**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

----

# ** **

# **FORM 10-K**

 

**x****ANNUAL REPORT PURSUANT TO SECTION 13OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**For The Fiscal Year Ended December 27, 2008**

 

**OR**

 

**o****TRANSITION REPORT UNDER SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the Transition Period from              to              **

 

**Commission File Number 1-15611**

 

----

 

**iPARTYCORP.**

(Exact Name of Registrant as Specified in Its Charter)

 

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

 

**(781) 329-3952**

(Registrant’s TelephoneNumber, Including Area Code)

 

----

 

Securities Registeredpursuant to Section 12(b) of the Act:

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

 

Securities Registered pursuant to Section 12(g) of theAct:  **None**

 

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act. Yes o  No x

 

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act. Yes o  No x

 

Indicateby check mark whether 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

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. x

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer or smaller reporting company. Seedefinition of “large accelerated filer”, “accelerated filer”, and “smallerreporting company” in Rule 12b-2 of the Exchange Act (Check one).
| Large accelerated filer o   | Accelerated filer o | Non-accelerated filer o | (Do not check if a smaller  reporting company) |
|----------------------------------|--------------------------|------------------------------|------------------------------------------------|
| Smaller reporting company x |                     |                         |                                           |
|                                  |                          |                              |                                                |  |

 

Indicate by check mark whether theregistrant is a shell company as defined in Rule 12b-2 of the ExchangeAct. Yes o  No x

 

On June 28, 2008, theaggregate market value of the voting common equity of the registrant(consisting of common stock, $.001 par value (the “common stock”)) held bynonaffiliates of the registrant was approximately $4,125,942 based on theclosing price for such common stock on said date as reported by the NYSEAlternext US. On February 27, 2009 there were 22,731,667 shares of commonstock, $.001 par value, issued and outstanding.

 

**DOCUMENTSINCORPORATED BY REFERENCE**

 

Portions of the proxy statement forthe annual stockholders’ meeting scheduled to be held May 27, 2009, whichwe plan to file with the SEC no later than 120 days after the end of our fiscalyear ended December 27, 2008, are incorporated by reference into Part III.

 

 

 

----

 

**PART I**

 

**ITEM 1.  BUSINESS**

 

**General**

 

Webelieve we are a leading brand in the party industry in the markets we serveand a leading resource in those markets for consumers seeking party goods,party planning advice and relevant information. We are a party goods retailer operating stores throughout New England,where 45 of our 50 retail stores are located, and Florida.  We also license the name iParty.com (atwww.iparty.com) to a third party in exchange for royalties, which to date havenot been significant.  We generated $81.2million in total revenues and a net loss of $0.4 million in fiscal 2008.

 

As of December 27, 2008, weoperated 25 stores in Massachusetts, 7 in Connecticut, 6 in New Hampshire, 3 inRhode Island, 3 in Maine, 1 in Vermont and 5 stores in Florida.  In January 2008, we acquired twoadditional stores and closed one existing store in Rhode Island, and closed onestore in Massachusetts.  Our stores rangein size from approximately 8,000 square feet to 20,500 square feet and averageapproximately 10,300 square feet in size. We lease our properties, typically for 10 years and usually with optionsfrom our landlords to renew our leases for an additional 5 or 10 years.

 

Our stores feature over 20,000products ranging from paper party goods, Halloween costumes, greeting cards andballoons to more unique merchandise such as piñatas, tiny toys, masquerade andHawaiian Luau items.  Our sales areprimarily 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 a seasonalpattern.  In the past three years, wehave realized an average of approximately 34.7% of our annual revenues in ourfourth quarter, which includes Halloween and Christmas, and an average ofapproximately 24.5% of our revenues in the second quarter, which includesschool graduations.  Also, during thesepast three years, we have had net income in our second and fourth quarters andgenerated losses in our first and third quarters.

 

Our executive offices are locatedat 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 made in thisAnnual Report to a particular year or years, it is a reference to our fiscalyear, unless the context indicates otherwise. For example, “2008” refers to our 52-week fiscal year ended December 27,2008, “2007” refers to our 52-week fiscal year ended December 29, 2007,and “2006” refers to our 52-week fiscal year ended December 30, 2006.

 

**Organization**

 

Whilewe are currently a party goods retail chain operating 50 stores, when we werefirst incorporated as iParty Corp. (“iParty”) on March 12, 1998 we were anInternet-based merchant of party goods and services.  On January 2, 2000, iParty Corp. waslisted on the American Stock Exchange, which is now known as the NYSE AlternextUS, under the ticker symbol “IPT”.

 

On August 3, 2000, iPartyRetail Stores Corp. (“iParty Retail”) was incorporated as a wholly-ownedsubsidiary of iParty Corp. to operate a chain of retail stores selling partygoods.  On August 15, 2000, 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 States BankruptcyCourt for the District of Delaware. We have subsequently opened an additionalseventeen stores, acquired three stores, and closed three stores.

 

1

----

** **

**Capital Structure**

 

Our capital structure currently consistsof common stock and five outstanding series of convertible preferredstock.  We have also issued warrantsconvertible into common stock and have a stock option plan that offers bothqualified and nonqualified options to purchase common stock.

 

Our common stock has a par value of$0.001 per share.  We have 150,000,000shares of common stock authorized, 22,731,667 of which were issued andoutstanding as of December 27, 2008. These shares are listed on the NYSE Alternext US, formerly known as the AmericanStock Exchange**,** and trade under the symbol “IPT”.

 

We currently have five outstandingseries of convertible preferred stock, Series B through F (“convertiblepreferred stock”).  On January 13,2004, all 1,000,000 shares of our Series A convertible preferred stockwere converted into 1,000,000 shares of common stock.  As of December 27, 2008, we had a totalof 1,224,038 shares of convertible preferred stock outstanding which wereconvertible into 15,478,916 shares of common stock on that date based on thefollowing conversion rates.  As of December 27,2008, each share of Series B convertible preferred stock is presentlyconvertible into 13.396 shares of common stock; each share of Series Cconvertible preferred stock is presently convertible into 13.652 shares ofcommon stock; each share of Series D convertible preferred stock ispresently convertible into 14.609 shares of common stock; each share of Series Econvertible preferred stock is presently convertible into 10.359 shares ofcommon stock; and each share of Series F convertible preferred stock ispresently convertible into 10.367 shares of common stock.  Our convertible preferred stock is presentedon our balance sheet at its carrying value, which was $13,647,720 at December 27,2008.

 

We also have a stockholder rightsplan (the “rights plan”).  The rightsplan associates rights to our capital stock, such that each share of our commonstock is entitled to one right and each share of our preferred stock isentitled to such number of rights equal to the number of common shares intowhich it is convertible. The rights will become exercisable only in the eventthat, with certain exceptions, an acquiring party accumulates 10 percent ormore of our voting stock or if a party announces an offer to acquire 15 percentor more of our voting stock.  Whenexercisable, 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. In addition,upon the occurrence of certain events, holders of the rights would be entitledto purchase either iParty Corp. stock or shares in an “acquiring entity” athalf of market value.

 

The holders of our convertiblepreferred stock have a liquidation preference senior to the holders of ourcommon 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 a liquidationvalue, which was $17,874,221 at December 27, 2008.  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 grants 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 have also issued warrants inconnection with the issuance of certain convertible preferred stock, certainlicensing, marketing and financing arrangements, and certain investor relationsservices.  At December 27, 2008, wehad a warrant outstanding with an exercise price of $0.475, which wasexercisable for 2,083,334 shares of our common stock, warrants outstanding witha weighted average exercise price of $3.79, which were exercisable for 528,210shares of our common stock, and warrants outstanding with a weighted averageexercise price of $1.50, which were exercisable for 100,000 shares of ourcommon stock.

 

Under our stock option plan, we areauthorized to grant options to purchase up to 11,000,000 shares of our commonstock.  At December 27, 2008, we hadoptions outstanding that were exercisable for the purchase of

 

2

----

 

8,117,720 shares of common stock.In addition, at December 27, 2008, we had options outstanding that werenot yet exercisable for the purchase of 964,478 shares of our common stock. On December 8,2006, we entered into option cancellation agreements with three of ourexecutive officers pursuant to which options that had been exercisable for acombined aggregate of 1,324,730 shares of our common stock at exercise pricesof $2.00 per share or greater were cancelled effective as of such date.

 

Thefollowing chart summarizes our capital structure at December 27, 2008.

** **
| ** **                                | ** ** | ** **      | ** ** | ** **      | ** ** | ** **       | ** ** | **Weighted**  | ** ** | ** **      | ** ** |
|-------------------------------------------|------------|-----------------|------------|-----------------|------------|------------------|------------|---------------|------------|-----------------|------------|
| ** **                                | ** ** | ** **      | ** ** | ** **      | ** ** | **Total**        | ** ** | **Average**   | ** ** | ** **      | ** ** |
| ** **                                | ** ** | **Number of**   | ** ** | ** **      | ** ** | **Common**       | ** ** | **Exercise**  | ** ** | ** **      | ** ** |
| ** **                                | ** ** | **Shares/**     | ** ** | ** **      | ** ** | **Shares**       | ** ** | **Price per** | ** ** | ** **      | ** ** |
| ** **                                | ** ** | **Warrants/**   | ** ** | **Conversion/** | ** ** | **Issued**       | ** ** | **Common**    | ** ** | ** **      | ** ** |
| ** **                                | ** ** | **Options**     | ** ** | **Exercise**    | ** ** | **and**          | ** ** | **Share**     | ** ** | **Liquidation** | ** ** |
| ** **                                | ** ** | **Outstanding** | ** ** | **Ratios**      | ** ** | **Issuable (1)** | ** ** | **Issuable**  | ** ** | **Value**       | ** ** |
| Common stock                              |       | 22,731,667      |       |            |       | 22,731,667       |       |          |       | $               | —     |   |
|                                      |       |            |       |            |       |             |       |          |       |            |       |
| Series B convertible preferred stock |       | 463,086         |       | 13.396          |       | 6,203,500        |       |          |       | 9,261,724       |       |
| 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         |       | 1,224,038       |       |            |       | 15,478,916       |       |          |       | 17,874,221      |       |
|                                      |       |            |       |            |       |             |       |          |       |            |       |
| Warrant                                   |       | 2,083,334       |       | 1.000           |       | 2,083,334        |       | $             | 0.48       |            | —     |   |
| Warrants                                  |       | 528,210         |       | 1.000           |       | 528,210          |       | $             | 3.79       |            | —     |   |
| Warrants                                  |       | 100,000         |       | 1.000           |       | 100,000          |       | $             | 1.50       |            | —     |   |
|                                      |       |            |       |            |       |             |       |          |       |            |       |
| Stock options                             |       | 9,082,198       |       | 1.000           |       | 9,082,198        |       | $             | 0.55       |            | —     |   |
|                                      |       |            |       |            |       |             |       |          |       |            |       |
| Totals                                    |       |            |       |            |       | 50,004,325       |       |          |       | 17,874,221      |       |
|                                           |            |                 |            |                 |            |                  |            |               |            |                 |            |  |  |

 

----

(1)  Includes common stock outstanding and commonstock issuable upon conversion of convertible preferred stock and exercise ofoutstanding warrants and stock options.

 

**Competition**

 

The party supplies retailing business is highly competitiveand fragmented.  We compete with avariety of smaller and larger retailers, including single owner-operated partysupply stores, specialty party supplies retailers, discount department stores,retail drug store chains, general mass merchants and supermarkets, as well ascatalog, Internet merchants and temporary seasonal stores, especially Halloweenstores.

 

Our success depends in part on our ability to be competitiveagainst many different competitors in each local market area we serve.  If we fail to anticipate evolving innovationsand product offerings from our competitors and fail to offer products thatappeal to the changing needs and preferences of our customers in the variousmarkets 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.

 

Barriersto entry are minimal.  New competitorscan open new stores and launch new Internet sites at a relatively low cost.However, we believe that the costs to remain competitive over the longer termin the party supplies retailing business can be significant. These costsinclude the hiring of human resources with industry knowledge and the marketingcosts associated with building a widely recognized brand.

 

3

----

 

**Seasonality**

 

Ourbusiness has a seasonal pattern.  In thepast three years, we have realized an average of approximately 34.7% of ourannual revenues in our fourth quarter, which includes Halloween and Christmas,and an average of approximately 24.5% of our revenues in the second quarter,which includes 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.

** **

**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.

 

The following represents suppliers fromwhom we purchased at least 5% of our merchandise in either 2008 or 2007:

 
| **Supplier**                  | ** ** | **Products supplied** | ** ** | **2008** | ** ** | **2007** | ** ** |
|-------------------------------|------------|----------------------------|------------|----------|------------|----------|------------|
| Amscan, Inc.             |       | Paper party  goods         |       | 22.2     | %          | 18.4     | %          |
| Hallmark Marketing Corp.      |       | Paper party  goods         |       | 6.7      | %          | 5.9      | %          |
| Fun World                     |       | Halloween  costumes        |       | 4.0      | %          | 5.8      | %          |
| Unique Industries, Inc.  |       | Paper party  goods         |       | 5.2      | %          | 5.7      | %          |
| Kendall Confectionery Company |       | Candy                      |       | 5.1      | %          | 4.7      | %          |
| Lagasse Inc.                  |       | Paper party  goods         |       | 4.8      | %          | 5.5      | %          |
| Total                         |       |                       |       | 48.0     | %          | 46.0     | %          |

 

In August 2006, we enteredinto a Supply Agreement with Amscan, Inc. (“Amscan”) which extends to 2012and obligates us to purchase increased levels of merchandise from Amscan, ourlargest supplier, in exchange for, among other things, the right to receivecertain additional rebates and more favorable pricing terms over the life ofthe agreement than were generally available to us under our previous terms withAmscan.

 

The loss of any of these supplierscould materially adversely affect our business, results of operations,financial condition and cash flow.  Weconsider numerous factors in supplier selection, including, but not limited 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 maydiscontinue selling to us at any time.

 

**Intellectual Property**

 

Wehold trademarks for “iParty” issued by the U.S. Patent and TrademarkOffice.  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.

 

**Employees**

 

Asof December 27, 2008, we had 269 full-time employees and 717 part-timeemployees.  None of these employees isrepresented by a labor union, and we consider our relationship with ouremployees to be good.

** **

**Available Information**

 

Our licensed Internet websiteaddress is www.iparty.com.  Our AnnualReports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reportson Form 8-K and amendments to those reports filed or furnished pursuant toSection 13(a) or 15(d) of the Securities Exchange Act of 1934are available through the investor relations page of our licensed Internetwebsite as soon as reasonably practicable after we electronically file suchmaterial with, or

 

4

----

 

furnish it to, the SEC.  Our licensed Internet website and theinformation contained therein or connected thereto are not incorporated into ora part of this Annual Report on Form 10-K or any other report we file orfurnish to the SEC.

 

The public may read and copy anymaterials that we file with the SEC at the SEC’s website, www.sec.gov, whichcontains reports, proxy and information statements and other information thatpublic 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 on official business daysduring the hours of 10:00 am to 3:00 pm. The public may obtain informationabout the SEC’s Public Reference Room by calling 1-800-SEC-0330.

 

**ITEM 1A.       RISKFACTORS**

 

Ourbusiness is subject to certain risks that could materially affect our financialcondition, results of operations, and the value of our common stock.  These risks include, but are not limited to,the ones described below. Additional risks and uncertainties that we areunaware of, or that we may currently deem immaterial, may become important factorsthat may harm our business, financial condition, results of operations, or thevalue of our common stock.

 

***Our success depends on economic and otherexternal factors, particularly in the New England region and during theHalloween season, that affect consumer decisions about whether and when topurchase party goods and supplies.***

 

Ourbusiness success depends in large measure on consumer decisions to buy partygoods and supplies and seek party planning advice, particularly in the NewEngland region, where 45 of our 50 stores are located, and particularly duringthe Halloween season, which is our single most important season. Demand for ourproducts and our business results are sensitive to external factors that,directly or indirectly, affect consumer confidence, consumer spending patterns,levels of disposable consumer income, or otherwise lead consumers to host ornot host parties or purchase party goods and supplies.  Examples of such external factors include:unseasonable weather, especially in New England; the timing, duration andeffects of adverse changes in overall economic conditions, including rates ofjob loss or growth, energy prices, and increases or decreases in interestrates, nationally or more locally in the markets we serve; and the competitivesuccess or failure of local sports teams, such as the New England Patriots orBoston Red Sox, particularly in post-season play.  The precise impact of any of these externalfactors 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.

* *

***The U.S. consumer has been experiencing risingunemployment, increasing mortgage foreclosures, higher food and gas prices,credit market turmoil, and a significant decline in the stock market.  This has contributed to a loss in consumerconfidence and a decline in consumer spending that has had and may continue tohave an impact on our business, which represents relatively discretionaryspending.***

** **

Becausepurchases of our merchandise are dependent upon discretionary spending by ourcustomers, our financial performance is sensitive to changes in overalleconomic conditions that affect consumer spending. Consumer spending habits areaffected by, among other things, prevailing economic conditions, levels ofemployment, salaries and wage rates, consumer confidence and consumerperception of economic conditions.  TheUnited States is experiencing a general slowdown that has led to a decline inconsumer spending.  A steeper orprolonged slowdown could further reduce consumer spending or cause a shift inconsumer discretionary spending to other products, adversely affecting ourliquidity and results of operations.  Inresponse to this economic slowdown, we have enacted a number of cost cuttinginitiatives to reduce expenses and we do not expect to open new stores in2009.  We cannot make any assurances thatthese initiatives will be effective.  Inaddition, if the economy further deteriorates or the recession lasts longerthan many economists expect, we may need to make further cuts, which couldadversely affect our business and results of operations.

 

5

----

 

***Our failure togenerate sufficient cash to meet our liquidity needs may affect our ability toservice our indebtedness and grow our business.***

** **

Our business requires access tocapital to support growth, improve our infrastructure, respond to economicconditions, and meet contractual commitments. In the event that our current operating plan or long term goals changedue to changes in our strategic plans, lower-than-expected revenues,unanticipated expenses, increased competition, unfavorable economic conditions,other risk factors discussed in this report, or other unforeseen circumstances,our liquidity may be negatively impacted. Our ability to make payments on and to refinance our indebtedness,principally the amounts borrowed under our bank line of credit and notespayable, and to fund any capital expenditures for systems upgrades and newstore openings, if any, we may make in the future will depend in large part onour 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 from othersources, we cannot assure you that we will be able to do so on terms andconditions acceptable to us.

 

We currently have three notespayable outstanding with principal balances totaling $3,612,549 at December 27,2008. The principal amount of one of these notes is paid monthly ininstallments. The principal amounts of the other two notes are due in full inthe amounts of $2,500,000 and $600,000 on September 15, 2009 and August 7,2010, respectively.  We expect to pay offthe note due September 2009 from the availability under our bank line ofcredit and available cash flow.  We arein preliminary discussion with Wells Fargo to extend our bank line of creditbeyond its current expiration date of January 2010, three months after theSeptember 2009 note becomes due and payable.  While we believe we have a positive and longterm relationship with Wells Fargo, given the adverse events in the creditmarkets and the weak economy, which is negatively impacting consumer spendingand preferences, we do not expect to extend the existing bank line of credit onterms more favorable or substantially the same as the existing line.  If the terms are less favorable than theexisting line, our results of operations and liquidity may be adverselyaffected.    If we need to refinance allor a portion of our indebtedness from other sources, we cannot assure you thatwe will be able to do so on commercially reasonable terms.  In addition, to the extent we use ourexisting line of credit to refinance the debt, we could have less availabilityunder the line for working capital and acquisition needs, which could adverselyimpact our results of operations, liquidity and growth opportunities.  Our existing bank line of credit with WellsFargo allows us to borrow up to $12,500,000, subject to a limitation based onqualified inventory and receivables levels, with an option to increase thatlimit up to $15 million and matures on January 2, 2010.  As of December 27, 2008, there was$1,950,019 outstanding under our line of credit with additional availability of$4,694,603. Borrowings under our line of credit are secured by our inventoryand accounts receivable. We borrow against these assets at agreed upon advancerates, which vary at different times of the year.

