 2.91                                   |       | 0.13                 |       | — |   | 5.38 |   |
| Exercised                            |       | (27,315                                                                               | )          | 0.20                                   |       | 0.16                 |       | — |   | 0.33 |   |
|                                 |       |                                                                                  |       |                                   |       |                 |       |   |   |   |   |
| Outstanding - December 30, 2006 |       | 8,922,440                                                                             |       | 0.62                                   |       | 0.13                 |       | — |   | 4.25 |   |
| Granted                              |       | 1,350,000                                                                             |       | 0.42                                   |       | 0.42                 |       | — |   | 0.42 |   |
| Expired/Forfeited                    |       | (125,444                                                                              | )          | 0.54                                   |       | 0.20                 |       | — |   | 0.69 |   |
| Exercised                            |       | (16,402                                                                               | )          | 0.28                                   |       | 0.23                 |       | — |   | 0.36 |   |
|                                 |       |                                                                                  |       |                                   |       |                 |       |   |   |   |   |
| Outstanding - December 29, 2007 |       | 10,130,594                                                                            |       | 0.59                                   |       | 0.13                 |       | — |   | 4.25 |   |
|                                 |       |                                                                                  |       |                                   |       |                 |       |   |   |   |   |
| Exercisable - December 29, 2007 |       | 8,799,073                                                                             |       | $                                      | 0.62       |                 | $          | 0.13 |   | — |   | $ | 4.25 |   |
|                                      |            |                                                                                       |            |                                        |            |                      |            |  |  |  |  |  |  |  |

 

The following table summarizes information foroptions outstanding and exercisable at December 29, 2007:

 
| ** **           | ** ** | **Outstanding**                                                                       | ** ** | **Exercisable**                                 | ** ** |
|----------------------|------------|---------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| **Price Range** | ** ** | **Number of  Shares of  Common Stock  Underlying  Stock Options** | ** ** | **Weighted  Average  Remaining  Life  (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  of  Stock  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                 | $          | 0.13                                                                                  | -          | $                                               | 0.20       | ** ** | 139,250 |   | 3.6 |   | $ | 0.18 |   | 139,250 |   | $ | 0.18 |   |
| 0.21                 | -          | 0.30                                                                                  |       | 3,788,682                                       |       | 2.8 |   | 0.25 |   | 3,788,682 |   | 0.25 |   |
| 0.31                 | -          | 0.50                                                                                  |       | 2,474,527                                       |       | 7.3 |   | 0.39 |   | 1,151,953 |   | 0.36 |   |
| 0.51                 | -          | 1.00                                                                                  |       | 3,086,935                                       |       | 4.7 |   | 0.77 |   | 3,077,988 |   | 0.78 |   |
| 1.01                 | -          | 3.50                                                                                  |       | 541,200                                         |       | 1.6 |   | 2.33 |   | 541,200 |   | 2.33 |   |
| 3.51                 | -          | 4.25                                                                                  |       | 100,000                                         |       | 2.0 |   | 4.14 |   | 100,000 |   | 4.14 |   |
| Total                |       |                                                                                  |       | 10,130,594                                      |       | 4.4 |   | $ | 0.59 |   | 8,799,073 |   | $ | 0.62 |   |
|                      |            |                                                                                       |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The Company has reserved28,252,066 shares of common stock for issuance in connection with theconversion of convertible preferred stock (15,509,928 shares), the exercise ofwarrants (2,611,544 shares) and the exercise of stock options (10,130,594shares).

 

F-24

----

 

**13.  STOCKHOLDER RIGHTS PLAN:**

** **

The Company has aStockholder Rights Plan (the “Plan”) effective November 9, 2001.  Under the Plan each share of the Company’scapital stock outstanding at the close of business on November 9, 2001 andeach share of the Company’s capital stock issued subsequent to that date has aright associated with it, such that each share of its common stock is entitledto one right and each share of its preferred stock is entitled to such numberof rights equal to the number of common shares into 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 votingstock.  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 initialpurchase price of $2.00, subject to adjustment. In addition, upon the occurrence of certain events, holders of the rightswill be entitled to purchase either iParty Corp. stock or shares in an “acquiringentity” at half of market value.  TheCompany generally will be entitled to redeem the rights at $0.001 per right atany time until the date on which a 10 percent position in its voting stock isacquired by any person or group.  Until aright is exercised, the holder thereof, as such, will have no rights as astockholder of the Company, including, without limitation, the right to vote orreceive dividends.

