**UNITED
        STATES**
 **SECURITIES
        AND EXCHANGE COMMISSION**
 WASHINGTON
        D.C. 20549
 
 **FORM
        10-K**
 
 (MARK
        ONE)
 x
              ANNUAL
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                  ACT OF
                  1934
 FOR
        THE
        FISCAL YEAR ENDED DECEMBER 31, 2005
 
 OR
 
 o
              TRANSITION
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                  ACT OF
                  1934
 FOR
        THE
        TRANSITION PERIOD FROM __________ TO __________
 
 COMMISSION
        FILE NUMBER: 0-22963
 
 **BIG
        DOG HOLDINGS, INC.**
 (EXACT
        NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
 
 
 DELAWARE
              52-1868665(STATE
                  OR OTHER JURISDICTION OF
              (I.R.S.
                  EMPLOYER INCORPORATIONOR
                  ORGANIZATION)
              IDENTIFICATION
                  NO.)121
                  GRAY AVENUE, SANTA BARBARA, CALIFORNIA
              93101(ADDRESS
                  OF PRINCIPAL EXECUTIVE OFFICE)
              (ZIP
                  CODE)
 
 (805)
        963-8727
 (REGISTRANT’S
        TELEPHONE NUMBER INCLUDING AREA CODE)
 
 SECURITIES
        REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
 
 SECURITIES
        REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: Common Stock, $0.01 par
        value
 
 Indicate
        by check mark if the registrant is a well-known seasoned issuer, as defined
        in
        Rule 405 of the Securities Act. Yes o No x
  Indicate
        by check mark if the registrant is not required to file reports pursuant
        to
        Section 13 or Section 15(d) of the
        Act. Yes o No x
  Indicate
        by check mark whether the registrant (1) has filed all reports required to
        be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
        during the preceding 12 months (or for such shorter period that the registrant
        was required to file such reports) and (2) has been subject to such filing
        requirements for the past 90 days. Yes x No o
  Indicate
        by check mark if disclosure of delinquent filers pursuant to Item 405 of
        Regulation S-K (§229.405 of this chapter) is not contained herein, and will not
        be contained, to the best of registrant’s knowledge, in definitive proxy or
        information statements incorporated by reference in Part III of this
        Form 10-K or any amendment to this Form 10-K. x
  Indicate
        by check mark whether registrant is a large accelerated filer, an accelerated
        filer, or a non-accelerated filer. See definition of “accelerated filer and
        large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
        one):
  Large
        accelerated filer o Accelerated filer o Non-accelerated filer x
  Indicate
        by check mark whether registrant is a shell company (as defined in
        Rule 12b-2 of the Exchange Act). Yes o No x
  As
        of the
        close of business on June 30, 2005, the last business day of the registrant’s
        most recently completed second fiscal quarter, the aggregate market value
        of the
        Common Stock held by non-affiliates of the registrant was $15,873,000 based
        upon
        the closing price $6.25 on NASDAQ on such date. All
        outstanding shares of Common Stock, other than those held by executive officers,
        directors and 10% shareholders are deemed to be held by
        non-affiliates.
  As
        of the
        close of business on March 1, 2006, the registrant had 9,096,332 shares of
        common stock outstanding.
  **DOCUMENTS
        INCOPORATED BY REFERENCE**
  Part
        III
        incorporates information by reference from the definitive Proxy Statement
        for
        the 2005 Annual Meeting of Shareholders, to be filed with the Commission
        no
        later than 120 days after the end of the registrant’s fiscal year covered by
        this Form 10-K.















(THIS
      PAGE INTENTIONALLY LEFT BLANK)









2





PART
      I





ITEM
                1.
            BUSINESS





Unless
      the context indicates otherwise, when this Annual Report on Form 10-K refers
      to
“we,” “us” or “the Company,” we are referring to Big Dog Holdings, Inc. and its
      subsidiaries on a consolidated basis.





The
      following discussion should be read in conjunction with the audited financial
      statements and notes thereto included elsewhere in this Annual Report on Form
      10-K.





GENERAL





Big
      Dog
      Holdings, Inc. is the parent company of two retail chains, Big Dog USA, Inc.
      (“Big Dogs”) and The Walking Company (“TWC”). Big Dogs develops, markets and
      retails a branded, lifestyle collection of unique, high-quality, popular-priced
      consumer products, including active wear, casual sportswear, accessories and
      gifts. TWC is the leading specialty retailer of authentic comfort footwear
      and accessories.





The
      Company’s Big Dogs products were first sold in 1983 and operations remained
      limited through 1992 when the current controlling stockholders acquired the
      BIG
      DOGS® brand and related assets. Following the acquisition of Big Dogs, the
      Company initiated a strategy of leveraging the brand through dramatic expansion
      of the Big Dog’s product line and rapid growth in our retail stores. The number
      of Big Dog stores has grown from 5 in 1993 to 176 as of December 31, 2005.
      After
      early years of rapid growth, Big Dogs has reached a level of maturity in the
      number of stores and breadth of products. In recent years the Company has
      focused on profitability and brand management for Big Dogs.





In
      March
      2004, the Company, through a newly formed subsidiary, acquired substantially
      all
      of the assets of TWC out of bankruptcy. TWC is the leading specialty retailer
      of
      authentic comfort footwear, operating 92 specialty stores as of
      December 31, 2005 in premium malls across the nation. TWC
      sells high-quality, technically designed comfort footwear and accessories
      from around the world to both men and women. During 2005, the Company added
      to the TWC chain through the acquisition of Footworks. Footworks operated a
      chain of seven comfort footwear stores in strategic locations, including several
      locations on the Las Vegas Strip. Substantially all of such stores are being
      converted to TWC stores. Subsequent to year ended December 31, 2005, the Company
      acquired assets of Steve’s Shoes, Inc. out of bankruptcy. Steve’s Shoes, Inc.
      operated a chain of comfort footwear stores throughout the US under the names
      Steve’s Shoes, Overland Trading Company and Sole Outdoor. TWC has acquired 37
      stores from such chain, a large majority of which are to be converted to TWC
      stores.





BUSINESS
      OF BIG DOGS





BIG
      DOGS®
is an All-American, family-oriented brand that we believe has established a
      unique niche in its dedication to providing quality, value and fun. Our products
      are centered around the signature BIG DOGS® name, logo and “Big Dog” characters
      and are designed to appeal to a broad range of customers. The BIG DOGS® brand
      conveys a sense of fun, humor and a “Big Dog attitude,” whereby each customer
      can feel that he or she is a “Big Dog.” The Big Dog attitude and sense of fun
      are brought to life through our graphic capabilities that portray the Big Dog
      characters in a number of engaging, positive and inspiring situations and
      activities. The Big Dog attitude is further defined by a number of slogans
      such
      as “If You Can't Run with the Big Dogs Stay on the Porch”®, “Large and In
      Charge” and “Attitude is Everything.” These graphics and slogans combine a bold,
      spirited attitude with wry, lighthearted humor. The appeal of the brand is
      further strengthened through a customer's personal identification with
      particular sports and other activities depicted in these graphics. In addition
      to our focus on fun, Big Dogs develops customer loyalty and enhances its brand
      image by providing a consistently high level of quality at moderate price
      points. We accomplish this primarily through (i) selling our own brand directly
      to the consumer, (ii) low-cost product development, and (iii) sourcing
      high-volume/low-cost basic apparel with limited fashion risk.





The
      BIG
      DOGS® brand is designed to appeal to men, women and children of all ages,
      particularly baby boomers and their kids, especially when they are engaged
      in
      leisure or recreational activities. We develop our apparel products, which
      include a wide variety of basic apparel and related products, with an emphasis
      on being functional rather than fashion-forward or trendy. These apparel
      products include graphic T-shirts, shorts, knit and woven shirts, fleece items,
      loungewear and boxer shorts. In addition to its BIG DOGS® line of activewear and
      casual sportswear for men and women, we have a LITTLE BIG DOGS® line of infants'
      and children's apparel and a BIG BIG DOGS® line of big-size apparel. We also
      sell a line of non-apparel products, including plush animals, stationery and
      pet
      products, which feature Big Dog graphics and are developed to complement our
      apparel.





3





We
      reinforce our brand image by distributing BIG DOGS® products primarily through
      our own retail stores. This distribution strategy enables us to present a
      complete selection of our merchandise in a creative and fun environment. In
      addition, this strategy enables us to more effectively reach our target
      customers by locating stores in tourist-oriented and other casual environments
      where we believe our products have their highest appeal. We operate our retail
      stores primarily in outlet malls. In addition to our retail stores, we market
      our products through other channels, including our catalog and corporate sales
      accounts, website and licensing opportunities.





BUSINESS
      STRATEGY





Promote
      the Big Dog Spirit of Fun .
      A key
      and unique element in our Big Dogs brand image is the focus on fun. This spirit
      of fun revolves around our Big Dog character that has broad appeal to men,
      women
      and children of all ages. We foster this spirit by creating positive, humorous,
      topical and inspiring graphics and slogans that we apply to our merchandise.
      More than just a logo, “the Big Dog” represents the leader, athlete, child,
      comedian, musician, boss, traveler, parent and dog lover that a wide range
      of
      customers can identify with. Big Dog products are fun, not only because of
      their
      graphics and slogans, but also because they are designed for recreational,
      sports and leisure activities and make ideal gifts. Our focus on fun is further
      enhanced by the lively, enjoyable atmosphere in our retail stores and is also
      reflected in our catalog, website and marketing promotions and activities.





Deliver
      High Quality at a Good Value .
      Big
      Dogs' products are constructed using high-quality fabrics and other materials.
      Many of our products feature unique graphics characterized by advanced print
      techniques, as well as unique appliqués and embroideries on many of our apparel
      products. We believe this combination of quality fabrics and graphics in our
      apparel products provides the customer with a product that has an exceptional
      look and feel. We are able to deliver this level of quality at reasonable prices
      primarily as a result of (i) selling our own brand direct to the consumer,
      (ii)
      low-cost product development, (iii) sourcing of basic apparel, and (iv) low
      marketing costs. We believe that delivering quality and value is instrumental
      in
      generating customer appeal and brand loyalty for our products, particularly
      those that do not prominently feature Big Dog graphics.




Enhance
      Functional Products with Graphics .
      Big
      Dogs develops functional rather than fashion-forward products. We believe we
      have a special competency in creating distinctive, popular graphics which we
      use
      to differentiate our products from those of our competitors. We have developed
      a
      broad assortment of classic, functional clothing (“basics”) in traditional, less
      fashion-forward colors. Our focus on basics and our ability to leverage our
      graphics across multiple product categories have allowed us to eliminate the
      need for a traditional buyer or design staff, and thereby lower our product
      development costs compared to most fashion apparel companies. Furthermore,
      since
      our graphics are added in the last stage of production, we are able to be more
      responsive to customer preferences while also lowering our inventory
      risk.




Target
      a Broad, Diverse Customer Base .
      We
      believe we have established Big Dogs as an All-American, family-oriented brand
      featuring products, graphic themes, slogans and promotions that appeal to a
      broad range of consumers. Although our marketing focus is on baby boomers and
      their kids, our customers include men, women and children of all ages, who
      span
      a wide range of geographic areas and income levels. Furthermore, we believe
      that
      the millions of dog and other pet owners in the United States, as well as
      children, have a strong natural affinity for the dog-related images and themes
      in Big Dogs graphics. In addition, we believe that the positive image the brand
      brings to being a "Big Dog" has a special appeal to big-size customers.





Maintain
      Controlled Distribution .
      We sell
      our products primarily through our own stores and, to a lesser extent, through
      our catalog and website. By selling direct to customers, we are able to present
      our complete line of merchandise in a creative and fun environment. This also
      allows us to target our customers more precisely by locating stores in
      tourist-oriented and other high-traffic areas where we believe consumers are
      more likely to be of the mind to purchase Big Dogs’ fun, casual apparel. Selling
      direct to the consumer also allows us (i) to enhance our margins while still
      providing customer value, (ii) to be more responsive to customer feedback,
      especially with regard to new product development, (iii) to reduce the need
      to
      build brand awareness through large-scale media advertising, and (iv) to collect
      customer names for our catalog through in-store sign-ups.





4





Create
      an Entertaining Shopping Experience .
      Big
      Dogs seeks to create a distinctive and fun shopping environment in its stores
      through an innovative display of our graphic art and humor, including in-store
      "T-shirt walls" and other displays designed to immediately put the customer
      in a
      relaxed, fun state of mind. By showcasing our complete product line, Big Dogs
      stores offer something for everyone in the family. Effective cross-merchandising
      in the stores is designed to add excitement and prompt add-on purchases. We
      believe the customer's shopping experience is further enhanced by our
      knowledgeable and enthusiastic sales staff.





Emphasize
      Grassroots Marketing .
      We
      believe Big Dogs’ most effective marketing is by the products themselves and
      their presentation in our retail stores, catalog and website. As a result,
      we
      have spent relatively little on advertising. Also important to our marketing
      strategy is our targeted “grassroots” marketing activities. These activities
      include local and charity sponsorships (such as high school sports teams) and
      community-oriented promotional events (such as the Company's annual dog parade
      in Santa Barbara).





MERCHANDISING





The
      Big
      Dogs product line features a branded, lifestyle collection of unique,
      high-quality, popular-priced consumer products, including activewear, casual
      sportswear, accessories and gifts. Our apparel lines include full collections
      of
      classic unisex casual sportswear and activewear for adults, as well as
      collections for infants and children and the big-size market. We continuously
      explore opportunities to further leverage our brand and graphics into new
      product lines.




Our
      apparel products are manufactured from premium cotton, or, in some instances,
      cotton/synthetic blends. Big Dogs' apparel is characterized by quality fabrics,
      construction and embellishments, and is distinguished from other apparel lines
      by the BIG DOGS® name, dog logo, graphics and slogans. In addition to our
      distinctive graphics, we believe we have achieved recognition for the quality
      and performance of our products.





The
      majority of our products range from between $4 and $45. The following table
      sets
      forth the approximate contribution that each of our product categories made
      to
      total net sales in our retail stores for the year ended December
      31:




%
                OF RETAIL STORE* NET SALES
              YEARS
                ENDED DECEMBER 31,2005
            
            2004
            
            2003Adult
                Apparel and Accessories
            
            
            54.4
            %
            
            53.9
            %
            
            53.0
            %Big-sizeApparel
            
            
            26.1
            
            
            23.7
            
            
            22.8Infants'
                and Children's Apparel and Accessories
            
            
            14.3
            
            
            16.8
            
            
            18.7Non-Apparel
                Products
            
            
            5.2
            
            
            5.6
            
            
            5.5Total
            
            
            100.0
            %
            
            100.0
            %
            
            100.0
            %


*Does
      not
      include catalog, wholesale and internet sales, which are skewed toward larger
      sizes.





Adult
      Apparel and Accessories .
      Big
      Dogs sells a complete line of adult unisex activewear and casual sportswear.
      We
      offer screen-printed and embroidered T-shirts and sweatshirts, in a variety
      of
      styles and colors that prominently display the Big Dogs graphics and slogans.
      In
      addition, we offer shorts, knit and woven casual shirts, fleece tops and
      bottoms, loungewear, boxer shorts, swimwear and sleepwear, all of which feature
      print designs or simply the BIG DOGS® name and/or dog logo. Our adult apparel
      line primarily focuses on basic items that recur with relatively minor variation
      from season-to-season and year-to-year. While certain of our classic, popular
      items and graphics have been in the Big Dogs line with very little change for
      over 10 years, we introduce new apparel and other products throughout the year
      to ensure that the merchandise assortments are consistent with the top sellers
      within our competitive market.





We
      leverage the Big Dogs trademarks, characters and more popular graphics by
      carefully translating them to a wide variety of apparel accessories, including
      caps, socks, sunglasses, bags, and wallets. These products are
      developed and introduced based on their consistency with Big Dog's brand image
      and whether they complement our other products. Our accessories not only provide
      an opportunity to create add-on purchases, but also minimize product development
      costs and inventory risk by utilizing graphics and slogans that have first
      proven popular on our graphic T-shirts.





5





Big-Size
      Apparel .
      We
      believe the BIG DOGS® image and the positive emphasis the brand gives to being a
“Big Dog” have a unique appeal to consumers who wear big sizes. Our BIG BIG
      DOGS® category offers a line of unisex activewear and casual sportswear. As with
      the regular adult sizes, this category features screen-printed and embroidered
      T-shirts and sweatshirts, in a variety of styles and colors that prominently
      display the Big Dogs graphic themes and slogans. In addition, we offer shorts,
      knit and woven casual and sports shirts, fleece tops and bottoms, loungewear,
      boxer shorts, swimwear and sleepwear, which may feature print designs or simply
      the BIG DOGS® name and/or dog logo. We sell our BIG BIG DOGS® line primarily
      through our retail stores, catalog and website.





Infant’s
      and Children’s Apparel and Accessories .
      The
      LITTLE BIG DOGS® line includes infants, toddlers, kids and youth sizes. Products
      in this line include graphic T-shirts, shirts, fleece items, infant and toddler
      one-pieces, boxer shorts, dresses and shorts, virtually all of which feature
      distinctive graphics. The graphics and fabrics of this line are designed to
      mirror many of the more popular graphics and fabrics in the BIG DOGS® adult line
      in order to encourage family purchases and leverage overall product development
      costs. We sell our LITTLE BIG DOGS® line primarily through our retail stores,
      catalog and website. Our sales of children’s apparel have decreased somewhat in
      recent years, primarily due to increased competitive pressure in that category
      in pricing and from the mass market.





Non-Apparel
      Products .
      We
      further leverage our trademarks, characters and more popular graphics by
      applying them to a wide variety of adult's and children's non-apparel items,
      including pet products, plush animals and other toys, sporting goods,
      stationery, calendars and lunch boxes. As with apparel accessories, new
      non-apparel products are developed and introduced based on whether they are
      consistent with Big Dogs' brand image and complement our other products. As
      with
      apparel accessories, the graphics applied to these products have first proven
      popular on our T-shirts, resulting in lower product development costs and
      inventory risk. In general, non-apparel items have higher gross margins than
      many of our other products.





MARKETING





Big
      Dogs
      strives to maintain a consistent brand image through the coordination of our
      merchandising, marketing and sales efforts. The goal of our marketing efforts
      is
      to present a distinctive image of quality, value and fun that consumers will
      associate with our products and thereby enhance the BIG DOGS® brand image. The
      BIG DOGS® brand image has been developed with relatively little advertising, as
      we believe it’s most effective marketing is its products themselves and their
      presentation in our retail stores, catalog and website. Our catalog and website
      serve not only as a means of product distribution, but also as key marketing
      pieces for our retail stores.





Also
      important to our marketing strategy is our targeted "grassroots" marketing
      activities. These activities include local and charity sponsorships (such as
      high school sports teams) and community-oriented promotional events (such as
      our
      annual dog parade in Santa Barbara). We train and incentivize our store managers
      to actively involve their stores in local, grassroots activities. In addition,
      we utilize billboard advertising designed to direct customers to local Big
      Dogs
      retail stores.





RETAIL
      STORES





We
      seek
      to create a distinctive and fun shopping environment in Big Dogs stores through
      the innovative display of our graphic art and humor, including in-store "T-shirt
      walls" and other displays designed to immediately put the customer in a fun,
      relaxed state of mind. In addition, our cross-merchandising and colorful signage
      is designed to add excitement in the stores and prompt add-on purchases. By
      showcasing our complete product line and broad assortment, Big Dogs stores
      offer
      something for everyone in the family and are particularly appealing to the
      dedicated Big Dogs customer.





In
      2005,
      our retail stores contributed approximately 94% of Big Dog Sportswear total
      net
      sales. As of December 31, 2005, we operated a total of 176 stores, 175 stores
      in
      38 states and 1 store in Puerto Rico. Big Dogs stores are typically located
      in
      tourist and recreation-oriented shopping locations and other casual environments
      where the Company believes consumers are more likely to be in a fun, relaxed
      state of mind. In making site selections, we also consider a variety of other
      factors, including proximity to large population centers, area income, the
      prestige and potential customer-draw of the other tenants in the center or
      area,
      projected profitability, store location and visibility within the center, and
      the accessibility and visibility of the center from nearby thoroughfares.





6





The
      table
      below sets forth the number of Big Dogs stores located in each state and
      territory as of December 31, 2005:





**State**
            
            **No.
                of Stores**
            
            **State**
            
            **No.
                of Stores**Alabama
            
            1
            
            Michigan
            
            6Arizona
            
            6
            
            Minnesota
            
            4California
            
            32
            
            Mississippi
            
            3Colorado
            
            5
            
            Missouri
            
            7Connecticut
            
            1
            
            Nevada
            
            3Delaware
            
            2
            
            New
                Hampshire
            
            2Florida
            
            13
            
            New
                Jersey
            
            1Georgia
            
            6
            
            New
                Mexico
            
            1Hawaii
            
            1
            
            New
                York
            
            4Idaho
            
            2
            
            North
                Carolina
            
            5Illinois
            
            3
            
            Ohio
            
            4Indiana
            
            3
            
            Oregon
            
            5Iowa
            
            1
            
            Pennsylvania
            
            8Kansas
            
            3
            
            South
                Carolina
            
            5Kentucky
            
            1
            
            Tennessee
            
            7Louisiana
            
            2
            
            Texas
            
            9Maine
            
            1
            
            Virginia
            
            2Maryland
            
            5
            
            Washington
            
            5Massachusetts
            
            3
            
            Wisconsin
            
            3**U.S.
                Territory**
            
            **No.
                of Stores**Puerto
                Rico
            
            1








We
      operate Big Dogs retail stores primarily in outlet malls. Big Dogs' traditional
      emphasis has been on outlet malls because those malls are often located in
      tourist areas and attract significant numbers of Big Dogs' targeted customers.
      While the growth in the outlet industry has slowed in recent years, we expect
      to
      continue opening stores in new quality outlet malls as they are opened to the
      extent they meet our requirements.