 

***Our businessmay be adversely affected by the actions of and risks associated with ourthird-party vendors.***

 

Theproducts we sell are sourced from a wide variety of third-party vendors.  We cannot control the supply, design,function or cost of most of the products that we offer for sale and aredependent on the availability and pricing of various products, including,without limitation, paper-based party goods, Halloween masks, and costumes,many of which are manufactured overseas in foreign countries such asChina.  Global sourcing of many of theproducts we sell is thus an important factor in our financial performance.  Our ability to find qualified vendors and accessproducts in a timely and efficient manner is a significant challenge,especially with respect to goods sourced outside the United States.  Disruptions in the availability of rawmaterials used in production of these products may adversely affect our salesand result in customer dissatisfaction. Political instability, the financial instability of suppliers,merchandise quality issues, trade restrictions, tariffs, currency exchangerates, transport capacity and costs, inflation and other factors relating toforeign trade are beyond our control.  Inparticular, volatile oil and gasoline prices impact prices ofpetroleum-based/plastic products, which are a key raw material in much of ourmerchandise, affect our freight costs, and affect consumer confidence andspending patterns.  Additionally, we have

 

6

----

 

seenshortages in helium supplies affecting the pricing of certain popular products,such as balloons. These and other issues directly or indirectly affecting ourvendors could adversely affect our business and financial performance.

 

In addition, if our overallperformance deteriorates, or if we experience liquidity challenges, our thirdparty suppliers and vendors may demand accelerated payment of amounts due tothem or require advance payments or letters of credit before goods are shippedto us.  These demands could have asignificant adverse impact on our operating cash flow and on ourliquidity.  Our third party suppliers andvendors are also experiencing the current impact of the slowing economy.  If one or more of our third party suppliersfails or is unable to supply us with adequate goods, due to their own financialtroubles or the financial troubles of their suppliers, including factories inChina, we may experience an adverse effect on our business and results ofoperations.

 

***We face intense competition from manysources.***

 

Theindustry we serve is highly competitive and fragmented. We face intensecompetition from other party supply stores and stores that merchandise andmarket party supplies, including big discount retailers, such as Wal-Mart,retail drug store chains, like CVS and Walgreen, dollar store chains, andtemporary Halloween stores.  Our successthus depends on our ability to be competitive against many differentcompetitors in each local market area we serve. If we fail to anticipate evolving innovations and product offerings fromour competitors and fail to offer products that appeal to the changing needsand preferences of our customers in the various markets we serve, demand forour products could decline and our operating results would be adverselyaffected. While the competitive importance of product quality, price, serviceand innovation varies from product to product, price is a factor, and weexperience pricing pressures from competitors in our markets.

 

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

 

AmscanHoldings, Inc. (“AHI”), the parent company of Amscan, Inc. (“Amscan”)our largest supplier and the largest supplier in our industry, or AHI’s parent,AAH Holdings Corporation (“AAH”), acquired Party City Corporation, PartyAmerica and Factory Card & Party Outlet Corp. (“Factory Card”).  With the acquisitions of these party goodscompanies, AHI and AAH own a total of approximately 956 corporate and franchiseparty supply stores nationwide. None of these companies currently has asignificant presence in the New England region.

 

Wehave a Supply Agreement with Amscan which extends to 2012 and obligates us topurchase increased levels of merchandise from Amscan, in exchange for, amongother 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.  In addition to the Supply Agreement withAmscan, we have a five-year non-competition agreement from Party City and itsaffiliates that covers Massachusetts, Maine, New Hampshire, Vermont, RhodeIsland, and Windsor and New London counties in Connecticut.

 

Anyfurther geographic expansion by us outside of the New England market couldresult in greater direct competition with one or all of Party City, PartyAmerica and Factory Card.  If so, AAH andAHI’s acquisitions of Party City, Party America and Factory Card, and itsstatus as our largest supplier and the largest supplier in our industry couldadversely affect our ability to compete favorably or operate successfully in achanged marketplace.  Price pressuresfrom such new sources of competition, particularly in the event of a strain or rupturein our relationship with Amscan, could erode our margins and cause ourfinancial results of operations to suffer. Our success depends on our ability to evaluate and respond to thethreats arising from growing consolidation and changing marketplaces andidentify ways in which we can competitively operate and strategically grow ourstore base.

 

***A major failure of our information systemswould harm our business.***

 

Thefailure of any of our systems, including, without limitation, our point-of-salesystem and our existing merchandise management system, the latter of which wasdeveloped by a vendor who is no longer in business and is thus currentlyunsupported by a third-party, would have a material adverse effect on ourbusiness and financial results of operations. We depend on these information systems to operate our retail stores,process transactions, respond to customer inquiries, manage inventory, purchaseand sell goods on a timely basis, and maintain

 

7

----

 

cost-efficientoperations.  We may experienceoperational problems with our information systems as a result of systemfailures or any inability on our part to find and retain qualified personnel tomonitor, maintain, and upgrade these systems, particularly with respect to ourmerchandise management system, or other causes.

 

Wecannot assure you that our systems will be adequate to support future growth,either as currently configured or as we plan to possibly update them.  Any material disruption or slowdown of oursystems would severely interfere with the normal operation of our retail storeoperations and could have a materially negative impact on our businessoperations and financial results.  Inparticular, our total borrowing base under our line of credit depends, amongother things, on our inventory levels, credit card receivables, customerdeposits, and merchandise credits. Accordingly, any material disruption or problem affecting ourpoint-of-sale or merchandise management systems could materially and adverselyaffect our borrowing level, our compliance with various covenants under ourbank agreement, and our liquidity and cash resources.

 

***Our quarterly operating results are subjectto significant fluctuation.***

 

Our operating results havefluctuated from quarter to quarter in the past, and we expect that they willcontinue to do so in the future.  Factorsthat could cause these quarterly fluctuations, both sequentially and on ayear-over-year basis, include the following: extreme weather-related disruptions,particularly in New England; the timing of movable holidays, such as Easter,which typically falls in the second quarter but on occasion falls in the firstquarter; the competitive success or failure of local sports teams, such as theNew England Patriots or Boston Red Sox, particularly in post-season play, whichmay result in fluctuations from one year to the next in our sales in the firstand fourth quarters; the extent to which sales in new stores result in the lossof sales in existing stores; the mix of products sold; pricing and marketingactions of competitors; the level of advertising and promotional expenses; andseasonality, primarily because the sales and profitability of our stores aretypically lower in the first and third quarters, when we have often operated ata loss, and are typically higher in the second quarter, which includes schoolgraduations, and the fourth quarter, which includes Halloween, our single mostimportant selling season, as well as the Christmas holiday season.  Most of 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 salesshortfall would have a disproportionate effect on our net income (or loss) forthe quarter.

 

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

 

Oursuccess depends in large part on the efforts and abilities of our seniormanagement team.  Their skills,experience and industry contacts significantly benefit our operations and administration.  The failure to attract, retain, and properlymotivate the members of our senior management team and other key employees, orto find suitable replacements for them in the event of death, ill health, or theirdesire to pursue other professional opportunities, could have a negative effecton our operating results.

 

Ourperformance is also largely dependent on attracting and retaining qualityassociates that are able to make the consumer shopping experience at our storesa fun and informative experience.  Weface intense competition for qualified associates, and many of our associatesare in entry-level or part-time positions with historically high rates ofturnover.  Our ability to meet our laborneeds generally while controlling our labor costs is subject to numerousexternal factors, including the availability of a sufficient number ofqualified persons in the work force, unemployment levels, prevailing wagerates, changing demographics, health and other insurance costs and changes inemployment legislation, particularly in the New England region.  If we are unable to attract and retainqualified associates or our labor costs increase significantly, our businessand financial performance may be adversely affected.

 

***Risks associated with recent and possiblefuture new store openings could adversely affect our business.***

 

Animportant part of our long-range business plan is to increase our number ofstores and, over time, enter new geographic markets.  We have opened 15 new stores, acquired threestores and closed three stores and operated two temporary Halloween stores overthe past six years, bringing our total number of stores from 35 at thebeginning of 2003 to 50 at the end of 2008. We do not currently anticipate opening new stores in 2009 as part of ourstrategy

 

8

----

 

tomaintain liquidity during this economic slowdown, however, our long term growthgoals include opening additional stores. For a growth strategy to be successful, we must identify and lease oracquire favorable store sites, hire and train associates and store managers,and adapt management and operational systems to meet the needs of our expandedoperations.  These tasks may be difficultto accomplish successfully.  If we are unableto open or acquire new stores in locations and on terms acceptable to us asquickly as planned, our future sales and profits may be adverselyaffected.  Even if we succeed in openingor acquiring new stores, these new stores may not achieve the same sales orprofit levels as our existing stores. Also, our expansion strategy includes opening new stores in marketswhere we already have a presence so we can take advantage of economies of scalein 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 and 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 ownership structure includes largeinvestors who own preferred stock and whose interests and rights in our companymay differ in important respects from those of our common stock investors.***

 

 As of December 27, 2008, there were22,731,667 shares of common stock outstanding, and 27,272,658 potentialadditional common share equivalents outstanding that may be issued upon theconversion of outstanding convertible preferred stock, warrants and options topurchase our common stock.  The averageweekly trading volumes in our common stock as reported on the NYSE****Alternext US (formerly known as the American StockExchange) for the fifty two week periods ended December 27, 2008 and December 29,2007 were 51,683 shares and 188,408 shares, respectively.  Additionally, a number of investors in theCompany own large concentrations of our common and convertible preferred stockmaking our shares more illiquid than if our ownership structure were morewidely distributed. The ownership rights of these holders of our convertiblepreferred stock impact the trading liquidity of our common shares, ourcorporate governance, and the relative economic stake that our common stock andconvertible preferred stock investors have in the enterprise value of ourbusiness.  Although a more active tradingmarket may develop in the future, the limited market liquidity for our stockmay affect your ability to sell at a price that is satisfactory to you.

 

Ourcorporate governance is affected by our ownership structure to the extent thatcertain of our convertible preferred stock investors currently enjoy, amongother things, contractual rights to nominate and elect two of the members ofour board of directors, although only one of these board seats is currentlyfilled.  These rights and theconcentration of share ownership enjoyed by certain of our preferred stock investorsmean that our largest investors can influence our strategic direction and thatof our senior management in ways that are different from most of our commonstock investors.  Our preferred stockinvestors also enjoy certain economic rights that differentiate their ownershiprights and interests from those of our common stock investors.  For instance, upon the occurrence of merger,acquisition or similar transaction involving the acquisition of our company,the holders of our preferred stock would generally be entitled to a “liquidationpreference” that would entitle them, collectively, to the first $17.9 millionof net proceeds, unless they decide to convert their shares of preferred stockinto common stock.  This feature of ourpreferred stock investors’ rights could make the attractiveness of our companyas an acquisition target differ materially from what it would be withoutit.  In addition, our preferred stockinvestors enjoy certain “anti-dilution” protections not afforded to our commonstock investors, which generally means that investors in shares of our commonstock could be adversely affected by subsequent dilutive financings, if any, inways that are different from some or all of our preferred stock investors.

 

****Shares that may beresold pursuant to our prospectus on Form S-3 by the selling stockholdernamed therein declared effective by the SEC on April 4, 2007, or eligiblefor sale in the future could negatively affect our stock price.****

 

Certain securities may be sold inthe future pursuant to registration statements filed with the SEC or withoutregistration 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 of sharesof our common stock or the

 

9

----

 

perceptionthat these sales could occur.  This mayalso make it more difficult for us to raise funds through the issuance of debtor the sale of equity securities.

 

Asof December 27, 2008, there were 27,272,658 potential additional commonshare equivalents outstanding.  Theseincluded 15,478,916 shares issuable upon the conversion of immediatelyconvertible preferred stock, 2,083,334 shares issuable upon the exercise of awarrant with an exercise price of $0.475, 528,210 shares issuable upon theexercise of warrants with a weighted average exercise price of $3.79, 100,000shares issuable upon the exercise of warrants with a weighted average exerciseprice of $1.50, and 9,082,198 shares issuable upon the exercise of stockoptions with a weighted average exercise price of $0.55.

 

***Our common stock is thinly traded, mayfluctuate based on relatively small levels of trading activity, and may beadversely affected by our capital structure, which makes it more difficult forinvestors to value our business.***

 

Investingin shares of our common stock entails a high degree of risk.  Public trading of our common stock on the NYSEAlternext US (formerly known as the****American StockExchange) typically occurs at relatively low sales volumes and very few, ifany, security analysts regularly follow our stock.  Moreover, our common stock price has tradedbelow $1.00 for significant periods of time. In addition, our capital structure, which includes various series ofconvertible preferred stock with various contractual rights, generally makes itmore difficult for investors, or prospective acquirers of our company, to valueour business on an aggregate basis or to value our shares of common stock on atrading basis.  As a result of thesefactors, speculative investors may have a greater effect on our common stockprice than would be the case for a company with a simpler ownership structure,a larger market capitalization, or common shares that are more diffusely heldor heavily traded.  Accordingly, ourcommon stock price could be subject to considerable speculative volatility andmay not necessarily follow market expectations regarding our business prospectsor financial performance.  In particular,our common stock price may be sensitive to non-financial developments involvingour company as well as market rumors disseminated on the Internet or otherforms of media regarding our company or our industry. If our quarterlyfinancial performance does not meet the expectations of investors that trade inshares of our 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 changing regulation ofcorporate governance, public disclosure, and accounting standards may result inadditional expenses and risks.***

 

Changinglaws, regulations and standards relating to corporate governance, publicdisclosure and changes to accounting standards and practices, including theSarbanes-Oxley Act of 2002, new SEC regulations, corporate law developments inDelaware, and evolving rules applicable to publicly-traded companies onthe NYSE Alternext US (formerly known as the****AmericanStock Exchange), are creating uncertainty, and hence risks, for companies suchas ours.  These new or changed laws,regulations and standards are subject to varying interpretations due to thefact that they are new and there has not yet emerged a well-developed body ofinterpretation.  As a result, theirapplication in practice may evolve over time as new guidance is provided byregulatory and governing bodies.  Thisdevelopment could result in continuing uncertainty regarding compliance mattersand higher costs necessitated by ongoing revisions to disclosure, governanceand accounting practices.

 

Ourefforts to comply with evolving laws, regulations and standards have resultedin, and are likely to continue to result in, increased general andadministrative expenses and a diversion of management time and attention fromrevenue-generating activities to compliance activities.  In particular, we have applied significantmanagement and financial resources to document, test, monitor and enhance ourinternal control over financial reporting in order to meet the various currentrequirements of the Sarbanes-Oxley Act of 2002. Additional costs may berequired to be incurred in 2009 since current regulations will require ourinternal controls to be audited by our external auditors. Currently, onlymanagement is required to certify as to the effectiveness of our internalcontrols. Any failure in the effectiveness of our internal control overfinancial reporting could have a material effect on our financial reporting orcause us to fail to meet reporting obligations, which upon disclosure, could negativelyimpact the market price of our common stock. Our efforts to comply with these types of new regulatory requirementsregarding our required assessment of our internal controls over financialreporting and our external auditors’ audit of our financial statements haverequired the commitment of increasing levels of financial and managerialresources. If our efforts to comply with new or changed laws, regulations andstandards differ from the activities intended by

 

10

----

 

regulatoryor governing bodies, we could face various material and adverse consequences,including, a decline in our common stock price or a possible delisting of ourcommon stock.

 

***Our stock is listed on the NYSE Alternext US andsubject to a number of continued listing requirements, the failure to complywith which may result in the delisting of our common stock.***

 

Ourcommon stock is currently listed on the NYSE Alternext US (formerly known asthe American Stock Exchange or AMEX). Subject to NYSE Alternext US rules, we are required to maintaincompliance with a number of continued listing standards, including but notlimited to, the requirement that our stock trade above certain pricing levelsfor a continued period. Our common stock price has traded below $1.00 forsignificant periods of time.  If theexchange considers our common stock to be a low priced stock, our common stockcould be subject to delisting.  Adelisting of our common stock could negatively impact us by reducing further theliquidity and market price of our common stock, or by reducing the number ofinvestors willing to hold or acquire our common stock, which could negativelyimpact our ability to raise equity capital.

 

***Product liability may adversely impact our operationsand merchandise offerings.***

 

Weand our vendors are subject to regulations by a variety of state and federalregulatory authorities, including the Consumer Product Safety Commission. Ifone or more of our vendors fails to adhere to product safety requirements ourreputation and brands could be damaged and we could be subject to productliability suits and government fines and penalties, which could adverselyaffect our business and results of operations. Furthermore, to the extent we are unable to replace any non-compliantproducts, we may have to reduce our merchandise offerings, resulting in adecrease in sales.

 

***A privacy breach could adversely affect the Company’sbusiness.***

 

The protection of customer, employee, and companydata is critical to the Company. The regulatory environment surroundinginformation security and privacy is increasingly demanding, with the frequentimposition of new and constantly changing requirements. In addition, customershave a high expectation that the Company will adequately protect their personalinformation. A significant breach of customer, employee, or company data coulddamage the Company’s reputation and result in lost sales, fines, or lawsuits.

 

**Forward LookingStatements**

 

Certainstatements in this Annual Report, particularly statements contained in Item 7, “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”constitute “forward-looking statements” within the meaning of Section 27Aof the Securities Act of 1933, as amended, and Section 21E of theSecurities 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-looking statements included in thisAnnual Report or hereafter included in other publicly available documents filedwith the 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.  Our forward-looking statements speak only asof the date of this document, and we do not intend to update these statementsto reflect events or circumstances that occur after that date.

 

Various risks, uncertainties and contingencies could causeour actual results, performance or achievements to differ materially from thoseexpressed in, or implied by, the forward-looking statements contained in thisAnnual Report.  These include, but arenot limited to, those listed above in this Item 1A, “Risk Factors.”

 

**ITEM 1B. UNRESOLVED STAFF COMMENTS**

 

Not applicable.

 

11

----

** **

**ITEM 2.  PROPERTIES**

 

The following table identifies thenumber of our stores operating as of December 27, 2008, December 29,2007 and December 30, 2006, by state:

 
| ** **    | ** ** | **Number of Stores, for the fiscal year ended** | ** ** |
|---------------|------------|------------------------------------------------------------------------------------|------------|
| ** **    | ** ** | **Dec 27, 2008**                                                         | ** ** | **Dec 29, 2007** | ** ** | **Dec 30, 2006** | ** ** |
| ** **    | ** ** | **End**                                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | **End** | ** ** | ** ** | ** ** | ** ** | ** ** | **End** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **    | ** ** | **of**                                                                             | ** ** | ** ** | ** ** | **Acquired/** | ** ** | **of** | ** ** | ** ** | ** ** | **Acquired/** | ** ** | **of** | ** ** | ** ** | ** ** | **Acquired/** | ** ** |
| **States**    | ** ** | **Period**                                                                         | ** ** | **Closings** | ** ** | **Openings** | ** ** | **Period** | ** ** | **Closings** | ** ** | **Openings** | ** ** | **Period** | ** ** | **Closings** | ** ** | **Openings** | ** ** |
| Connecticut   |       | 7                                                                                  |       | — |   | — |   | 7 |   | — |   | — |   | 7 |   | — |   | — |   |
| Florida       |       | 5                                                                                  |       | — |   | — |   | 5 |   | — |   | — |   | 5 |   | — |   | — |   |
| Maine         |       | 3                                                                                  |       | — |   | — |   | 3 |   | — |   | — |   | 3 |   | — |   | — |   |
| Massachusetts |       | 25                                                                                 |       | 1 |   | — |   | 26 |   | — |   | — |   | 26 |   | — |   | 1 |   |
| New Hampshire |       | 6                                                                                  |       | — |   | — |   | 6 |   | — |   | — |   | 6 |   | — |   | — |   |
| Rhode Island  |       | 3                                                                                  |       | 1 |   | 2 |   | 2 |   | — |   | — |   | 2 |   | 1 |   | — |   |
| Vermont       |       | 1                                                                                  |       | — |   | — |   | 1 |   | — |   | — |   | 1 |   | — |   | — |   |
| Total         |       | 50                                                                                 |       | 2 |   | 2 |   | 50 |   | — |   | — |   | 50 |   | 1 |   | 1 |   |

 

Our stores range in size from approximately 8,000 squarefeet to approximately 20,500 square feet and average approximately 10,300square feet.  We lease all of our retailstores.  The leases generally provide forfixed minimum rentals, which typically increase periodically during the life ofthe lease, and, in some instances, contingent rentals based on a percentage ofsales in excess of specified minimum sales levels, as well as related occupancycosts, such as property taxes 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 our 50 stores, we lease office space at 270Bridge Street, Suite 301, Dedham, Massachusetts, 02026.  The lease, which expires November 30,2011, is for 10,600 square feet of space and the monthly rent is $17,917.  We also lease office and retail space at 1457VFW Parkway, West Roxbury, Massachusetts, 02132.  This lease, which expires December 31,2012, is for 20,500 square feet of space. The retail store at our West Roxbury location uses 10,688 square feetand the remainder is used primarily for our corporate training center.  The total monthly rent for the retail storeand corporate training center space is $20,037, subject to certain ConsumerPrice Index escalation clauses. We believe that these spaces are adequate forour immediate needs.