 

On September 15,2006, the Company amended the rights plan to clarify that the issuance of theHighbridge Warrant did not constitute a triggering event under the rights plan.

 

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

** **

The iParty 401(k) Plan is a qualifiedprofit sharing plan covering substantially all of its employees.  Contributions to this plan are at thediscretion of the Board of Directors. The Company’s expense, including matching contributions and anydiscretionary amounts was $120,084 in 2007, $108,863 in 2006 and $113,127 in2005.

 

**15.  SEGMENT REPORTING:**

** **

SFAS No. 131, *Disclosuresabout Segments of an Enterprise and Related Information*, establishesstandards for the way business enterprises report information about operatingsegments in annual financial statements and requires that those enterprisesreport selected information about operating segments in interim financialreports issued to stockholders.  TheCompany reports one operating segment as revenues from the other segment arenot material.

 

**16.  SUBSEQUENT EVENTS:**

** **

On January 2,2008, the Company completed the purchase from the franchisees of two franchisedParty City Corporation (“Party City”) retail stores in Lincoln, Rhode Islandand Warwick, Rhode Island.  The purchase was made pursuant to theAsset Purchase Agreement entered into on August 15, 2007 (the “AssetPurchase Agreement”). The aggregate consideration for the assets purchased andrelated non-competition covenants was $1,350,000, plus approximately $195,000for associated inventory, paid in cash at closing, on terms and conditionsspecified in the Asset Purchase Agreement. Funding for the purchase was obtained from the Company’s existing lineof credit with Wells Fargo Retail Finance. Both locations were converted intoiParty stores immediately following the closing.

 

The Asset PurchaseAgreement also provides that the selling Party City franchisees and theiraffiliates will not compete with iParty in Rhode Island for a period of fiveyears from closing, and will not compete with iParty within a three-and-one-halfmile radius anywhere in Massachusetts, Rhode Island, New Hampshire, Vermont,Maine, or Connecticut for a three-year period from closing, subject to certainterms specified more fully in the Asset Purchase Agreement.

 

F-25

----

 

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

** **
| **QUARTERLY FINANCIAL DATA** | ** ** |
|----------------------------------------|------------|
| ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Mar 31, 2007** | ** ** | **Jun 30, 2007** | ** ** | **Sep 29, 2007** | ** ** | **Dec 29, 2007** | ** ** |
| Revenues                               |       | $ | 15,599,159 |   | $ | 20,411,919 |   | $ | 18,208,760 |   | $ | 27,578,796 |   |
| Cost of products sold (1), (2)         |       | 9,371,315 |   | 11,554,475 |   | 10,638,322 |   | 14,901,329 |   |
| Operating income (loss)                |       | (1,241,087 | ) | 788,549 |   | (878,851 | ) | 2,929,209 |   |
| Net income (loss)                      |       | (1,467,397 | ) | 558,537 |   | (1,092,267 | ) | 2,612,818 |   |
|                                   |       |   |   |   |   |   |   |   |   |
| Net income (loss) per share            |       |   |   |   |   |   |   |   |   |
| Basic                                  |       | $ | (0.06 | ) | $ | 0.01 |   | $ | (0.05 | ) | $ | 0.07 |   |
| Diluted                                |       | $ | (0.06 | ) | $ | 0.01 |   | $ | (0.05 | ) | $ | 0.07 |   |
|                                   |       |   |   |   |   |   |   |   |   |
| Weighted-average shares outstanding:   |       |   |   |   |   |   |   |   |   |
| Basic                                  |       | 22,614,544 |   | 38,199,738 |   | 22,642,280 |   | 38,210,588 |   |
| Diluted                                |       | 22,614,544 |   | 40,054,445 |   | 22,642,280 |   | 39,411,558 |   |
|                                   |       |   |   |   |   |   |   |   |   |
| ** **                             | ** ** | **Apr 1, 2006** | ** ** | **Jul 1, 2006** | ** ** | **Sep 30, 2006** | ** ** | **Dec 30, 2006** | ** ** |
| Revenues                               |       | $ | 13,545,799 |   | $ | 18,587,169 |   | $ | 17,240,535 |   | $ | 29,084,826 |   |
| Cost of products sold (1), (2)         |       | 8,429,170 |   | 10,803,021 |   | 10,178,878 |   | 15,531,473 |   |
| Operating income (loss)                |       | (1,931,745 | ) | 386,720 |   | (1,162,116 | ) | 3,861,184 |   |
| Net income (loss)                      |       | (2,089,273 | ) | 216,727 |   | (1,384,401 | ) | 3,631,594 |   |
|                                   |       |   |   |   |   |   |   |   |   |
| Net income (loss) per share            |       |   |   |   |   |   |   |   |   |
| Basic                                  |       | $ | (0.09 | ) | $ | 0.01 |   | $ | (0.06 | ) | $ | 0.10 |   |
| Diluted                                |       | $ | (0.09 | ) | $ | 0.01 |   | $ | (0.06 | ) | $ | 0.09 |   |
|                                   |       |   |   |   |   |   |   |   |   |
| Weighted-average shares outstanding:   |       |   |   |   |   |   |   |   |   |
| Basic                                  |       | 22,544,257 |   | 37,728,932 |   | 22,555,333 |   | 38,191,009 |   |
| Diluted                                |       | 22,544,257 |   | 39,283,126 |   | 22,555,333 |   | 40,186,640 |   |