Our
      outlet mall stores average approximately 2,800 square feet. Our outlet stores
      offer a complete and current line of our products priced approximately 25%
      less
      than the same items are sold for in our catalog and website, our full-price
      stores and by other retailers.





Our
      Big
      Dogs store operations are managed by a Senior Vice President—Retail, Director of
      Retail Operations, 5 regional managers and 25 district and area managers. Each
      of the stores is managed and operated by a store manager, an assistant manager
      and full-time and part-time sales associates. We seek to further enhance our
      customers' shopping experience by developing a knowledgeable and enthusiastic
      sales staff to distinguish Big Dogs from its competition. In this regard, we
      have implemented employee training and incentive programs and encourage our
      sales associates to be friendly and courteous and to guide customers to graphics
      and products that tie into their individual interests. We believe our commitment
      to customer service enhances our ability to generate repeat business and to
      attract new customers. We also believe that the fun nature of our products
      create employee enthusiasm and positive morale that in turn enhance customer
      service and contribute to the fun shopping experience.





NON-RETAIL
      DISTRIBUTION





Non-retail
      distribution channels, which include catalog and internet sales, represents
      approximately 6% of Big Dog Sportswear total net sales in 2005.





Catalog
      and Internet .
      In
      addition to generating their own sales, our catalog and website serve as key
      marketing pieces for our products and stores. Our catalog and Internet sales
      in
      2005 were approximately $5.7 million, or approximately 6% of Big Dog Sportswear
      total net sales. Such sales have had growth in recent years, on a relatively
      small base. We have the benefit of being able to develop names for our mailing
      list through our retail store chain, which has been the primary source for
      such
      list.





7




SOURCING





Domestic
      and International Sourcing .
      Big
      Dogs does not own or operate any manufacturing facilities but instead source
      our
      products through third-party contractors with manufacturing facilities that
      are
      primarily overseas and to a limited extent, in Central America. We believe
      that
      outsourcing allows us to enhance production flexibility and capacity, while
      substantially reducing capital expenditures and avoiding the costs of managing
      a
      large production workforce. In addition, outsourcing allows us to leverage
      working capital, transfer risk and focus our energy and resources on
      merchandising, marketing and sales.





Big
      Dogs’
domestic sourcing is primarily limited to graphic T-shirts. Our graphic
      T-shirt business is managed in-house. This includes management of screen
      printing art and blanks, but not the actual screen-printing operations
      which are outsourced. The majority of our other products, excluding T-shirts,
      are manufactured overseas, primarily in Asia, the Middle East and Turkey. In
      order to reduce our exposure to production risks and delays arising from trade
      disputes, political disruption or other factors relating to any one vendor
      or
      country, we utilize a diverse group of vendors. We source the majority of our
      product from trading companies. Through these trading companies and directly,
      we
      source from approximately 65 unaffiliated vendors, including over 35 foreign
      vendors in a number of countries. In order to enhance our sourcing flexibility,
      we use trading companies rather than operate our own foreign sourcing office.
      These trading companies assist us in selecting and overseeing third-party
      vendors, sourcing fabric and monitoring quotas and other trade regulations.
      We
      do not have supply contracts with any of our suppliers. Although the loss of
      major suppliers could have a significant effect on our immediate operating
      results, since we are focused on basic apparel, we believe alternate sources
      of
      merchandise for most product categories are available at comparable prices
      and
      that we could replace these suppliers without any long-term adverse
      effect.





We
      forecast Big Dogs’ production requirements to secure necessary manufacturing
      capacity and quota. Since our foreign manufacturers are located at greater
      geographic distances from us than our domestic manufacturers, we generally
      allow
      greater lead-times for foreign orders. However, due to our focus on widely
      available basics rather than fashion items, we believe these lead times do
      not
      present significant risks.





Quality
      Control. Our
      quality control program is designed to ensure that all goods bearing BIG DOGS®
trademarks meet our standards. With respect to our products, Big Dogs, through
      its employees and sourcing agents, develops and inspects prototypes of each
      product prior to manufacture. For apparel products, Big Dogs, through its
      employees and sourcing agents, inspects the prototypes and fabrics prior to
      cutting by the contractors, establishes fittings based on the prototype and
      inspects samples. We or our sourcing agents inspect the final product prior
      to
      shipment to our warehouse or at the warehouse prior to payment.





BUSINESS
      OF TWC





TWC
      is a
      chain of specialty retail stores selling high-quality, technically designed
      comfort footwear and accessories from around the world to both men and
      women, including such brands as ECCO®, Mephisto®, Dansko®, Merrell® and
      Birkenstock®.





TWC
      was
      founded in 1991 and grew rapidly from a base of 20 stores in 1995
      to over 100 stores in 2003.  As a result of its rapid expansion,
      TWC made certain real estate and merchandising mistakes and eventually
      declared bankruptcy in July 2003.  The bankruptcy process
      allowed TWC to reject its non-performing stores and
      liquidate excess and obsolete inventory.





Having
      purchased the assets of TWC out of bankruptcy in March 2004, the Company has
      re-focused TWC’s operations on its original core business of operating specialty
      stores in premium malls selling the best brands in the comfort shoe
      category.  We acquired the business of TWC based on, among other factors,
      our favorable assessment of its market niche, the favorable demographics of
      that
      market, and an anticipated ability to realize efficiencies and increase
      profitability by utilizing the retail store expertise of the Company and by
      consolidating TWC’s corporate overhead operations with those of the Company. The
      footwear products sold by TWC appeal to a large and growing
      demographic.





8





During
      2005, the Company added to the TWC chain through the acquisition of Footworks.
      Footworks operated a chain of seven comfort footwear stores in strategic
      locations, including several locations on the Las Vegas Strip. Substantially
      all
      of such stores are being converted to TWC stores.





In
      January 2006, the Company acquired assets of Steve’s Shoes, Inc. out of
      bankruptcy. Steve’s Shoes operated a chain of comfort footwear stores throughout
      the US under the names Steve’s Shoes, Overland Trading Company and Sole Outdoor.
      TWC has acquired 37 stores from such chain, a large majority of which are to
      be
      converted to TWC stores. A few of these acquired stores have short remaining
      lease terms or overlap with TWC stores, and TWC is in the process of negotiating
      such leases.





BUSINESS
      STRATEGY





Offer
      the Best Brands from Around the World .
      TWC
      seeks out and offers to its customers shoe brands that are of high quality,
      integrate comfort features, and are not widely distributed. TWC feature a number
      of European and other foreign comfort shoe brands not widely found in other
      US
      shoe retailers.





Authentic
      ComfortTM .
      Each
      brand carried integrates comfort features such as shock absorbing EVA midsoles,
      hydrophobic foam insoles, waterproof leathers, anatomically contoured footbeds,
      and roomy toe boxes that follow the shape of the foot.





Target
      a Large and Growing Demographic. The
      Company has established TWC as the leading specialty retailer of comfort
      footwear appealing to a broad range of consumers. Although marketing focus
      is on
      baby boomers and working professionals, our customers include men and women
      of
      all ages. As the baby boomers age, there is an increasing focus on comfort
      footwear for both work and play. In addition, many of our brands are popular
      with working professionals such as teachers, medical staff, foodservice
      personnel and others who spend long days on their feet.





MERCHANDISING





The
      TWC
      product line features high-quality branded comfort footwear and accessories
      from
      around the world. The professional comfort line focuses on working professionals
      who spend long hours on their feet. The dress comfort line includes more formal
      styles while maintaining the comfort for which TWC is known. The sport &
active comfort line combines function and performance with style and design
      to
      create products that fit an active lifestyle. The casual comfort line includes
      comfort footwear for casual, everyday use. TWC also sells accessories that
      are
      designed to add to the comfort of the walking experience.





TWC
      experiences a level of seasonality in the types of products it sells. During
      spring/summer, the focus shifts toward sandals. During the fall/winter, the
      focus shifts toward boots, slippers and all-weather footwear.




The
      majority of our footwear products range from between $80 and $150. The following
      table sets forth the approximate contribution made to total net sales in our
      retail stores for the year ended December 31, 2005:





%
                OF RETAIL STORE* NET SALES
              YEARS
                ENDED DECEMBER 31,2005
            
            2004Women’s
                footwear
            
            
            54.2
            %
            
            52.5
            %Men’s
                footwear
            
            
            30.0
            
            
            32.7Accessories
            
            
            15.8
            
            
            14.8Total
            
            
            100.0
            %
            
            100.0
            %




9





MARKETING





Historically,
      TWC lacked a coherent marketing strategy for THE WALKING COMPANY brand. A
      significant focus of the Company’s efforts since its acquisition of TWC has been
      the development of an effective, coherent marketing image and strategy. This
      strategy is being implemented through consistent store design and image,
      collateral materials (in-store posters, etc.), and development of
      brand-identifying trademarks and slogans (Authentic ComfortTM, The Best Brands
      From Around the World, etc.) Such strategy is also being effected with
      relatively little media advertising, as we believe TWC’s most cost-effective
      marketing is through its stores themselves and our catalog and website. In
      addition, many of the brands we feature engage in their own media advertising,
      which acts to supports our stores. TWC is also able to leverage its marketing
      dollars by co-marketing with the companies whose brands it sells and with the
      malls in which it has stores.





RETAIL
      STORES





In
      2005,
      our retail stores contributed nearly 100% of TWC total net sales. As of December
      31, 2005, we operated a total of 92 stores in 27 states and the District of
      Columbia. TWC stores are typically located in leading regional malls in
      prosperous urban areas where the Company believes demographics are favorable.
      In
      making site selections, we also consider a variety of other factors, including
      proximity to large population centers, area income, the prestige and potential
      customer-draw of the other tenants in the center or area, rent and operating
      costs, store location and visibility within the center, and the accessibility
      and visibility of the center from nearby thoroughfares.





The
      table
      below sets forth the number of TWC stores located in each state as of December
      31, 2005. TWC stores average approximately 1300 square feet.




**State**
            
            **No.
                of Stores**
            
            **State**
            
            **No.
                of Stores**Arizona
            
            1
            
            Michigan
            
            3California
            
            19
            
            Minnesota
            
            1Colorado
            
            2
            
            Missouri
            
            1Connecticut
            
            2
            
            Nevada
            
            6Delaware
            
            1
            
            New
                Jersey
            
            2District
                of Columbia
            
            1
            
            New
                York
            
            2Florida
            
            9
            
            North
                Carolina
            
            3Georgia
            
            3
            
            Ohio
            
            3Hawaii
            
            2
            
            Oregon
            
            3Illinois
            
            4
            
            Pennsylvania
            
            2Indiana
            
            2
            
            South
                Carolina
            
            1Louisiana
            
            1
            
            Texas
            
            1Maryland
            
            3
            
            Virginia
            
            4Massachusetts
            
            5
            
            Washington
            
            5





See
      “Business of TWC” above regarding recent store acquisitions.





Our
      TWC
      store operations are managed by a Senior Vice President - Retail, Vice President
      - Retail, Director of Stores, a Western Regional Manager, 10 district managers,
      and 2 district training coordinators. Each of the stores is managed and operated
      by a store manager, an assistant manager and full-time and part-time sales
      associates. We seek to further enhance the TWC customer’s shopping experience by
      developing a knowledgeable and enthusiastic sales staff to distinguish TWC
      from
      its competition. In this regard, we (and the companies whose shoe brands we
      feature) provide instructive seminars and training to our staff to educate
      them
      on the technical quality of our shoes and to allow them to guide our customers
      to the products that best meet their comfort needs. We believe our commitment
      to
      knowledgeable customer service enhances our ability to generate repeat business
      and to attract new customers.





SOURCING





Domestic
      and International Sourcing. TWC
      sources its product from a number of selected and approved brands located in
      the
      United States and abroad. No one brand represents more than 10% of the Company’s
      consolidated sales. TWC does not own or operate any manufacturing facilities.
      Occasionally, the Company goes directly to the manufacturer and has a shoe
      made
      to TWC specifications.





10





BIG
      DOGS
      AND TWC OPERATIONS





MANAGEMENT
      INFORMATION SYSTEMS





The
      Company is committed to utilizing technology to enhance its competitive
      position. We have put in place computer hardware, systems applications and
      networks that are the same as those used by a number of large retailers. These
      systems support the sales and distribution of products to our stores and
      customers and improve the integration and efficiency of our domestic and foreign
      sourcing operations. The Company’s management information system (“MIS”)
      provides integration of store, merchandising, distribution and financial
      systems. These systems include stock keeping unit (“SKU”) and classification
      inventory tracking, purchase order management, open-to-buy, merchandise
      distribution, automated ticket making, general ledger, sales audit, accounts
      payable, fixed asset management, payroll and integrated financials. These
      systems operate on an IBM AS 400 platform and a Microsoft NT server network
      and
      utilize Island Pacific software. Our point-of-sale (“POS”) system consists of
      registers providing price look-up, e-mail and credit card and check
      authorization. Through automated two-way communication with each store, sales
      information, e-mail and timekeeping information are uploaded to the host system,
      and receiving, price changes and systems maintenance are down-loaded through
      the
      POS devices. Sales are updated daily in the merchandising report systems by
      polling sales from each store's POS terminals. We evaluate information obtained
      through daily polling, including a daily tracking of gross margin, to implement
      merchandising decisions regarding reorders, markdowns and allocation of
      merchandise. Catalog operations are also supported by MIS applications from
      an
      established vendor, designed specifically to meet the unique requirements of
      this business. These applications include customer service phone center, order
      processing and mailing list maintenance.





ALLOCATION
      AND DISTRIBUTION OF MERCHANDISE





Allocation
      and distribution of our inventory is performed centrally at the SKU, merchandise
      classification and store levels using integrated third-party software. Utilizing
      our MIS capabilities, our planning and allocation group works closely with
      the
      merchandising and retail departments to monitor and respond to customer
      purchasing trends and meet the seasonal and locale-specific merchandising
      requirements of our retail stores.





Our
      main
      warehouse facility and our mail order warehouse and fulfillment facility are
      located in a 143,000 square-foot distribution facility in Santa Fe Springs,
      California. All merchandise is delivered by vendors to this facility, where
      it
      is inspected, entered into our merchandising software system, picked and boxed
      for shipment to the stores or customers. We ship merchandise to our stores
      at
      least weekly, to provide a steady flow of merchandise.





TRADEMARKS





The
      Company utilizes a variety of trademarks which it owns; including the U.S.
      registered trademarks BIG DOGS®, BIG DOG SPORTSWEAR®, dog logo, BIG DOG®, LITTLE
      BIG DOGS®, BIG BIG DOGS®, THE WALKING COMPANY®, and FOOTWORKS®. In addition, we
      have registered certain of our trademarks or have registration applications
      pending in over 22 other countries. We regard our trademarks and other
      proprietary rights as valuable assets and believe they have significant value
      in
      the marketing of our products. Like most popular brands, from time to time
      in
      the course of business we discover products or businesses in the marketplace
      that we believe infringe upon our trademark rights. In addition, in regard
      to
      Big Dogs, companies occasionally claim that a certain product or graphic of
      ours
      infringes on their intellectual property rights (sometimes in regard to our
      parodies of other’s trademarks that we do as part of the Big Dogs sense of fun).
      We vigorously protect our trademarks and defend ourselves against claims of
      others. Actions against infringers include the use of cease and desist letters,
      administrative proceedings and lawsuits.





COMPETITION





Although
      the level and nature of competition differ somewhat for Big Dogs versus TWC,
      and
      among the product categories each of them feature, both companies compete
      primarily on the basis of the brand image we develop and maintain for them,
      as
      well as product quality assortment and price, store location and layout, and
      customer service. Big Dogs also competes by offering a unique combination of
      quality, value and fun (in both its products and its store experience). TWC
      also
      competes by offering a unique assortment of quality, hard-to-find brands. The
      markets for each of our products are highly competitive. We believe that our
      long-term competitive position will depend upon our ability to anticipate and
      respond effectively to changing consumer demands and to offer customers a wide
      variety of high-quality, unique products at competitive prices.





11





Although
      we believe Big Dogs does not compete directly with any single company with
      respect to its entire range of merchandise, within each merchandise category
      it
      competes with well-known apparel and specialty retail companies such as The
      GAP
      and Eddie Bauer and The Disney Stores, as well as a large number of national
      and
      regional department stores, specialty retailers and apparel designers and
      manufacturers. In addition, in recent years, the amount of casual sportswear
      and
      activewear manufactured specifically for department stores and sold under their
      own labels has significantly increased.





TWC
      competes primarily with small independent specialty shoe retailers (“mom &
pop” operators), small shoes chains and also department store operators such as
      Nordstrom and Federated. We believe that due to the relatively high price points
      for the shoes TWC offers and the high-level of customer service required to
      effectively sell the technical comfort benefits of such shoes, the big-box,
      mass-market retailers do not present a significant potential competitive threat
      to TWC.





Some
      of
      the Company’s competitors are significantly larger and more diversified and have
      substantially greater financial, distribution, marketing and other resources
      and
      have achieved greater recognition for their brand names than the
      Company.





EMPLOYEES





At
      March
      1, 2006, we had approximately 1,000 full-time and 1,100 part-time employees.
      Our
      need for part-time retail employees fluctuates significantly based on seasonal
      needs. No employees are covered by collective bargaining agreements.





AVAILABLE
      INFORMATION





Big
      Dogs’
website is www.bigdogs.com and
      TWC’s website is at www.thewalkingcompany.com .
      We make
      available free of charge through our www.bigdogs.com website
      the Company’s annual, quarterly and current reports, and any amendments to those
      reports, as soon as reasonably practical after electronically filing such
      reports with the Securities and Exchange Commission. This website is intended
      to
      be an inactive textual reference only and none of the information contained
      in
      our website is part of this report or is incorporated in this report by
      reference.





ITEM
                1a.
            RISK
                FACTORS





See
      discussion of Risk Factors in “Item 7. Management’s Discussion and Analysis of
      Financial Condition and Results of Operations.”





ITEM
                1b.
            UNRESOLVED
                STAFF COMMENTS





Not
      applicable.





ITEM
                2.
            PROPERTIES





Our
      corporate headquarters are in leased offices comprising approximately 24,000
      square feet in Santa Barbara, California. This lease expires July 2011, with
      two
      options to extend for another 5 years. Our distribution facility is located
      in
      Santa Fe Springs, California in a building comprising approximately 143,000
      square feet under a lease that expires in January 2008. We have an option to
      extend this lease for 5 years. Additionally, the TWC
      merchandising department is in an office comprising approximately
      7,000 square feet in Westlake, California. This lease expires in September
      2006.





We
      lease
      all of our store locations. Big Dogs store leases are typically for an initial
      term of 5 years with a 5-year option and provide for base rent plus contingent
      rent based upon a percentage of sales in excess of agreed-upon sales levels.
      In
      recent years, we have negotiated shorter-term renewals for Big Dogs stores
      in
      malls where we perceive a risk of declining sales. See “Item 1. BUSINESS -
      RETAIL STORES.” TWC stores typically have longer terms, as required by leading
      mall developers.





12





ITEM
                3.
            LEGAL
                PROCEEDINGS





In
      July
      2004, a lawsuit was filed against the Company by Big Dog Motorcycles LLC (“BDM”)
      in the Central District of California. The complaint alleges, among other
      things, breach and wrongful termination of a trademark license agreement, and
      claims attorneys fees.  While we are diligently evaluating BDM’s claims and
      seeking additional information, we currently believe that BDM’s claims lack
      merit and intend to defend the lawsuit vigorously. At this stage of the dispute,
      we believe any impact of the lawsuit will not be material to our business,
      financial position, results of operations and cash flows.





We
      are
      also involved from time to time in litigation incidental to our business. We
      believe that the outcome of such litigation will not have a material adverse
      effect on our results of operation or financial condition.





ITEM
                4.
            SUBMISSION
                OF MATTERS TO A VOTE OF THE SECURITY
                HOLDERS





Not
      applicable.





PART
      II





ITEM
                5.
            MARKET
                FOR THE REGISTRANT’S COMMON EQUITY AND RELATED SHAREHOLDER
                MATTERS





The
      common stock of our Company is traded on the NASDAQ National Market under the
      symbol BDOG. The following table sets forth, for the period from the first
      quarter 2004 through the fourth quarter 2005, the high and low “sales” price of
      the shares of our common stock, as reported on the NASDAQ National
      Market.





2005
            
            2004High
            
            Low
            
            High
            
            LowFirst
                Quarter
            
            $
            7.55
            
            $
            5.82
            
            $
            6.40
            
            $
            3.49Second
                Quarter
            
            
            7.80
            
            
            5.00
            
            
            6.32
            
            
            4.01Third
                Quarter
            
            
            7.40
            
            
            5.57
            
            
            7.10
            
            
            4.35Fourth
                Quarter
            
            
            7.50
            
            
            6.07
            
            
            7.10
            
            
            5.50





On
      March
      1, 2006, the last sales price of the common stock as reported on the NASDAQ
      National Market was $9.87 per share. As of March 1, 2006, we had approximately
      147 shareholders of record of our common stock.