 

We believe that all properties are adequately covered byinsurance.

 

**ITEM3.  LEGAL PROCEEDINGS**

 

We are not a party to any material pending legal proceedingsother than ordinary routine matters incidental to our business, which we do notexpect, individually or in the aggregate, to have a material adverse effect onthe Company.

 

**ITEM 4.  SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

No matters were submitted to a voteof our security holders during the fourth quarter of fiscal 2008.

 

12

----

 

**PART II**

 

**ITEM 5.  MARKET FORREGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OFEQUITY SECURITIES**

 

**Market Information**

 

The NYSE Alternext US (formerlyknown as the****American Stock Exchange) is theprincipal market for our common stock, where our shares are traded under thesymbol “IPT”.

 

The following table setsforth the range of high and low sales prices on the NYSE Alternext US for ourcommon stock for each of the fiscal quarters of 2008 and 2007:

 

**MARKET PRICE OF COMMON STOCK**

 
| **Period**            | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------------------|------------|----------|------------|---------|------------|
| **2008**              |       |     |       |    |       |
| Fourth fiscal quarter |       | $        | 0.20       |    | $          | 0.06 |   |
| Third fiscal quarter  |       | 0.25     |       | 0.16    |       |
| Second fiscal quarter |       | 0.30     |       | 0.20    |       |
| First fiscal quarter  |       | 0.34     |       | 0.17    |       |
|                  |       |     |       |    |       |
| **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    |       |

 

**Holders**

 

Theapproximate number of record holders of our common stock as of February 27,2009 was 116.  The number of recordowners was determined from our stockholder records, and does not includebeneficial owners of our common stock whose shares are held in the names ofvarious security holders, dealers and clearing agencies.  We believe that the number of beneficialowners of our common stock held by others as or in nominee names exceeds 500 innumber.

** **

**Dividends**

 

Wehave never paid a cash dividend on our shares of common stock and have noexpectation of doing so for the foreseeable future.  Our existing line of credit agreement withWells Fargo Retail Finance, LLC generally prohibits the payment of anydividends or other distributions to any of our classes of capital stock.

 

**Recent Sales of Unregistered Securities**

 

There were no sales of unregisteredsecurities made during the fourth quarter of 2008.

 

**Purchases of Equity Securities by the Issuer and AffiliatedPurchasers**

 

There were no stock repurchasesmade during the fourth quarter of 2008.

 

13

----

 

**Stock PerformanceGraph**

 

**COMPARISON OFCUMULATIVE TOTAL RETURN AMONG iPARTY CORP. (“IPT”), RUSSELL 2000**

**INDEX (“RUSSELL2000”) AND S&P RETAIL INDEX**

 

The following graph compares thecumulative total stockholder return of our common stock during the five fiscalyears ended December 27, 2008 with the cumulative return of the Russell2000 Index and the Standard & Poor’s Retail Index.

 

This graph is not deemed to be “filed” with the SEC orsubject to the liabilities of Section 18 of the Securities Exchange Act of1934, and the graph shall not be deemed incorporated by reference into anyprior or subsequent filings by us under the Securities Act or the Exchange Act.

 

 
| ** **               | ** ** | **12/27/03** | ** ** | **12/25/04** | ** ** | **12/31/05** | ** ** | **12/30/06** | ** ** | **12/29/07** | ** ** | **12/27/08** | ** ** |
|--------------------------|------------|--------------|------------|--------------|------------|--------------|------------|--------------|------------|--------------|------------|--------------|------------|
| IPT                      |       | $            | 100.00     |         | $          | 77.53        |       | $            | 43.82      |         | $          | 44.94        |       | $ | 24.72 |   | $ | 8.99 |   |
| Russell 2000             |       | $            | 100.00     |         | $          | 117.02       |       | $            | 121.32     |         | $          | 141.95       |       | $ | 139.08 |   | $ | 85.92 |   |
| S&P Retail Index-Rlx |       | $            | 100.00     |         | $          | 121.77       |       | $            | 122.31     |         | $          | 133.76       |       | $ | 109.89 |   | $ | 72.71 |   |

 

----

(1)                      Assumes$100 invested on December 27, 2003 in our common stock, the Russell 2000Index and the S&P Retail Index, including reinvestment of any dividendspaid on the investment.  The Russell 2000Index 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 Indexis a capitalization-weighted index of domestic equities that consist of theretail sector stocks contained in the S&P 500 Index.

 

14

----

 

**ITEM 6.  SELECTED FINANCIAL DATA**

 

Thefollowing selected consolidated financial data is derived from our auditedconsolidated financial statements and should be read in conjunction with ouraudited consolidated financial statements and related notes, which are includedin Item 8 “Financial Statements and Supplementary Data” below, and “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”included in Item 7 below.

 
| ** **                                                    | ** ** | **2008**          | ** ** | **2007**          | ** ** | **2006**          | ** ** | **2005 (1)** | ** ** | **2004**          | ** ** |
|---------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                                    | ** ** | **52 weeks** | ** ** | **52 weeks** | ** ** | **52 weeks** | ** ** | **53 weeks** | ** ** | **52 weeks** | ** ** |
| **Statement of Operations Data:**                             |       |              |       |              |       |              |       |              |       |              |       |
| Revenues                                                      |       | $                 | 81,210,999 |              | $          | 81,798,634        |       | $                 | 78,458,329 |              | $          | 72,537,998 |   | $ | 64,276,225 |   |
| Operating costs:                                              |       |              |       |              |       |              |       |              |       |              |       |
| Cost of products sold                                         |       | 46,885,215        |       | 46,465,441        |       | 44,942,542        |       | 41,395,193        |       | 35,826,820        |       |
| Marketing and sales                                           |       | 26,793,885        |       | 26,181,504        |       | 25,625,547        |       | 24,116,050        |       | 21,176,925        |       |
| General and administrative                                    |       | 7,205,067         |       | 7,553,869         |       | 6,736,197         |       | 6,762,583         |       | 6,335,067         |       |
|                                                          |       |              |       |              |       |              |       |              |       |              |       |
| Operating income                                              |       | 326,832           |       | 1,597,820         |       | 1,154,043         |       | 264,172           |       | 937,413           |       |
|                                                          |       |              |       |              |       |              |       |              |       |              |       |
| Other income                                                  |       | —            |       | —            |       | —            |       | —            |       | 382,500           |       |
|                                                          |       |              |       |              |       |              |       |              |       |              |       |
| Income before interest and taxes                              |       | 326,832           |       | 1,597,820         |       | 1,154,043         |       | 264,172           |       | 1,319,913         |       |
|                                                          |       |              |       |              |       |              |       |              |       |              |       |
| Interest income                                               |       | 4,609             |       | 17,806            |       | 10,217            |       | 801               |       | 1,354             |       |
| Interest expense                                              |       | (720,891          | )          | (857,612          | )          | (772,334          | )          | (532,649          | )          | (225,074          | )          |
|                                                          |       |              |       |              |       |              |       |              |       |              |       |
| Income (loss) before taxes                                    |       | (389,450          | )          | 758,014           |       | 391,926           |       | (267,676          | )          | 1,096,193         |       |
|                                                          |       |              |       |              |       |              |       |              |       |              |       |
| Income taxes                                                  |       | 50,605            |       | 146,323           |       | 17,279            |       | —            |       | 105,000           |       |
|                                                          |       |              |       |              |       |              |       |              |       |              |       |
| Net income (loss)                                             |       | $                 | (440,055   | )                 | $          | 611,691           |       | $                 | 374,647    |              | $          | (267,676 | ) | $ | 991,193 |   |
|                                                          |       |              |       |              |       |              |       |              |       |              |       |
| Net income (loss) available to common  stockholders           |       | $                 | (440,055   | )                 | $          | 611,691           |       | $                 | 374,647    |              | $          | (267,676 | ) | $ | 991,193 |   |
|                                                          |       |              |       |              |       |              |       |              |       |              |       |
| Income (loss) per share:                                      |       |              |       |              |       |              |       |              |       |              |       |
| Basic                                                         |       | $                 | (0.02      | )                 | $          | 0.02              |       | $                 | 0.01       |              | $          | (0.01 | ) | $ | 0.03 |   |
| Diluted                                                       |       | $                 | (0.02      | )                 | $          | 0.02              |       | $                 | 0.01       |              | $          | (0.01 | ) | $ | 0.02 |   |
|                                                          |       |              |       |              |       |              |       |              |       |              |       |
| Net income (loss) per share available to  common stockholders |       |              |       |              |       |              |       |              |       |              |       |
| Basic                                                         |       | $                 | (0.02      | )                 | $          | 0.02              |       | $                 | 0.01       |              | $          | (0.01 | ) | $ | 0.03 |   |
| Diluted                                                       |       | $                 | (0.02      | )                 | $          | 0.02              |       | $                 | 0.01       |              | $          | (0.01 | ) | $ | 0.02 |   |
|                                                          |       |              |       |              |       |              |       |              |       |              |       |
| Weighted-average shares outstanding:                          |       |              |       |              |       |              |       |              |       |              |       |
| Basic                                                         |       | 22,722,485        |       | 38,204,374        |       | 37,862,928        |       | 22,186,581        |       | 37,649,400        |       |
| Diluted                                                       |       | 22,722,485        |       | 39,913,274        |       | 39,535,874        |       | 22,186,581        |       | 41,517,036        |       |
|                                                          |       |              |       |              |       |              |       |              |       |              |       |
| **Other Data:**                                               |       |              |       |              |       |              |       |              |       |              |       |
| Net cash provided by (used in) operating  activities          |       | $                 | 3,229,642  |              | $          | (239,008          | )          | $                 | 4,412,036  |              | $          | (259,907 | ) | $ | 129,690 |   |
| Net cash used in investing activities                         |       | (2,027,709        | )          | (802,174          | )          | (2,579,007        | )          | (1,663,647        | )          | (2,121,134        | )          |
| Net cash provided by (used in) financing  activities          |       | (1,213,215        | )          | 352,338           |       | (1,771,847        | )          | 865,591           |       | 1,306,130         |       |
| Capital expenditures (2)                                      |       | 2,027,709         |       | 802,174           |       | 709,892           |       | 1,663,647         |       | 2,121,134         |       |

 
| ** **                  | ** ** | **Dec 27, 2008** | ** ** | **Dec 29, 2007** | ** ** | **Dec 30, 2006** | ** ** | **Dec 31, 2005** | ** ** | **Dec 25, 2004** | ** ** |
|-----------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|
| **Balance Sheet Data:**     |       |                       |       |                       |       |                       |       |                       |       |                       |       |
| Working capital             |       | $                          | 3,489,893  |                       | $          | 6,184,373                  |       | $                          | 4,954,989  |                       | $          | 2,091,213 |   | $ | 3,236,148 |   |
| Total assets                |       | 20,995,273                 |       | 22,977,086                 |       | 22,697,373                 |       | 21,717,076                 |       | 19,479,937                 |       |
| Total long-term liabilities |       | 1,800,174                  |       | 4,394,367                  |       | 4,707,964                  |       | 1,095,998                  |       | 1,268,452                  |       |
|                             |            |                            |            |                            |            |                            |            |                            |            |                            |            |  |  |  |  |  |

 

----

(1) Fiscal year 2005 refers to a 53-weekfiscal year, while fiscal years 2008, 2007, 2006 and 2004 refer to 52-weekfiscal years.

 

(2) Capital expenditures exclude assetsacquired under capital leases.

 

15

----

 

**ITEM 7.  MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

*The following discussion should be read in conjunction withour Consolidated Financial Statements and the related Notes included below.*

 

*Certain statements in this Annual Report, particularlystatements contained in this Item 7, “Management’s Discussion and Analysis ofFinancial 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 Securities andExchange Commission (“SEC”), reports to our stockholders and other publiclyavailable statements issued or released by us involve known and unknown risks, uncertainties,and other factors which could cause our actual results, performance (financialor operating) or achievements to differ from the future results, performance(financial or operating) or achievements expressed or implied by such forwardlooking statements.  Such future resultsare based upon our best estimates based upon current conditions and the mostrecent 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 AnnualReport.  These include, but are notlimited to, those described above under Item 1A, “Risk Factors.”  Our forward-looking statements speak only asof the date of this document, and we do not intend to update these statementsto reflect events or circumstances that occur after that date.*

 

**Overview**

 

At the end of 2008, we operated 50retail stores, including 45 in New England and five in Florida, and for theyear we generated approximately $81.2 million in sales and had a net loss ofapproximately $0.4 million. Total sales for fiscal 2008 (a 52-week period)decreased 0.7% compared to fiscal 2007 (also a 52-week period). Comparablestore sales in 2008 decreased 2.4% compared to sales in 2007. Comparable storesales are defined as sales from those stores open for at least one full year.

 

The year began with a 2.2% increasein comparable store sales in the first quarter of 2008. Total sales for thefirst quarter of 2008 increased 3.5% compared to the first quarter of 2007.This performance was mainly due to strong sales associated with the post-seasonfootball playoffs, especially the 2008 Super Bowl, between the New EnglandPatriots and New York Giants football teams, and the occurrence of Easter inthe first quarter of 2008. Despite the increase in sales, net loss for thequarter increased due to increased merchandise costs, increased markdowns, duein part to a weather related decline in sales in December 2007, andincreased store operating expenses, as we opened two stores and closed twostores in January 2008. Our net loss for the quarter was $1.9 million,compared to a net loss of $1.5 million for the first quarter of 2007.

 

In the second quarter, comparablestores sales decreased 2.8% compared to the same period in 2007. Total salesdecreased by 1.5%. During this quarter, our sales results suffered from themovement of Easter from the second to the first quarter of the year. Productmargins stabilized in the second quarter. However, store operating costscontinued to increase compared to 2007 levels, resulting in a lower profit forthe quarter compared to the second quarter of 2007. Our net income was $184thousand for the quarter compared to a net income of $512 thousand for thesecond quarter of 2007.

 

In the third quarter, ourcomparable stores sales decreased by 4.2% compared to the third quarter of2007. Total sales decreased 2.6% compared to third quarter 2007. The decreasein sales for the third quarter was caused by an overall weakening of customertraffic, which we believe may have been caused in part by consumer uneasinessin response to the then soaring price levels for petroleum products. Our lossfor the third quarter of 2008 was $1.3 million compared to a net loss in thethird quarter of 2007 of $1.1 million.

 

16

----

 

The year ended with a 3.3% decreasein comparable store sales in the fourth quarter, which included a 1.1% increasein comparable store sales in the month of October. Total company salesdecreased 1.3 % in the fourth quarter as compared to the fourth quarter of2007. This decrease included a 3.9% increase in total company sales for themonth of October. Overall, the fourth quarter was negatively affected by thedeepening financial crisis in the U.S. and world economies. Falloff in consumerconfidence led to a continued softening in store traffic and sales. Theresultant sales shortfall was offset to a certain extent by a slightly better marginrate, and by lower expenses in certain categories, notably general andadministrative expenses and interest, as compared to 2007. For the quarter, ournet income was $2.6 million, compared to $2.7 million in the fourth quarter of2007.

 

For the full fiscal year 2008, ourcomparable stores sales decrease was 2.4% which follows a 2.6% increase for2007 and a 3.8% increase for 2006.  Ournet loss for 2008 was $0.4 million compared to net income of $0.6 million in 2007.

 

**Overview Summary for 2008**

 

In 2008, the US economy enteredinto a recessionary period combined with a systematic lack of liquidity.  During the year, we saw the housing crisisdeepen, the stock market decline dramatically, and unemployment rise steeply.  All of these factors contributed to adifficult retail environment.   Manyeconomists anticipate a difficult 2009. Although we fared better than many ofour competitors in 2008, we have taken significant steps in response to theeconomic crisis.  We reviewed andrevamped our headquarters and store expenses, which included reducing ourheadcount and decreasing our advertising and other administrative costs . Weexpect to save up to $3 million in expenses in 2009 from these actions.  In addition, we do not expect to open anyadditional stores in 2009, unless we see an early recovery in the economy.   For the remainder of 2009 we will focus onmaintaining maximum liquidity in anticipation of continued lower sales levelsassociated with anticipated continued weakness in consumer confidence and overallspending levels.

** **

**Fiscal 2008 Compared to Fiscal 2007**

 

*Revenues*

 

Our consolidated revenues for 2008were $81,210,999, a decrease of $587,635, or 0.7% from 2007.  Revenues include the selling price of partygoods sold, net of returns and discounts, and are recognized at the point ofsale.

 
| ** **                           | ** ** | **For the year ended** | ** ** |
|--------------------------------------|------------|---------------------------------------|------------|
| ** **                           | ** ** | **Dec 27, 2008**            | ** ** | **Dec 29, 2007** | ** ** |
| Revenues                             |       | $                                     | 81,210,999 |   | $ | 81,798,634 |   |
|                                 |       |                                  |       |   |   |
| Increase in revenues from prior year |       | -0.7                                  | %          | 4.3 | % |
|                                      |            |                                       |            |  |  |  |  |

 

Sales for 2008 included a decreaseof 2.4% in comparable store sales, and sales from two stores that we acquiredin the first quarter of 2008, but were not included in the comparable storessales calculation until the first quarter of 2009, the stores’ one yearanniversary.

 

*Cost ofgoods sold and occupancy costs*

 

Our cost of products sold andoccupancy costs for 2008 was $46,885,215, or 57.7% of revenues, an increase of$419,774 and an increase of 0.9 percentage points, as a percentage of revenues,from 2007.  Cost of products sold andoccupancy costs consist of the cost of merchandise sold to customers and theoccupancy costs for our stores.

 

17

----

 
| ** **                             | ** ** | **For the year ended** | ** ** |
|----------------------------------------|------------|---------------------------------------|------------|
| ** **                             | ** ** | **Dec 27, 2008**            | ** ** | **Dec 29, 2007** | ** ** |
| Cost of goods sold and occupancy costs |       | $                                     | 46,885,215 |   | $ | 46,465,441 |   |
|                                   |       |                                  |       |   |   |
| Percentage of revenues                 |       | 57.7                                  | %          | 56.8 | % |
|                                        |            |                                       |            |  |  |  |  |

 

As a percentage of revenues, theincrease in cost of products sold was primarily attributable to increasedoccupancy costs due to scheduled rent escalations and other occupancy relatedcosts.

 

*Marketingand sales expense*

 

Our consolidated marketing andsales expense for 2008 was $26,793,885 or 33.0% of revenues, an increase of$612,381 and an increase of 1.0 percentage point, as a percentage of revenues,from 2007.  Marketing and sales expensesconsist primarily of advertising and promotional expenditures, all storepayroll and related expenses for personnel engaged in marketing and sellingactivities and other non-payroll expenses associated with operating our stores.

 
| ** **             | ** ** | **For the year ended** | ** ** |
|------------------------|------------|---------------------------------------|------------|
| ** **             | ** ** | **Dec 27, 2008**            | ** ** | **Dec 29, 2007** | ** ** |
| Marketing and sales    |       | $                                     | 26,793,885 |   | $ | 26,181,504 |   |
|                   |       |                                  |       |   |   |
| Percentage of revenues |       | 33.0                                  | %          | 32.0 | % |
|                        |            |                                       |            |  |  |  |  |

 

As a percentage of revenues, theincrease in marketing and sales expense was primarily attributable to storeopening costs associated with the two Rhode Island stores acquired on January 2,2008 and two temporary Halloween stores opened in September 2008, plusincreased payroll costs.

 

*Generaland administrative expense*

 

Our consolidated general andadministrative (“G&A”) expenses for 2008 were $7,205,067, or 8.9% ofrevenues, a decrease of $348,802, or 0.3 percentage point as a percentage ofrevenues, from 2007. 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 27, 2008**            | ** ** | **Dec 29, 2007** | ** ** |
| General and administrative |       | $                                     | 7,205,067  |   | $ | 7,553,869 |   |
|                       |       |                                  |       |   |   |
| Percentage of revenues     |       | 8.9                                   | %          | 9.2 | % |
|                            |            |                                       |            |  |  |  |  |

 

As a percentage of revenues, thedecrease in general and administrative expense was primarily attributable tothe reduction in executive payroll expense and incentive based compensation.