 

----

(1) Cost of products sold consists of the cost of merchandise sold to customers andthe occupancy costs for stores.

 

(2)  The fourth quarterof 2007 included an estimated reduction of $123,249 to the cost of productssold during the previous three quarters due to the completion of physicalinventories, for which shortage had been estimated during the year.

 

(2)  The fourth quarterof 2006 included an estimated reduction of $251,806 to the cost of productssold during the previous three quarters due to the completion of physical inventories,for which shortage had been estimated during the year.

 

F-26

----

 

**EXHIBITINDEX**

 
| **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                 | (9)    |   |            | 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                | (20)   |   |            | Amended and Restated By-Laws  of iParty Corp. |
| 10.1                | (1)    |   |            | Agreement and Plan of  Merger between iParty Corp. and WSI Acquisitions Corp. |
| 10.2                | (9)    | ##     |            | Amended and Restated  1998 Incentive and Non-Qualified Stock Option Plan. |
| 10.3                | (12)   | ##     |            | Form of Non-qualified  Stock Option Agreement. |
| 10.4                | (12)   | ##     |            | Form of Incentive  Stock Option Agreement. |
| 10.5                | (11)   | ##     |            | Form of Stock  Option Agreement granted to Messrs. DeWolf, Haydu, Schindler, and  Vassalluzzo. |
| 10.6                | (16)   | ##     |            | Option Cancellation  Agreement between Sal Perisano and iParty Corp., dated December 8, 2006. |
| 10.7                | (16)   | ##     |            | Option Cancellation  Agreement between Patrick Farrell and iParty Corp., dated December 8,  2006. |
| 10.8                | (16)   | ##     |            | Option Cancellation  Agreement between Dorice Dionne and iParty Corp, dated December 8, 2006. |
| 10.9                | (22)   | ##     |            | Employment Agreement  between iParty Corp. and Sal Perisano, dated March 22, 2007. |
| 10.10               | (22)   | ##     |            | Employment Agreement  between iParty Corp. and Dorice Dionne, dated March 22, 2007. |
| 10.11               | (18)   | ##     |            | Amended and Restated  Employment Agreement between iParty Corp. and Patrick Farrell, dated  January 8, 2007. |
| 10.12               | (23)   | ##     |            | Compensation  Arrangements dated June 6, 2007 with Messrs. DeWolf, Haydu,  Schindler, and Vassalluzzo. |
| 10.13               | (23)   | ##     |            | Written Summary of  Renewed One-Year Part-time Consulting Arrangement with Joseph Vassalluzzo  dated June 7, 2007. |
| 10.14               | (10)   |   |            | Web Site License  Agreement between iParty Corp. and Taymark, Inc. |
| 10.15               | (7)    |   |            | Rights Agreement  between iParty Corp. and Continental Stock Transfer & Trust, as  Rights Agent. |
| 10.16               | (14)   |   |            | Amendment to Rights  Agreement between iParty Corp. and Continental Stock Transfer &  Trust, as Rights Agent, dated September 15, 2006. |
| 10.17               | (17)   |   |            | Amended and Restated  Loan and Security Agreement by and among iParty Corp., iParty Retail Stores  Corp. and Wells Fargo Retail Finance II, LLC dated December 21, 2006. |
| 10.18               | (13)   |   |            | Supply Agreement with  Amscan Inc., dated August 7, 2006. |
| 10.19               | (13)   |   |            | Asset Purchase  Agreement with Party City Corporation, dated August 7, 2006. |
| 10.20               | (14)   |   |            | Securities Purchase  Agreement with Highbridge International LLC, dated September 15, 2006. |
| 10.21               | (19)   |   |            | Amendment Agreement  between iParty Corp. and Highbridge International LLC, dated January 9,  2007. |
| 10.22               | (14)   |   |            | Senior Subordinated  Note with Highbridge International LLC, dated September 15, 2006. |
| 10.23               | (19)   |   |            | Warrant to Purchase  Common Stock with Highbridge International LLC, issued September 15,  2006, as amended January 9, 2007. |