Our
      current credit agreement prohibits the payment of dividends (see Liquidity
      and
      Capital Resources). We did not pay a dividend in 2005 and 2004, and do not
      expect to pay dividends in the future.





13





ITEM
                6.
            SELECTED
                FINANCIAL DATA





The
      selected consolidated financial data set forth below should be read in
      conjunction with the Consolidated Financial Statements and the Notes thereto
      and
      with "Management's Discussion and Analysis of Financial Condition and Results
      of
      Operations" appearing elsewhere in this Form 10-K.





YEARS
                ENDED DECEMBER 31,2005
            
            2004
            
            2003
            
            2002
            
            2001(in
                thousands, except per share and operating data)STATEMENT
                OF OPERATIONS DATA:Net
                sales
            
            $
            179,115
            
            $
            161,358
            
            $
            103,757
            
            $
            108,756
            
            $
            112,369Cost
                of goods sold
            
            
            80,311
            
            
            72,733
            
            
            45,025
            
            
            46,970
            
            
            49,154Gross
                profit
            
            
            98,804
            
            
            88,625
            
            
            58,732
            
            
            61,786
            
            
            63,215Selling,
                marketing and distribution expenses
            
            
            80,624
            
            
            73,956
            
            
            49,089
            
            
            51,528
            
            
            52,660General
                and administrative expenses
            
            
            9,631
            
            
            8,060
            
            
            5,199
            
            
            5,252
            
            
            5,618Total
                operating expenses
            
            
            90,255
            
            
            82,016
            
            
            54,288
            
            
            56,780
            
            
            58,278Income
                from operations
            
            
            8,549
            
            
            6,609
            
            
            4,444
            
            
            5,006
            
            
            4,937Other
                income(1)
            
            
            ---
            
            
            (82
            )
            
            ---
            
            
            ---
            
            
            (334
            )Interest
                income(2)
            
            
            (44
            )
            
            (26
            )
            
            (2
            )
            
            (3,175
            )
            
            (39
            )Interest
                expense(2)
            
            
            976
            
            
            857
            
            
            320
            
            
            3,761
            
            
            1,158Income
                before provision for income taxes
            
            
            7,617
            
            
            5,860
            
            
            4,126
            
            
            4,420
            
            
            4,152Provision
                for income taxes
            
            
            2,894
            
            
            2,172
            
            
            1,489
            
            
            603
            
            
            1,512Net
                income
            
            $
            4,723
            
            $
            3,688
            
            $
            2,637
            
            $
            3,817
            
            $
            2,640Net
                income per shareBasic
            
            $
            0.52
            
            $
            0.42
            
            $
            0.32
            
            $
            0.45
            
            $
            0.31Diluted
            
            $
            0.49
            
            $
            0.40
            
            $
            0.32
            
            $
            0.45
            
            $
            0.31Weighted
                average common sharesBasic
            
            
            9,145
            
            
            8,722
            
            
            8,307
            
            
            8,409
            
            
            8,457Diluted
            
            
            9,726
            
            
            9,174
            
            
            8,307
            
            
            8,409
            
            
            8,477OPERATING
                DATA:Number
                of stores(3)Stores
                open at beginning of period
            
            
            262
            
            
            203
            
            
            209
            
            
            208
            
            
            198Stores
                added due to acquisitions
            
            
            7
            
            
            72
            
            
            ---
            
            
            ---
            
            
            ---Stores
                opened during period
            
            
            14
            
            
            5
            
            
            7
            
            
            7
            
            
            16Stores
                closed during period
            
            
            (15
            )
            
            (18
            )
            
            (13
            )
            
            (6
            )
            
            (6
            )Stores
                open at end of period
            
            
            268
            
            
            262
            
            
            203
            
            
            209
            
            
            208Comparable
                stores sales increase (decrease)(4)
                (5)
            
            
            3.3
            %
            
            3.4
            %
            
            (3.6
            )%
            
            (6.3
            )%
            
            (4.4
            )%BALANCE
                SHEET DATA:Working
                capital
            
            $
            31,639
            
            $
            32,727
            
            $
            29,574
            
            $
            26,122
            
            $
            22,261Total
                assets
            
            
            72,753
            
            
            58,831
            
            
            42,582
            
            
            39,679
            
            
            40,307Total
                indebtedness(6)
            
            
            9,183
            
            
            1,092
            
            
            ---
            
            
            ---
            
            
            1,767Stockholders’
                equity
            
            
            46,448
            
            
            42,541
            
            
            34,214
            
            
            31,983
            
            
            28,408





(1)  In
      2000, we wrote off our entire $3,000,000 investment in PETsMART.com preferred
      stock. Subsequently, in 2001, a proposal and acceptance occurred whereby we
      sold
      this preferred stock for $334,000.





(2)  In
      2002, we earned $3,172,000 of interest income and incurred $3,288,000 of
      interest expense relating to the short-sale and repurchase of $95,384,000 of
      U.S. Treasury Securities.





14





(3)  Includes
      3 temporary stores which were open as of December 31, 2003.





(4)  Comparable
      store sales represent net sales of stores open at least one full year. Stores
      are considered comparable beginning on the first day of the third month
      following the one-year anniversary of their opening. Stores that are relocated
      but remain in the same shopping area remain in the comparable store base. The
      Company believes this method best reflects the effect of one-time promotional
      events and is most consistent with industry methods.





(5)  In
      2005, comparable store sales increase consists of a 12.8% increase in TWC
      comparable store sales, which is offset by a 4.1% decrease in Big Dogs
      comparable store sales. In 2004, comparable store sales increase consists of
      a
      12.7% increase in TWC comparable store sales, which is offset by a 1.9% decrease
      in Big Dogs comparable store sales.





(6)  Includes
      subordinated debt, obligations under the bank line of credit and obligations
      under capital leases.








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





The
      following discussion and analysis should be read in conjunction with the
      Consolidated Financial Statements and Notes thereto of the Company contained
      elsewhere in this Form 10-K.





GENERAL





Big
      Dog
      Holdings, Inc. is the parent company of two retail chains, Big Dog USA, Inc.,
      which does business as “Big Dog Sportswear” (“Big Dogs” or “Big Dog
      Sportswear”)) and The Walking Company (“TWC”). Big Dogs develops, markets and
      retails a branded, lifestyle collection of unique, high-quality, popular-priced
      consumer products, including active wear, casual sportswear, accessories and
      gifts. TWC, acquired March 3, 2004, is a specialty retailer of authentic
      comfort footwear and accessories.





RESULTS
      OF OPERATIONS





The
      following table sets forth, for the periods indicated, certain selected
      statement of operations data expressed as a percentage of net sales:





YEARS
                ENDED DECEMBER 31,2005
            
            2004
            
            2003Net
                sales
            
            
            100.0
            %
            
            100.0
            %
            
            100.0
            %Cost
                of goods sold
            
            
            44.8
            
            
            45.1
            
            
            43.4Gross
                profit
            
            
            55.2
            
            
            54.9
            
            
            56.6Selling,
                marketing and distribution expenses
            
            
            45.0
            
            
            45.8
            
            
            47.3General
                and administrative expenses
            
            
            5.4
            
            
            5.0
            
            
            5.0Total
                operating expenses
            
            
            50.4
            
            
            50.8
            
            
            52.3Income
                from operations
            
            
            4.8
            %
            
            4.1
            %
            
            4.3
            %




15





YEARS
      ENDED DECEMBER 31, 2005 AND 2004


NET
        SALES. Net sales consist of sales from the Company’s stores, catalog, internet
        website, and corporate sales accounts, all net of returns and allowances.
        Net
        sales increased to $179.1 million in 2005 from $161.4 million in 2004, an
        increase of $17.7 million, or 11.0%. The increase is primarily driven by
        our TWC
        segment and relates to the impact of the TWC acquisitions as well as sales
        growth. Increased hurricane activity this year, including Hurricane Katrina,
        impacted a number of Company stores on a short-term basis. Losses as a result
        of
        these store closures are covered under the Company’s insurance policy and are
        not anticipated to have a significant effect on the Company’s results of
        operations.
 
 TWC
        Operations*.* Net sales from TWC operations increased to $87.0 million in 2005 from $62.6 million in 2004, an increase
        of
        $24.4 million, or 39.0%. The increase was primarily related to the acquisition
        of TWC on March 3, 2004 and Footworks on September 1, 2005, which accounted
        for
        an increase in net sales of $13.7 million. In addition, an increase of $7.4
        million was attributable to a 12.3% increase in comparable store sales for
        TWC
        subsequent to the acquisition, $3.0 million attributable to an increase in
        TWC
        sales for stores not yet qualifying as comparable stores, which includes
        the
        closure of stores netted against new stores opened in the period and a $0.3
        million increase in the Company’s TWC catalog/Internet business. The increase in
        TWC comparable store sales is primarily related to improved inventory levels
        and
        merchandise selection at the TWC stores since the Company purchased TWC out
        of
        bankruptcy in March 2004.
 
 Big
        Dog operations. Net
        sales
        from Big Dog operations decreased to $92.1 million in 2005 from $98.8 million in 2004, a decrease
        of
        $6.7 million, or 6.8%. The decrease was related to $3.7 million attributable
        to
        a 4.1% decrease in Big Dog Sportswear comparable store sales for the period,
        $2.9 million attributable to a decrease in Big Dog Sportswear sales for stores
        not yet qualifying as comparable stores, which includes the closure of
        unprofitable stores netted against new stores opened in the period, and $0.8
        million attributable to a decrease in the Company’s Big Dog Sportswear wholesale
        business. The decreases were offset by a $0.7 million increase in the Company’s
        Big Dog Sportswear catalog/Internet business. The decrease in Big Dog Sportswear
        comparable store sales is primarily related to an overall decrease in consumer
        traffic in our stores and outlet locations. The Company closed its Big Dog
        wholesale division in the second quarter of 2004.




GROSS
      PROFIT. Gross profit increased to $98.8 million in 2005 from $88.6 million
      in
      2004, an increase of $10.2 million, or 11.5%. As a percentage of net sales,
      gross profit increased to 55.2% in 2005 from 54.9% in 2004. TWC’s gross profit
      remained relatively constant in 2005 and 2004 at 51.8% and 51.9%, respectively.
      Big Dogs’ gross profit increased to 58.4% in 2005 compared to 56.8% in 2004. The
      1.6% increase was primarily due to less promotional sales. Gross profit may
      not
      be comparable to those of other retailers, since some retailers include
      distribution costs and store occupancy costs in costs of goods sold, while
      we
      exclude them from gross margin, including them instead in selling, marketing
      and
      distribution expenses.




SELLING,
      MARKETING AND DISTRIBUTION EXPENSES. Selling, marketing and distribution
      expenses consist of expenses associated with creating, distributing, and selling
      products through all channels of distribution, including occupancy, payroll
      and
      catalog costs. Selling, marketing and distribution expenses increased to $80.6
      million in 2005 from $74.0 million in 2004, an increase of $6.6 million, or
      8.9%. The $6.6 million increase is primarily due to the acquisition of TWC
      on
      March 3, 2004 and Footworks on September 1, 2005. However, as a percentage
      of
      net sales these expenses decreased to 45.0% in 2005 from 45.8% in 2004, a
      decrease of 0.8%. The decrease is primarily related to spreading the expenses
      over a larger sales base and the net closure of 12 Big Dog stores in
      2005.





GENERAL
      AND ADMINISTRATIVE EXPENSES. General and administrative expenses consist of
      administrative salaries, corporate occupancy costs and other corporate expenses.
      General and administrative expenses increased to $9.6 million in 2005 from
      $8.1
      million in 2004. As a percentage of net sales these expenses increased to 5.4%
      in 2005 from 5.0% in 2004, an increase of 0.4%. The increase is attributable
      to
      TWC and Footworks acquisitions, as well as an increase in legal expenses related
      to litigation.





OTHER
      INCOME. Other income of $0.1 million in 2004 is the gain from early debt
      extinguishment at a discount of the redeemable convertible notes related to
      The
      Walking Company acquisition.





INTEREST
      INCOME. Interest income for 2005 and 2004 was less than $0.1 million. Interest
      income is primarily earned on excess cash balances invested on an overnight
      basis. As the Company generally uses excess cash to reduce the outstanding
      balances on their lines of credit, interest income in future periods is not
      expected to be significant.





INTEREST
      EXPENSE. Interest expense remained relatively constant in 2005 and 2004 at
      $1.0
      million and $0.9 million, respectively.





INCOME
      TAXES. In 2005, the provision for income taxes reflects a 38.0% effective tax
      rate, compared to a 37.1% effective tax rate in 2004.





16





YEARS
      ENDED DECEMBER 31, 2004 AND 2003




NET
        SALES. Net sales increased to $161.4 million in 2004 from $103.8 million
        in
        2003, an increase of $57.6 million, or 55.5%. The increase is primarily related
        to the acquisition of The Walking Company on March 3,
        2004.
 
 TWC
        Operations.  Net sales from TWC operations were
        $62.6 million in
        2004 .
        Prior
        to the acquisition of The Walking Company on March 3, 2004, the Company had
        only
        one reportable segment.
 
 Big
        Dog Operations.  Net sales from Big Dog operations decreased to $98.8 million in 2004 from $103.8 million in 2003, a decrease
        of
        $5.0 million, or 4.8%. The decrease was related to $1.8 million attributable
        to
        a decrease in Big Dog comparable store sales of 1.9%, $1.7 million attributable
        to a decrease in Big Dog sales for stores not yet qualifying as comparable
        stores, which includes the closure of unprofitable stores netted against
        new
        stores opened in the year, $1.3 million attributable to a decrease in our
        Big
        Dog wholesale business, and $0.2 million attributable to a decrease in our
        Big
        Dog mail order business. The decrease in Big Dog comparable store sales is
        primarily related to an overall decrease in consumer traffic in our stores
        and
        outlet locations. During the second quarter 2004, we closed the Big Dog
        wholesale division, which accounted for 2% of revenues in 2003.


GROSS
      PROFIT. Gross profit increased to $88.6 million in 2004 from $58.7 million
      in
      2003, an increase of $29.9 million, or 50.9%. As a percentage of net sales,
      gross profit decreased to 54.9% in 2004 from 56.6% in 2003. The decrease was
      attributable to the addition of TWC store sales as of the acquisition date
      of
      March 3, 2004. Such lower margin is expected to continue for future periods,
      as
      TWC margin contribution is generally lower than the Company’s historical
      results. TWC gross margin was 51.9% in 2004 as compared to Big Dogs’
contribution of 56.8%. The Big Dogs’ gross profit for 2004 increased to 56.8%
      from 56.6% in 2003. The 0.2% increase was primarily due to a shift from
      promotional or lower-margined sales to higher-margined sales. Gross profit
      may
      not be comparable to those of other retailers, since some retailers include
      distribution costs and store occupancy costs in costs of goods sold, while
      we
      exclude them from gross margin, including them instead in selling, marketing
      and
      distribution expenses.




SELLING,
      MARKETING AND DISTRIBUTION EXPENSES. Selling, marketing and distribution
      expenses increased to $74.0 million in 2004 from $49.1 million in 2003, an
      increase of $24.9 million, or 50.7%. The $24.9 million increase is primarily
      due
      to $26.2 million related to TWC. However, as a percentage of net sales these
      expenses decreased to 45.8% in 2004 from 47.3% in 2003, a decrease of 1.5%.
      The
      decrease as a percentage of sales is primarily related to cost reductions
      related to store closures and efficiencies created as a result of the
      acquisition of The Walking Company. With the addition of TWC, this lower level
      of expenses as a percentage of revenue is expected to continue in future
      periods.





GENERAL
      AND ADMINISTRATIVE EXPENSES. General and administrative expenses increased
      to
      $8.1 million in 2004 from $5.2 million in 2003. The increase is directly
      attributable to The Walking Company acquisition. However, as a percentage of
      net
      sales these expenses remained constant at 5.0% for both 2004 and
      2003.





OTHER
      INCOME. Other income of $0.1 million in 2004 is the gain from early debt
      extinguishment at a discount of the redeemable convertible notes related to
      The
      Walking Company acquisition.





INTEREST
      EXPENSE. Interest expense increased to $0.9 million in 2004 from $0.3 million
      in
      2003. The increase in intere s t
      expense
      is due to higher average outstanding borrowings due to the acquisition of the
      operations of The Walking Company. Such higher level of interest expense, as
      a
      dollar amount, is expected to continue in future periods as a result of The
      Walking Company acquisition.





INCOME
      TAXES. In 2004, the provision for income taxes reflects a 37.1% effective tax
      rate, compared to a 36.1% effective tax rate in 2003.





SEASONALITY
      AND QUARTERLY RESULTS





We
      believe our seasonality is somewhat different than many apparel retailers since
      a significant number of our Big Dog Sportswear stores are located in tourist
      areas and outdoor malls that have different visitation patterns than urban
      and
      suburban retail centers. We believe that the seasonality of TWC stores will
      more
      closely resemble traditional retailers. The third and fourth quarters
      (consisting of the summer vacation, back-to-school and Christmas seasons) have
      historically accounted for the largest percentage of our annual sales and
      profits. We have historically incurred operating losses in the first half of
      the
      year and may be expected to do so in the foreseeable future.





Our
      quarterly results of operations may also fluctuate as a result of a variety
      of
      factors, including the timing of store openings, the amount of revenue
      contributed by new stores, changes in comparable store sales, changes in the
      mix
      of products sold, customer acceptance of new products, the timing and level
      of
      markdowns, competitive factors and general economic conditions.





17





LIQUIDITY
      AND CAPITAL RESOURCES





During
      2005, our primary uses of cash were for merchandise inventories, the acquisition
      of Footworks, capital expenditures, and general operating activity. We satisfied
      our cash requirements from existing cash balances, short-term borrowings under
      our line of credit agreements and other borrowings.





Cash
      provided by operating activities was $7.2 million and $6.3 million for 2005
      and
      2004, respectively. The $0.9 million increase in cash provided by operating
      activities relates to an increase in our net income of $1.0 million, $4.7
      million in 2005 compared to $3.7 million in 2004, which was offset in part
      by
      various fluctuations in operating assets and liabilities.





Cash
      used
      in investing activities was $9.6 million and $3.5 million for 2005 and 2004,
      respectively. Of the cash used in investing activities in 2005, $4.1 million
      relates to the acquisition of Footworks and $5.4 million relates to capital
      expenditures including 11 new TWC store openings, 3 new Big Dog Sportswear
      store
      openings, retrofitting existing stores and corporate additions. Of the cash
      used
      in investing activities in 2004, $1.6 million relates to the acquisition of
      The
      Walking Company.





Cash
      provided by financing activities in 2005 was $1.2 million in 2005 compared
      to
      $8.7 million of cash used in financing activities in 2004. The increase in
      cash
      provided by financing is primarily due to increased cash borrowings under the
      lines of credit. As of December 31, 2005, we had short term borrowings of $2.8
      million compared to $0.3 million on December 31, 2004.





In
      October 2001, the Company entered into a credit facility with Wells Fargo Retail
      Finance, which was most recently amended in July 2005 (the “Amended Credit
      Agreement”). Prior to the July 2005 amendment, the Amended Credit Agreement
      provided for a total commitment of $28,000,000 with the ability for the Company
      to issue documentary and standby letters of credit of up to $3,000,000. The
      Company’s ability to borrow under the facility was determined using an
      availability formula based on eligible assets. The facility was collateralized
      by substantially all of the Company’s assets and requires daily, weekly and
      monthly financial reporting as well as compliance with financial, affirmative
      and negative covenants. The most significant of these financial covenants was
      compliance with a pre-defined annual maximum capital expenditure amount. For
      all
      periods presented, the Company was in compliance with all covenants. This credit
      agreement provides for a performance-pricing structured interest charge which
      was based on excess availability levels. The interest rate ranged from the
      bank’s base rate or a LIBOR loan rate plus a margin ranging up to 1.75%. As of
      December 31, 2004, the Company had no outstanding borrowings and $899,000 of
      letters of credit outstanding under this agreement.





In
      addition to the Amended Credit Agreement of the Company, TWC entered into a
      separate $17,500,000 three-year revolving credit facility with Wells Fargo
      Retail Finance on March 3, 2004, which was recently amended as of July 2005.
      Prior to the July 2005 amendment, this line was secured by substantially all
      assets of TWC and required daily, weekly and monthly financial reporting as
      well
      as compliance with financial, affirmative and negative covenants. The most
      significant of these financial covenants was compliance with a maximum annual
      capital expenditure amount. For all periods presented, TWC was in compliance
      with all covenants. This credit agreement provided for a performance-pricing
      structured interest charge which was based on excess availability levels. The
      interest rate was either the Bank’s base rate or a LIBOR loan rate plus a margin
      which ranges up to 2.75%. At December 31, 2004, TWC had approximately $304,000
      outstanding under this credit agreement and $341,000 of outstanding letters
      of
      credit.