 

*Operating income*

 

Our operating income for 2008 was$326,832, or 0.4% of revenues, compared to an operating income of $1,597,820,or 2.0% of revenues in 2007.

 

### *Interestexpense*

 

Ourinterest expense in 2008 was $720,891, a decrease of $136,721 from 2007.  The decrease during 2008 was due primarily tointerest expense related to the decrease in prime rate during the year.  The effective interest rate on our borrowingsunder our line of credit decreased to 4.7% during 2008 compared to 8.2% in2007, which 

 

18

----

 

decreasedinterest expense by approximately $126,664. The interest rate was based on thebank’s base rate. Our average revolving loan balance was approximately$3,656,861 during 2008 compared to $2,071,953 in 2007, which increased interestexpense by approximately $129,983. Interest expense related to notes payable in2008 was $338,630, compared to interest expense in 2007 of $463,862. Thesedecreases were due to lower interest rates on the Highbridge note and thedecreasing principal on the Amscan note. Our average notes payable balance wasapproximately $3,689,225 during 2008, compared to $4,079,132 in 2007, whichdecreased interest by approximately $63,891. The effective interest rate on ournotes payable decreased to 14.7% in 2008, compared to 16.3% in 2007, whichdecreased interest expense by $61,341. Additionally, interest expense fromcapital leases and other sources in 2008 decreased by $14,809 from 2007.Interest expense in 2008 was also slightly offset by interest income of $4,609.

 

*Income taxes*

 

In 2008, our provision for incometaxes was $50,605, which included $16,485 for federal alternative minimum taxesand $34,120 for state income taxes. Our provision for state taxes exceeds theaverage statutory rate net of federal tax benefit because of permanent andtemporary differences, for which we provide a valuation allowance, betweentaxable and book income, including amounts associated with stock basedcompensation expense, depreciation, and amortization of intangibles and commonstock warrants. We were able to utilize approximately $1,012,902 of netoperating loss carryforwards for federal income tax purposes in 2008, whichwere fully reserved for in the prior year due to the uncertainty of futuretaxable income.

 

In 2007, our provision for incometaxes was $146,323, which included $19,215 for federal alternative minimumtaxes and $127,108 for state income taxes. Our provision for state taxesexceeds the average statutory rate net of federal tax benefit because ofpermanent and temporary differences, for which we provided a valuation allowance,between taxable and book income, including amounts associated with stock basedcompensation expense, depreciation, and note payable amortization. We were ableto utilize approximately $1,436,844 of net operating loss carryforwards forfederal income tax purposes in 2007, which were fully reserved for in the prioryear due to the uncertainty of future taxable income.

 

At the end of 2008, we hadestimated net operating loss carryforwards of approximately $20.3 million,which begin to expire in 2019.  Inaccordance with Section 382 of the Internal Revenue Code, the use of thesecarryforwards may be subject to annual limitations based upon certain ownershipchanges of our stock that may have occurred or that may occur.

 

*Net income (loss)*

 

Our net loss in 2008 was $440,055or $0.02 net loss per basic and diluted share, compared to net income of$611,691, or $0.02 net income per basic and diluted share, in 2007.

** **

**Fiscal 2007 Compared to Fiscal 2006**

 

*Revenues*

 

Our consolidated revenues for 2007were $81,798,634, an increase of $3,340,305, or 4.3% from 2006.  Revenues include the selling price of partygoods sold, net of returns and discounts, and are recognized at the point ofsale.

 
| ** **                           | ** ** | **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 | % |
|                                      |            |                                       |            |  |  |  |  |

 

19

----

 

Sales for 2007 included an increaseof 2.6% in comparable store sales, and sales from one store that we acquired inthe third quarter of 2006, but was not included in the comparable stores salescalculation until the third quarter of 2007, the store’s one year anniversary.

 

*Cost ofgoods sold and occupancy costs*

 

Our cost of products sold andoccupancy costs for 2007 was $46,465,441, or 56.8% of revenues, an increase of$1,522,899 and a decrease of 0.5 percentage points, as a percentage ofrevenues, from 2006.  Cost of productssold and occupancy costs consist of the cost of merchandise sold to customersand 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 of revenues, thedecrease in cost of products sold was primarily attributable to improvedleveraging of occupancy costs and increased sales in our comparable stores.

 

*Marketingand sales expense*

 

Our consolidated marketing andsales expense for 2007 was $26,181,504 or 32.0% of revenues, an increase of $555,957and a decrease of 0.7 percentage points, as a percentage of revenues, from2006.  Marketing and sales expensesconsist primarily of advertising and promotional expenditures, all storepayroll and related expenses for personnel engaged in marketing and sellingactivities and other non-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 of revenues, thedecrease in marketing expenses was primarily due to improved leveraging ofadvertising and store operating costs from increased sales in our comparablestores.

 

*Generaland administrative expense*

 

Our consolidated general and administrative(“G&A”) expenses for 2007 were $7,553,869, or 9.2% of revenues, an increaseof $817,672, or 0.6 percentage points as a percentage of revenues, from 2006.G&A expenses consist of payroll and related expenses for executive,merchandising, finance and administrative personnel, as well as informationtechnology, 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 general andadministrative expenses was primarily due to increases in executive payroll andrecruitment costs, and to increases in professional fees associated with ourcompliance activities related to the Sarbanes-Oxley Act.

 

20

----

 

*Operating income*

 

Our operating income for 2007 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.

 

### *Interestexpense*

 

Ourinterest expense in 2007 was $857,612, an increase of $85,278 from 2006.  The increase during 2007 was due primarily tointerest expense and warrant expense related to notes payable.  The effective interest rate on our borrowingsunder our line of credit decreased to 8.2% during 2007 compared to 8.6% in2006, which decreased interest expense by approximately $7,201. The interestrate was based on the bank’s base rate. Our average revolving loan balance wasapproximately $2,071,953 during 2007 compared to $5,385,117 in 2006, whichdecreased interest expense by approximately $318,988. Interest expense andwarrant expense related to notes payable in 2007 were $463,862 and $204,550,respectively, compared to interest and warrant expense in 2006 of $129,498 and$68,184, respectively. These increases were due to the Amscan, Party City andHighbridge notes being outstanding the full fiscal year 2007, while beingoutstanding only part of the fiscal year 2006. Our average notes payablebalance was approximately $4,079,132 during 2007, compared to $1,367,544 in2006, which increased interest by approximately $391,967. The effectiveinterest rate on our notes payable increased to 16.3% in 2007, compared to14.5% in 2006, which increased interest expense by $78,763. Additionally, interestexpense from capital leases and other sources in 2007 decreased by $59,263 from2006.  Interest expense in 2007 was alsoslightly offset by interest income of $17,806.

 

*Income taxes*

 

In 2007, our provision for incometaxes was $146,323, which included $19,215 for federal alternative minimumtaxes and $127,108 for state income taxes. Our provision for state taxesexceeds the average statutory rate net of federal tax benefit because ofpermanent and temporary differences, for which we have provided a valuationallowance, between taxable and book income, including amounts associated withstock based compensation expense, depreciation, and note payable amortization.We were able to utilize approximately $1,436,844 of net operating losscarryforwards for federal income tax purposes in 2007, which were fullyreserved for in the prior year due to the uncertainty of future taxable income.

 

In 2006, our provision for incometaxes was $17,279, which included $5,717 for federal alternative minimum taxesand $11,562 for state income taxes. Our provision for state taxes was less thanthe average statutory rate net of federal tax benefit because we were able touse state tax loss carryforwards to reduce state taxes payable. Those state taxloss carryforwards were fully exhausted in 2006 and were therefore notavailable to reduce state taxes payable in 2007. 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.

 

At the end of 2007, we hadestimated net operating loss carryforwards of approximately $21.2 million,which begin to expire in 2019.  Inaccordance with Section 382 of the Internal Revenue Code, the use of thesecarryforwards may be subject to annual limitations based upon certain ownershipchanges of our stock that may have occurred or that may occur.

 

*Net income*

 

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

** **

**Critical Accounting Policies**

 

Our financial statements are basedon the application of significant accounting policies, many of which requireour management to make significant estimates and assumptions (see Note 2 to ourconsolidated financial statements).  Webelieve the following accounting policies to be those most important to theportrayal of our financial condition and operating results and those thatrequire the most subjective judgment.  Ifactual results differ 

 

21

----

 

significantly from management’sestimates and projections, there could be a material effect on our financialstatements.

 

*Inventory and Related Allowance for Obsolete and ExcessInventory*

 

Ourinventory consists of party supplies and is valued at the lower of movingweighted-average cost or market.  Werecord vendor rebates, discounts and certain other adjustments to inventory,including freight costs, and we recognize these amounts in the income statementas the related goods are sold.

 

Duringeach interim reporting period, we estimate the impact on cost of products soldassociated with inventory shortage.  Theactual inventory shortage is determined upon reconciliation of the annualphysical inventory, which occurs shortly before and after our year end, and anadjustment to cost of products sold is recorded at the end of the fourthquarter to recognize the difference between the estimated and actual inventoryshortage for the full year.  Theadjustment in the fourth quarter of 2008 included an estimated reduction of$261,915 to the cost of products sold during the previous three quarters.  The adjustment in the fourth quarter of 2007included an estimated reduction of $123,249 to the cost of products sold duringthe previous three quarters.  Theadjustment in the fourth quarter of 2006 included an estimated reduction of$251,806 to the cost of products sold during the previous three quarters.

 

Wealso make adjustments to reduce the value of our inventory for an allowance forobsolete and excess inventory, which is based on our review of inventories onhand compared to estimated future sales. We conduct reviews periodicallythroughout the year on each stock keeping unit (“SKU”). As we identify obsoleteand excess inventory, we take immediate measures to reduce our inventory riskon these items and we adjust our allowance accordingly. Thus, actual resultscould differ from our estimates.

 

*Revenue Recognition*

 

Revenues include the selling priceof party goods sold, net of returns and discounts, and are recognized at thepoint of sale. We estimate returns based upon historical return rates and suchamounts have not been significant.

 

*Property andEquipment*

 

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 assets consistprimarily of the values of two non-compete agreements acquired in conjunctionwith the purchase of retail stores in 2006 and 2008, and the values of retailstore leases acquired in those transactions.

 

The first non-competeagreement, from Party City Corporation and its affiliates, coversMassachusetts, Maine, New Hampshire, Vermont, Rhode Island, and Windsor and NewLondon counties in Connecticut, and expires in 2011.  The second non-compete agreement was acquiredin connection with the Company’s purchase in January 2008 of twofranchised party supply stores in Lincoln and Warwick, Rhode Island.  The acquired Rhode Island stores had beenoperated as Party City franchise stores, and were converted to iParty storesimmediately following the closing. The second non-compete agreement coversRhode Island for five years from the date of closing and within a certaindistance from the Company’s stores in the rest of New England for three years.Both non-compete agreements have an estimated life of 60 months and are subjectto certain terms and conditions in their respective acquisition agreements.

 

The occupancy valuationsrelated to acquired retail store leases are for stores in Peabody,Massachusetts (estimated life of 90 months), Lincoln, Rhode Island (estimatedlife of 79 months) and Warwick, Rhode Island (estimated life of 96 months).Intangible assets also include legal and other transaction costs incurredrelated to the purchase of the Peabody, Lincoln and Warwick stores.

 

22

----

 

Non-competeagreements are amortized based on the pattern of their expected cash flowbenefits. Occupancy valuations are amortized over the terms of the relatedleases.

 

*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 had been reduced to zero. Weclosed two stores in early January 2008, at the end of their leaseterms.  No impairment charges wererequired for these stores, as the assets related to them have been fullyamortized, except for immaterial amounts, and no liability existed for futurelease costs. We are not aware of any impairment indicators for any of ourremaining stores at December 27, 2008.

 

*Income Taxes*

 

Historically,we have not recognized an income tax benefit for our losses. Accordingly, werecord a valuation allowance against our deferred tax assets because of theuncertainty of future taxable income and the realizability of the deferred taxassets.  In determining if a valuationallowance against our deferred tax asset is appropriate, we consider bothpositive and negative evidence.  Thepositive evidence that we considered included (1) we were profitable in2007 and 2006, and were able to use a portion of our net operating losscarryforwards in those years and expect to do so in 2008, (2) we haveachieved positive comparable store sales growth for six out of the last sevenyears and (3) we had improved merchandise margins in 2007.  The negative evidence that we consideredincluded (1) we realized a net loss in 2005 and 2008, (2) ourmerchandise margins decreased in 2008, 2006 and 2005, (3) our futureprofitability is vulnerable to certain risks, including (a) the risk thatwe may not be able to generate significant taxable income to fully utilize ournet operating loss carryforwards of approximately $20.3 million at December 27,2008, (b) the risk of unseasonable weather and other factors in a singlegeographic region, New England, where our stores are concentrated, (c) therisk of being so dependent upon a single season, Halloween, for a significantamount of annual sales and profitability and (d) the risk of fluctuatingprices for petroleum products, which are a key raw material for much of ourmerchandise and which affect our freight costs and those of our suppliers andaffect our customers’ spending levels and patterns, (4) the costs thatopening or acquiring new stores will put pressure on our profit margins untilthese stores reach maturity, (5) the expected costs of increasedregulatory compliance, including, without limitation, those associated with Section 404of the Sarbanes-Oxley Act, will likely have a negative impact on ourprofitability, (6) the risk that a general or perceived slowdown in theU.S economy, or uncertainty as to the economic outlook, which the U.S. andworld economies are experiencing, could reduce discretionary spending or causea shift in consumer discretionary spending to other products.

 

Thenegative evidence is strong enough for us to conclude that the level of ourfuture profitability is uncertain at this time. We believe that it is prudentfor us to maintain a valuation allowance against our deferred tax assets untilwe have a longer track record of profitability and we can reduce our exposureto the 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 adoptedStatement No. 123(R) using the modified prospective method in whichcompensation 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 

 

23

----

 

agreements with employees under theprovisions of Accounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees*and the disclosure-only provisions of Statement No. 123, *Accounting for Stock-Based Compensation*,as amended by SFAS No. 148, *Accountingfor Stock-Based Compensation — Transition and Disclosure, an amendment ofFinancial Accounting Standards Board (“FASB”) Statement No. 123*.

 

*Use ofEstimates*

 

The preparation of financialstatements in conformity with accounting principles generally accepted in theUnited States requires us to make estimates and assumptions that affect thereported amounts of assets and liabilities and disclosure of contingent assetsand liabilities at the date of the financial statements and the reportedamounts of revenue and expenses during the reporting period.  Our actual results could differ from ourestimates.

 

**New AccountingPronouncements**

 

InMarch 2008, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 161,*Disclosures about Derivative Instruments andHedging Activities — an amendment of FASB Statement No. 133*.   SFAS 161 requires enhanced disclosuresregarding derivative and hedging activities. SFAS 161 will be effective for financial statements issued for fiscalyears and interim periods beginning after November 15, 2008, with earlyadoption encouraged, or for us the fiscal year ending December 26, 2009.We do not expect the adoption of SFAS No. 161 to have a material effect onour financial statements.

 

InMay 2008, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 162,*The Hierarchy of Generally AcceptedAccounting Principles*.  SFAS162 identifies a consistent framework, or hierarchy, for selecting accountingprinciples to be used in preparing financial statements that are presented inconformity with U.S. generally accepted accounting principles (GAAP) fornongovernmental entities.   Statement 162was effective 60 days following the SEC’s approval of the Public CompanyAccounting Oversight Board Auditing amendments to AU Section 411, *The Meaning of**Present Fairly in Conformity with Generally Accepted AccountingPrinciples*.  The SEC issued anapproval order on September 16, 2008. Therefore, SFAS 162 was effective on November 15, 2008.  The adoption of SFAS 162 has not had amaterial effect on our financial statements.

 

InDecember 2007, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 141 (Revised 2007), *Business Combinations*(“SFAS 141(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 prospectively to businesscombinations with acquisition dates on or after the beginning of the firstannual reporting period beginning on or after December 15, 2008, or for usthe fiscal year ending December 26, 2009. We do not expect the adoption ofSFAS 141(R) to have a material effect on our financial statements.

** **

**Liquidity and Capital Resources**

 

Ourprimary uses of cash are:

 

·      purchases of inventory,including purchases under our Supply Agreement with Amscan, as described morefully below;

·      occupancy expenses of ourstores;

·      employee salaries; and

·      new store openings,including acquisitions.

 

Ourprimary sources of cash are:

 

·      cash from operatingactivities; and

·      debt, including our line ofcredit and notes payable.

 

24

----

 

Our prospective cash flows are subject to certain trends,events and uncertainties, including demands for capital to support growth,improve our infrastructure, respond to economic conditions, and meetcontractual commitments. Based on our current operating plan, we believe thatanticipated revenues from operations and borrowings available under ourexisting line of credit, which expires on January 2, 2010, will besufficient to fund our operations, working capital requirements and capitalexpenditures through the next twelve months. In the event that our operating plan changes due to changes in ourstrategic plans, lower-than-expected revenues, unanticipated expenses,increased competition, unfavorable economic conditions or other unforeseen circumstances,including the continued turmoil and tightening of the credit markets, andfurther weakening of consumer confidence and spending, our liquidity may benegatively impacted.  If so, we could berequired to further****adjust ourexpenditures for 2009 to conserve working capital or raise additional capital,possibly including debt or equity financing, to fund operations and our growthstrategy and to refinance our outstanding debt. The Company is in the process of negotiating financing to extend orreplace its existing line of credit, which expires on January 2, 2010, asdiscussed further below.

*** ***

*NotesPayable*

** **

We currently have three notes payable outstanding withprincipal balances totaling $3,612,549 at December 27, 2008.  We refer to the notes as the Highbridge Note,the Amscan Note and the Party City Note. For a full description of these notes, we refer you to Item 9 in theNotes to Consolidated Financial Statements for the fiscal years ended December 29,2008 and December 27, 2007 included in Item 8 of this Annual Report on Form 10-K.  The Amscan Note bears interest at the rate of11.0% per annum and is payable in thirty-six (36) equal monthly installments ofprincipal and interest of $59,562 commencing on November 1, 2006, and onthe first day of each month thereafter until October 1, 2009.  The Party City Note, which has a principalamount of $600,000, is payable by quarterly interest-only payments over fouryears, with the full principal amount due at the note’s maturity on August 7,2010.

 

In September 2006, we closed a financing transactionwith an institutional accredited investor whereby we issued a three-year $2.5million subordinated note (the “Highbridge Note”) that bears interest at aninterest rate of prime plus one percent and a warrant (the “Highbridge Warrant”)exercisable for 2,083,334 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 dayimmediately prior to the closing of the transaction.  The Highbridge Note matures on September 15,2009.  The agreements entered into inconnection with the financing provide for certain restrictions and covenantsconsistent with Highbridge’s status as a subordinated lender, and also grantHighbridge resale registration rights with respect to the shares of commonstock underlying the Highbridge Warrant. The issuance of the Highbridge Warranttriggered certain anti-dilution provisions of our Series B, C, and Dconvertible preferred stock. We expect to pay off the Highbridge Note from theavailability under our bank line of credit and available cash flow. If we areunable to use our bank line of credit or available cash flow to pay off theHighbridge note when due, or if there is a material increase in the cost to doso, we would need to secure alternative financing, which may not be availableon commercially reasonable terms or at all, and could result in a materiallyadverse effect on our results of operations and financial position. We are inpreliminary discussion with Wells Fargo to extend our bank line of creditbeyond its current expiration date of January 2010, three months after theHighbridge Note becomes due and payable. While we expect to extend the bank line of credit with Wells Fargo oranother lender, given the state of the economy, we expect that the borrowingmargins will increase and the terms of the loan will be more stringent.  If the terms are less favorable than theexisting line, our results of operations and liquidity may be adverselyaffected.

 

*Line of Credit*

 

We have a line of credit (the “line”) with Wells Fargo,which expires on January 2, 2010. The maximum loan amount available under the line of credit with WellsFargo is $12,500,000, which may be increased up to a maximum level of $15million, upon 15 days written notice, as long as we are in compliance with alldebt covenants and the other provisions of the loan agreement.   The agreement permits us, at our option, touse the London Interbank Offered Rate (“LIBOR”) for certain of our borrowingsrather than 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.

 

25

----

 

Our inventory consists of partysupplies which are valued at the lower of weighted-average cost or market andare reduced by an allowance for obsolete and excess inventory and are furtherreduced or increased by other adjustments, including vendor rebates anddiscounts and freight costs.  Our line ofcredit availability calculation allows us to borrow against “acceptableinventory at cost”, which is based on our inventory at cost and appliesadjustments that our lender has approved, which may be different thanadjustments we use for valuing our inventory in our financial statements, suchas the adjustment to reserve for inventory shortage.  The amount of “acceptable inventory at cost”was approximately $13,233,451 at December 27, 2008.