 

F-27

----

 
| 10.24 | (14) |   |   | Registration Rights  Agreement with Highbridge International LLC, dated September 15, 2006.                                                                                                              |
|-------|------|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.25 | (15) |   |   | Subordinated Promissory  Note of iParty Corp., dated October 24, 2006.                                                                                                                                   |
| 10.26 | (9)  |   |   | Trademark Security  Agreement between iParty Corp. and Wells Fargo Retail Finance, LLC.                                                                                                                       |
| 10.27 | (5)  |   |   | Stock Purchase  Agreement by and among iParty Corp., Ajmal Khan and Robert Lessin.                                                                                                                            |
| 10.28 | (6)  |   |   | Stock Purchase  Agreement between iParty Corp. and Patriot Capital Ltd.                                                                                                                                       |
| 10.29 | (3)  |   |   | Funding Agreement among  iParty Corp., Robert Lessin and Ajmal Khan.                                                                                                                                          |
| 10.30 | (21) |   |   | Asset Purchase  Agreement by and among Party City of Warwick, Inc. and Party City of  Lincoln, LLC, as Sellers, and iParty Corp. and iParty Retail Stores Corp., as  Buyers, dated as of August 15, 2007 |
| 10.31 | (22) | ##     |   | Letter Agreement between  iParty Corp. and David E. Robertson, dated March 22, 2007                                                                                                                      |
| 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 or arrangement.                                                                                                                                                                      |
| (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 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.                           |
| (10) |   | 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.                                                                    |
| (11) |   | 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.                                                                        |
| (12) |   | Filed as an exhibit to  iParty’s Annual Report on Form 10-K, filed with the SEC on  March 30, 2006 and incorporated herein by reference.                                                                        |
| (13) |   | Filed as an exhibit to  iParty’s Current Report on Form 8-K, filed with the SEC on  August 7, 2006 and incorporated herein by reference.                                                                        |
| (14) |   | Filed as an exhibit to  iParty’s Current Report on Form 8-K, filed with the SEC on  September 18, 2006 and incorporated herein by reference.                                                                    |
| (15) |   | Filed as an exhibit to  iParty’s Current Report on Form 8-K, filed with the SEC on  October 25, 2006 and incorporated herein by reference.                                                                      |

 

F-28

----

 

 
| (16) |   | Filed as an exhibit to  iParty’s Current Report on Form 8-K, filed with the SEC on  December 12, 2006 and incorporated herein by reference. |
|------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (17) |   | Filed as an exhibit to  iParty’s Current Report on Form 8-K, filed with the SEC on  December 26, 2006 and incorporated herein by reference. |
| (18) |   | Filed as an exhibit to  iParty’s Current Report on Form 8-K, filed with the SEC on  January 8, 2007 and incorporated herein by reference.   |
| (19) |   | Filed as an exhibit to  iParty’s Current Report on Form 8-K, filed with the SEC on  January 10, 2007 and incorporated herein by reference.  |
| (20) |   | Filed as an exhibit to  iParty’s Current Report on Form 8-K filed with the SEC on  December 10, 2007 and incorporated herein by reference.  |
| (21) |   | Filed as an exhibit to  iParty’s Current Report on Form 8-K filed with the SEC on  August 16, 2007 and incorporated herein by reference.    |
| (22) |   | Filed as an exhibit to  iParty’s Current Report on Form 8-K filed with the SEC on March 26,  2007 and incorporated herein by reference.     |
| (23) |   | Filed as an exhibit to  iParty’s Current Report on Form 8-K filed with the SEC on June 12,  2007 and incorporated herein by reference.      |

 

F-29

----