In
      July
      2005, the Company combined both credit facilities discussed above and
      entered into a $47,000,000 revolving credit facility with Wells Fargo Retail
      Finance.  The line is secured by substantially all assets of the Company
      and requires daily, weekly and monthly financial reporting as well as compliance
      with financial, affirmative and negative covenants.  The most significant
      of these financial covenants is compliance with a capital expenditures covenant
      which limits the Company to $5,000,000 expenditures for 2005 (amount is adjusted
      annually based on an annual business plan) if minimum excess availability levels
      fall below $7,500,000. For all periods presented, the Company was in compliance
      with all covenants. This credit agreement provides for a performance-pricing
      structured interest charge which is based on excess availability levels. The
      interest rate ranges from the bank’s base rate (7.25% on December 31, 2005) or a
      LIBOR loan rate plus a margin ranging up to 1.75%. The Company did not have
      any
      LIBOR loans outstanding at December 31, 2005. The Amended Credit Agreement
      expires in October 2009. At December 31, 2005, the Company had approximately
      $2,796,000 outstanding under this credit agreement and $2,258,000 of outstanding
      letters of credit expiring through October 2008, which includes a $2,000,000
      stand-by letter of credit related to a promissory note entered in conjunction
      with the acquisition of Footworks.





18





In
      March
      2004, in conjunction with the acquisition of The Walking Company, the Company
      also entered into a $3 million two-year unsecured revolving promissory note
      facility with Israel Discount Bank (“IDB”). This facility bears interest at IDB
      prime plus 1% and is personally guarantied by the Chairman of the Company,
      for
      which he received an annual 2.5% guarantee fee of $75,000. At December 31,
      2004,
      no amounts were outstanding under this facility. In February 2005, this facility
      was cancelled by the Company.





In
      conjunction with the acquisition of The Walking Company, the Company assumed
      $3,279,000 of secured promissory notes and $721,000 of unsecured promissory
      notes, respectively, payable to certain former creditors of The Walking Company.
      The secured note holders were also granted rights to convert the notes into
      a
      total of 753,793 shares of common stock of the Company at a conversion price
      of
      $4.35 per share through June 30, 2004. In addition, the holders of the secured
      notes received a right to sell (“put”) 50% of the outstanding principal amount
      of such notes to the Company at a 20% discount through June 30, 2004 (the “note
      put rights”). The unsecured note holders also were granted rights to convert the
      notes into a total of 165,748 shares of common stock of the Company at a
      conversion price of $4.35 per share through June 30, 2004. In addition, the
      holders of such unsecured notes received note put rights to put 100% of the
      outstanding principal amount of such notes to the Company at a 20% discount
      through June 30, 2004.





In
      order
      to facilitate the acquisition of The Walking Company, the Chairman of the Board
      and the Chief Executive Officer of the Company each personally guarantied the
      potential obligation of the secured and unsecured note put rights and another
      $2,800,000 of other potential obligations in regard to certain administrative
      claims. In connection therewith, the Chairman and CEO were given the right
      to
      purchase the secured and unsecured put rights if such put rights were exercised.
      The Chairman and the CEO then assigned part of their right to purchase such
      rights to certain executive officers and individuals (the “Assigned Group”). In
      March 2004, the holders of the $721,000 of unsecured notes exercised the right
      to put such notes, which the Assigned Group purchased for $576,000. The Company
      recorded $328,000 as compensation expense, which was equal to the difference
      between the market value of the Company common stock into which such notes
      were
      convertible and the amount at which the Assigned Group had the right to purchase
      such notes. This amount is included in general and administrative expenses
      in
      the accompanying consolidated statements of operations for year ended December
      31, 2004.





During
      the second quarter 2004, certain note holders and the Assigned Group exercised
      their rights to convert $2,918,000 in secured notes, $721,000 in unsecured
      notes
      and $64,000 in accrued interest into 851,117 shares of common stock. As an
      inducement to cash out, the Company offered to redeem the remaining secured
      notes at a 10% discount instead of the contractual 20% discount. Accordingly,
      all of the remaining secured notes were redeemed for a cash payment of 90%
      of
      the face value. As a result of the above transactions the Company recognized
      a
      gain on the early extinguishment of debt of $82,000 which was recorded as other
      income in the accompanying consolidated statement of operations for year ended
      December 31, 2004.





As
      part
      of the acquisition of The Walking Company, TWC assumed priority tax claims
      totaling approximately $627,000. The Bankruptcy Code requires that each holder
      of a priority tax claim will be paid in full with interest at the rate of six
      percent per year with annual payments for a period of six years. At December
      31,
      2005 and 2004, $59,000 and $72,000, respectively, of the priority tax claim
      note
      is classified as current and is included in current portion of long-term debt
      in
      the accompanying consolidated balance sheet. As of December 31, 2005 and 2004,
      the remaining notes had a balance of $121,000 and $289,000,
      respectively.





In
      conjunction with the acquisition of Footworks, Wells Fargo Retail Finance issued
      a $3,000,000 four-year term loan facility. Monthly payments of $55,555 are
      due
      beginning March 2006 with the balance due at the maturity date of the loan,
      October 2009. The term loan interest charge is Prime plus .5% or LIBOR plus
      2.75% (7.75% at December 31, 2005). At December 31, 2005, $556,000 of the term
      loan facility is classified as current and is included in current portion of
      long-term debt in the accompanying consolidated balance sheet.





Additionally,
      in conjunction with the acquisition of Footworks, the Company also entered
      into
      a $3,000,000 three-year promissory note with the seller, Bianca of Nevada,
      Inc.
      The principal on this note is payable in three annual installments beginning
      August 31, 2006. The note bears an interest rate of 5.0% and accrued interest
      is
      payable quarterly beginning December 2005. The note is partially secured by
      a
      $2,000,000 stand-by letter of credit. Upon payment of the second principal
      installment, the stand-by letter of credit shall be reduced to $1,000,000.
      At
      December 31, 2005, $1,000,000 of the promissory note is classified as current
      and is included in current portion of long-term debt in the accompanying
      consolidated balance sheet.





19





Management
      believes that available cash, the credit facilities in place in 2005 and 2006,
      and cash generated from operations will be adequate to fund the Company’s
      working capital requirements for the foreseeable future.





COMMITMENTS
      AND OBLIGATIONS





As
      of
      December 31, 2005, we had the following obligations:




Amounts
                of Commitment Expiration per PeriodTotal
                Amounts
              Committed
            
            Less
                than 1 year
            
            1
                to 3 years
            
            4
                to 5 years
            
            Over
                5 yearsDebt:Revolving
                lines of credit
            
            $
            2,796,000
            
            $
            2,796,000
            
            $
            ---
            
            $
            ---
            
            $
            ---Notes
                payable
            
            
            6,000,000
            
            
            1,556,000
            
            
            3,333,000
            
            
            1,111,000
            
            
            ---Priority
                tax claims
            
            
            180,000
            
            
            59,000
            
            
            121,000
            
            
            ---
            
            
            ---Contractual
                Obligations:Operating
                leases
            
            
            117,049,000
            
            
            26,477,000
            
            
            39,304,000
            
            
            23,836,000
            
            
            27,432,000Capital
                leases
            
            
            207,000
            
            
            160,000
            
            
            47,000
            
            
            ---
            
            
            ---Other
                Commercial Commitments:Letters
                of credit
            
            
            2,258,000
            
            
            258,000
            
            
            2,000,000
            
            
            ---
            
            
            ---Total
                Commitments
            
            $
            128,490,000
            
            $
            31,306,000
            
            $
            44,805,000
            
            $
            24,947,000
            
            $
            27,432,000





Revolving
      Lines of Credit - We have a revolving credit facility with Wells Fargo Retail
      Finance that we use to finance our operations. See “Part I. Item 7. - Liquidity
      and Capital Resources” for additional information regarding our credit
      facility.





Notes
      Payable - In conjunction with the acquisition of Footworks, we entered into
      two
      loans used to finance the purchase. See “Part I. Item 7. - Liquidity and Capital
      Resources” for additional information regarding our credit
      facility.





Priority
      Tax Claims - In conjunction with the acquisition of The Walking Company, we
      assumed priority tax claims. See “Part I. Item 7. - Liquidity and Capital
      Resources” for additional information regarding our priority tax claim
      debt.





Operating
      Leases - We lease retail and office space under various operating leases.
      Certain leases are cancelable with substantial penalties. See “Part I. Item 2. —
Properties” for additional information regarding our leases. Big Dog operating
      leases that expire in less than a year, 1 to 3 years, or greater than 3 years
      total $1.3 million, $2.0 million, and $0.6 million, respectively.





Capital
      Leases - We lease certain computer and copier equipment under various capital
      leases. Certain leases are cancelable with substantial penalties.





Letters
      of Credit - We open letters of credit to facilitate inventory purchases as
      required by certain vendors.  The letters of credit list certain
      documentation requirements that each vendor must present to our bank before
      payment is made.  We are obligated to make these payments upon presentation
      of these documents.





See
      additional discussion above under Liquidity and Capital Resources.





20





RECENT
      ACCOUNTING PRONOUNCEMENTS





In
      April
      2003, the FASB issued Statement
      of Financial Accounting Standards (“SFAS”) No. 149 (“ SFAS
      No.
      149”), Amendment of Statement 133 on Derivative Instruments and Hedging
      Activities. SFAS No. 149 amends and clarifies accounting for derivative
      instruments, including certain derivative instruments embedded in other
      contracts, and for hedging activities under Statement 133. SFAS No. 149 is
      effective for contracts entered into or modified after June 30, 2003 and for
      hedging relationships designated after June 30, 2003. The adoption of this
      statement did not have an impact on our consolidated financial
      statements.





In
      May
      2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments
      with Characteristics of both Liabilities and Equity. SFAS No. 150 clarifies
      the
      accounting for certain financial instruments with characteristics of both
      liabilities and equity and requires that those instruments be classified as
      liabilities in statements of financial position. Previously, many of those
      financial instruments were classified as equity. SFAS No. 150 is effective
      for
      financial instruments entered into or modified after May 31, 2003 and otherwise
      effective at the beginning of the first interim period beginning after June
      15,
      2003.





In
      November 2004, the FASB issued SFAS No. 151, “Inventory Costs”. SFAS No. 151
      amends the accounting for abnormal amounts of idle facility expense, freight,
      handling costs, and wasted material (spoilage) under the guidance in ARB No.
      43,
      Chapter 4, “Inventory Pricing”. Paragraph 5 of ARB No. 43, Chapter 4, previously
      stated that “. . . under some circumstances, items such as idle facility
      expense, excessive spoilage, double freight, and rehandling costs may be so
      abnormal as to require treatment as current period charges. . . .” This
      statement requires that those items be recognized as current-period charges
      regardless of whether they meet the criterion of “so abnormal.” In addition,
      this statement requires that allocation of fixed production overhead to the
      costs of conversion be based on the normal capacity of the production
      facilities. This statement is effective for inventory costs incurred during
      fiscal years beginning after June 15, 2005. Management does not expect adoption
      of SFAS No. 151 to have a material impact, if any, on the Company's consolidated
      financial position or results of operations.





In
      December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets,”
an amendment to Opinion No. 29, “Accounting for Nonmonetary Transactions”. SFAS
      No. 153 eliminates certain differences in the guidance in Opinion No. 29 as
      compared to the guidance contained in standards issued by the International
      Accounting Standards Board. The amendment to Opinion No. 29 eliminates the
      fair
      value exception for nonmonetary exchanges of similar productive assets and
      replaces it with a general exception for exchanges of nonmonetary assets that
      do
      not have commercial substance. Such an exchange has commercial substance if
      the
      future cash flows of the entity are expected to change significantly as a result
      of the exchange. SFAS No. 153 is effective for nonmonetary asset exchanges
      occurring in periods beginning after June 15, 2005. Earlier application is
      permitted for nonmonetary asset exchanges occurring in periods beginning after
      December 16, 2004. The adoption of this statement did not have an impact on
      our
      consolidated financial statements.





In
      December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment”. SFAS
      123(R) amends SFAS No. 123, “Accounting for Stock-Based Compensation”, and APB
      Opinion No. 25, “Accounting for Stock Issued to Employees”. SFAS No.123(R)
      requires that the cost of share-based payment transactions (including those
      with
      employees and non-employees) be recognized in the financial statements. SFAS
      No.
      123(R) applies to all share-based payment transactions in which an entity
      acquires goods or services by issuing (or offering to issue) its shares, share
      options, or other equity instruments (except for those held by an ESOP) or
      by
      incurring liabilities (1) in amounts based (even in part) on the price of the
      company’s shares or other equity instruments, or (2) that require (or may
      require) settlement by the issuance of a company’s shares or other equity
      instruments. This statement is effective (1) for public companies qualifying
      as
      SEC small business issuers, as of the first interim period or fiscal year
      beginning after December 15, 2005, or (2) for all other public companies, as
      of
      the first interim period or fiscal year beginning after June 15, 2005, or (3)
      for all nonpublic entities, as of the first fiscal year beginning after December
      15, 2005. Subsequent to issuance, the SEC deferred implementation to the first
      fiscal year beginning after June 15, 2005. Management is currently assessing
      the
      impact of this statement on its financial position and results of operations
      in
      the first quarter of 2006. In the interim, the Company is continuing to use
      the
      intrinsic value method in estimating employee stock compensation expense based
      on the fair value method of accounting. This method is allowed under SFAS No.
      148, which amended SFAS No. 123 in December 2002, and proforma disclosure of
      fair value amounts is provided.





21





In
      January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), “Consolidation
      of Variable Interest Entities - an Interpretation of ARB No. 51, Consolidated
      Financial Statements.” This interpretation addresses consolidation by business
      enterprises of entities in which equity investors do not have the
      characteristics of a controlling financial interest or do not have sufficient
      equity at risk for the entity to finance its activities without additional
      subordinated financial support from other parties. Variable interest entities
      are required to be consolidated by their primary beneficiaries if they do not
      effectively disperse risks among the parties involved. The primary beneficiary
      of a variable interest entity is the party that absorbs a majority of the
      entity’s expected losses or receives a majority of its expected residual
      returns. In December 2003, the FASB amended FIN 46, now known as FIN 46 Revised
      (“FIN 46R”). The requirements of FIN 46R are effective no later than the end of
      the first reporting period that ends after March 15, 2004. A company that has
      applied FIN 46 to an entity prior to the effective date of FIN 46R shall either
      continue to apply FIN 46 until the effective date of FIN 46R or apply FIN 46R
      at
      an earlier date. The adoption of this interpretation did not have an impact
      on
      our consolidated financial statements.





In
      May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error
      Corrections”, an amendment to Accounting Principles Bulletin Opinion
      No. 20, “Accounting Changes” (“APB No. 20”), and SFAS No. 3,
“Reporting Accounting Changes in Interim Financial Statements”. Though SFAS
      No. 154 carries forward the guidance in APB No.20 and SFAS No.3 with
      respect to accounting for changes in estimates, changes in reporting entity,
      and
      the correction of errors, SFAS No. 154 establishes new standards on
      accounting for changes in accounting principles, whereby all such changes must
      be accounted for by retrospective application to the financial statements of
      prior periods unless it is impracticable to do so. SFAS No. 154 is
      effective for accounting changes and error corrections made in fiscal years
      beginning after December 15, 2005, with early adoption permitted for
      changes and corrections made in years beginning after May 2005. The Company
      will implement SFAS No. 154 in 2006. We are currently evaluating the
      impact of this new standard but believe that it will not have a material
      impact on the Company’s consolidated financial position, results of operations,
      or cash flows.





In
      February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid
      Financial Instruments”, which amends SFAS No. 133, “Accounting for Derivatives
      Instruments and Hedging Activities” and SFAS No. 140, “Accounting for Transfers
      and Servicing of Financial Assets and Extinguishment of Liabilities”. SFAS No.
      155 amends SFAS No. 133 to narrow the scope exception for interest-only and
      principal-only strips on debt instruments to include only such strips
      representing rights to receive a specified portion of the contractual interest
      or principle cash flows. SFAS No. 155 also amends SFAS No. 140 to allow
      qualifying special-purpose entities to hold a passive. We are currently evaluating the impact this new Standard but believe that it will
      not
      have a material impact on the Company’s consolidated financial position, results
      of operations, or cash flows.





In
      March
      2005, the FASB issued FIN 47, “Accounting for Conditional Asset Retirement
      Obligations,” which is an interpretation of SFAS No. 143 (“SFAS 143”),
“Accounting for Asset Retirement Obligations.” FIN 47 clarifies terminology
      within SFAS 143 and requires an entity to recognize a liability for the fair
      value of a conditional asset retirement obligation when incurred if the
      liability’s fair value can be reasonably estimated. FIN 47 is effective for
      fiscal years ending after December 15, 2005. The adoption of FIN 47 did not
      have
      a material impact on our consolidated financial statements.





In
      June
      2005, the Emerging Issues Task Force (“EITF”) issued EITF Issue 05-6,
“Determining the Amortization Period for Leasehold Improvements Purchased after
      Lease Inception or Acquired in a Business Combination”. The EITF reached a
      consensus that the amortization period for leasehold improvements acquired
      in a
      business combination or acquired subsequent to lease inception should be based
      on the lesser of the useful life of the leasehold improvements or the period
      of
      the lease including all renewal periods that are reasonably assured of exercise
      at the time of the acquisition. This consensus is consistent with the Company’s
      policy regarding leasehold improvements and therefore its adoption did not
      have
      a material impact on the consolidated financial statements.




In
      October 2005, the FASB issued FASB Staff Position (“FSP”) No. FAS 13-1 (“FSP FAS
      13-1”), “Accounting for Rental Costs Incurred during Construction Period.” FSP
      FAS 13-1 clarifies the accounting for rental costs associated with operating
      leases that are incurred during a construction period. In addition, SFAS No.151
      requires that a lessee shall cease capitalizing rental costs as of the effective
      date of this FSP FAS 13-1 for operating lease arrangements entered into prior
      to
      the effective date of FSP FAS 13-1. FSP FAS 13-1 is effective for periods
      beginning after December 15, 2005. We do not expect the adoption of FSP FAS
      13-1 to have a material impact on our consolidated operating results or
      financial condition.





22





CRITICAL
      ACCOUNTING POLICIES





We
      prepare our consolidated financial statements in accordance with accounting
      principles generally accepted in the United States of America. Our significant
      accounting policies are discussed in Note 1 to the consolidated financial
      statements. Certain of these accounting policies as discussed below require
      management to make estimates and assumptions about future events that could
      materially affect the reported amounts of assets, liabilities, revenues and
      expenses and disclosure of contingent assets and liabilities. Our most critical
      estimate relates to projecting future cash flows used in assessing future store
      operating performance and testing long-lived assets for impairment.





We
      evaluate the carrying value of long-lived assets for impairment whenever events
      or changes in circumstances indicate that the carrying value of such assets
      may
      not be recoverable. This evaluation is performed based on the estimated
      undiscounted future cash flows from operating activities compared with the
      carrying value of the related asset. If the undiscounted future cash flows
      are
      less than the carrying value, an impairment loss is recognized, measured by
      the
      difference between the carrying value and the estimated fair value of the
      assets, with such estimated fair values determined using the best information
      available generally based on prices for similar assets for stores recently
      opened.





We
      are
      self-insured for medical insurance coverage. Our policy has maximum exposure
      limits. We maintain a liability for estimated claims based on historical claims
      experience and other actuarial assumptions.





Our
      inventories are valued at the lower of cost (first-in, first-out and weighted
      average method) or market. We continually evaluate our inventories by assessing
      slow moving current product as well as prior seasons' inventory. Market value
      of
      non-current inventory is estimated based on historical sales trends for this
      category of inventory, the impact of market trends, and an evaluation of
      economic conditions. The Company closely monitors its off-price sales to ensure
      the actual results closely match initial estimates. Estimates are regularly
      updated based upon this continuing review.





We
      account for income taxes using an asset and liability approach for measuring
      deferred income taxes based on temporary differences between the financial
      statement and income tax bases of assets and liabilities existing at each
      balance sheet date. A valuation allowance is established, when necessary, to
      reduce deferred income tax assets to the amount expected to be realized.





We
      make
      limited use of derivative instruments. On the date we enter into a derivative
      contract, management designates the derivative as a hedge for the identified
      exposure. We formally document all relationships between hedging instruments
      and
      hedged items, as well as the risk-management objective and strategy for entering
      into various hedge transactions. In this documentation, we identify the asset,
      liability, firm commitment, or forecasted transaction that has been designated
      as a hedged item and indicate how the hedging instrument is expected to hedge
      the risks related to the hedged item. We formally measure effectiveness of
      hedging relationships both at the hedge inception and on an ongoing basis in
      accordance with its risk management policy. We would discontinue hedge
      accounting prospectively if it is determined that the derivative is no longer
      effective in offsetting changes in the hedged item.





RISK
      FACTORS





Investors
      in the Company should consider the following risk factors as well as the other
      information contained herein.





CONTROL
      BY MAJORITY SHAREHOLDER, SMALL PUBLIC FLOAT, AND LOW TRADING VOLUME OF SHARES.
      Our Chairman of the Board, Fred Kayne, owns approximately 60% of Big Dogs
      outstanding common stock. In addition, over 70% of our shares are held by Mr.
      Kayne and other directors, officers or beneficial owners of more than 10%,
      none
      of whom have historically traded in the shares on any regular basis. As a
      result, Mr. Kayne, acting either individually or with the Company’s current
      directors and executive officers, will be able to control the election of
      directors, and to determine the outcome of any other matter submitted to a
      vote
      of our stockholders, including a change in control. While our shares are
      currently listed on the NASDAQ National Market System, the average daily trading
      volume, particularly in recent years, has been very low. Due to all the
      foregoing, and other factors, there has been and can expect to be significant
      illiquidity in our shares.