 

Our accounts receivable consistprimarily of credit card receivables and vendor rebate receivables.  Our line of credit availability calculationallows us to borrow against “eligible credit card receivables”, which are thecredit card receivables for the previous two to three days of business.  The amount of “eligible credit cardreceivables” was approximately $106,727 at December 27, 2008.

 

Our total borrowing base isdetermined 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$12,500,000 at December 27, 2008. Under the terms of our line of credit, our $12,500,000 credit limit wasfurther reduced by (1) a minimum availability block, (2) customerdeposits, (3) gift certificates, (4) merchandise credits and (5) outstandingletters of credit. The amounts outstanding under our line were $1,950,019 at December 27,2008 and $2,613,511 as of December 29, 2007, a decrease of $663,492. Ouradditional availability was $4,694,603 at December 27, 2008 and $4,354,468at December 29, 2007. The decrease in the amount outstanding under ourline of credit was due primarily to net payments on the line from cash providedby operating activities.

 

The outstanding balances under our line are classified ascurrent liabilities in the accompanying consolidated balance sheets since weare required to apply daily lock-box receipts to reduce the amount outstanding.

 

Our line of credit includes a number of covenants,including a financial covenant requiring us to maintain a minimum availabilityunder the line of 5% of the credit limit. The agreement also has a covenant that requires us to limit our capitalexpenditures to within 110% of those amounts included in our business plan,which may be updated from time to time. At December 27, 2008, we were in compliance with these financialcovenants.

 

On January 17, 2006, we amended our line to allow fora $500,000 term loan, which increased our borrowing base, but was containedwithin the $12.5 million credit limit. The interest rate on the term loan was the bank’s prime rate plus 125basis points. During the time the term loan remained outstanding, the interestrate on the line of credit was the bank’s base rate plus 75 basis points.  The term loan had an amended maturity date ofOctober 31, 2007.  We repaid theterm loan on March 2, 2007.

 

*Supply Agreement with Amscan*

 

Our Supply Agreement with Amscan gives us the right toreceive certain additional rebates and more favorable pricing terms over theterm of the agreement than generally were available to us under our previousterms with Amscan.  The right to receiveadditional rebates, and the amount of such rebates, are subject to our achievementof increased levels of purchases and other factors provided for in the SupplyAgreement.  In exchange, the SupplyAgreement obligates us to purchase increased levels of merchandise from Amscanuntil 2012.  The Supply Agreementprovided for a ramp-up period during 2006 and 2007 and, for five yearsbeginning with calendar year 2008, requires us to purchase on an annual basismerchandise equal to the total number of our stores open during such calendaryear, multiplied by $180,000.  The SupplyAgreement provides for penalties in the event we fail to attain the annualpurchase commitment that would require us to pay to Amscan the differencebetween the purchases for that year and the annual purchase commitment for thatyear. Under the terms of the Supply Agreement, the annual purchase commitmentfor any individual year can be reduced for orders placed by the Company but notfilled by the supplier.  During 2008, thesupplier experienced difficulty in fulfilling certain of our orders sourced outof China.  Accordingly, the supplieragreed to reduce the Company’s purchase commitment for 2008 to 90% of thecontractual minimum for that year. The Company’s purchases for 2008 exceededthe minimum purchase amount commitments, as adjusted, under the SupplyAgreement. Although we do not expect to incur any penalties under this supplyagreement, if they were to occur, there could be a material adverse effect onour uses and sources of cash.

 

26

----

 

*Operating, Investing and FinancingActivities*

 

Ouroperating activities provided $3,229,642 in 2008 compared to use of $239,008 in2007, an increase of $3,468,650.  Theincrease in cash provided by operating activities was primarily due to lowerinventory purchases during 2008 as compared to 2007, as well as lower prepaidexpenses at the end of 2008 compared to the end of 2007.

 

Weused $2,027,709 in investing activities in 2008 compared to $802,174 in 2007,an increase of $1,225,535.  The cashinvested in 2008 was primarily due to the acquisition in January 2008 oftwo retail stores located in Rhode Island and the related non-compete agreement(see discussion below).  The cashinvested in 2007 was primarily due to fixture and equipment improvements in ourexisting retail stores, plus the implementation of a new human resourceinformation and payroll system.

 

Our financing activities used $1,213,215 in 2008 comparedto providing $352,338 in 2007, an increase of $1,565,553.  The increase was primarily related todecreased borrowings on our line of credit in 2008 as compared to 2007. Asmentioned above, on January 2, 2008, we completed the purchase of twofranchised Party City Corporation retail stores in Lincoln, Rhode Island andWarwick, Rhode Island.   The aggregateconsideration for the assets purchased and related non-competition covenantswas $1,350,000, plus approximately $195,000 for associated inventory, paid incash at closing, on terms and conditions specified in the particular assetpurchase agreement.  Funding for thepurchase was obtained from our existing line of credit with Wells Fargo.

 

*Contractual Obligations*

 

Contractualobligations at December 27, 2008 were as follows:

 
| ** **                                        | ** ** | **Payments Due By Period** | ** ** |
|---------------------------------------------------|------------|----------------------------|------------|
| ** **                                        | ** ** | ** **                 | ** ** | **Within** | ** ** | **Within** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                        | ** ** | **Within**                 | ** ** | **2 - 3** | ** ** | **4 - 5** | ** ** | **After** | ** ** | ** ** | ** ** |
| ** **                                        | ** ** | **1 Year**                 | ** ** | **Years** | ** ** | **Years** | ** ** | **5 Years** | ** ** | **Total** | ** ** |
| Line of credit                                    |       | $                          | 1,951,315  |   | $ | — |   | $ | — |   | $ | — |   | $ | 1,951,315 |   |
| Capital lease obligations                         |       | 7,295                      |       | — |   | — |   | — |   | 7,295 |   |
| Notes payable                                     |       | 3,222,473                  |       | 644,100 |   | — |   | — |   | 3,866,573 |   |
| Supply agreement                                  |       | 9,000,000                  |       | 18,000,000 |   | 9,000,000 |   | — |   | 36,000,000 |   |
| Operating leases (including retail space  leases) |       | 9,133,967                  |       | 16,034,549 |   | 10,649,134 |   | 8,870,535 |   | 44,688,185 |   |
| Total contractual obligations                     |       | $                          | 23,315,050 |   | $ | 34,678,649 |   | $ | 19,649,134 |   | $ | 8,870,535 |   | $ | 86,513,368 |   |

 

In addition, at December 27,2008, we had outstanding purchase orders totaling approximately $2,201,665 forthe acquisition of inventory and non-inventory items that were scheduled fordelivery after December 27, 2008.

 

**Acquisitions**

 

We operate in a largely un-brandedmarket that has many small businesses. As a result, we have considered, and may continue to consider, growingour 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 would enhance ourprospects.  Given the current state ofthe economy and our focus on maintaining maximum liquidity, we do not expect toacquire any new stores in 2009 unless we see an early recovery in the economy.

 

On January 2, 2008, wecompleted the purchase of the two stores. The aggregate consideration paid was$1,350,000 plus approximately $195,000 for associated inventory. The storeswere converted into iParty stores immediately following the closing of thetransaction. We did not complete any other acquisitions in 2008, although weopened two temporary Halloween stores during the fourth quarter of the year.

 

27

----

 

**Stockholder Rights Plan**

 

On November 9, 2001, weannounced that our board of directors adopted a stockholder rights plan (the “rightsplan”).  Under the rights plan each shareof 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, weamended the rights plan to clarify that the issuance of the Highbridge Warrantdid not constitute a triggering event under the rights plan.

 

**Seasonality**

 

**Due to the seasonality of our business,sales and operating income are typically higher in our second and fourthquarters.  Our business is highlydependent upon sales of Easter, graduation and summer merchandise in the secondquarter and sales of Halloween and Christmas merchandise in the fourthquarter.  We have typically operated at aloss during the first and third quarters.**

 

**Geographic Concentration**

 

**As of December 27, 2008, weoperated a total of 50 stores, 45 of which are located in New England and 5 ofwhich are located in Florida. As a result, a severe or prolonged regionalrecession or regional changes in demographics, employment levels, population,weather patterns, real estate market conditions, consumer confidence andspending patterns or other factors specific to the New England region or inFlorida may adversely affect us more than a company that is more geographicallydiverse.**

** **

**Effects of Inflation**

 

While we do not view the effects of inflation as having adirect material effect upon our business, we believe that volatility in oil andgasoline prices impact the cost of producing petroleum-based/plastic products,which are a key raw material in much of our merchandise, and also impact pricesof shipping products made overseas in foreign countries, such as China, whichincludes much of our merchandise. Volatile oil and gasoline prices also impact our freight costs, consumerconfidence and spending patterns.  Theseand other issues directly or indirectly affecting our vendors and us couldadversely affect our business and financial performance.

 

**Off-Balance Sheet Arrangements**

 

Wedo not have any off-balance sheet arrangements that have or are reasonablylikely to have a current or future effect on our financial condition, changesin financial condition, revenues or expenses, results of operations, liquidity,capital expenditures or capital resources that is material to investors.

 

28

----

 

**ITEM 7A.  QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

Weare exposed to market risk from changes in interest rates and, indirectly,foreign exchange rates and commodity price risk with respect to fluctuating oilprices as more fully described in Item 1A, “Risk Factors.”  In general, however, we do not believe wehave the various market or price risks that require the quantitative andqualitative 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.  FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**

 

Theresponse to this item is included in a separate section of this report. See “Indexto Consolidated Financial Statements” on page F-1.

 

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

 

None.

 

**ITEM 9A.  CONTROLS ANDPROCEDURES**

 

(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 27, 2008, the end ofthe fiscal year to which this report relates, that iParty’s disclosure controlsand procedures: are effective to ensure that information required to bedisclosed by iParty in the reports filed or submitted by it under theSecurities Exchange Act of 1934, as amended, is recorded, processed, summarizedand 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 Officer andthe 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.

 

Ourmanagement has assessed the effectiveness of its internal control overfinancial reporting as of December 27, 2008. This evaluation was based onthe framework in *Internal Control-IntegratedFramework* issued by the Committee of Sponsoring Organizations (“COSO”).Based on its assessment, our management concluded that our internal control overfinancial reporting was effective as of December 27, 2008 to providereasonable assurance regarding the reliability of financial reporting and thepreparation of financial statements for external purposes in accordance withgenerally accepted accounting principles.

 

*This report shallnot be deemed to be filed for purposes of Section 18 of the SecuritiesExchange 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.*

 

29

----

 

(c)       *AttestationReport of the Registered Public Accounting Firm*.  We are not an accelerated filer, as such termis defined in Rule 12b-2 under the Securities Exchange Act of 1934, asamended.  Accordingly, this annual reportdoes not include an attestation report of our independent registered publicaccounting firm regarding internal control over financial reporting asmanagement’s report was not subject to attestation by the Company’s registeredpublic accounting firm pursuant to temporary rules of the SEC that permitthe Company to provide 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 year ended December 27, 2008 that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

 

**ITEM 9A(T). CONTROLS AND PROCEDURES**

 

Theinformation required by this Item is included in Item 9A of this report.

 

**ITEM 9B.  OTHER INFORMATION**

 

None.

** **

**PART III**

 

**ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE**

 

Theinformation required by this Item is contained in our proxy statement for theannual meeting of stockholders scheduled to be held on May 27, 2009, whichwe plan to file with the SEC no later than 120 days after the end of our fiscalyear ended December 27, 2008.  Suchinformation is hereby incorporated by reference.

 

We have adopted a written code of business conduct andethics that applies to all our directors, officers and employees, a copy ofwhich is located on the Investor Relations page of our website which islocated at www.iparty.com.  We intend todisclose any amendments to, or waivers from, our code of business conduct andethics on that same page of our website*.*

 

**ITEM 11. EXECUTIVE COMPENSATION**

 

Theinformation required by this Item is contained in our proxy statement for theannual meeting of stockholders scheduled to be held on May 27, 2009, whichwe plan to file with the SEC no later than 120 days after the end of our fiscalyear ended December 27, 2008.  Suchinformation is hereby incorporated by reference.

 

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

**RELATED STOCKHOLDER MATTERS**

 

Certainof the information required by this Item is contained in our proxy statementfor the annual meeting of stockholders scheduled to be held on May 27,2009, which we plan to file with the SEC no later than 120 days after the endof our fiscal year ended December 27, 2008.  Such information is hereby incorporated byreference.

 

**ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**

 

Theinformation required by this Item is contained in our proxy statement for theannual meeting of stockholders scheduled to be held on May 27, 2009, whichwe plan to file with the SEC no later than 120 days after the end of our fiscalyear ended December 27, 2008.  Suchinformation is hereby incorporated by reference.

 

30

----

 

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

 

Theinformation required by this Item is contained in our proxy statement for theannual meeting of stockholders scheduled to be held on May 27, 2009, whichwe plan to file with the SEC no later than 120 days after the end of our fiscalyear ended December 27, 2008.  Suchinformation is hereby incorporated by reference.

 

**PART IV**

 

**ITEM 15. EXHIBITS AND FINANCIAL STATEMENTSCHEDULES**

 
| (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

----

 

**SIGNATURES**

 

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

 
|                             | iPARTY CORP. |
|----------------------------------|--------------|
|                             |         |   |
|                             | By:          | /s/ SAL PERISANO |
|                             |         | Sal Perisano |
| * *                         | * *     | *Chairman  of the Board and* |
| * *                         | * *     | *Chief  Executive Officer* |
| * *                         | * *     | * * |
| Dated:  March 23, 2009 | * *     | * * |

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, this report has been signed below by thefollowing persons on behalf of the registrant and in the capacities and on thedates indicated.

 
| **SIGNATURE**          | ** ** | **TITLE**                                   | ** ** | **DATE**            |
|------------------------|------------|---------------------------------------------|------------|---------------------|
|                   |       |                                        |       |                |
| /s/ SAL PERISANO       |       | Chairman of the Board and                   |       | March 23, 2009 |
| Sal Perisano           |       | Chief Executive Officer                     |       |                |
|                   |       | (Principal Executive Officer)               |       |                |
|                   |       |                                        |       |                |
| /s/ DAVID ROBERTSON    |       | Chief Financial Officer                     |       | March 23, 2009 |
| David Robertson        |       | (Principal Financial Officer and  Principal |       |                |
|                   |       | Accounting Officer)                         |       |                |
|                   |       |                                        |       |                |
| /s/ DANIEL DE WOLF     |       | Director                                    |       | March 23, 2009 |
| Daniel De Wolf         |       |                                        |       |                |
|                   |       |                                        |       |                |
| /s/ FRANK HAYDU        |       | Director                                    |       | March 23, 2009 |
| Frank Haydu            |       |                                        |       |                |
|                   |       |                                        |       |                |
| /s/ ROBERT JEVON       |       | Director                                    |       | March 23, 2009 |
| Robert Jevon           |       |                                        |       |                |
|                   |       |                                        |       |                |
| /s/ ERIC SCHINDLER     |       | Director                                    |       | March 23, 2009 |
| Eric Schindler         |       |                                        |       |                |
|                   |       |                                        |       |                |
| /s/ JOSEPH VASSALLUZZO |       | Director                                    |       | March 23, 2009 |
| Joseph Vassalluzzo     |       |                                        |       |                |

 

32

----

 

**iPARTYCORP.**

 

**INDEX TOCONSOLIDATED 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      |

 

The accompanying notes are an integral partof these Consolidated Financial Statements.

 

F-1

----

 

**Report of Independent Registered Public Accounting Firm**

 

Board of Directors and Stockholders

iParty Corp.

 

We haveaudited the accompanying consolidated balance sheets of iParty Corp. andsubsidiaries as of December 27, 2008 and December 29, 2007, and therelated consolidated statements of operations, convertible preferred stock andstockholders’ equity (deficit), and cash flows for each of the three years inthe period ended December 27, 2008. These financial statements are the responsibility of the Company’smanagement.  Our responsibility is toexpress an opinion on these financial statements based on our audits.

 

Weconducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  We were not engaged to perform an audit ofthe Company’s internal control over financial reporting.  Our audit included consideration of internalcontrol over financial reporting as a basis for designing audit procedures thatare appropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting. Accordingly, we express no such opinion. An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation.  We believe thatour audits provide a reasonable basis for our opinion.

 

In ouropinion, the financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of iParty Corp. andsubsidiaries at December 27, 2008 and December 29, 2007, and theconsolidated results of their operations and their cash flows for each of thethree years in the period ended December 27, 2008, in conformity with U.S.generally accepted accounting principles.

 
|                  | /s/ Ernst & Young LLP |
|-----------------------|--------------------------------|
|                  |                           |
|                  |                           |
| Boston, Massachusetts |                           |
| March 19, 2009   |                           |

 

The accompanying notes are an integral partof these Consolidated Financial Statements.

 

F-2

----

 

**iPARTY CORP.**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                                                              | ** ** | **Dec 27, 2008** | ** ** | **Dec 29, 2007** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| **ASSETS**                                                                                                                                                                                                                                                              | ** ** | ** **                 | ** ** | ** **                 | ** ** |
| Current assets:                                                                                                                                                                                                                                                         |       |                       |       |                       |       |
| Cash and cash equivalents                                                                                                                                                                                                                                               |       | $                          | 60,250     |                       | $          | 71,532 |   |
| Restricted cash                                                                                                                                                                                                                                                         |       | 775,357                    |       | 862,536                    |       |
| Accounts receivable                                                                                                                                                                                                                                                     |       | 730,392                    |       | 1,105,807                  |       |
| Inventory, net                                                                                                                                                                                                                                                          |       | 13,022,142                 |       | 13,639,531                 |       |
| Prepaid expenses and other assets                                                                                                                                                                                                                                       |       | 279,185                    |       | 996,779                    |       |
| Total current assets                                                                                                                                                                                                                                                    |       | 14,867,326                 |       | 16,676,185                 |       |
| Property and equipment, net                                                                                                                                                                                                                                             |       | 3,646,481                  |       | 4,360,123                  |       |
| Intangible assets, net                                                                                                                                                                                                                                                  |       | 2,303,692                  |       | 1,756,800                  |       |
| Other assets                                                                                                                                                                                                                                                            |       | 177,774                    |       | 183,978                    |       |
| Total assets                                                                                                                                                                                                                                                            |       | $                          | 20,995,273 |                       | $          | 22,977,086 |   |
|                                                                                                                                                                                                                                                                    |       |                       |       |                       |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                          |       |                       |       |                       |       |
| Current liabilities:                                                                                                                                                                                                                                                    |       |                       |       |                       |       |
| Accounts payable and book overdrafts                                                                                                                                                                                                                                    |       | $                          | 4,048,833  |                       | $          | 4,723,370 |   |
| Accrued expenses                                                                                                                                                                                                                                                        |       | 2,495,955                  |       | 2,503,752                  |       |
| Current portion of capital lease  obligations                                                                                                                                                                                                                           |       | 6,444                      |       | 30,473                     |       |
| Current notes payable, net of discount of  $136,367 at December 27, 2008                                                                                                                                                                                           |       | 2,876,182                  |       | 620,706                    |       |
| Borrowings under line of credit                                                                                                                                                                                                                                         |       | 1,950,019                  |       | 2,613,511                  |       |
| Total current liabilities                                                                                                                                                                                                                                               |       | 11,377,433                 |       | 10,491,812                 |       |
|                                                                                                                                                                                                                                                                    |       |                       |       |                       |       |
| Long-term liabilities:                                                                                                                                                                                                                                                  |       |                       |       |                       |       |
| Capital lease obligations, net of current  portion                                                                                                                                                                                                                      |       | —                     |       | 9,213                      |       |
| Notes payable, net of discount of $340,917  at December 29, 2007                                                                                                                                                                                                   |       | 600,000                    |       | 3,271,632                  |       |
| Other liabilities                                                                                                                                                                                                                                                       |       | 1,200,174                  |       | 1,113,522                  |       |
| Total long-term liabilities                                                                                                                                                                                                                                             |       | 1,800,174                  |       | 4,394,367                  |       |
|                                                                                                                                                                                                                                                                    |       |                       |       |                       |       |
| 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; 463,086 and 465,401 shares issued and  outstanding at December 27, 2008 and December 29, 2007,  respectively (aggregate liquidation value of $9,261,724 at December 27,  2008) |       | 6,890,723                  |       | 6,925,170                  |       |
| Series C convertible preferred stock -  100,000 shares authorized, issued and outstanding (aggregate liquidation  value of $2,000,000 at December 27, 2008)                                                                                                   |       | 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 27, 2008)                                                                                                   |       | 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 27, 2008)                                                                                    |       | 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 27, 2008)                                                                                                     |       | 500,000                    |       | 500,000                    |       |
| Total convertible preferred stock                                                                                                                                                                                                                                       |       | 13,647,720                 |       | 13,682,167                 |       |
|                                                                                                                                                                                                                                                                    |       |                       |       |                       |       |
| Common stock - $.001 par value; 150,000,000  shares authorized; 22,731,667 and 22,700,655 shares issued and outstanding at  December 27, 2008 and December 29, 2007, respectively                                                                             |       | 22,732                     |       | 22,701                     |       |
|                                                                                                                                                                                                                                                                    |       |                       |       |                       |       |
| Additional paid-in capital                                                                                                                                                                                                                                              |       | 52,095,711                 |       | 51,894,481                 |       |
| Accumulated deficit                                                                                                                                                                                                                                                     |       | (57,948,497                | )          | (57,508,442                | )          |
| Total stockholders’ equity                                                                                                                                                                                                                                         |       | 7,817,666                  |       | 8,090,907                  |       |
|                                                                                                                                                                                                                                                                    |       |                       |       |                       |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                                         |       | $                          | 20,995,273 |                       | $          | 22,977,086 |   |

 

Theaccompanying notes are an integral part of these Consolidated FinancialStatements.

 

F-3

----

 

**iPARTY CORP.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

 
| ** **                        | ** ** | **For the periods ended** | ** ** |
|-----------------------------------|------------|------------------------------------------|------------|
| ** **                        | ** ** | **Dec 27, 2008**               | ** ** | **Dec 29, 2007** | ** ** | **Dec 30, 2006** | ** ** |
| ** **                        | ** ** | **(52 weeks)**                      | ** ** | **(52 weeks)** | ** ** | **(52 weeks)** | ** ** |
| Revenues                          |       | $                                        | 81,210,999 |   | $ | 81,798,634 |   | $ | 78,458,329 |   |
| Operating costs:                  |       |                                     |       |   |   |   |   |
| Cost of products sold             |       | 46,885,215                               |       | 46,465,441 |   | 44,942,542 |   |
| Marketing and sales               |       | 26,793,885                               |       | 26,181,504 |   | 25,625,547 |   |
| General and administrative        |       | 7,205,067                                |       | 7,553,869 |   | 6,736,197 |   |
|                              |       |                                     |       |   |   |   |   |
| Operating income                  |       | 326,832                                  |       | 1,597,820 |   | 1,154,043 |   |
|                              |       |                                     |       |   |   |   |   |
| Income before income taxes        |       | 326,832                                  |       | 1,597,820 |   | 1,154,043 |   |
|                              |       |                                     |       |   |   |   |   |
| Interest income                   |       | 4,609                                    |       | 17,806 |   | 10,217 |   |
| Interest expense                  |       | (720,891                                 | )          | (857,612 | ) | (772,334 | ) |
|                              |       |                                     |       |   |   |   |   |
| Income (loss) before income taxes |       | (389,450                                 | )          | 758,014 |   | 391,926 |   |
|                              |       |                                     |       |   |   |   |   |
| Income taxes                      |       | 50,605                                   |       | 146,323 |   | 17,279 |   |
|                              |       |                                     |       |   |   |   |   |
| Net income (loss)                 |       | $                                        | (440,055   | ) | $ | 611,691 |   | $ | 374,647 |   |
|                              |       |                                     |       |   |   |   |   |
| Income (loss) per share:          |       |                                     |       |   |   |   |   |
| Basic                             |       | $                                        | (0.02      | ) | $ | 0.02 |   | $ | 0.01 |   |
| Diluted                           |       | $                                        | (0.02      | ) | $ | 0.02 |   | $ | 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 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 |   |
|                                                                                   |       |                                              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Issuance of common stock upon conversion of  Series B convertible preferred stock |       | (2,315                                            | )          | (34,447 | ) | 31,012 |   | 31 |   | 34,416 |   | — |   | — |   |
| Stock based compensation                                                               |       | —                                            |       | — |   | — |   | — |   | 156,484 |   | — |   | 156,484 |   |
| Issuance of warrants                                                                   |       | —                                            |       | — |   | — |   | — |   | 10,330 |   | — |   | 10,330 |   |
| Net loss                                                                               |       | —                                            |       | — |   | — |   | — |   | — |   | (440,055 | ) | (440,055 | ) |
| Balance December 27, 2008                                                         |       | 1,224,038                                         |       | $ | 13,647,720 |   | 22,731,667 |   | $ | 22,732 |   | $ | 52,095,711 |   | $ | (57,948,497 | ) | $ | 7,817,666 |   |

 

The accompanying notes are an integral partof these Consolidated Financial Statements.

 

F-5

----

 

**iPARTY CORP.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 
| ** **                                                                                          | ** ** | **For the periods ended** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                          | ** ** | **Dec 27, 2008**               | ** ** | **Dec 29, 2007** | ** ** | **Dec 30, 2006** | ** ** |
| ** **                                                                                          | ** ** | **(52 weeks)**                      | ** ** | **(52 weeks)** | ** ** | **(52 weeks)** | ** ** |
| **Operating activities:**                                                                           |       |                                     |       |   |   |   |   |
|                                                                                                |       |                                     |       |   |   |   |   |
| Net income (loss)                                                                                   |       | $                                        | (440,055   | ) | $ | 611,691 |   | $ | 374,647 |   |
| Adjustments to reconcile net income (loss)  to net cash provided by (used in) operating activities: |       |                                     |       |   |   |   |   |
| Depreciation and amortization                                                                       |       | 2,037,108                                |       | 1,705,948 |   | 1,343,857 |   |
| Deferred rent                                                                                       |       | 86,652                                   |       | 184,323 |   | 260,196 |   |
| Non cash stock based compensation expense                                                           |       | 156,484                                  |       | 129,628 |   | 35,592 |   |
| Non cash warrant expense                                                                            |       | 197,834                                  |       | 204,550 |   | 68,183 |   |
| Changes in operating assets and  liabilities:                                                       |       |                                     |       |   |   |   |   |
| Accounts receivable                                                                                 |       | 375,415                                  |       | 10,235 |   | 130,503 |   |
| Inventory                                                                                           |       | 617,389                                  |       | (1,374,794 | ) | 1,283,983 |   |
| Prepaid expenses and other assets                                                                   |       | 881,149                                  |       | (351,302 | ) | (149,766 | ) |
| Accounts payable and book overdrafts                                                                |       | (674,537                                 | )          | (793,036 | ) | 821,312 |   |
| Accrued expenses and other liabilities                                                              |       | (7,797                                   | )          | (566,251 | ) | 243,529 |   |
| Net cash provided by (used in) operating activities                                                 |       | 3,229,642                                |       | (239,008 | ) | 4,412,036 |   |
|                                                                                                |       |                                     |       |   |   |   |   |
| **Investing activities:**                                                                           |       |                                     |       |   |   |   |   |
|                                                                                                |       |                                     |       |   |   |   |   |
| Acquisition of retail stores and  non-compete agreements                                            |       | (1,350,000                               | )          | — |   | (1,869,115 | ) |
| Purchase of property and equipment                                                                  |       | (677,709                                 | )          | (802,174 | ) | (709,892 | ) |
| Net cash used in investing activities                                                               |       | (2,027,709                               | )          | (802,174 | ) | (2,579,007 | ) |
|                                                                                                |       |                                     |       |   |   |   |   |
| **Financing activities:**                                                                           |       |                                     |       |   |   |   |   |
|                                                                                                |       |                                     |       |   |   |   |   |
| Net borrowings (repayments) under line of  credit                                                   |       | (663,492                                 | )          | 1,450,792 |   | (5,473,155 | ) |
| Proceeds from notes payable                                                                         |       | —                                   |       | — |   | 4,319,373 |   |
| Principal payments on notes payable                                                                 |       | (603,660                                 | )          | (600,036 | ) | (86,081 | ) |
| Decrease (Increase) in restricted cash                                                              |       | 87,179                                   |       | (156,470 | ) | (54,449 | ) |
| Principal payments on capital lease  obligations                                                    |       | (33,242                                  | )          | (346,531 | ) | (483,136 | ) |
| Proceeds from exercise of stock options                                                             |       | —                                   |       | 4,583 |   | 5,601 |   |
| Net cash provided by (used in) financing  activities                                                |       | (1,213,215                               | )          | 352,338 |   | (1,771,847 | ) |
|                                                                                                |       |                                     |       |   |   |   |   |
| **Net increase (decrease) in cash and cash  equivalents**                                           |       | (11,282                                  | )          | (688,844 | ) | 61,182 |   |
|                                                                                                |       |                                     |       |   |   |   |   |
| **Cash and cash equivalents, beginning of  year**                                                   |       | 71,532                                   |       | 760,376 |   | 699,194 |   |
|                                                                                                |       |                                     |       |   |   |   |   |
| **Cash and cash equivalents, end of year**                                                          |       | $                                        | 60,250     |   | $ | 71,532 |   | $ | 760,376 |   |
|                                                                                                |       |                                     |       |   |   |   |   |
| Supplemental disclosure of non-cash  financing activities:                                          |       |                                     |       |   |   |   |   |
|                                                                                                |       |                                     |       |   |   |   |   |
| Conversion of Series B convertible  preferred stock to common stock                            |       | $                                        | 34,447     |   | $ | 89,280 |   | $ | 44,651 |   |
|                                                                                                |       |                                     |       |   |   |   |   |
| Conversion of accounts payable to notes  payable                                                    |       | $                                        | —     |   | $ | — |   | $ | 1,819,373 |   |

 

The accompanying notes are an integral part of these ConsolidatedFinancial Statements.

 

F-6

----

 

**iPARTY CORP.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 27,2008**

 

**1.  THE COMPANY**

 

*Background*

 

The Company’s efforts are devotedto the sale of party goods and services through its retail stores.  At the end of fiscal 2008, the Company had 45retail stores located throughout New England, with five additional storeslocated in Florida. The Company licenses its Internet business to a third partyin exchange for royalties under a license agreement, which to date have notbeen significant.

 

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

 

The Company’s fiscal years ended December 27,2008, December 29, 2007 and December 30, 2006, each consisted of 52weeks.

 

*Management’sPlans*

 

The Company operates in a largelyun-branded market that has many small businesses.  As a result, it may consider growing itsbusiness 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, geographicallocation and the extent to which any acquisition by iParty would enhance thetarget entity’s prospects.

 

On August 15, 2007, theCompany entered into an Asset Purchase Agreement to purchase two franchisedParty City Corporation retail stores in Lincoln, Rhode Island and Warwick, RhodeIsland. The purchase was completed on January 2, 2008. The aggregateconsideration paid was $1,350,000 plus approximately $195,000 for associatedinventory. Funding for the purchase was obtained from the Company’s existingline of credit with Wells Fargo Retail Finance. The stores were converted intoiParty stores immediately following the closing of the transaction.

 

The Company believes, based on itscurrent operating plan, that anticipated revenues from operations andborrowings available under the existing line of credit, which expires on January 2,2010, 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 2009 to conserve working capital orraise additional capital to fund operations. On September 15, 2009 theHighbridge Note, in the amount of $2.5 million, matures. The Company expectsto pay off the note from the availability under our bank line of credit and availablecash flow. The Company is currently in the process of negotiating financing toextend or replace the existing line of credit scheduled to expire on January 2,2010. There can be no assurance that this financing or additional financingwill be available or on terms and conditions acceptable to it.

 

F-7

----

 

**2.  SIGNIFICANTACCOUNTING POLICIES:**

 

*Principles ofConsolidation*

 

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

 

*RevenueRecognition*

 

Revenues include the selling priceof party goods sold, net of returns and discounts, and are recognized at thepoint of sale. The Company estimates returns based upon historical return ratesand such amounts have not been significant to date.

 

*Concentrations*

 

The Companypurchases its inventory from a diverse group of vendors. Six suppliers accountfor approximately 48.2% of the Company’s purchases of merchandise in 2008, butthe Company does not believe that it is overly dependent upon any single sourcefor its merchandise, often using more than one vendor for similar kinds ofproducts.  The Company entered into aSupply Agreement with its largest supplier on August 7, 2006. The SupplyAgreement had 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.  Underthe terms of the Supply Agreement, the annual purchase commitment for anyindividual year can be reduced for orders placed by the Company but not filledwithin a specified time period by the supplier. During 2008, the supplier experienced difficulty in filling completelycertain orders sourced out of China. Accordingly, the supplier agreed to reduce the Company’s purchasecommitment for 2008 to 90% of the contractual minimum for that year. TheCompany’s purchases for 2008 exceeded the minimum purchase amount commitments,as adjusted, under the Supply Agreement.

 

Accountsreceivable primarily represent amounts due from credit card companies and fromvendors for inventory rebates. Management does not provide for doubtful accounts as such amounts havenot been significant to date; the Company does not require collateral.

 

### *Use ofEstimates*

 

The preparation of financialstatements in conformity with accounting principles generally accepted in theUnited States requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period.  Actual results could differ from theseestimates.

 

*Cash and Cash Equivalents and Restricted Cash*

 

The Company considers all highlyliquid investments with an original maturity date of three months or less to becash equivalents.  Cash equivalentsconsist primarily of store cash funds and daily store receipts in transit toour concentration bank and are carried at cost.

 

TheCompany uses controlled disbursement banking arrangements as part of its cashmanagement program.  Outstanding checks,which were included in accounts payable and book overdrafts, totaled $194,381at December 27, 2008 and $329,756 at December 29, 2007.  The decrease in outstanding checks as of December 27,2008 is due to the timing of store lease payments.

 

F-8

----

 

Restrictedcash represents funds on deposit established for the benefit of and under thecontrol of Wells Fargo Retail Finance LLC, the Company’s lender under its lineof credit, and constitutes collateral for amounts outstanding under this line.

 

*Fair Value ofFinancial Instruments*

 

Thecarrying values of cash and cash equivalents, accounts receivable and accountspayable approximate fair value because 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 carrying value since the majority of the principal bearsinterest at a variable market rate.  Thefair value of the warrants issued in 2006 was determined by using the Black-Scholesmodel (volatility of 108%, interest of 4.73% and expected life of fiveyears).  The fair value of the warrantsissued in 2008 was also determined by using the Black-Scholes model (volatilityof 101%, risk free rate of 3.21% 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:

 
| ** **                 | ** ** | **2008** | ** ** | **2007** | ** ** |
|----------------------------|------------|----------|------------|----------|------------|
| Beginning balance          |       | $        | 969,859    |     | $          | 1,079,814 |   |
| Increases to reserve       |       | 405,000  |       | 263,847  |       |
| Write-offs against reserve |       | (432,272 | )          | (373,802 | )          |
| Ending balance             |       | $        | 942,587    |     | $          | 969,859 |   |

 

### *Advertising*

 

Advertising costs are expensed uponfirst showing.  Advertising costsamounted to $3,638,752, $3,721,516 and $3,659,743 for the years ended December 27,2008, December 29, 2007, and December 30, 2006,  respectively.

 

*Deferred Rent*

 

Certain operating lease agreementscontain scheduled rent increases, which are being amortized over the terms ofthe agreements using the straight-line method, and are included in otherliabilities in the accompanying consolidated balance sheet.  Deferred rent was $1,200,174 at December 27,2008 and $1,113,522 at December 29, 2007.

 

*Net Income (Loss)per Share*

 

Net income (loss) per basic shareis computed by dividing net income (loss) available to common shareholders bythe weighted-average number of common shares outstanding.  The common share equivalents of Series B-Fpreferred stock are required to be included in the calculation of net income(loss) per basic share in accordance with EITF Consensus 03-6, *Participating**Securities and the Two-Class Method under SFAS No. 128*,which supersedes EITF Topic D-95, *Effect ofParticipating Convertible Securities on the Computation of Basic Earnings PerShare.* Since the preferred stockholders are entitled to participatein dividends when and if declared by the Board of Directors on the same basisas if the shares of Series B-F preferred stock were converted to commonstock, the application of EITF 03-6 has no effect on the amount of income(loss) per basic share of common stock. For periods with net losses, the Company does not allocate losses to Series B-Fpreferred stock.

 

F-9

----

 

Net income (loss) per diluted shareunder EITF 03-6 is computed by dividing net income (loss) by the weightedaverage number of common shares outstanding, plus the common share equivalentsof Series B-F preferred stock on an as if-converted basis, plus the commonshare equivalents of the “in the money” stock options and warrants as computedby the treasury method.  For the periodswith net losses, the Company excludes those common share equivalents sincetheir impact would be anti-dilutive.

 

The following table sets forth thecomputation of net income (loss) per basic and diluted share available tocommon stockholders:

 
| ** **                                                               | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|--------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Common shares                                                            |       | $          | (440,055   | )          | $          | 362,525    |       | $ | 223,203 |   |
| Convertible preferred Series B-F                                    |       | —     |       | 249,166    |       | 151,444    |       |
| Net income (loss)                                                        |       | $          | (440,055   | )          | $          | 611,691    |       | $ | 374,647 |   |
|                                                                     |       |       |       |       |       |       |       |
| Net income (loss) per share                                              |       |       |       |       |       |       |       |
| Basic                                                                    |       | $          | (0.02      | )          | $          | 0.02       |       | $ | 0.01 |   |
| Diluted                                                                  |       | $          | (0.02      | )          | $          | 0.02       |       | $ | 0.01 |   |
|                                                                     |       |       |       |       |       |       |       |
| Weighted-average shares outstanding:                                     |       |       |       |       |       |       |       |
| Common shares - basic                                                    |       | 22,722,485 |       | 22,642,564 |       | 22,557,436 |       |
| Common share equivalents of Series B-F  convertible preferred stock |       | —     |       | 15,561,810 |       | 15,305,492 |       |
| If - converted weighted-average shares  outstanding                      |       | 22,722,485 |       | 38,204,374 |       | 37,862,928 |       |
|                                                                     |       |       |       |       |       |       |       |
| 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                              |       | 22,722,485 |       | 39,913,274 |       | 39,535,874 |       |

 

The common share equivalents of “outof the money” stock options and warrants which were excluded from thecomputation of net income (loss) per diluted share available to commonstockholders were 9,082,198 and 2,711,544 in 2008, respectively, 4,654,753 and2,611,544 in 2007, respectively, and 3,858,769 and 2,611,544 in 2006,respectively.

 

*Stock OptionCompensation Expense*

 

On January 1, 2006, theCompany adopted the Financial Accounting Standards Board (“FASB”) Statement No. 123(R),*Share-Based Payment*, using themodified prospective method.  Under thismethod, stock based compensation expense is recognized for new grants beginningin 2006 and any unvested grants prior to the adoption of Statement No. 123(R).  Prior to fiscal 2006, the Company accountedfor share-based payments to employees using the Accounting Principles Board (“APB”)Opinion No. 25, *Accounting for StockIssued to Employees*, and the disclosure-only provisions of StatementNo. 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.

 

Under Statement No. 123(R),the Company uses the Black-Scholes option pricing model to determine the fairvalue of stock based compensation.  TheBlack-Scholes model requires the Company to make several subjectiveassumptions, including the estimated length of time employees will retain theirvested stock options before exercising them (“expected term”), and theestimated volatility of the Company’s common stock price over the expectedterm, which is based on historical volatility of the Company’s common stockover a time period equal to the expected term. The Black-Scholes model also requires a risk-free interest rate, whichis based on the U.S. Treasury yield curve in effect at the time of the grant,and the dividend yield on the Company’s common stock, which is assumed to bezero since the Company does not pay dividends and has no current plans to do soin the future.  Changes in theseassumptions can materially affect the estimate of fair value of stock basedcompensation and consequently, the related expense recognized on theconsolidated statement of operations. Under the modified prospective method, stock based compensation expenseis recognized for new grants beginning in the fiscal year

 

F-10

----

 

endedDecember 30, 2006 and any unvested grants prior to the adoption ofStatement No. 123(R). The Company recognizes stock based compensationexpense on a straight-line basis over the vesting period of each grant.