CONTINUED
      STORE CLOSURES. The Company continues to evaluate its current Big Dogs and
      TWC
      store portfolio for potential store closures. In 2005, the Company closed 15
      underperforming Big Dogs stores and in 2006 to date has closed 9 Big Dogs
      stores. We will continue to take a careful position in regard to long-term
      real
      estate commitments and may close additional stores if considered appropriate.





23





CHANGES
      IN CONSUMER PREFERENCES. The consumer products industry in general and the
      apparel industry in particular, are subject to changing consumer demands and
      preferences. Although we believe our Big Dogs and TWC products historically
      have
      not been significantly affected by fashion trends, its products are subject
      to
      changing consumer preferences. Big Dogs’ success will depend significantly on
      our ability to continue to produce popular graphics and products that
      anticipate, gauge and respond in a timely manner to changing consumer demands
      and preferences. We also continue to evaluate our introduction of more risqué
graphics in the Big Dogs line in recent years, and balance their sales against
      the risk of offending some customers. In addition, over the years general
      consumer preferences rise and decline in regard to the type of graphic and
      logo-oriented merchandise provided by Big Dogs, which can have an effect on
      our
      business.





FACTORS
      AFFECTING STORE TRAFFIC. Nearly all of our stores for both Big Dogs and TWC
      are
      located in malls. Accordingly our sales in such stores are, and will in the
      future continue to be, affected by the ability of such malls to continue to
      generate customer traffic. Big Dogs stores are located largely in outlet malls,
      with a majority of such malls we have selected being in tourist areas or
      tourist-serving areas where we think the customers will be attracted to Big
      Dogs
      merchandise. Outlet mall traffic appears to have declined overall in recent
      years. In addition, tourism, upon which a number of the outlet malls in which
      we
      have stores depend for traffic, may from time to time adversely be affected
      by
      such factors as economic downturns, adverse weather, war or international
      conflict, acts of terrorism or terrorism alerts, and increases in the cost
      of
      travel. In addition, customer traffic in both outlet malls and the regional
      malls in which TWC has stores is also affected by such factors as changing
      consumer preferences, opening of new malls in the area, the closing of
      high-profile stores in the mall and declines in the desirability of the shopping
      environment in a particular mall.





DEPENDENCE
      ON KEY PERSONNEL. Our success is significantly dependent on the performance
      of
      our key management, particularly Chief Executive Officer, Andrew Feshbach,
      Executive Vice President—Merchandising, Doug Nilsen, Executive Vice President -
      Business Affairs, General Counsel, Anthony Wall, Chief Financial Officer,
      Roberta Morris, Senior Vice President - Retail Operations, Lee Cox and Senior
      Vice President - Merchandising, Michael Grenley.





DEPENDENCE
      ON THIRD-PARTY AND FOREIGN MANUFACTURERS AND SUPPLIERS. We do not own or operate
      any manufacturing facilities and are therefore dependent on third parties for
      the manufacture and supply of our Big Dogs and TWC products. The loss of major
      suppliers or the failure of such suppliers to timely deliver our products or
      to
      meet our quality standards, could adversely affect our ability to deliver
      products to our customers in a timely manner. The majority of our Big Dogs
      products are purchased from trading companies with relationships with
      manufacturing facilities located outside the United States. Our operations
      could
      be adversely affected by events that result in disruption of trade from foreign
      countries in which our suppliers are located. Our staff or agents periodically
      visit and observe the operations of such foreign and domestic manufacturers,
      but
      we do not control such manufacturers or their labor practices. Therefore we
      cannot necessarily prevent legal or ethical violations by independent
      manufacturers of Big Dogs goods, and it is uncertain what impact such violations
      would have on us.





SUBSTANTIAL
      COMPETITION. The markets for each of our products are highly competitive. In
      regard to our Big Dogs apparel products, the increased consumer shift toward
      large mass-market and discount retailers has put substantial pricing and
      competitive pressure on apparel retailers in general. We believe Big Dogs’
long-term competitive position will depend upon our ability to anticipate and
      respond effectively to changing consumer demands and to offer customers a wide
      variety of high-quality, fun products at competitive prices.





RELIANCE
      ON INFORMATION SYSTEMS. We rely on various information systems to manage our
      operations and regularly make investments to upgrade, enhance or replace such
      systems. Substantial disruptions affecting our information systems could have
      an
      adverse effect on our business.





DEPENDENCE
      ON TRADEMARKS. We use a number of trademarks, the primary ones of which are
      registered with the United States Patent and Trademark Office and in a number
      of
      foreign countries. While we believe our trademark rights are strong, in our
      pursuit and defense of particular infringement claims it cannot be assured
      that
      we will always prevail. See “Business - Trademarks.”





24





FORWARD-LOOKING
      STATEMENTS





This
      Annual Report on Form 10-K contains forward-looking statements that involve
      risks and uncertainties. The statements contained in this Form 10-K that are
      not
      purely historical are forward-looking statements, including without limitation
      statements regarding our expectations, beliefs, intentions or strategies
      regarding the future. Such forward-looking statements include the discussions
      in
      this Management’s Discussion and Analysis of Financial Condition and Results of
      Operations regarding the seasonality of business, expected new store openings,
      integration of acquisition and costs and inflation risks. All forward-looking
      statements in this document are based upon information available to us on the
      date hereof, and we assume no obligation to update any such forward-looking
      statements.





ITEM
                7A.
            QUANTITATIVE
                AND QUALITATIVE DISCLOSURES ABOUT MARKET
                RISK





We
      do not
      believe we have material exposure to losses from market-rate sensitive
      instruments. We have not invested in derivative financial instruments. In the
      normal course of business, our financial position and results of operations
      are
      subject to market risk associated with interest rate movements on borrowings.
      Currently, our credit facilities contain a performance-pricing
      structured-interest charge based on excess availability levels and indexed
      based
      on Prime or LIBOR. Additionally, we have a term loan with an interest charge
      indexed based on Prime or LIBOR. We had $5,796,000 outstanding borrowings under
      these arrangements as of December 31, 2005. Based on these outstanding
      borrowings at December 31, 2005 and the current market condition, a one percent
      increase in the applicable interest rates would decrease our annual cash flow
      and pretax earnings by approximately $58,000. Conversely, a one percent decrease
      in the applicable interest rates would increase annual cash flow and pretax
      earnings by $58,000. Our market risk on interest rate movements will increase
      based on higher borrowing levels. See “Item 7. Management’s Discussion and
      Analysis of Financial Condition and Results of Operations—Liquidity and Capital
      Resources.”




ITEM
                8.
            FINANCIAL
                STATEMENTS AND SUPPLEMENTARY DATA





See
      “Index to Consolidated Financial Statements” at Item 15(a) for a listing of the
      consolidated financial statements filed as part of this report.





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





None.





ITEM
                9a.
            CONTROLS
                AND PROCEDURES




EVALUATION
        OF DISCLOSURE CONTROLS AND PROCEDURES .  Based
        on the evaluation of our management, including the Chief Executive Officer
        and
        Chief Financial Officer, we have concluded that our disclosure controls and
        procedures were effective as of December 31, 2005 to provide reasonable
        assurance that information we are required to disclose in reports that we
        file
        or submit under the Securities Exchange Act ("Act") is recorded, processed,
        summarized and reported within the time periods as defined under the Act. 
There has been no change in our internal controls over financial reporting
        that
        occurred during the quarter ended December 31, 2005 that has materially
        affected, or is reasonably likely to materially affect, the Company's internal
        controls over financial reporting.


ITEM
                9b.
            OTHER
                INFORMATION.





None.





25





ITEM
                10.
            DIRECTORS
                AND EXECUTIVE OFFICERS OF THE
                REGISTRANT





Other
      information with respect to this item is incorporated by reference from the
      registrant’s definitive proxy
      statement to be filed with the Commission not later than 120 days after the
      end
      of the registrant’s fiscal year.





EXECUTIVE
      OFFICERS OF THE REGISTRANT





Set
      forth
      below are the names, ages, titles and present and recent past positions of
      persons serving as our executive officers as of March 1, 2006:





NAME
            
            AGE
            
            POSITIONAndrew
                D. Feshbach
            
            45
            
            President,
                Chief Executive Officer and DirectorDouglas
                N. Nilsen
            
            57
            
            Executive
                Vice President - Merchandising (Big Dog USA)Anthony
                J. Wall
            
            50
            
            Executive
                Vice President - Business Affairs, General Counsel and SecretaryRoberta
                J. Morris
            
            46
            
            Chief
                Financial Officer, Treasurer and Assistant SecretaryLee
                M. Cox
            
            37
            
            Senior
                Vice President - Retail OperationsMichael
                Grenley
            
            48
            
            Senior
                Vice President-Merchandising (TWC)





ANDREW
      D.
      FESHBACH co-founded the Company in May 1992 and has served as President, Chief
      Executive Officer and as a director since that time. From 1990 until the
      present, he has served as a Vice President of Fortune Financial, a private
      merchant banking firm owned by the Company’s Chairman and majority stockholder,
      Fred Kayne. Mr. Feshbach has an M.B.A. from Harvard University.





DOUGLAS
      N. NILSEN has served as Executive Vice President—Merchandising for Big Dog USA
      for more than five years. From 1990 to September 1995, he served as Director
      of
      Merchandise at Walt Disney Attractions, Inc. for its U.S. theme parks and
      resorts, and in such capacity was responsible for merchandising all apparel
      and
      accessories. Mr. Nilsen has an M.B.A. from New York University.





ANTHONY
      J. WALL has served as Executive Vice President, General Counsel and Secretary
      of
      the Company for more than five years. Mr. Wall also serves as General Counsel
      of
      Fortune Fashions Industries LLC, a custom manufacturer of embellished apparel,
      Fortune Casuals, LLC, a manufacturer of casual apparel for the mass market,
      and
      Fortune Swimwear, a manufacturer of swimwear for the mass market, and a Vice
      President of Fortune Financial, all of which are controlled by Fred
      Kayne.





ROBERTA
      J. MORRIS has served as Chief Financial Officer since March 1998, having
      previously served as Senior Vice President—Finance since January 1995. Prior to
      joining the Company in 1993, Ms. Morris was employed as a Senior Audit Manager
      with Deloitte & Touche LLP. Ms. Morris is a certified public accountant.





LEE
      M.
      COX joined the Company in September 2000 and has served as Senior Vice President
      - Retail since February 2001. From 1994 until September 2000, Mr. Cox was
      employed by Adidas Retail, Inc. in various capacities, most recently as Director
      of Retail Stores.





MICHAEL
      GRENLEY joined the Company in March 2004 and serves as Senior Vice President
      -
      Merchandising for TWC. From 1994 until the Company’s acquisition of The Walking
      Company, Mr. Grenley served as Executive Vice President - Merchandise and
      Chief Operations Officer for the previous The Walking Company. Prior
      to The Walking Company, Mr. Grenley was a Vice President of Merchandise at
      Macy's California.





The
      members of the Audit Committee of the Board of Directors are Steven Good
      (Chairman), David Walsh and Skip Coomber. Our Board, in its judgment, has
      determined that Mr. Good meets the Securities and Exchange Commission’s
      definition of audit committee financial expert and has designated him as such.
      Our Board has further determined that Messrs. Good, Walsh and Coomber are
      independent as such term is used under Schedule 14A of the Securities Exchange
      Act of 1934.





26





We
      have
      adopted a code of ethics for our principal executive officer and senior
      financial officers. Copies of the code of ethics are available by writing to
      Big
      Dog Holdings, Inc., Attention General Counsel, 121 Gray Ave., Santa Barbara,
      CA
      93101. Should any changes to or waivers of this code of ethics be made, such
      changes to or waivers will be timely disclosed on the Company’s website, unless
      the same is disclosed in a current report on Form 8-K filed with the Securities
      Exchange Commission.





ITEM
                11.
            EXECUTIVE
                COMPENSATION





Information
      with respect to this item is incorporated by reference from the registrant’s
      definitive proxy statement to be filed with the Commission not later than 120
      days after the end of the registrant’s fiscal year.





ITEM
                12.
            SECURITY
                OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
                MANAGEMENT





Information
      with respect to this item is incorporated by reference from the registrant’s
      definitive proxy statement to be filed with the Commission not later than 120
      days after the end of the registrant’s fiscal year.





ITEM
                13.
            CERTAIN
                RELATIONSHIPS AND RELATED
                TRANSACTIONS





Information
      with respect to this item is incorporated by reference from the registrant’s
      definitive proxy statement to be filed with the Commission not later than 120
      days after the end of the registrant’s fiscal year.





ITEM
                14.
            PRINCIPAL
                ACCOUNTING FEES AND SERVICES





The
      information required by Item 14 of Part III is incorporated by reference from
      the Proxy Statement of Big Dog Holdings, Inc., relating to the 2005 Annual
      Meeting of Stockholders, to be filed with the SEC within 120 days of the fiscal
      2005 year end.





PART
      IV





ITEM
                15.
            EXHIBITS,
                FINANCIAL STATEMENT SCHEDULES.





(a)
            1.
            The
                financial statements listed in the “Index to Consolidated Financial
                Statements” at page F-1 are filed as a part of this
                report.





2.
            Schedule
                II - Valuation and Qualifying
                Accounts




**SCHEDULE
        II**
 **VALUATION
        AND QUALIFYING ACCOUNTS**
 **FOR
        THE YEARS ENDED DECEMBER 31, 2003, 2004 AND 2005**
 
 Balance
                  at Beginning of Year
              
              Additions
                  Charged to Costs and Expense
              
              Write-offs,
                  Net of Recoveries
              
              Balance
                  at End of YearYear
                  ended December 31, 2003Reserves
                  and allowances deducted from asset accounts:Allowance
                  for uncollectible accounts receivable
              
              $
              201,000
              
              $
              (25,000
              )
              $
              (80,000
              )
              $
              96,000Year
                  ended December 31, 2004Reserves
                  and allowances deducted from asset accounts:Allowance
                  for uncollectible accounts receivable
              
              $
              96,000
              
              $
              87,000
              
              $
              (180,000
              )
              $
              3,000Year
                  ended December 31, 2005Reserves
                  and allowances deducted from asset accounts:Allowance
                  for uncollectible accounts receivable
              
              $
              3,000
              
              $
              1,000
              
              $
              (2,000
              )
              $
              2,000


Schedules
      other than that referred to above have been omitted because they are not
      applicable or are not required under the instructions contained in Regulation
      S-X or because the information is included elsewhere in the Consolidated
      Financial Statements or the Notes thereto.





3.
            Exhibits
                included or incorporated herein:


See
      “Index to Exhibits.”





(b)
            Reports
                on Form 8-K.


On
      November 7, 2005 the Company filed a Form 8-K to disclose third quarter
      financial results.





27





SIGNATURES





Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
      1934, the Registrant has duly caused this report to be signed on March 31,
      2006
      on its behalf by the undersigned, thereunto duly authorized.





BIG
                DOG HOLDINGS, INC.By
            /s/ANDREW
                D. FESHBACHAndrew
                D. FeshbachChief
                Executive Officer and President





Each
      person whose signature appears below hereby authorizes Andrew D. Feshbach and
      Anthony J. Wall or either of them, as attorneys-in-fact to sign on his behalf,
      individually, and in each capacity stated below and to file all amendments
      and/or supplements to the Annual Report on Form 10-K.





Pursuant
      to the requirements of the Securities Exchange Act of 1934, this report has
      been
      signed below by the following persons on behalf of the Registrant and in the
      capacities and on the dates indicated.





**SIGNATURE**
            
            **TITLE**
            
            **DATE**/s/ANDREW
                D. FESHBACH
            
            
            Chief
                Executive Officer, President and
            
            March
                31, 2006Andrew
                D. Feshbach
            
            Director
                (Principal Executive Officer)________________________/s/ROBERTA
                J. MORRIS
            
            
            Chief
                Financial Officer, Treasurer and
            
            March
                31, 2006Roberta
                J. Morris
            
            Assistant
                Secretary(Principal
              Financial
              and Accounting Officer)/s/FRED
                KAYNE
            
            
            Chairman
                of the Board
            
            March
                31, 2006Fred
                Kayne/s/SKIP
                R. COOMBER, III
            
            
            Director
            
            March
                31, 2006Skip
                R. Coomber, III/s/STEVEN
                C. GOOD
            
            
            Director
            
            March
                31, 2006Steven
                C. Good/s/ROBERT
                H. SCHNELL
            
            
            Director
            
            March
                31, 2006Robert
                H. Schnell/s/DAVID
                J. WALSH
            
            
            Director
            
            March
                31, 2006David
                J. Walsh




28





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





INDEX
      TO
      CONSOLIDATED FINANCIAL STATEMENTS





YEARS
      ENDED DECEMBER 31, 2005, 2004, and 2003








PAGEReport
                of Independent Registered Public Accounting Firm
            F-2Report
                of Independent Registered Public Accounting Firm
            F-3Consolidated
                Balance Sheets as of December 31, 2005 and 2004
            F-4Consolidated
                Statements of Income for the years ended December 31, 2005, 2004,
                and
                2003
            F-5Consolidated
                Statements of Stockholders’ Equity for the years ended December 31, 2005,
                2004, and 2003
            F-6Consolidated
                Statements of Cash Flows for the years ended December 31, 2005, 2004,
                and
                2003
            F-7Notes
                to the Consolidated Financial Statements
            F-9




F-1





REPORT
      OF
      INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM








To
      the
      Board of Directors


Big
      Dog
      Holdings, Inc. and subsidiaries


Santa
      Barbara, CA





We
      have
      audited the consolidated balance sheets of Big Dog Holdings, Inc. and
      subsidiaries (collectively, the “Company”) as of December 31, 2005 and 2004, and
      the related consolidated statements of income, stockholders’ equity and cash
      flows for each of the two years in the period ended December 31, 2005. Our
      audits also included the financial statement schedule of the Company, listed
      in
      Item 15(a). These financial statements and financial statement schedule are
      the
      responsibility of the Company's management. Our responsibility is to express
      an
      opinion on these financial statements based on our audits.





We
      conducted our audits in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement. An audit includes examining,
      on a
      test basis, evidence supporting the amounts and disclosures in the financial
      statements. An audit also includes assessing the accounting principles used
      and
      significant estimates made by management, as well as evaluating the overall
      financial statement presentation. We believe that our audits provided a
      reasonable basis for our opinion.





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the financial position of the Company as of December
      31, 2005 and 2004, and the results of their operations and their cash flows
      for
      each of the two years in the period ended December 31, 2005, in conformity
      with
      U.S. generally accepted accounting principles. Also, in our opinion, the related
      financial statement schedule, when considered in relation to the basic
      consolidated financial statements, taken as a whole, present fairly in all
      material respects the information set forth therein.





SINGER
      LEWAK GREENBAUM & GOLDSTEIN LLP








Los
      Angeles, CA


March
      3,
      2006





F-2





REPORT
      OF
      INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To
      the
      Board of Directors and Stockholders of Big Dog Holdings, Inc.:





We
      have
      audited the accompanying consolidated statements of income, stockholders'
      equity, and cash flows of Big Dog Holdings, Inc. and subsidiaries (the
“Company”) for the year ended December 31, 2003. Our audit also included the
      financial statement schedule listed in the Index at Item 15(a) for the year
      ended December 31, 2003. These consolidated financial statements and the
      financial statement schedule are the responsibility of the Company's
      management. Our responsibility is to express an opinion on these financial
      statements and the financial statement schedule based on our audit.





We
      conducted our audit in accordance with the standards of the Public Company
      Accounting Oversight Board (United States).  Those standards require that
      we plan and perform the audit to obtain reasonable assurance about whether
      the
      financial statements are free of material misstatement.  The Company is not
      required to have, nor were we engaged to perform, an audit of its internal
      control over financial reporting.  Our audit included consideration of
      internal control over financial reporting as a basis for designing audit
      procedures that are appropriate in the circumstances, but not for the purpose
      of
      expressing an opinion on the effectiveness of the Company’s internal control
      over financial reporting.  Accordingly, we express no such
      opinion *.* An
      audit also includes examining, on a test basis, evidence supporting the amounts
      and disclosures in the financial statements, assessing the accounting principles
      used and significant estimates made by management, as well as evaluating the
      overall financial statement presentation.  We believe that our audit
      provides a reasonable basis for our opinion.





In
      our
      opinion, such consolidated financial statements present fairly, in all material
      respects, the results of operations and cash flows of Big Dog Holdings, Inc.
      and
      subsidiaries for the year ended December 31, 2003 in conformity with accounting
      principles generally accepted in the United States of America. Also, in our
      opinion, such financial statement schedule, when considered in relation to
      the
      basic consolidated financial statements taken as a whole, presents fairly in
      all
      material respects the information set forth therein.