 

The stock based compensationexpense recognized by the Company was:

 
| ** **                       | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Stock Based Compensation Expense |       | $        | 156,484    |     | $          | 129,628  |       | $ | 35,592 |   |
|                                  |            |          |            |          |            |          |            |  |  |  |

 

Stock based compensation expense isincluded in general and administrative expense. The adoption of Statement No. 123(R) had no impact on cashflow from operations and cash flow from financing activities for the yearsended December 27, 2008, December 29, 2007 and December 30,2006.

 

On September 26,2007, the Board of Directors, acting on the recommendation of the CompensationCommittee, extended the expiration date on options to purchase 970,087 sharesof the Company’s common stock held by a former officer for an additional sixmonths following his termination date, making the expiration date August 15,2008.  As a result, additional stockbased compensation of $14,569, representing the change in the fair value ofthese options immediately before and after this modification, was recorded asof September 26, 2007 as required by Statement No. 123(R). Theoptions covered by this extension were not exercised, and expired on August 15,2008.

 

Under the Company’sAmended and Restated 1998 Incentive and Nonqualified Stock Option Plan (the “1998Plan”) options to acquire 11,000,000 shares of common stock may be granted toofficers, directors, key employees and consultants.  The exercise price for qualified incentiveoptions cannot be less than the fair market value of the stock on the grantdate and the exercise price of nonqualified options can be fixed by the Board.Options 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.

 

The Company granted options for thepurchase of an aggregate of 200,000 shares of common stock to a key employeeand each of the four independent members of the Board of Directors on June 4,2008 at an exercise price of $0.29 per share.  Similarly, the Company granted options for thepurchase of an aggregate of 1,350,000 shares of common stock to key employeesand each of the four independent members of the Board of Directors on June 6,2007 at an exercise price of $0.42 per share. In addition, the Company grantedoptions for the purchase of 25,000 shares of common stock to each of the fourindependent members of the Board of Directors on June 7, 2006 at anexercise price of $0.36 per share.  Theweighted-average fair market value using the Black-Scholes option pricing modelof the options granted on June 4, 2008 was $0.22 per share, was $0.33 pershare for the options granted on June 6, 2007 and was $0.30 per share forthe options granted on June 7, 2006. The fair market value of the stockoptions at the date of the grant was estimated using the Black-Scholesoption-pricing model with the following weighted average assumptions:

 
| ** **                                | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Risk-free interest rate                   |       | 3.21     | %          | 4.94     | %          | 5.18     | %          |
| Expected volatility                       |       | 101.2    | %          | 102.6    | %          | 115.6    | %          |
| Weighted average expected life (in years) |       | 5.0      |       | 5.0      |       | 5.0      |       |
| Expected dividends                        |       | 0.00     | %          | 0.00     | %          | 0.00     | %          |

 

The total fair value of sharesvested during 2008 was $0.  The remainingunrecognized stock based compensation expense related to unvested awards at December 27,2008, was $248,949 and the period of time over which this expense will berecognized is 3.5 years.

 

F-11

----

 

*Property andEquipment*

 

Property and equipment are statedat cost less accumulated depreciation and are depreciated on the straight-linemethod over the estimated useful lives of the assets.  Expenditures for maintenance and repairs arecharged to operations as incurred.  Alisting of the estimated useful life of the various categories of property andequipment is as follows:

 

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

 

*Intangible Assets*

 

On August 15, 2007, theCompany entered into an Asset Purchase Agreement to purchase two franchisedParty City 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 for associated inventory.  On January 2,2008, the Company completed the purchase of the two stores. The aggregateconsideration paid was $1,350,000 plus approximately $195,000 for associatedinventory. Funding for the purchase was obtained from the Company’s existingline of credit with Wells Fargo Retail Finance, LLC. The stores were convertedinto iParty stores immediately following the closing of the transaction.

 

Intangible assets consistprimarily of (i) the values of two non-compete agreements acquired inconjunction with the purchase of retail stores in 2006 and 2008, and (ii) thevalues of retail store leases acquired in those transactions. These assets havebeen accounted for at fair value as of their respective acquisition dates usingsignificant other observable inputs, or Level 2 criteria, specified by SFAS No. 157.

 

The first non-competeagreement, from Party City Corporation and its affiliates, coversMassachusetts, Maine, New Hampshire, Vermont, Rhode Island, and Windsor and NewLondon counties in Connecticut, and expires in 2011.  The second non-compete agreement was acquiredin connection with the Company’s purchase in January 2008 of the two partysupply stores in Lincoln and Warwick, Rhode Island described above. It coversRhode Island for five years from the date of closing and within a certaindistance from the Company’s stores in the rest of New England for three years.Both non-compete agreements have an estimated life of 60 months and are subjectto certain terms and conditions in their respective acquisition agreements.

 

The occupancy valuationsrelate to acquired retail store leases for stores in Peabody, Massachusetts(estimated life of 90 months), Lincoln, Rhode Island (estimated life of 79months) and Warwick, Rhode Island (estimated life of 96 months). Intangibleassets also include legal and other transaction costs incurred related to thepurchase of the Peabody, Lincoln and Warwick stores.

 

F-12

----

 

Intangibleassets as of December 27, 2008 and December 29, 2007 were:

 
| ** **                     | ** ** | **Dec 27, 2008** | ** ** | **Dec 29, 2007** | ** ** |
|--------------------------------|------------|----------------------------|------------|----------------------------|------------|
| Non-compete agreement          |       | $                          | 2,358,540  |                       | $          | 1,688,346 |   |
| Lease valuation                |       | 944,716                    |       | 449,716                    |       |
| Other                          |       | 157,855                    |       | 182,049                    |       |
|                           |       |                       |       |                       |       |
| Intangible assets              |       | 3,461,111                  |       | 2,320,111                  |       |
|                           |       |                       |       |                       |       |
| Less: accumulated amortization |       | (1,157,419                 | )          | (563,310                   | )          |
|                           |       |                       |       |                       |       |
| Intangible assets, net         |       | $                          | 2,303,692  |                       | $          | 1,756,800 |   |

 

Amortization expense for theseintangible assets was $594,109 in 2008, $393,991 in 2007 and $169,319 in 2006,respectively.  The non-compete agreementamortization expense is included in general and administrative expense on theConsolidated Statement of Operations. The lease valuation amortization expense is included in cost of goodssold and occupancy costs.

 

Futureamortization expense related to these intangible assets as of December 27,2008:

 
| **Year**   | ** ** | **Amount** | ** ** |
|------------|------------|------------|------------|
| 2009       |       | $          | 697,108    |   |
| 2010       |       | 672,108    |       |
| 2011       |       | 467,412    |       |
| 2012       |       | 242,438    |       |
| Thereafter |       | 224,626    |       |
| Total      |       | 2,303,692  |       |
|            |            |            |            |  |

 

*Accountingfor the Impairment of Long-Lived Assets*

 

In accordance with SFAS No. 144,*Accounting for the Impairment or Disposal ofLong-Lived Assets*, the Company reviews each store for impairmentindicators whenever events and changes in circumstances suggest that thecarrying amounts may not be recoverable from estimated future store cashflows.  The Company’s review considersstore operating 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 wereincurred as a result of that decision. As of December 27, 2008, the Company has not identified anyindicators of impairment based on its review of each of its stores’ operationsand, accordingly, does not believe that any of its remaining long-lived assetsare impaired.

 

*New Accounting Pronouncements*

 

InMarch 2008, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 161,*Disclosures about Derivative Instruments andHedging Activities — an amendment of FASB Statement No. 133*.   SFAS 161 requires enhanced disclosures regardingderivative and hedging activities.

 

SFAS161 will be effective for financial statements issued for fiscal years andinterim periods beginning  after November 15,2008, with early adoption encouraged, or for us the fiscal year ending December 26,2009. The Company does not expect the adoption of SFAS No. 161 to have amaterial effect on its financial position or results of operations.

 

F-13

----

 

InMay 2008, the Financial Accounting Standards Board (“FASB”) also issuedSFAS No. 162, *The Hierarchy ofGenerally Accepted Accounting Principles*.  SFAS 162 identifies a consistent framework,or hierarchy, for selecting accounting principles to be used in preparingfinancial statements that are presented in conformity with U.S. generallyaccepted accounting principles (GAAP) for nongovernmental entities.

 

Statement162 was effective 60 days following the SEC’s approval of the Public CompanyAccounting Oversight Board Auditing amendments to AU Section 411, *The Meaning of**Present Fairly in Conformity with Generally Accepted AccountingPrinciples*.  The SEC issued anapproval order on September 16, 2008. Therefore, SFAS 162 was effective on November 15, 2008.  The adoption of SFAS 162 has not had amaterial effect on the Company’s financial position or results of operations.

 

InDecember 2007, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 141 (Revised 2007), *Business Combinations*(“SFAS 141(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 prospectively to businesscombinations with acquisition dates on or after the beginning of the firstannual reporting period beginning on or after December 15, 2008, or for usthe fiscal year ending December 26, 2009. We do not expect the adoption ofSFAS 141(R) to have a material effect on our financial statements.

 

*Reclassifications*

 

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

** **

**3.  PROPERTY ANDEQUIPMENT:**

 

Propertyand equipment consist of the following:

 
| ** **                     | ** ** | **Dec 27, 2008** | ** ** | **Dec 29, 2007** | ** ** |
|--------------------------------|------------|----------------------------|------------|----------------------------|------------|
| Leasehold improvements         |       | $                          | 3,557,500  |                       | $          | 3,138,079 |   |
| Furniture and fixtures         |       | 2,822,854                  |       | 2,635,838                  |       |
| Equipment under capital leases |       | 1,416,334                  |       | 1,416,334                  |       |
| Computer hardware and software |       | 1,888,592                  |       | 1,841,359                  |       |
| Equipment                      |       | 680,484                    |       | 656,445                    |       |
|                           |       |                       |       |                       |       |
| Property and equipment         |       | 10,365,764                 |       | 9,688,055                  |       |
| Less accumulated depreciation  |       | (6,719,283                 | )          | (5,327,932                 | )          |
|                           |       |                       |       |                       |       |
| Property and equipment, net    |       | $                          | 3,646,481  |                       | $          | 4,360,123 |   |

 

**4.  LEASES:**

 

TheCompany conducts its operations in leased facilities with certain leasedequipment accounted for as operating and capital leases.  Real estate leases generally provide forfixed minimum rentals, which typically increase periodically during the life ofthe lease, and, in some instances, contingent rentals based on a percentage ofsales in excess of specified minimum sales levels, as well as occupancy 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.

 

Theoriginal cost of assets under capital leases at December 27, 2008 and December 29,2007 was $1,416,334. The accumulated depreciation of assets under capitalleases at December 27, 2008 and December 29, 2007 was $1,271,391 and$987,425, respectively.  The amortizationrelated to those assets under capital lease is included in depreciationexpense.

 

F-14

----

 

At December 27, 2008, theminimum rental commitments under all non-cancelable operating leases withinitial or remaining terms of more than one year were as follows:

 
| **Year**                            | ** ** | **Operating** | ** ** |
|-------------------------------------|------------|---------------|------------|
| 2009                                |       | $             | 9,133,967  |   |
| 2010                                |       | 8,499,261     |       |
| 2011                                |       | 7,535,288     |       |
| 2012                                |       | 5,960,262     |       |
| 2013                                |       | 4,688,872     |       |
| Thereafter                          |       | 8,870,535     |       |
| Total future minimum lease payments |       | $             | 44,688,185 |   |

 

The Company’s rental expense underoperating leases amounted to $9,114,774 in 2008, $8,857,650 in 2007, and$8,699,501 in 2006.  Included in theseamounts are contingent rentals totaling $65,425 in 2008, $50,643 in 2007 and$47,334 in 2006.

 

**5.  INCOME TAXES:**

 

A reconciliation of the effective ratewith the federal statutory rate is as follows:

 
| ** **                                 | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Federal statutory rate                     |       | 34.0     | %          | 34.0     | %          | 34.0     | %          |
| State income taxes, net of federal benefit |       | -19.8    | %          | 9.5      | %          | 1.9      | %          |
| Permanent differences                      |       | -33.1    | %          | 7.2      | %          | 4.9      | %          |
| Net operating loss deduction and other     |       | 5.9      | %          | -31.3    | %          | -36.4    | %          |
| Effective tax rate                         |       | -13.0    | %          | 19.4     | %          | 4.4      | %          |

 

The Company’s provision for state taxes exceeds the averagestatutory rate net of federal tax benefit because of permanent and temporarydifferences, for which valuation allowances have been provided, between taxableand book income, including amounts associated with stock based compensationexpense, depreciation, and note payable amortization.

 

Deferred tax assets consist of the following:

 
| ** **                       | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|----------------------------------|------------|------------|------------|------------|------------|
| Net operating loss carryforwards |       | $          | 6,909,000  |       | $          | 7,200,000 |   |
| Inventory reserves               |       | 232,000    |       | 385,000    |       |
| Deferred rent                    |       | 478,000    |       | 441,000    |       |
| Accrued compensation             |       | 63,000     |       | 61,000     |       |
| Accrued expenses                 |       | —     |       | 9,000      |       |
| Intangible assets                |       | 283,000    |       | 143,000    |       |
| Deferred compensation            |       | 30,000     |       | —     |       |
| Property and equipment           |       | 285,000    |       | 99,000     |       |
|                             |       | 8,280,000  |       | 8,338,000  |       |
| Less valuation allowance         |       | (8,280,000 | )          | (8,338,000 | )          |
| Net deferred tax asset           |       | $          | —     |       | $          | — |   |

 

The Company has recorded avaluation allowance against its deferred tax assets because of the uncertaintyregarding the realizability of these assets against future taxable income.

 

The Company used approximately$1,012,902 and $1,436,844 of net operating loss carryforwards in 2008 and 2007,respectively.

 

F-15

----

 

As of December 27, 2008, theCompany has estimated net operating loss carryforwards of approximately $20.3million, which begin to expire in 2019. In accordance with Section 382 of the Internal Revenue Code, theuse of some of these carryforwards may be subject to annual limitations basedupon ownership changes of the Company’s stock which may have occurred or thatmay occur.

 

The Company made cash payments forstate income taxes of $159,386 in 2008, $56,478 in 2007, and $33,509 in2006.  The Company made cash payments forfederal income taxes of $5,000 in 2008, $0 in 2007, and $0 in 2006.

 

The Company adopted the provisionsof Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accountingfor Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109”(“FIN 48”) on December 31, 2006. At December 27, 2008, the Companyhad no material unrecognized tax benefits and no adjustments to liabilities oroperations were required.

 

The Company recognizes interest andpenalties related to uncertain tax positions in income tax expense which were$2,248 for the year ended December 27, 2008.

 

Tax years 2005 through 2007 aresubject to examination by the federal and state taxing authorities. There areno income tax examinations currently in process.

 

**6.  CONTRACTUAL ARRANGEMENTS:**

 

*LicenseArrangement*

 

TheCompany has an agreement with Taymark, a direct marketer of party supplies, tolicense the iParty.com name to Taymark, which now operates the website atwww.iparty.com.  Under the agreement,Taymark pays the Company a 15% royalty on all net sales realized through itsoperation of www.iparty.com.  Royaltieshave not been material in 2006, 2007 or 2008. The original term of thisagreement was for a period of two (2) years.  If this agreement is not terminated, itautomatically renews for successive one-year periods.  On July 8, 2008, the Company enteredinto its fourth consecutive one-year renewal period.

 

**7.  RELATED PARTYTRANSACTIONS:**

 

On June 7, 2006, the Company’sBoard of Directors approved the payment of up to $60,000 to Joseph Vassalluzzo,a Director of the Company, for services as a part-time consultant for aone-year period.  As of December 27,2008, this amount had been earned and paid.

 

On June 6, 2007, the Company’sBoard of Directors approved the payment of up to $60,000 to Joseph Vassalluzzo,a Director of the Company, for services as a part-time consultant for aone-year period.  As of December 27,2008, this amount had been earned and paid.

 

On June 4, 2008, the Company’sBoard of Directors approved the payment of up to $60,000 to Joseph Vassalluzzo,a Director of the Company, for services as a part-time consultant for aone-year period.  As of December 27,2008, $30,000 had been earned and paid.

 

**8.**  **LINE OFCREDIT:**

 

 On December 21, 2006, the Company amendedand restated its existing line of credit (the “line”) with Wells Fargo RetailFinance II, LLC, which agreement has since been assigned to Wells Fargo RetailFinance LLC (“Wells Fargo”). The amendment continued the line of credit withWells Fargo at $12,500,000 and extended it for three additional years to January 2,2010.  In addition, the agreement withWells Fargo includes an option whereby the Company may increase its line ofcredit up to a maximum level of $15 million, 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

 

F-16

----

 

theLondon Interbank Offered Rate (“LIBOR”) rate for certain of itsborrowings.  Inventory and accountsreceivable secure the Company’s line.

 

The line includes a financial covenant requiring theCompany to maintain a minimum availability under the line of 5% of the creditlimit.  At the current credit limit of$12,500,000, the minimum availability is $625,000.  At December 27, 2008, 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 fiscal year2007 totaled $802,174, or 116% of the Company’s business plan amount. On December 28,2007, Wells Fargo waived compliance with the capital expenditure covenant for2007.   For fiscal year ended December 27,2008, the Company was in compliance with all debt covenants.  The agreement also includes a 0.25% unusedline fee.  The line generally prohibitsthe payment of any dividends or other distributions to any of the Company’sclasses of capital stock.

 

On January 17, 2006, the Company amended its prioragreement to allow for a $500,000 term loan which increased its borrowing base,but did not increase the $12,500,000 million credit limit.  The Company borrowed the full $500,000 onthat date.  The interest rate on the termloan 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 ofits outstanding 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 itsprior agreement with Wells Fargo to permit it to enter into a Supply Agreementwith Amscan and an Asset Purchase Agreement with Party City.  The amendment also allows for the Company toincur the indebtedness represented by the Amscan Note and the Party City Note,and to incur other unsecured subordinated indebtedness consented to by WellsFargo.

 

The amounts outstanding under theline as of December 27, 2008 and December 29, 2007 were $1,950,019and $2,613,511, respectively.  The interestrate on these borrowings was 4.7% at December 27, 2008 and 8.2% at December 29,2007.  The agreement also includes a0.25% unused line fee.  The outstandingbalances under the line are classified as current liabilities in theaccompanying consolidated balance sheets since the Company is required to applydaily lock box receipts to reduce the amount outstanding.  At December 27, 2008, the Company hadapproximately $4,694,603 of additional availability under the line.

 

**9.  NOTES PAYABLE:**

** **

Notes payable consist of threenotes entered into in fiscal 2006.

 

The “Highbridge Note” is a subordinated note in the statedprincipal amount of $2,500,000 that bears interest at the rate of prime plusone percent.  The note matures on September 15,2009.  Interest only is payable quarterlyin arrears and the entire principal balance is due at the maturity date. Theoriginal discount associated with the warrant issued in conjunction with theHighbridge Note (original discount amount $613,651) is being amortized using theeffective interest method over the life of the note payable. The note payablebalance of $2,363,633 as of December 27, 2008 is presented net of theremaining unamortized discount.

 

The “Amscan Note” is a subordinated promissory note in theoriginal principal amount of $1,819,373, with a balance as of December 27,2008 of $512,549. The note bears interest at the rate of 11.0% per annum and ispayable in thirty-six (36) equal monthly installments of principal and interestof $59,562 beginning on November 1, 2006, and on the first day of eachmonth thereafter until October 1, 2009, when the entire remainingprincipal balance and all accrued interest are due and payable.

 

F-17

----

 

The “Party City Note” is a subordinated promissory note inthe principal amount of $600,000.   Thenote bears interest at the rate of 12.25% per annum and is payable by quarterlyinterest-only payments over four years, with the full principal amount due atthe note’s maturity on August 7, 2010.

 

On August 7, 2006, the Company entered into a SupplyAgreement with Amscan Inc. (“Amscan”), the largest supplier in the party goodsindustry.  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 of increasedlevels 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 provided for an initial ramp-up period during 2006 and 2007 and,beginning with calendar year 2008, requires the Company to purchase on anannual basis merchandise equal to the total number of its stores open duringsuch calendar year, multiplied by $180,000 until 2012.  The Supply Agreement provides for penaltiesin the event the Company fails to attain the annual purchase commitment.  Under the terms of the Supply Agreement, theannual purchase commitment for any individual year can be reduced for ordersplaced by the Company but not filled by the supplier within a specified timeperiod.  During 2008, the supplierexperienced difficulty in filling completely certain orders sourced out ofChina.  Accordingly, the supplier agreedto reduce the Company’s purchase commitment for 2008 to 90% of the contractualminimum for that year.   The Company’spurchases for 2008 exceeded the minimum purchase amount commitments, asadjusted, under the Supply Agreement.

 

The Supply Agreement also providedfor Amscan to extend, until October 31, 2006, approximately $1,150,000 ofcertain currently due amounts owed by the Company to Amscan which wouldotherwise have been payable on August 8, 2006 (the “extended payables”)and gave the Company the right, at its option, to convert the extended payablesinto a subordinated promissory note. On October 24, 2006, the Companyconverted $1,143,896 of extended payables originally 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 single subordinated promissory note in the total principal amountof $1,819,373, which is the Amscan Note defined above.

 

On August 7, 2006, the Company also entered into andsimultaneously closed an Asset Purchase Agreement with Party City, an affiliateof Amscan, pursuant to which the Company acquired a Party City retail partygoods store in Peabody, Massachusetts and received a five-year non-competitioncovenant from Party City, for aggregate consideration of $2,450,000, payable bya subordinated note in the principal amount of $600,000, which is the PartyCity Note defined above, and $1,850,000 in cash.

 

Total cash payments for interestunder the Company’s line of credit, Notes Payable and capital leases totaled$500,090 in 2008, $645,392 in 2007 and $748,656 in 2006.

 

F-18

----

 

**10.  PREFERRED STOCK:**

 

The following table summarizes thechanges in the number of shares of convertible preferred stock during the pasttwo years:

 
| ** **                                | ** ** | **Shares**                   | ** ** | ** **      | ** ** | **Shares**                   | ** ** | ** **      | ** ** | **Shares**                   | ** ** |
|-------------------------------------------|------------|------------------------------|------------|-----------------|------------|------------------------------|------------|-----------------|------------|------------------------------|------------|
| ** **                                | ** ** | **Issued**                   | ** ** | **Conversions** | ** ** | **Issued**                   | ** ** | **Conversions** | ** ** | **Issued**                   | ** ** |
| ** **                                | ** ** | **and**                      | ** ** | **to**          | ** ** | **and**                      | ** ** | **to**          | ** ** | **and**                      | ** ** |
| ** **                                | ** ** | **Outstanding**              | ** ** | **Common**      | ** ** | **Outstanding**              | ** ** | **Common**      | ** ** | **Outstanding**              | ** ** |
| ** **                                | ** ** | **as of 12/27/08** | ** ** | **Stock**       | ** ** | **as of 12/29/07** | ** ** | **Stock**       | ** ** | **as of 12/30/06** | ** ** |
| Series B convertible preferred stock |       | 463,086                      |       | (2,315          | )          | 465,401                      |       | (6,000          | )          | 471,401                      |       |
| 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                                     |       | 1,224,038                    |       | (2,315          | )          | 1,226,353                    |       | (6,000          | )          | 1,232,353                    |       |

 

*Series B Convertible Preferred Stock*

 

The shares of Series Bconvertible preferred stock are immediately convertible into 6,203,500 sharesof common stock on a 1.000 to 13.396 ratio at December 27, 2008, and carryan aggregate liquidation value of $9,261,724 ($1.49 per common share issuableupon conversion) at December 27, 2008. 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 B 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.

 

In the event of liquidation, theholders of Series B convertible preferred stock have preference to holdersof the Company’s common stock, and are *paripassu* with the Company’s Series C, D, E and F convertiblepreferred 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 27, 2008, and carryan aggregate liquidation value of $2,000,000 ($1.47 per common share issuableupon conversion) at December 27, 2008. 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.

 

In the event of liquidation, theholders of Series C convertible preferred stock have preference to holdersof the Company’s common stock, and are *paripassu* with the Company’s Series B, D, E and F convertiblepreferred stock.

 

F-19

----

 

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.

 

*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 27, 2008, and carryan aggregate liquidation value of $5,000,000 ($1.37 per common share issuableupon conversion) at December 27, 2008. 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 of Incorporation,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 offering resultingin gross proceeds to the Company of at least $10,000,000.

 

In the event of liquidation, theholders of Series D convertible preferred stock have preference to holdersof the Company’s common stock, and are *paripassu* with the Company’s Series B, C, E and F convertiblepreferred 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 E Convertible 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 27, 2008, and carryan aggregate liquidation value of $1,112,497 ($0.36 per common share issuableupon conversion) at December 27, 2008. 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 of liquidation, theholders of Series E convertible preferred stock have preference to holdersof the Company’s common stock, and are *paripassu* with the Company’s Series B, C, D and F convertiblepreferred 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.

 

*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 27, 2008, and carryan aggregate liquidation value of $500,000 ($0.42 per common share issuableupon conversion) at December 27, 2008. With certain exceptions, the conversion price will be adjusted on aweighted-average basis in the event the Company issues common stock or

 

F-20

----

 

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, theholders of Series F convertible preferred stock have preference to holdersof the Company’s common stock, and are *paripassu*with the Company’s Series B, C, D and E convertiblepreferred stock.

 

Holders of Series F preferredstock are entitled to 10 votes per share (i.e., one vote for each whole numberof shares of common stock into which each such share is presently convertible)on all matters submitted to a vote of the Company’s stockholders and areentitled to participate in dividends when and if declared by the Board ofDirectors.

 

*Highbridge Warrant Anti-DilutionShares*

 

On September 15, 2006, the Company entered into aSecurities Purchase Agreement pursuant to which it raised $2.5 million througha combination of subordinated debt and warrant issued on September 15,2006 to Highbridge, an institutional accredited investor.  The warrant issued to Highbridge isexercisable for 2,083,334 shares of the Company’s common stock at an exerciseprice of $0.475 per share.  The issuanceof the Highbridge Warrant triggered certain anti-dilution provisions of theCompany’s Series B, C, and D convertible preferred stock.  As a result, the number of shares of commonstock into which the Series B, C and D preferred stock convert increasedby 249,254, 54,600, and 138,500 additional shares, respectively.

 

*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 towhich the Company allocated value and included in additional paid incapital.  Should such a liquidation eventoccur, the difference between the carrying value of the convertible preferredstock and their liquidation value will be accreted.  This amount was $4,266,501 on December 27,2008.

 

**11.  WARRANTS:**

 

At December 27, 2008, therewere warrants outstanding which were exercisable for 2,711,544 shares of theCompany’s common stock.  These warrantswere issued in connection with certain preferred stock and subordinated debtfinancings and professional service contracts.

 

During the period April 1999 through August 1999,the Company issued warrants in connection with convertible debt exercisable fora total of 528,210 shares of its common stock, at exercise prices ranging from$2.81 to $5.13 per share. The weighted average exercise price of these warrantsat December 27, 2008 was $3.79 per share. These warrants expire between April andAugust 2009.

 

On September 15, 2006, the Company entered into aSecurities Purchase Agreement pursuant to which it raised $2.5 million througha combination of subordinated debt and warrant issued on September 15,2006 to Highbridge, an institutional accredited investor. Under the terms ofthe financing, the Company issued Highbridge a warrant (the “Highbridge Warrant”)exercisable for 2,083,334 shares of its common stock at an exercise price of$0.475 per share, or 125% of the closing price of the Company’s common stock onthe day immediately prior to the closing of the transaction.  The Company allocated approximately $613,651of value to the Highbridge Warrant using the Black-Scholes model withvolatility of 108%, interest of 4.73% and expected life of five years.  The Highbridge Warrant is being amortizedusing the effective interest method over the life of the Highbridge Note.  The agreements entered into in connectionwith the financing provide for certain restrictions and covenants consistentwith Highbridge’s status as a subordinated lender, and also grant Highbridgeresale registration rights with respect to the shares of common stockunderlying the Highbridge Warrant.

 

F-21

----

 

On February 28, 2008, the Company entered into anagreement with Booke and Company, Inc. for investor relations services. Inconnection with that agreement, the Company issued warrants to purchase 100,000shares of its common stock at an exercise price of $1.50 per share. Thewarrants expire on February 28, 2013. The Company determined the fairvalue of the 2008 warrants to be $10,330 by using the Black-Scholes model(volatility of 101%, risk free rate of 3.21% and expected life of five years).The fair value of the 2008 warrants is being amortized over their vestingperiod of one year.

 

The following table summarizes theCompany’s outstanding warrants at December 27, 2008:

 

| ** **   | ** ** | **Exercise**       | ** ** | ** **     | ** ** |
|--------------|------------|--------------------|------------|----------------|------------|
| **Total**    | ** ** | **Price per** | ** ** | ** **     | ** ** |
| **Common**   | ** ** | **Common**         | ** ** | ** **     | ** ** |
| **Shares**   | ** ** | **Share**          | ** ** | **Expiration** | ** ** |
| **Issuable** | ** ** | **Issuable**       | ** ** | **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       |       |
| 100,000      |       | 1.50               |       | 02/28/13       |       |
| 2,711,544    |       | $                  | 1.16       |           |       |   |

 

**12.  STOCK OPTIONPLAN**

 

Under theCompany’s Amended and Restated 1998 Incentive and Nonqualified Stock Option Plan(the “1998 Plan”) options to acquire 11,000,000 shares of common stock may begranted 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 exerciseprices not exceeding fair market value at the date of grant.  Generally, the options become exercisableover periods of up to four years, and expire ten years from the date of grant.

 

On January 1,2006, the Company adopted the Financial Accounting Standards Board (“FASB”)Statement No. 123(R), *Share-BasedPayments*, using the modified prospective method.  Under this method, stock based compensationexpense is recognized for new grants beginning in fiscal 2006 and any unvestedgrants prior to the adoption of Statement No. 123(R).  Prior to fiscal 2006, the Company accountedfor share-based payments to employees using the Accounting Principles Board (“APB”)Opinion No. 25, *Accounting for StockIssued to Employees*, and the disclosure-only provisions of StatementNo. 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-22

----

 

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

 
| ** **                                    | ** ** | **Number of**     | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|--------------|------------|------------|------------|------------|
| ** **                                    | ** ** | **Shares of**     | ** ** | **Weighted** | ** ** | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | **Common Stock**  | ** ** | **Average**  | ** ** | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | **Underlying**         | ** ** | **Exercise** | ** ** | **Price**  | ** ** |
| ** **                                    | ** ** | **Stock Options** | ** ** | **Price**    | ** ** | **Range**  | ** ** |
| 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 |   |
| Granted                                       |       | 200,000                |       | 0.29         |       | 0.29       |       | -          |   | 0.29 |   |
| Expired/Forfeited                             |       | (1,248,396             | )          | 0.82         |       | 0.20       |       | -          |   | 2.50 |   |
| Exercised                                     |       | —                 |       | —       |       | —     |       | -          |   | — |   |
|                                          |       |                   |       |         |       |       |       |       |   |   |   |
| Outstanding - December 27, 2008          |       | 9,082,198              |       | 0.55         |       | 0.13       |       | -          |   | 4.25 |   |
|                                          |       |                   |       |         |       |       |       |       |   |   |   |
| Exercisable - December 27, 2008          |       | 8,117,720              |       | $            | 0.57       |       | $          | 0.13       |   | - |   | $ | 4.25 |   |
|                                          |       |                   |       |         |       |       |       |       |   |   |   |
| Available for grant - December 27,  2008 |       | 1,482,541              |       |         |       |       |       |       |   |   |   |
|                                               |            |                        |            |              |            |            |            |            |  |  |  |  |  |  |  |

 

The following table summarizesinformation for options outstanding and exercisable at December 27, 2008:

 
| ** **       | **Outstanding**       | ** **         | **Exercisable** | ** **  |
|------------------|-----------------------|--------------------|-----------------|-------------|
| ** **       | **Number of**    | ** **         | **Weighted**    | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **       | **Shares of**    | ** **         | **Average**     | ** **  | **Weighted** | ** ** | **Number** | ** ** | **Weighted** | ** ** |
| ** **       | **Common Stock** | ** **         | **Remaining**   | ** **  | **Average** | ** ** | **of** | ** ** | **Average** | ** ** |
| ** **       | **Underlying**        | ** **         | **Life**        | ** **  | **Exercise** | ** ** | **Stock** | ** ** | **Exercise** | ** ** |
| **Price  Range** | ** **            | **Stock  Options** | ** **      | **(Years)** | ** ** | **Price** | ** ** | **Options** | ** ** | **Price** | ** ** |
| $                | 0.13                  |               | -               |        | $ | 0.20 |   | 137,750 |   | 2.5 |   | $ | 0.18 |   | 137,750 |   | $ | 0.18 |   |
| 0.21             |                  | -                  |            | 0.30        |   | 3,414,252 |   | 2.7 |   | 0.25 |   | 3,264,252 |   | 0.25 |   |
| 0.31             |                  | -                  |            | 0.50        |   | 2,463,118 |   | 6.3 |   | 0.39 |   | 1,651,335 |   | 0.37 |   |
| 0.51             |                  | -                  |            | 1.00        |   | 2,678,778 |   | 4.3 |   | 0.77 |   | 2,676,083 |   | 0.77 |   |
| 1.01             |                  | -                  |            | 3.50        |   | 288,300 |   | 1.3 |   | 2.51 |   | 288,300 |   | 2.51 |   |
| 3.51             |                  | -                  |            | 4.25        |   | 100,000 |   | 1.0 |   | 4.14 |   | 100,000 |   | 4.14 |   |
| Total            |                  |               |            |        |   | 9,082,198 |   | 4.1 |   | $ | 0.55 |   | 8,117,720 |   | $ | 0.57 |   |
|                  |                       |                    |                 |             |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**The Company has reserved 27,272,658 shares ofcommon stock for issuance in connection with the conversion of convertiblepreferred stock (15,478,916 shares), the exercise of warrants (2,711,544shares) and the exercise of stock options (9,082,198 shares).**

 

**13.**       STOCKHOLDER RIGHTS PLAN:

 

TheCompany has a Stockholder Rights Plan (the “Plan”) effective November 9,2001.  Under the Plan each share of theCompany’s capital stock outstanding at the close of business on November 9,2001 and each share of 

 

F-23

----

 

the Company’s capital stockissued subsequent to that date has a right associated with it, such that eachshare of its common stock is entitled to one right and each share of itspreferred stock is entitled to such number of rights equal to the number ofcommon shares into which it is convertible.

 

The rights are exercisable only inthe event, with certain exceptions, an acquiring party accumulates 10 percentor more of the Company’s voting stock, or if a party announces an offer toacquire 15 percent or more of the Company’s voting stock.  The rights expire on November 9, 2011.

 

When exercisable, each rightentitles the holder to purchase from the Company, one one-hundredth of a shareof a new series of Series G junior preferred stock at an initial purchaseprice of $2.00, subject to adjustment. In addition, upon the occurrence of certain events, holders of therights will 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, theCompany amended the Plan to clarify that the issuance of the Highbridge Warrantdid not constitute a triggering event under the Plan.

 

**14.  PROFIT SHARING401(k) PLAN:**

 

TheiParty 401(k) Plan is a qualified profit sharing plan coveringsubstantially all of its employees. Contributions to this plan are at the discretion of the Board ofDirectors.  The Company’s expense,including matching contributions and any discretionary amounts was $164,954 in2008, $120,084 in 2007 and $108,863 in 2006.

 

**15.  SEGMENTREPORTING:**

 

SFASNo. 131, *Disclosures about Segments ofan Enterprise and Related Information*, establishes standards for theway business enterprises report information about operating segments in annualfinancial statements and requires that those enterprises report selectedinformation about operating segments in interim financial reports issued tostockholders.  The Company reports oneoperating segment as revenues from the other segment are not material.

 

F-24

----

 

**16.  QUARTERLYFINANCIAL DATA (UNAUDITED):**

** **

**QUARTERLY FINANCIAL DATA**

** **
| ** **                           | ** ** | **Mar 29, 2008** | ** ** | **Jun 28, 2008** | ** ** | **Sep 27, 2008** | ** ** | **Dec 27, 2008** | ** ** |
|--------------------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|
| Revenues                             |       | $                          | 16,144,088 |                       | $          | 20,103,668                 |       | $                          | 17,742,315 |   | $ | 27,220,928 |   |
| Cost of products sold (1),(2)        |       | 9,905,029                  |       | 11,515,061                 |       | 10,543,073                 |       | 14,922,052                 |       |
| Operating income (loss)              |       | (1,573,858                 | )          | 465,513                    |       | (1,058,738                 | )          | 2,493,915                  |       |
| Net income (loss)                    |       | (1,786,210                 | )          | 281,132                    |       | (1,236,559                 | )          | 2,301,582                  |       |
|                                 |       |                       |       |                       |       |                       |       |                       |       |
| Net income (loss) per share          |       |                       |       |                       |       |                       |       |                       |       |
| Basic                                |       | $                          | (0.08      | )                          | $          | 0.01                       |       | $                          | (0.05      | ) | $ | 0.06 |   |
| Diluted                              |       | $                          | (0.08      | )                          | $          | 0.01                       |       | $                          | (0.05      | ) | $ | 0.06 |   |
|                                 |       |                       |       |                       |       |                       |       |                       |       |
| Weighted-average shares outstanding: |       |                       |       |                       |       |                       |       |                       |       |
| Basic                                |       | 22,708,383                 |       | 38,210,583                 |       | 22,730,295                 |       | 38,210,583                 |       |
| Diluted                              |       | 22,708,383                 |       | 38,319,767                 |       | 22,730,295                 |       | 38,212,561                 |       |

 
| ** **                           | ** ** | **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                 |       |
|                                 |       |                       |       |                       |       |                       |       |                       |       |

----

| (1) Cost of products sold consists of the  cost of merchandise sold to customers and the occupancy costs for stores.                                                                                                                                 |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                 |   |   |   |   |   |   |   |   |   |
| (2) The  fourth quarter of 2008 included an estimated reduction of $261,915 to the  cost of products sold during the previous three quarters due to the  completion of physical inventories, for which shortage had been estimated  during the year. |
|                                                                                                                                                                                                                                                 |   |   |   |   |   |   |   |   |   |
| (2) The  fourth quarter of 2007 included an estimated reduction of $123,249 to the  cost of products sold during the previous three quarters due to the  completion of physical inventories, for which shortage had been estimated  during the year. |

 

F-25

----

 

**EXHIBIT INDEX**

 
| **EXHIBIT** | ** ** | ** ** | ** **      |
|-------------|------------|------------|-----------------|
| **NUMBER**  |       |       | **DESCRIPTION** |
| 3.1         | (1)        |       |            | Restated Certificate of Incorporation of WSI Acquisition Corp. and  Certificate of Merger by iParty Corp. into WSI Acquisition Corp. |
| 3.2         | (1)        |       |            | Certificate of Designation of Series A Preferred Stock of WSI  Acquisitions, Corp. |
| 3.3         | (2)        |       |            | Certificate of Designation of Series B Preferred Stock of iParty  Corp. |
| 3.4         | (2)        |       |            | Certificate of Designation of Series C Preferred Stock of iParty  Corp. |
| 3.5         | (4)        |       |            | Certificate of Designation of Series D Preferred Stock of iParty  Corp. |
| 3.6         | (5)        |       |            | Certificate of Designation of Series E Preferred Stock of iParty  Corp. |
| 3.7         | (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. |
| 10.9a       | (25)       | ##         |            | First Amendment dated December 30, 2008 to Employment Agreement  by and between iParty Corp. and Sal Perisano. |
| 10.10       | (22)       | ##         |            | Employment Agreement between iParty Corp. and Dorice Dionne, dated  March 22, 2007. |
| 10.10a      | (25)       | ##         |            | First Amendment dated December 30, 2008 to Employment Agreement  by and between iParty Corp. and Dorice Dionne. |
| 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. |
| 10.12a      | (24)       | ##         |            | Compensation Arrangements dated June 4, 2008 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. |
| 10.13a      | (24)       | ##         |            | Written Summary of Renewed One-Year Part-time Consulting Arrangement  with Joseph Vassalluzzo dated June 4, 2008. |
| 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. |

 

F-26

----

 
| 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.                                                                               |
| 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                                                                                                                            |
| 10.31a | (25) | ##     |   | First Amendment dated December 30, 2008 to Letter Agreement  dated March 22, 2007 by and between iParty Corp. and David E. Robertson.                                                                     |
| 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.                                                                       |

 

F-27

----

 
| (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.   |
| (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.        |
| (24) | Filed as an exhibit to iParty’s Quarterly Report on Form 10-Q,  filed with the SEC on August 11, 2008 and incorporated herein by  reference. |
| (25) | Filed as an exhibit to iParty’s Current Report on Form 8-K,  filed with the SEC on January 5, 2009 and incorporated herein by  reference.    |

 

F-28

----