DELOITTE
      & TOUCHE LLP





Los
      Angeles, California


March
      23,
      2004





F-3





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





CONSOLIDATED
      BALANCE SHEETS (Note 5)





DECEMBER
                31,2005
            
            2004ASSETSCURRENT
                ASSETS:Cash
                and cash equivalents
            
            $
            3,530,000
            
            $
            4,670,000Receivables,
                net
            
            
            894,000
            
            
            411,000Inventories
                (Note 12)
            
            
            44,518,000
            
            
            39,581,000Prepaid
                expenses and other current assets
            
            
            1,046,000
            
            
            928,000Deferred
                income taxes (Note 7)
            
            
            1,681,000
            
            
            1,691,000Total
                current assets
            
            
            51,669,000
            
            
            47,281,000PROPERTY
                AND EQUIPMENT, net (Note 2)
            
            
            11,931,000
            
            
            9,956,000INTANGIBLE
                ASSETS, net (Notes 1 and 4)
            
            
            4,473,000
            
            
            172,000GOODWILL
                (Note 4)
            
            
            3,131,000
            
            
            ---DEFERRED
                INCOME TAXES (Note 7)
            
            
            1,187,000
            
            
            1,042,000OTHER
                ASSETS
            
            
            362,000
            
            
            380,000TOTAL
            
            $
            72,573,000
            
            $
            58,831,000LIABILITIES
                AND STOCKHOLDERS' EQUITYCURRENT
                LIABILITIES:Short-term
                borrowings (Note 5)
            
            $
            2,796,000
            
            $
            304,000Current
                portion of long-term debt (Note 6)
            
            
            1,775,000
            
            
            243,000Accounts
                payable
            
            
            7,478,000
            
            
            5,033,000Income
                taxes payable (Note 7)
            
            
            1,367,000
            
            
            2,643,000Accrued
                expenses and other current liabilities (Note 3)
            
            
            6,614,000
            
            
            6,331,000Total
                current liabilities
            
            
            20,030,000
            
            
            14,554,000NOTE
                PAYABLE (Note 6)
            
            
            4,565,000
            
            
            289,000CAPITAL
                LEASE OBLIGATIONS (Note 8)
            
            
            47,000
            
            
            256,000DEFERRED
                RENT AND LEASE INCENTIVES (Note 8)
            
            
            1,468,000
            
            
            943,000DEFERRED
                GAIN ON SALE-LEASEBACK (Note 2)
            
            
            195,000
            
            
            248,000Total
                liabilities
            
            
            26,305,000
            
            
            16,290,000COMMITMENTS
                AND CONTINGENCIES (Notes 5 and 8)STOCKHOLDERS'
                EQUITY (Note 9):Preferred
                stock, $.01 par value, 3,000,000 shares authorized, none issued and
                outstanding
            
            $
            ---
            
            $
            ---Common
                stock $.01 par value, 30,000,000 shares authorized, 10,784,280 and
                10,709,030 shares issued at December 31, 2005 and 2004,
                respectively
            
            
            108,000
            
            
            107,000Additional
                paid-in capital
            
            
            25,914,000
            
            
            25,513,000Retained
                earnings
            
            
            29,872,000
            
            
            25,149,000Treasury
                stock, 1,710,598 and 1,529,998 shares at December 31, 2005 and 2004,
                respectively
            
            
            (9,446,000
            )
            
            (8,228,000
            )Total
                stockholders' equity
            
            
            46,448,000
            
            
            42,541,000TOTAL
            
            $
            72,753,000
            
            $
            58,831,000








See
      notes
      to consolidated financial statements.





F-4





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





CONSOLIDATED
      STATEMENTS OF INCOME





YEARS
                ENDED DECEMBER 31,2005
            
            2004
            
            2003NET
                SALES
            
            $
            179,115,000
            
            $
            161,358,000
            
            $
            103,757,000COST
                OF GOODS SOLD (Note 12)
            
            
            80,311,000
            
            
            72,733,000
            
            
            45,025,000GROSS
                PROFIT
            
            
            98,804,000
            
            
            88,625,000
            
            
            58,732,000OPERATING
                EXPENSES:Selling,
                marketing and distribution
            
            
            80,624,000
            
            
            73,956,000
            
            
            49,089,000General
                and administrative
            
            
            9,631,000
            
            
            8,060,000
            
            
            5,199,000Total
                operating expenses
            
            
            90,255,000
            
            
            82,016,000
            
            
            54,288,000INCOME
                FROM OPERATIONS
            
            
            8,549,000
            
            
            6,609,000
            
            
            4,444,000OTHER
                INCOME (Note 5)
            
            
            ---
            
            
            (82,000
            )
            
            ---INTEREST
                INCOME
            
            
            (44,000
            )
            
            (26,000
            )
            
            (2,000
            )INTEREST
                EXPENSE (Note 5 and 6)
            
            
            976,000
            
            
            857,000
            
            
            320,000INCOME
                BEFORE PROVISION FOR INCOME TAXES
            
            
            7,617,000
            
            
            5,860,000
            
            
            4,126,000PROVISION
                FOR INCOME TAXES (Note 7)
            
            
            2,894,000
            
            
            2,172,000
            
            
            1,489,000NET
                INCOME
            
            $
            4,723,000
            
            $
            3,688,000
            
            $
            2,637,000NET
                INCOME PER SHAREBASIC
            
            $
            0.52
            
            $
            0.42
            
            $
            0.32DILUTED
            
            $
            0.49
            
            $
            0.40
            
            $
            0.32








See
      notes
      to consolidated financial statements.





F-5





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS' EQUITY





ADDITIONALCOMMON
                STOCK
            
            PAID-IN
            
            RETAINED
            
            TREASURY
                STOCKSHARES
            
            AMOUNT
            
            CAPITAL
            
            EARNINGS
            
            SHARES
            
            AMOUNT
            
            TOTALBALANCE,
              JANUARY
                1, 2003
            
            
            9,698,284
            
            $
            97,000
            
            $
            20,510,000
            
            $
            18,824,000
            
            
            1,305,636
            
            $
            (7,448,000
            )
            $
            31,983,000Repurchased
                common stock (Note 9)
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            149,516
            
            
            (406,000
            )
            
            (406,000
            )Net
                income
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            2,637,000
            
            
            ---
            
            
            ---
            
            
            2,637,000BALANCE,
              DECEMBER
                31, 2003
            
            
            9,698,284
            
            
            97,000
            
            
            20,510,000
            
            
            21,461,000
            
            
            1,455,152
            
            
            (7,854,000
            )
            
            34,214,000Repurchased
                common stock (Note 9)
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            74,846
            
            
            (374,000
            )
            
            (374,000
            )Warrants
                exercised (Note 6)
            
            
            993,146
            
            
            10,000
            
            
            4,922,000
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            4,932,000Options
                exercised
            
            
            17,600
            
            
            ---
            
            
            63,000
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            63,000Tax
                benefits related to exercise of stock options (Notes 7 and
                9)
            
            
            ---
            
            
            ---
            
            
            18,000
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            18,000Net
                income
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            3,688,000
            
            
            ---
            
            
            ---
            
            
            3,688,000BALANCE,
              DECEMBER
                31, 2004
            
            
            10,709,030
            
            
            107,000
            
            
            25,513,000
            
            
            25,149,000
            
            
            1,529,998
            
            
            (8,228,000
            )
            
            42,541,000Repurchased
                common stock (Note 9)
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            180,600
            
            
            (1,218,000
            )
            
            (1,218,000
            )Options
                exercised
            
            
            75,250
            
            
            1,000
            
            
            322,000
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            323,000Tax
                benefits related to exercise of stock options (Notes 7 and
                9)
            
            
            ---
            
            
            ---
            
            
            79,000
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            79,000Net
                income
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            4,723,000
            
            
            ---
            
            
            ---
            
            
            4,723,000BALANCE,
              DECEMBER
                31, 2005
            
            
            10,784,280
            
            $
            108,000
            
            $
            25,914,000
            
            $
            29,872,000
            
            
            1,710,598
            
            $
            (9,446,000
            )
            $
            46,448,000








See
      notes
      to consolidated financial statements.





F-6





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





CONSOLIDATED
      STATEMENTS OF CASH FLOWS





YEARS
                ENDED DECEMBER 31,2005
            
            2004
            
            2003CASH
                FLOWS FROM OPERATING ACTIVITIES:Net
                income
            
            $
            4,723,000
            
            $
            3,688,000
            
            $
            2,637,000Adjustments
                to reconcile net income to net cash provided by operating
                activities:Depreciation
                and amortization
            
            
            4,173,000
            
            
            3,666,000
            
            
            2,075,000Compensation
                expense
            
            
            ---
            
            
            328,000
            
            
            ---Gain
                on early extinguishment of notes payable
            
            
            ---
            
            
            (82,000
            )
            
            ---Amortization
                of deferred financing fees
            
            
            168,000
            
            
            273,000
            
            
            151,000Provision
                for losses on receivables
            
            
            2,000
            
            
            87,000
            
            
            (25,000
            )Loss
                on disposition of property and equipment
            
            
            39,000
            
            
            51,000
            
            
            2,000Write-off
                of impaired asset - fixed assets
            
            
            ---
            
            
            ---
            
            
            50,000Deferred
                income taxes
            
            
            (135,000
            )
            
            (912,000
            )
            
            139,000Tax
                benefit of stock option exercises
            
            
            79,000
            
            
            18,000
            
            
            ---Changes
                in operating assets and liabilities:Receivables
            
            
            (485,000
            )
            
            (381,000
            )
            
            368,000Inventories
            
            
            (2,843,000
            )
            
            (2,075,000
            )
            
            56,000Prepaid
                expenses and other current assets
            
            
            (176,000
            )
            
            1,635,000
            
            
            (332,000
            )Accounts
                payable
            
            
            2,301,000
            
            
            1,308,000
            
            
            (3,000
            )Income
                taxes payable
            
            
            (1,275,000
            )
            
            1,130,000
            
            
            958,000Accrued
                expenses and other current liabilities
            
            
            284,000
            
            
            (2,700,000
            )
            
            (143,000
            )Deferred
                rent and lease incentives
            
            
            526,000
            
            
            337,000
            
            
            (87,000
            )Deferred
                gain on sale-leaseback
            
            
            (53,000
            )
            
            (53,000
            )
            
            (53,000
            )Net
                cash provided by operating activities
            
            
            7,328,000
            
            
            6,318,000
            
            
            5,793,000CASH
                FLOWS FROM INVESTING ACTIVITIES:Capital
                expenditures
            
            
            (5,446,000
            )
            
            (1,886,000
            )
            
            (1,044,000
            )Acquisition
                of The Walking Company, net of cash acquired
            
            
            ---
            
            
            (1,577,000
            )
            
            ---Acquisition
                of Footworks, net of cash acquired
            
            
            (4,122,000
            )
            
            ---
            
            
            ---Proceeds
                from sale of property and equipment
            
            
            1,000
            
            
            ---
            
            
            ---Other
            
            
            (26,000
            )
            
            ---
            
            
            11,000Net
                cash used in investing activities
            
            
            (9,593,000
            )
            
            (3,463,000
            )
            
            (1,033,000
            )CASH
                FLOWS FROM FINANCING ACTIVITIES:Net
                borrowings under line of credit agreement
            
            
            2,491,000
            
            
            (7,634,000
            )
            
            ---Repayment
                of redeemable convertible notes and rights
            
            
            ---
            
            
            (363,000
            )
            
            ---Repurchase
                of common stock
            
            
            (1,218,000
            )
            
            (374,000
            )
            
            (406,000
            )Payment
                of deferred financing fees
            
            
            (70,000
            )
            
            (175,000
            )
            
            (45,000
            )Exercise
                of stock options
            
            
            322,000
            
            
            63,000
            
            
            ---Repayment
                of capital lease obligations
            
            
            (220,000
            )
            
            (166,000
            )
            
            ---Repayment
                of notes payable
            
            
            (180,000
            )
            
            (39,000
            )
            
            ---Net
                cash provided by (used in) financing activities
            
            
            1,125,000
            
            
            (8,688,000
            )
            
            (451,000
            )NET
                (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS
            
            
            (1,140,000
            )
            
            (5,833,000
            )
            
            4,309,000CASH
                AND CASH EQUIVALENTS, BEGINNING OF YEAR
            
            
            4,670,000
            
            
            10,503,000
            
            
            6,194,000CASH
                AND CASH EQUIVALENTS, END OF YEAR
            
            $
            3,530,000
            
            $
            4,670,000
            
            $
            10,503,000SUPPLEMENTAL
                DISCLOSURES OF CASH FLOW INFORMATION:Cash
                paid for:Interest
            
            $
            841,000
            
            $
            545,000
            
            $
            172,000Income
                taxes
            
            $
            4,305,000
            
            $
            1,954,000
            
            $
            392,000








See
      notes
      to consolidated financial statements.





F-7





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





CONSOLIDATED
      STATEMENTS OF CASH FLOWS





SUPPLEMENTAL
                INFORMATION ON NON-CASH INVESTING AND FINANCING
                ACTIVITIES:2005
            
            2004ACQUISITION
                OF FOOTWORKS:Inventories
            
            $
            1,951,000Properties
            
            
            508,000Intangibles
            
            
            4,532,000Goodwill
            
            
            3,131,000Notes
                payable
            
            
            (6,000,000
            )Net
                cash effect due to acquisition of net assets of Footworks
            
            $
            4,122,000ACQUISITION
                OF THE WALKING COMPANY:Working
                capital, other than cash
            
            
            
            
            $
            (4,000
            )Properties
            
            
            
            
            
            7,260,000Redeemable
                convertible notes and rights assumed
            
            
            
            
            
            (4,998,000
            )Notes
                payable
            
            
            
            
            
            (681,000
            )Net
                cash effect due to acquisition of net assets of The Walking
                Company
            
            
            
            
            $
            1,577,000REDEMPTION
                OF NOTES AND RIGHTS:Redeemable
                convertible notes and rights assumed
            
            
            
            
            $
            4,998,000Expiration
                of warrants
            
            
            
            
            
            328,000Accrued
                interest
            
            
            
            
            
            75,000Amortization
                of premium on convertible notes
            
            
            
            
            
            (24,000
            )Gain
                on early extinguishment of debt
            
            
            
            
            
            (82,000
            )Issuance
                of 993,146 shares of common stock
            
            
            
            
            
            (4,932,000
            )Net
                cash effect due to redemption of notes and rights
            
            
            
            
            $
            363,000OTHER:Capital
                leases
            
            $
            ---
            
            $
            383,000








See
      notes
      to consolidated financial statements.





F-8





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS





1.
      SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





*ORGANIZATION
      AND BUSINESS*





The
      consolidated financial statements include the accounts of Big Dog Holdings,
      Inc.
      and its subsidiaries (the "Company"). All significant intercompany accounts
      and
      transactions have been eliminated.





The
      Company principally develops and markets apparel and other consumer products
      through Company-operated retail stores, corporate sales accounts, catalog and
      Internet website.





*CASH
      AND CASH EQUIVALENTS*





The
      Company considers all highly liquid investments with a maturity of less than
      three months when purchased to be cash equivalents.




*INVENTORIES*





Inventories,
      consisting substantially of finished goods, are stated at the lower of cost
      (first-in, first-out method) or market.





*PROPERTY
      AND EQUIPMENT*





Property
      and equipment are stated at cost, less accumulated depreciation. Depreciation
      and amortization of property and equipment are provided using the straight-line
      method over the following useful lives:





Store
                fixtures
            
            
            5
                yearsMachinery
                and equipment
            
            
            5
                yearsComputer
                equipment
            
            
            3
                yearsSoftware
            
            
            5
                years





Leasehold
      improvements are depreciated over the lesser of the estimated useful life of
      the
      asset or the term of the lease, whichever is shorter.





*IMPAIRMENT
      OF LONG-LIVED ASSETS*





The
      Company evaluates the carrying value of long-lived assets for impairment
      whenever events or changes in circumstances indicate that the carrying value
      of
      such assets may not be recoverable. This evaluation is performed based on the
      estimated undiscounted future cash flows from operating activities compared
      with
      the carrying value of the related asset. If the undiscounted future cash flows
      are less than the carrying value, an impairment loss is recognized, measured
      by
      the difference between the carrying value and the estimated fair value of the
      assets, with such estimated fair values determined using the best information
      available generally based on prices for similar assets for stores recently
      opened. The Company’s evaluation for the years ended 2005 and 2004, which
      included all retail locations, indicated that no asset impairment existed and
      therefore no write-down of assets was recorded. The Company’s evaluation for
      year ended 2003, which included all retail locations, indicated that operating
      losses existed for certain retail locations with a projection that the operating
      losses for these retail locations will continue. As such, the Company recorded
      a
      write-down of leasehold improvements for certain retail stores which
      approximated $50,000 for 2003. Such costs are included in selling, marketing
      and
      distribution expenses in the consolidated statements of income.





F-9





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS (continued)





1.
      SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)





*GOODWILL
      AND OTHER INTANGIBLE ASSETS*





*Indefinite
      Lived Intangibles*





The
      Company accounts for indefinite lived intangible assets in accordance with
      Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other
      Intangible Assets. The Company tests trademarks and goodwill for impairment
      at
      least annually and more often as circumstances require. The Company’s evaluation
      for the year ended 2004 indicated that the trademark for its Lifeforms brand
      was
      impaired. As such, the Company recorded a $45,000 write-down of this asset
      in
      2004. Such costs are included in general and administrative expenses in the
      consolidated statements of income. Management did not believe any impairment
      of
      its trademark related intangible assets existed at December 31, 2005 and 2004,
      respectively. As of December 31, 2005 and 2004, net trademarks totaled $298,000
      and $172,000, respectively. In 2005, the Company recorded $3,131,000 of goodwill
      in conjunction with the Footworks acquisition (see Note 4).





*Leasehold
      Intangible Assets*





In
      conjunction with the Footworks acquisition in 2005 (see Note 4), the Company
      acquired lease related intangible assets valued at $4,408,000, which are being
      amortized over the life of the related leases. Accumulated amortization was
      $233,000 at December 31, 2005.





The
      estimate of aggregate amortization expense for the subsequent years is as
      follows:





FOR
                THE YEARS ENDED DECEMBER 31,2006
            
            $
            350,0002007
            
            
            437,0002008
            
            
            437,0002009
            
            
            439,0002010
            
            
            436,000Thereafter
            
            
            2,076,000$
            4,175,000





*DERIVATIVE
      INSTRUMENTS AND HEDGING ACTIVITY*





The
      Company makes limited use of derivative instruments. On the date the Company
      enters into a derivative contract, management designates the derivative as
      a
      hedge for the identified exposure. The Company formally documents all
      relationships between hedging instruments and hedged items, as well as the
      risk-management objective and strategy for entering into various hedge
      transactions. In this documentation, the Company identifies the asset,
      liability, firm commitment, or forecasted transaction that has been designated
      as a hedged item and indicates how the hedging instrument is expected to hedge
      the risks related to the hedged item. The Company formally measures
      effectiveness of its hedging relationships both at the hedge inception and
      on an
      ongoing basis in accordance with its risk management policy. The Company would
      discontinue hedge accounting prospectively if it is determined that the
      derivative is no longer effective in offsetting changes in the hedged item.





F-10





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS (continued)





1.
      SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)





*REVENUE
      RECOGNITION*





Substantially
      all of the Company's revenues are generated by its retail operations, which
      are
      recognized at the time of sale.  The Company also generates revenues
      through its corporate sales, Internet and mail order catalog operations, which
      are recognized at the time of shipment. Outbound shipping charges billed to
      customers are included in net sales when the products are shipped for corporate
      sales, Internet and mail order catalog sales. The Company records an allowance
      for estimated returns in the period of sale based on prior
      experience.





*INCOME
      STATEMENT COMPONENTS*





Cost
      of
      goods sold consists of the cost of the product and related overhead costs
      related to the product, including purchasing, inbound freight charges, warehouse
      receiving costs, quality control inspection costs, internal product development
      costs and shipping and other handling costs to our stores or
      customers.





Selling,
      marketing and distribution expenses consist of expenses associated with
      creating, distributing, and selling products through all channels of
      distribution, including occupancy, payroll and catalog costs. The distribution
      costs included in selling, marketing and distribution expense were $3,314,000,
      $3,147,000 and $2,505,000 for the years ended December 31, 2005, 2004 and 2003,
      respectively.





General
      and administrative expenses consist of administrative salaries, corporate
      occupancy costs and other corporate expenses.





*STORE
      PREOPENING EXPENSES*





The
      Company expenses store pre-opening costs as incurred, which totaled $236,000,
      $87,000 and $87,000 in 2005, 2004 and 2003, respectively.





*ADVERTISING
      COSTS*





Costs
      associated with the production of our mail order catalogs are capitalized and
      expensed over the expected revenue stream following the mailing of the
      respective catalog, generally three months. All other advertising costs are
      expensed as incurred. Advertising expense charged to operations for the years
      ended December 31, 2005, 2004 and 2003 was $1,389,000, $1,254,000 and $931,000,
      respectively. Capitalized advertising costs related to our mail order catalogs
      were $227,000 and $113,000 as of December 31, 2005 and 2004, respectively,
      and
      are included in prepaid expenses and other current assets on the consolidated
      balance sheets.





*DEFERRED
      RENT AND LEASE INCENTIVES*





When
      a
      lease includes lease incentives (such as a rent holiday or reimbursement of
      certain lessee construction costs) or requires fixed escalations of the minimum
      lease payments, rental expense is recognized on a straight-line basis over
      the
      initial term of the lease and the difference between the average rental amount
      charged to expense and amounts payable under the lease is included in deferred
      rent and lease incentives in the accompanying consolidated balance sheets.





F-11





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS (continued)





1.
      SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)





*INCOME
      TAXES*





The
      Company accounts for income taxes using an asset and liability approach for
      measuring deferred income taxes based on temporary differences between the
      financial statement and income tax bases of assets and liabilities existing
      at
      each balance sheet date. A valuation allowance is established, when necessary,
      to reduce deferred income tax assets to the amount expected to be realized.





*EARNINGS
      PER SHARE*





Basic
      earnings per share is calculated based on the weighted average number of shares
      outstanding. Diluted earnings per share is calculated based on the same number
      of shares plus additional shares representing stock distributable under
      stock-based plans computed using the treasury stock method.





The
      following reconciles the numerator and denominator of the basic and diluted
      per-share computations for net income:





YEARS
                ENDED DECEMBER 31,2005
            
            2004
            
            2003Net
                income
            
            $
            4,723,000
            
            $
            3,688,000
            
            $
            2,637,000Basic
                Weighted Average Shares:Weighted
                average number of shares outstanding
            
            
            9,145,000
            
            
            8,722,000
            
            
            8,307,000Effect
                of Dilutive Securities:Options
                and warrants
            
            
            581,000
            
            
            452,000
            
            
            ---Diluted
                Weighted Average Shares:Weighted
                average number of shares outstanding and Common share
                equivalents
            
            
            9,726,000
            
            
            9,174,000
            
            
            8,307,000Antidilutive
                options and warrants
            
            
            230,000
            
            
            566,000
            
            
            1,744,000





Antidilutive
      options and warrants consist of the weighted average of stock options and
      warrants for the respective years that had an exercise price greater than the
      average market price during the year. Such options and warrants are therefore
      excluded from the computation of diluted shares.





*ACCOUNTING
      FOR STOCK-BASED COMPENSATION*





SFAS
      No.
      123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148,
      Accounting for Stock-Based Compensation, requires companies to estimate employee
      stock compensation expense based on the fair value method of accounting.
      However, the statement allows the alternative of continued use of the intrinsic
      value method described in Accounting Principles Board (“APB”) Opinion No. 25,
      Accounting for Stock Issued to Employees, if pro forma disclosure of fair value
      amounts is provided. The Company has elected the alternative of continued use
      of
      APB Opinion No. 25.





F-12





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS (continued)





1.
      SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)





*ACCOUNTING
      FOR STOCK-BASED COMPENSATION (continued)*





Had
      compensation cost for the Company’s stock option plan been determined based on
      their fair value at the grant date for options granted in 2005, 2004 and 2003
      consistent with the provisions of SFAS No. 123, the Company’s net income and net
      income per share would have been adjusted to the pro forma amounts indicated
      below:





YEARS
                ENDED DECEMBER 31,2005
            
            2004
            
            2003Net
                income:As
                reported
            
            $
            4,723,000
            
            $
            3,688,000
            
            $
            2,637,000Add:  Stock-based
                employee compensation expense included in reported net income, net
                of
                related tax effects
            
            
            ---
            
            
            114,000
            
            
            ---Deduct:  Total
                stock-based employee compensation expense determined under fair value
                method, net of related tax effects
            
            
            (454,000
            )
            
            (380,000
            )
            
            (693,000
            )Pro
                forma
            
            $
            4,269,000
            
            $
            3,422,000
            
            $
            1,944,000Net
                income per share:As
                reported:Basic
            
            $
            0.52
            
            $
            0.42
            
            $
            0.32Diluted
            
            $
            0.49
            
            $
            0.40
            
            $
            0.32Pro
                forma:Basic
            
            $
            0.47
            
            $
            0.39
            
            $
            0.23Diluted
            
            $
            0.44
            
            $
            0.37
            
            $
            0.23





*USE
      OF ESTIMATES*





The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States of America requires management to make
      estimates and assumptions that affect the reported amounts of assets and
      liabilities and disclosure of contingent assets and liabilities at the date
      of
      the financial statements and the reported amounts of revenues and expenses
      during the reporting period. Actual results could differ from those
      estimates.





*CONCENTRATION
      OF CREDIT RISK*





The
      Company has $845,000 of cash on deposit with a high credit quality financial
      institution in excess of the Federal Deposit Insurance Corporation limits as
      of
      December 31, 2005.





*FAIR
      VALUE OF FINANCIAL INSTRUMENTS*





The
      estimated fair values of receivables, accounts payable and short-term borrowings
      approximate their carrying values because of the short-term maturity of these
      instruments.





The
      fair
      value of the Company’s debt instruments are based on the amount of future cash
      flows associated with each instrument discounted using the Company’s borrowing
      rate. At December 31, 2005 and 2004, the carrying value of all financial
      instruments was not materially different from fair value, as the fixed rate
      debt
      approximated rates currently available to the Company.





F-13





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS (continued)





1.
      SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)





*RECENTLY
      ISSUED ACCOUNTING STANDARDS*





In
      April
      2003, the FASB issued Statement
      of Financial Accounting Standards (“SFAS”) No. 149 (“ SFAS
      No.
      149”), Amendment of Statement 133 on Derivative Instruments and Hedging
      Activities. SFAS No. 149 amends and clarifies accounting for derivative
      instruments, including certain derivative instruments embedded in other
      contracts, and for hedging activities under Statement 133. SFAS No. 149 is
      effective for contracts entered into or modified after June 30, 2003 and for
      hedging relationships designated after June 30, 2003. The adoption of this
      statement did not have an impact on the Company’s consolidated financial
      statements.





In
      May
      2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments
      with Characteristics of both Liabilities and Equity. SFAS No. 150 clarifies
      the
      accounting for certain financial instruments with characteristics of both
      liabilities and equity and requires that those instruments be classified as
      liabilities in statements of financial position. Previously, many of those
      financial instruments were classified as equity. SFAS No. 150 is effective
      for
      financial instruments entered into or modified after May 31, 2003 and otherwise
      effective at the beginning of the first interim period beginning after June
      15,
      2003.





In
      November 2004, the FASB issued SFAS No. 151, “Inventory Costs”. SFAS No. 151
      amends the accounting for abnormal amounts of idle facility expense, freight,
      handling costs, and wasted material (spoilage) under the guidance in ARB No.
      43,
      Chapter 4, “Inventory Pricing”. Paragraph 5 of ARB No. 43, Chapter 4, previously
      stated that “. . . under some circumstances, items such as idle facility
      expense, excessive spoilage, double freight, and rehandling costs may be so
      abnormal as to require treatment as current period charges. . . .” This
      statement requires that those items be recognized as current-period charges
      regardless of whether they meet the criterion of "so abnormal." In addition,
      this statement requires that allocation of fixed production overhead to the
      costs of conversion be based on the normal capacity of the production
      facilities. This statement is effective for inventory costs incurred during
      fiscal years beginning after June 15, 2005. Management does not expect adoption
      of SFAS No. 151 to have a material impact, if any, on the Company's consolidated
      financial position or results of operations.





In
      December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets,”
an amendment to Opinion No. 29, “Accounting for Nonmonetary Transactions”. SFAS
      No. 153 eliminates certain differences in the guidance in Opinion No. 29 as
      compared to the guidance contained in standards issued by the International
      Accounting Standards Board. The amendment to Opinion No. 29 eliminates the
      fair
      value exception for nonmonetary exchanges of similar productive assets and
      replaces it with a general exception for exchanges of nonmonetary assets that
      do
      not have commercial substance. Such an exchange has commercial substance if
      the
      future cash flows of the entity are expected to change significantly as a result
      of the exchange. SFAS No. 153 is effective for nonmonetary asset exchanges
      occurring in periods beginning after June 15, 2005. Earlier application is
      permitted for nonmonetary asset exchanges occurring in periods beginning after
      December 16, 2004. The adoption of this statement did not have an impact on
      the
      Company’s consolidated financial statements.





In
      December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment”. SFAS
      123(R) amends SFAS No. 123, “Accounting for Stock-Based Compensation”, and APB
      Opinion No. 25, “Accounting for Stock Issued to Employees”. SFAS No.123(R)
      requires that the cost of share-based payment transactions (including those
      with
      employees and non-employees) be recognized in the financial statements. SFAS
      No.
      123(R) applies to all share-based payment transactions in which an entity
      acquires goods or services by issuing (or offering to issue) its shares, share
      options, or other equity instruments (except for those held by an ESOP) or
      by
      incurring liabilities (1) in amounts based (even in part) on the price of the
      company’s shares or other equity instruments, or (2) that require (or may
      require) settlement by the issuance of a company’s shares or other equity
      instruments. This statement is effective (1) for public companies qualifying
      as
      SEC small business issuers, as of the first interim period or fiscal





F-14





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS (continued)





1.
      SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)





*RECENTLY
      ISSUED ACCOUNTING STANDARDS (continued)*





year
      beginning after December 15, 2005, or (2) for all other public companies, as
      of
      the first interim period or fiscal year beginning after June 15, 2005, or (3)
      for all nonpublic entities, as of the first fiscal year beginning after December
      15, 2005. Subsequent to issuance, the SEC deferred implementation to the first
      fiscal year beginning after June 15, 2005. Management is currently assessing
      the
      impact of this statement on its financial position and results of operations
      in
      the first quarter of 2006. In the interim, the Company is continuing to use
      the
      intrinsic value method in estimating employee stock compensation expense based
      on the fair value method of accounting. This method is allowed under SFAS No.
      148, which amended SFAS No. 123 in December 2002, and proforma disclosure of
      fair value amounts is provided.





In
      January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), “Consolidation
      of Variable Interest Entities - an Interpretation of ARB No. 51, Consolidated
      Financial Statements.” This interpretation addresses consolidation by business
      enterprises of entities in which equity investors do not have the
      characteristics of a controlling financial interest or do not have sufficient
      equity at risk for the entity to finance its activities without additional
      subordinated financial support from other parties. Variable interest entities
      are required to be consolidated by their primary beneficiaries if they do not
      effectively disperse risks among the parties involved. The primary beneficiary
      of a variable interest entity is the party that absorbs a majority of the
      entity’s expected losses or receives a majority of its expected residual
      returns. In December 2003, the FASB amended FIN 46, now known as FIN 46 Revised
      (“FIN 46R”). The requirements of FIN 46R are effective no later than the end of
      the first reporting period that ends after March 15, 2004. A company that has
      applied FIN 46 to an entity prior to the effective date of FIN 46R shall either
      continue to apply FIN 46 until the effective date of FIN 46R or apply FIN 46R
      at
      an earlier date. The adoption of this interpretation did not have an impact
      on
      the Company’s consolidated financial statements.





In
      May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error
      Corrections”, an amendment to Accounting Principles Bulletin Opinion
      No. 20, “Accounting Changes” (“APB No. 20”), and SFAS No. 3,
“Reporting Accounting Changes in Interim Financial Statements”. Though SFAS
      No. 154 carries forward the guidance in APB No.20 and SFAS No.3 with
      respect to accounting for changes in estimates, changes in reporting entity,
      and
      the correction of errors, SFAS No. 154 establishes new standards on
      accounting for changes in accounting principles, whereby all such changes must
      be accounted for by retrospective application to the financial statements of
      prior periods unless it is impracticable to do so. SFAS No. 154 is
      effective for accounting changes and error corrections made in fiscal years
      beginning after December 15, 2005, with early adoption permitted for
      changes and corrections made in years beginning after May 2005. The Company
      will implement SFAS No. 154 in 2006. The Company is currently evaluating
      the impact of this new standard but believes that it will not have a
      material impact on the Company’s consolidated financial position, results of
      operations, or cash flows.





In
      February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid
      Financial Instruments”, which amends SFAS No. 133, “Accounting for Derivatives
      Instruments and Hedging Activities” and SFAS No. 140, “Accounting for Transfers
      and Servicing of Financial Assets and Extinguishment of Liabilities”. SFAS No.
      155 amends SFAS No. 133 to narrow the scope exception for interest-only and
      principal-only strips on debt instruments to include only such strips
      representing rights to receive a specified portion of the contractual interest
      or principle cash flows. SFAS No. 155 also amends SFAS No. 140 to allow
      qualifying special-purpose entities to hold a passive. The Company
      is currently evaluating the impact this new Standard but believes that it will
      not
      have a material impact on the Company’s consolidated financial position, results
      of operations, or cash flows.





In
      March
      2005, the FASB issued FIN 47, “Accounting for Conditional Asset Retirement
      Obligations,” which is an interpretation of SFAS No. 143 (“SFAS 143”),
“Accounting for Asset Retirement Obligations.” FIN 47 clarifies terminology
      within SFAS 143 and requires an entity to recognize a liability for the fair
      value of a conditional asset retirement obligation when incurred if the
      liability’s fair value can be reasonably estimated. FIN 47





F-15





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS (continued)





1.
      SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)





*RECENTLY
      ISSUED ACCOUNTING STANDARDS (continued)*





is
        effective for fiscal years ending after December 15, 2005. The adoption of
        FIN
        47 did not have a material impact on the Company’s consolidated financial
        statements.





In
      June
      2005, the Emerging Issues Task Force (“EITF”) issued EITF Issue 05-6,
“Determining the Amortization Period for Leasehold Improvements Purchased after
      Lease Inception or Acquired in a Business Combination”. The EITF reached a
      consensus that the amortization period for leasehold improvements acquired
      in a
      business combination or acquired subsequent to lease inception should be based
      on the lesser of the useful life of the leasehold improvements or the period
      of
      the lease including all renewal periods that are reasonably assured of exercise
      at the time of the acquisition. This consensus is consistent with the Company’s
      policy regarding leasehold improvements and therefore its adoption did not
      have
      a material impact on the consolidated financial statements.





In
      October 2005, the FASB issued FASB Staff Position (“FSP”) No. FAS 13-1 (“FSP FAS
      13-1”), “Accounting for Rental Costs Incurred during Construction Period.” FSP
      FAS 13-1 clarifies the accounting for rental costs associated with operating
      leases that are incurred during a construction period. In addition, SFAS No.151
      requires that a lessee shall cease capitalizing rental costs as of the effective
      date of this FSP FAS 13-1 for operating lease arrangements entered into prior
      to
      the effective date of FSP FAS 13-1. FSP FAS 13-1 is effective for periods
      beginning after December 15, 2005. We do not expect the adoption of FSP FAS
      13-1 to have a material impact on our consolidated operating results or
      financial condition.





*RECLASSIFICATIONS*





Certain
      amounts in the prior year’s consolidated financial statements have been
      reclassified to conform to the current year’s presentation.





2.
      PROPERTY AND EQUIPMENT





Property
      and equipment consist of the following:





DECEMBER
                31,2005
            
            2004Leasehold
                improvements
            
            $
            14,456,000
            
            $
            11,970,000Store
                fixtures
            
            
            14,660,000
            
            
            12,780,000Machinery
                and equipment
            
            
            3,943,000
            
            
            4,129,000Computer
                equipment and software
            
            
            7,932,000
            
            
            6,840,00040,991,000
            
            
            35,719,000Less
                accumulated depreciation and amortization
            
            
            29,060,000
            
            
            25,763,000Property
                and equipment, net
            
            $
            11,931,000
            
            $
            9,956,000





Depreciation
      and amortization expense of property and equipment totaled $3,940,000,
      $3,666,000 and $2,075,000 in 2005, 2004 and 2003, respectively.





In
      May
      1999, the Company purchased the building which houses its downtown Santa Barbara
      retail store for $1,600,000. In August 1999, the Company sold this building
      for
      $2,119,000 and simultaneously entered into a 10-year lease. The $527,000 gain
      related to the sale of this building is being deferred over the life of the
      lease.





F-16





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS (continued)





3.
      ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES





Accrued
      expenses and other current liabilities consist of the following:





DECEMBER
                31,2005
            
            2004Accrued
                compensation and benefits
            
            $
            3,015,000
            
            $
            2,677,000Sales
                tax payable
            
            
            1,596,000
            
            
            1,527,000Store
                credits
            
            
            446,000
            
            
            467,000Sales
                return reserve
            
            
            335,000
            
            
            285,000Other
                current liabilities
            
            
            1,222,000
            
            
            1,375,000Total
                accrued expenses and other current liabilities
            
            $
            6,614,000
            
            $
            6,331,000





4.
      ACQUISITIONS





THE
      WALKING COMPANY ACQUISITION





On
      March
      3, 2004 (the “TWC acquisition date”), the Company acquired substantially all of
      the assets and assumed certain liabilities of The Walking Company (the “TWC
      acquisition”), pursuant to an asset purchase agreement for a purchase price of
      approximately $22 million (subject to adjustment). The Walking Company is a
      leading independent specialty retailer of high quality, technically designed
      comfort footwear and accessories. The Walking Company had total annual sales
      of
      approximately $74 million in 2003 and had been operating under the protection
      of
      the U.S. Bankruptcy Court since July 2003. The Company was selected as the
      highest and best bidder for The Walking Company assets at a U.S. Bankruptcy
      Court ordered auction, which was confirmed on March 2, 2004.





Under
      the
      terms of the asset purchase agreement, a subsidiary of the Company acquired
      substantially all of the assets of The Walking Company including, but not
      limited to, the inventory and fixed assets of 72 stores located in 28 states
      and
      trademarks, all of which will be used by the subsidiary to continue the business
      under the name “The Walking Company” (“TWC”). The transaction was accounted for
      under the purchase method of accounting, and accordingly the results of
      operations of TWC have been consolidated in the Company financial statements
      since the TWC acquisition date.





The
      purchase price consisted of approximately $1.7 million in cash, $5.0 million
      in
      issuance of notes and rights (see Notes 5 and 6), $15.4 million of assumption
      of
      accounts payable, accrued expenses and other liabilities (including acquisition
      related costs of $1.3 million.) The Company funded the cash portion of the
      purchase price by drawing upon existing and new lines of credit, and from
      available cash.





F-17





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS (continued)





4.
      ACQUISITIONS (continued)





THE
      WALKING COMPANY ACQUISITION (continued)





During
      2005, the Company received additional invoices related to the acquisition and
      adjusted the purchase price allocation accordingly. The total purchase
      consideration is now finalized and allocated to the assets and liabilities
      acquired based on their respective estimated fair values as summarized below.





Cash
                and cash equivalents
            
            $
            123,000Inventories
            
            
            12,754,000Other
                current assets
            
            
            1,944,000Property,
                plant and equipment
            
            
            7,320,000Total
                assets acquired
            
            $
            22,141,000Current
                and other liabilities
            
            
            15,489,000Notes
                payable and rights issued
            
            
            4,952,000Total
                liabilities assumed
            
            $
            20,441,000Net
                assets acquired over liabilities
            
            $
            1,700,000





The
      following table presents unaudited pro forma results of the combined operations
      for the year ended December 31, 2004 and 2003, respectively, as if the TWC
      acquisition had occurred as of the beginning of such periods rather than as
      of
      the TWC acquisition date.





Year
                ended
              December
                31,2004
            
            2003Net
                sales
            
            $
            169,677,000
            
            $
            168,186,000Net
                income
            
            
            3,137,000
            
            
            2,345,000Net
                income per common share:Basic
            
            $
            0.36
            
            $
            0.28Diluted
            
            $
            0.34
            
            $
            0.28





The
      pro
      forma results have been prepared based on available information, using
      assumptions that the Company’s management believes are reasonable and include no
      significant non-recurring items. The results do not purport to represent the
      actual financial position or results of operations that would have occurred
      if
      the TWC acquisition had occurred on the dates specified. The results above
      are
      not necessarily indicative of the results that may be achieved in the future.
      These results also do not reflect any adjustments for the effect of certain
      operating synergies or expected cost reductions that the Company may realize
      as
      a result of the TWC acquisition. No assurances can be given that the amount
      of
      financial benefits, if any, may actually be realized as the result of the TWC
      acquisition.





FOOTWORKS
      ACQUISITION





On
      August
      31, 2005, the Company acquired substantially all of the assets of Footworks,
      a
      division of a privately held shoe retailer. The total purchase price was
      approximately $10.1 million which included the payment and issuance of cash
      and
      notes by the Company pursuant to the definitive agreement. The acquisition
      includes a chain of 7 retail stores selling comfort shoes and accessories.
      Footworks’ operations have historically focused on high-visibility stores in Las
      Vegas, Nevada. The Company has converted the majority of the acquired stores
      into “The Walking Company” stores. Through an independent valuation, intangibles
      related to below market leases





F-18





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS (continued)





4.
      ACQUISITIONS (continued)





FOOTWORKS
      ACQUISITION (continued)





acquired
      are valued at approximately $4.4 million and acquired trademark intangibles
      are
      valued at approximately $0.1 million. Goodwill recorded in connection with
      the
      acquisition is approximately $3.1 million. The purchase price allocation is
      subject to adjustment pending receipt of any unpaid acquisition related costs
      and will be finalized in third quarter 2006. The results of the Company’s
      operations for the Footworks stores have been included in the Company’s
      consolidated financial statements since the acquisition date. Pro forma results
      of operations are not presented as the acquisition is not considered material
      to
      the consolidated Company’s consolidated financial statements.





5.
      SHORT-TERM BORROWINGS





In
      October 2001, the Company entered into a credit facility with Wells Fargo Retail
      Finance, which was most recently amended in July 2005 (the “Amended Credit
      Agreement”). Prior to the July 2005 amendment, the Amended Credit Agreement
      provided for a total commitment of $28,000,000 with the ability for the Company
      to issue documentary and standby letters of credit of up to $3,000,000. The
      Company’s ability to borrow under the facility was determined using an
      availability formula based on eligible assets. The facility was collateralized
      by substantially all of the Company’s assets and requires daily, weekly and
      monthly financial reporting as well as compliance with financial, affirmative
      and negative covenants. The most significant of these financial covenants was
      compliance with a pre-defined annual maximum capital expenditure amount. For
      all
      periods presented, the Company was in compliance with all covenants. This credit
      agreement provides for a performance-pricing structured interest charge which
      was based on excess availability levels. The interest rate ranged from the
      bank’s base rate or a LIBOR loan rate plus a margin ranging up to 1.75%. As of
      December 31, 2004, the Company had no outstanding borrowings and $899,000 of
      letters of credit outstanding under this agreement.





In
      addition to the Amended Credit Agreement of the Company, TWC entered into a
      separate $17,500,000 three-year revolving credit facility with Wells Fargo
      Retail Finance on March 3, 2004, which was recently amended as of July 2005.
      Prior to the July 2005 amendment, this line was secured by substantially all
      assets of TWC and required daily, weekly and monthly financial reporting as
      well
      as compliance with financial, affirmative and negative covenants. The most
      significant of these financial covenants was compliance with a maximum annual
      capital expenditure amount. For all periods presented, TWC was in compliance
      with all covenants. This credit agreement provided for a performance-pricing
      structured interest charge which was based on excess availability levels. The
      interest rate was either the Bank’s base rate or a LIBOR loan rate plus a margin
      which ranges up to 2.75%. At December 31, 2004, TWC had approximately $304,000
      outstanding under this credit agreement and $341,000 of outstanding letters
      of
      credit.





In
      July
      2005, the Company combined both credit facilities discussed above and
      entered into a $47,000,000 revolving credit facility with Wells Fargo Retail
      Finance.  The line is secured by substantially all assets of the Company
      and requires daily, weekly and monthly financial reporting as well as compliance
      with financial, affirmative and negative covenants.  The most significant
      of these financial covenants is compliance with a capital expenditures covenant
      which limits the Company to $5,000,000 expenditures for 2005 (amount is adjusted
      annually based on an annual business plan) if minimum excess availability levels
      fall below $7,500,000. For all periods presented, the Company was in compliance
      with all covenants. This credit agreement provides for a performance pricing
      structured interest charge which is based on excess availability levels. The
      interest rate ranges from the bank’s base rate (7.25% on December 31, 2005) or a
      LIBOR loan rate plus a margin ranging up to 1.75%. The Company did not have
      any
      LIBOR loans outstanding at December 31, 2005. The Amended Credit Agreement
      expires in October 2009. At December 31, 2005, the Company had approximately
      $2,796,000 outstanding under this credit agreement and $2,258,000 of outstanding
      letters of credit expiring through October 2008, which includes





F-19





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS (continued)





5.
      SHORT-TERM BORROWINGS (continued)





a
      $2,000,000 stand-by letter of credit related to a promissory note entered in
      conjunction with the acquisition of Footworks. (Note 6)





In
      March
      2004, in conjunction with the acquisition of The Walking Company, the Company
      also entered into a $3 million two-year unsecured revolving promissory note
      facility with Israel Discount Bank (“IDB”). This facility bears interest at IDB
      prime plus 1% and is personally guarantied by the Chairman of the Company,
      for
      which he received an annual 2.5% guarantee fee of $75,000. At December 31,
      2004,
      no amounts were outstanding under this facility. In February 2005, this facility
      was cancelled by the Company.





6.
      REDEEMABLE CONVERTIBLE NOTES AND NOTES PAYABLE





DECEMBER
                31,2005
            
            2004Wells
                Fargo Retail Finance 4-year term facility
            
            $
            3,000,000
            
            $
            ---Bianca
                of Nevada, Inc. 3-year promissory note
            
            
            3,000,000
            
            
            ---Priority
                tax claim notes
            
            
            180,000
            
            
            361,0006,180,000
            
            
            361,000Less
                current installments
            
            
            1,615,000
            
            
            72,000Long
                term debt, excluding current installments
            
            $
            4,565,000
            
            $
            289,000







In
      conjunction with the acquisition, the Company assumed $3,279,000 of secured
      promissory notes and $721,000 of unsecured promissory notes, respectively,
      payable to certain former creditors of The Walking Company. The secured note
      holders were also granted rights to convert the notes into a total of 753,793
      shares of common stock of the Company at a conversion price of $4.35 per share
      through June 30, 2004. In addition, the holders of the secured notes received
      a
      right to sell (“put”) 50% of the outstanding principal amount of such notes to
      the Company at a 20% discount through June 30, 2004 (the “note put rights”). The
      unsecured note holders also were granted rights to convert the notes into a
      total of 165,748 shares of common stock of the Company at a conversion price
      of
      $4.35 per share through June 30, 2004. In addition, the holders of such
      unsecured notes received note put rights to put 100% of the outstanding
      principal amount of such notes to the Company at a 20% discount through June
      30,
      2004.





In
      order
      to facilitate the acquisition, the Chairman of the Board and the Chief Executive
      Officer of the Company each personally guarantied the potential obligation
      of
      the secured and unsecured note put rights and another $2,800,000 of other
      potential obligations in regard to certain administrative claims. In connection
      therewith, the Chairman and CEO were given the right to purchase the secured
      and
      unsecured put rights if such put rights were exercised. The Chairman and the
      CEO
      then assigned part of their right to purchase such rights to certain executive
      officers and individuals (the “Assigned Group”). In March 2004, the holders of
      the $721,000 of unsecured notes exercised the right to put such notes, which
      the
      Assigned Group purchased for $576,000. The Company recorded $328,000 as
      compensation expense, which was equal to the difference between the market
      value
      of the Company common stock into which such notes were convertible and the
      amount at which the Assigned Group had the right to purchase such notes. This
      amount is included in general and administrative expenses in the accompanying
      consolidated statements of operations for year ended December 31, 2004.





During
      the second quarter 2004, certain note holders and the Assigned Group exercised
      their rights to convert $2,918,000 in secured notes, $721,000 in unsecured
      notes
      and $64,000 in accrued interest into 851,117 shares of common stock. As an
      inducement to cash out, the Company offered to redeem the remaining secured
      notes at a 10% discount instead of the contractual 20% discount. Accordingly,
      all of the remaining secured notes were redeemed for a cash payment of 90%
      of
      the face value. As a result of the above transactions the Company





F-20





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS (continued)





6.
      REDEEMABLE CONVERTIBLE NOTES AND NOTES PAYABLE (continued)





recognized
      a gain on the early extinguishment of debt of $82,000 which was recorded as
      other income in the accompanying consolidated statement of operations for year
      ended December 31, 2004.





In
      conjunction with the acquisition of Footworks, Wells Fargo Retail Finance issued
      a $3,000,000 four-year term loan facility. Monthly payments of $55,555 are
      due
      beginning March 2006 with the balance due at the maturity date of the loan,
      October 2009. The term loan interest charge is Prime plus .5% or LIBOR plus
      2.75% (7.75% at December 31, 2005). At December 31, 2005, $556,000 of the term
      loan facility is classified as current and is included in current portion of
      long-term debt in the accompanying consolidated balance sheet.





Additionally,
      in conjunction with the acquisition of Footworks, the Company also entered
      into
      a $3,000,000 three-year promissory note with the seller, Bianca of Nevada,
      Inc.
      The principal on this note is payable in three annual installments beginning
      August 31, 2006. The note bears an interest rate of 5.0% and accrued interest
      is
      payable quarterly beginning December 2005. The note is partially secured by
      a
      $2,000,000 stand-by letter of credit. Upon payment of the second principal
      installment, the stand-by letter of credit shall be reduced to $1,000,000.
      At
      December 31, 2005, $1,000,000 of the promissory note is classified as current
      and is included in current portion of long-term debt in the accompanying
      consolidated balance sheets.





As
      part
      of the acquisition of The Walking Company, TWC assumed priority tax claims
      totaling approximately $627,000. The Bankruptcy Code requires that each holder
      of a priority tax claim will be paid in full with interest at the rate of six
      percent per year with annual payments for a period of six years. At December
      31,
      2005 and 2004, $59,000 and $72,000, respectively, of the priority tax claim
      note
      is classified as current and is included in current portion of long-term debt
      in
      the accompanying consolidated balance sheet. As of December 31, 2005 and 2004,
      the remaining notes had a balance of $121,000 and $289,000,
      respectively.





Maturities
      of long-term debt at December 31, 2005 are as follows:





2006
            
            $
            1,615,0002007
            
            
            1,723,0002008
            
            
            1,727,0002009
            
            
            1,113,0002010
            
            
            2,000$
            6,180,000




F-21





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS (continued)





7.
      INCOME
      TAXES





The
      provision for income taxes consists of the following:





YEARS
                ENDED DECEMBER 31,2005
            
            2004
            
            2003Current:Federal
            
            $
            2,520,000
            
            $
            2,615,000
            
            $
            1,224,000State
            
            
            509,000
            
            
            469,000
            
            
            126,000Total
            
            
            3,029,000
            
            
            3,084,000
            
            
            1,350,000Deferred:Federal
            
            
            (114,000
            )
            
            (767,000
            )
            
            101,000State
            
            
            (21,000
            )
            
            (145,000
            )
            
            38,000Total
            
            
            (135,000
            )
            
            (912,000
            )
            
            139,000Total
                income tax provision
            
            $
            2,894,000
            
            $
            2,172,000
            
            $
            1,489,000








The
      Company's effective income tax rate differs from the federal statutory rate
      due
      to the following:





YEARS
                ENDED DECEMBER 31,2005
            
            2004
            
            2003Federal
                statutory income tax rate
            
            
            34.0
            %
            
            34.0
            %
            
            34.0
            %State
                taxes, net of federal benefit
            
            
            3.9
            
            
            3.9
            
            
            3.6Other,
                net
            
            
            0.1
            
            
            (0.8
            )
            
            (1.5
            )Total
            
            
            38.0
            %
            
            37.1
            %
            
            36.1
            %








Significant
      components of the Company's net deferred income tax assets are as
      follows:





DECEMBER
                31,2005
            
            2004Deferred
                income tax assets:Allowance
                for doubtful receivables and sales returns
            
            $
            135,000
            
            $
            115,000Accrued
                vacation
            
            
            150,000
            
            
            156,000Inventory
                uniform capitalization
            
            
            1,051,000
            
            
            988,000Depreciation
            
            
            570,000
            
            
            472,000Intangible
                assets
            
            
            67,000
            
            
            95,000Deferred
                rent
            
            
            472,000
            
            
            376,000Deferred
                gain on sale of building
            
            
            78,000
            
            
            99,000State
                income taxes
            
            
            11,000
            
            
            27,000Reserve
                liabilities
            
            
            458,000
            
            
            518,000Total
                deferred income tax assets
            
            
            2,992,000
            
            
            2,846,000Deferred
                income tax liabilities:Prepaid
                expenses
            
            
            (124,000
            )
            
            (113,000
            )Total
                deferred income tax liabilities
            
            
            (124,000
            )
            
            (113,000
            )Deferred
                income tax asset
            
            $
            2,868,000
            
            $
            2,733,000





At
      December 31, 2005 and 2004 there are $1,681,000 and $1,691,000 in current
      deferred income tax assets, respectively, and $1,187,000 and $1,042,000 in
      non-current deferred tax assets, respectively, which are included in the
      accompanying consolidated balance sheets.





F-22





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS (continued)





8.
      COMMITMENTS AND CONTINGENCIES





*LEASES*





The
      Company leases retail stores, office buildings and warehouse space under lease
      agreements that expire through 2018. Future minimum lease payments under
      noncancelable operating and capital leases are as follows:





YEARS
                ENDING DECEMBER 31,
            
            
            Operating
              Leases
            
            Capital
              Leases2006
            
            $
            26,477,000
            
            $
            177,0002007
            
            
            21,948,000
            
            
            36,0002008
            
            
            17,356,000
            
            
            ---2009
            
            
            13,837,000
            
            
            ---2010
            
            
            9,999,000
            
            
            ---Thereafter
            
            
            27,432,000
            
            
            ---Total
                minimum obligations
            
            $
            117,049,000
            
            
            213,000Less
                amount representing interest
            
            
            
            
            
            6,000Present
                value of minimum lease payments
            
            
            
            
            
            207,000Less
                current portion
            
            
            
            
            
            160,000Long-term
                portion
            
            
            
            
            $
            47,000





The
      above
      amounts do not include contingent rentals based on sales in excess of the
      stipulated minimum that may be paid under certain leases on retail stores.
      Additionally, certain leases contain future adjustments in rental payments
      based
      on changes in a specified inflation index. The effective annual rent expense
      for
      the Company is the total rent paid over the term of the lease, amortized on
      a
      straight-line basis. The difference between the actual rent paid and the
      effective rent recognized for financial statement purposes is reported as
      deferred rent.





Rent
      expense for 2005, 2004 and 2003, totaled $26,478,000, $24,332,000 and
      $16,325,000, respectively, and includes contingent rentals of $586,000, $572,000
      and $370,000 for 2005, 2004, and 2003, respectively, which are included in
      operating expenses in the consolidated statements of income. The cost of
      equipment under capital leases at December 31, 2005 and 2004 was $535,000 and
      $496,000, respectively, and accumulated depreciation for such equipment at
      December 31, 2005 and 2004 was $179,000 and $68,000, respectively.





*LITIGATION*





In
      July
      2004, a lawsuit was filed against the Company by Big Dog Motorcycles LLC (“BDM”)
      in the Central District of California. The complaint alleges, among other
      things, breach and wrongful termination of a trademark license agreement, and
      claims attorneys fees.  While the Company is diligently evaluating BDM’s
      claims and seeking additional information, it currently believes that BDM’s
      claims lack merit and intends to defend the lawsuit vigorously. At this stage
      of
      the dispute, the Company believes any impact of the lawsuit will not
      be material to its business, financial position, results of operations and
      cash flows.





The
      Company is also involved from time to time in litigation incidental to its
      business. The Company believes that the outcome of such litigation will not
      have
      a material adverse effect on its results of operation or financial condition.





F-23





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS (continued)





8.
      COMMITMENTS AND CONTINGENCIES (continued)





*TAX
      RELATED CONTINGENCY*





On
      March
      14, 2006, the Company received a notice of proposed adjustments from the
      Internal Revenue Service ("IRS”) related to its audit of the Company’s 2002 Tax
      Year. The IRS has proposed adjustments to increase the Company’s income tax
      payable for the 2002 year under examination. The adjustments are related to
      the
      tax accounting for two short bond transactions recorded in 2002.





In
      2002,
      the Company entered into two transactions relating to the short-sale and
      repurchase of Treasury Securities. The transactions were intended to address
      interest rate exposure and generate capital gains that could be used to offset
      previously incurred capital losses. The IRS contends that the transactions
      were
      incorrectly characterized for IRS purposes. The notice of proposed changes
      to
      our 2002 federal income tax return would result in additional tax due of
      approximately $1.6 million plus penalties. The Company has obtained expert
      legal
      tax counsel and will immediately go to the appeals process. The Company believes
      that it has meritorious defenses and intends to vigorously contest the proposed
      adjustments. The Company does not believe the IRS will prevail in this matter
      and has not recorded a reserve for this proposed tax adjustment in the
      accompanying consolidated financial statements.





9.
      STOCKHOLDERS' EQUITY





*COMMON
      STOCK*





In
      March
      1998, the Board of Directors authorized the repurchase of up to $10,000,000
      of
      its common stock. The Company has repurchased 1,710,598 shares totaling
      $9,446,000 as of December 31, 2005 and 1,529,998 shares totaling $8,228,000
      as
      of December 31, 2004.





The
      Company’s credit agreement prohibits the payment of dividends. The Company did
      not pay a dividend in 2005 and 2004, and does not expect to pay dividends in
      the
      future.





*PREFERRED
      STOCK*





The
      Company is authorized to issue 3,000,000 of preferred stock. As of December
      31,
      2005 and 2004, the Company did not have any preferred stock issued or
      outstanding. Under the Company’s Certificate of Incorporation, the Board of
      Directors is authorized to fix the terms of the preferred stock provided for
      in
      such Certificate.





*STOCK
      OPTIONS*





In
      August
      1997, the Company adopted the 1997 Performance Award Plan to attract, reward
      and
      retain officers and employees. The maximum number of shares reserved for
      issuance under this plan was 1,000,000. In February 1998, the Company amended
      the 1997 Performance Award Plan (the “Plan”) to increase the maximum number of
      shares reserved for issuance under the Plan to 2,000,000. The Company amended
      the Plan again in April 2002 to increase the maximum number of shares reserved
      for issuance under the Plan to 3,000,000. Awards under this plan may be in
      the
      form of nonqualified stock options, incentive stock options, stock appreciation
      rights, restricted stock, performance shares, stock bonuses, or cash bonuses
      based upon performance.





F-24





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS (continued)





9.
      STOCKHOLDERS' EQUITY (continued)





The
      following summarizes stock option activity for the periods presented:





NUMBER
              OF
                SHARES
            
            WEIGHTED-
              AVERAGE
              EXERCISE
                PRICEBalance
                at January 1, 2003
            
            
            1,682,250
            
            $
            5.23Options
                granted
            
            
            128,500
            
            
            3.38Options
                cancelled
            
            
            (66,250
            )
            
            (5.06
            )Balance
                at December 31, 2003
            
            
            1,744,500
            
            
            5.10Options
                granted
            
            
            400,000
            
            
            4.50Stock
                rights granted
            
            
            1,067,817
            
            
            4.35Options
                exercised
            
            
            (17,600
            )
            
            (3.57
            )Options
                cancelled
            
            
            (45,250
            )
            
            (5.78
            )Stock
                rights exercised
            
            
            (993,146
            )
            
            (4.35
            )Stock
                rights cancelled
            
            
            (74,671
            )
            
            (4.35
            )Balance
                at December 31, 2004
            
            
            2,081,650
            
            
            4.98Options
                granted
            
            
            112,250
            
            
            6.93Options
                exercised
            
            
            (75,250
            )
            
            (4.30
            )Options
                cancelled
            
            
            (33,150
            )
            
            (5.35
            )Balance
                at December 31, 2005
            
            
            2,085,500
            
            $
            5.11








The
      following table summarizes information about stock options outstanding at
      December 31, 2005:





OPTIONS
                OUTSTANDING
            
            OPTIONS
                EXERCISABLERANGE
                OF
              EXERCISE
              PRICES
            
            OPTIONS
              OUTSTANDING
            
            WEIGHTED-AVERAGE
              REMAINING
              CONTRACTUALLIFE
            
            WEIGHTED-AVERAGE
              EXERCISEPRICE
            
            OPTIONS
              EXERCISABLE
            
            WEIGHTED-AVERAGE
              EXERCISEPRICE$2.90
                - 3.60
            
            511,500
            
            6.5
                years
            
            $
                3.47
            
            245,760
            
            $
                3.444.00
                - 4.85
            
            716,000
            
            5.4
                years
            
            4.28
            
            415,200
            
            4.275.00
                - 6.50
            
            687,000
            
            4.9
                years
            
            6.21
            
            406,200
            
            6.298.00
            
            85,000
            
            2.7
                years
            
            8.00
            
            65,500
            
            8.0010.00
                - 14.00
            
            86,000
            
            2.6
                years
            
            10.05
            
            56,350
            
            10.072.90
                - 14.00
            
            2,085,500
            
            5.3
                years
            
            5.11
            
            1,189,010
            
            5.27




F-25





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS (continued)





9.
      STOCKHOLDERS' EQUITY (continued)





At
      December 31, 2005, 2004 and 2003, the number of options exercisable for each
      year was 1,189,010, 1,237,850 and 1,046,875, respectively. The weighted-average
      exercise price of those options was $5.11, $5.23 and $5.20,
      respectively.





The
      Company accounts for its stock-based awards using the intrinsic value method
      in
      accordance with APB Opinion No. 25 and its related interpretations. Accordingly,
      no compensation expense has been recognized in the consolidated financial
      statements for employee stock options.





The
      weighted average fair values of the options granted were $2.73, $2.04 and $2.03
      during 2005, 2004, and 2003, respectively. The fair value of stock-based awards
      to employees is calculated through the use of an option pricing model, even
      though such models were developed to estimate the fair value of freely tradable,
      fully transferable options without vesting restrictions, which significantly
      differ from the Company's stock option awards. These models also require
      subjective assumptions, including future stock price volatility and expected
      time to exercise, which greatly affect the calculated values. The Company's
      calculations were made using the Black-Scholes option pricing model with the
      following weighted average assumptions used for grants in 2005, 2004, and 2003,
      respectively: expected cumulative volatility of 93%, 93% and 214%; risk-free
      interest rates of 4.0%, 4.4% and 2.7%; expected lives of 7.0, 7.0 and 10.0
      years.





10.
      SEGMENT INFORMATION





Since
      The
      Walking Company acquisition on March 3, 2004, the Company has operated its
      business under two reportable segments: (i) Big Dog Sportswear business, and
      (ii) TWC business. The Big Dog Sportswear business includes the Company’s 176
      Big Dog retail stores (primarily located in outlet malls), corporate sales,
      and
      its catalog and internet business selling quality sportswear. TWC business
      includes the Company’s 92 Walking Company stores located primarily in leading
      retail malls selling comfort footwear. These two retail chains are managed
      separately.





F-26





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS (continued)





10.
      SEGMENT INFORMATION (continued)





The
      accounting policies of the reportable segments are consistent with the
      consolidated financial statements of the Company. The Company evaluates
      individual store profitability in terms of a store’s contribution which is
      defined as gross margin less direct selling, occupancy, and certain indirect
      selling costs. Below are the results of operations on a segment basis for the
      years ended December 31, 2005 and 2004 (with TWC’s 2004 results being reported
      only for the period from the March 3, 2004 acquisition date):





Big
                Dog Sportswear
            
            The
                Walking Company
            
            TotalYear
                Ended December 31, 2005Statements
                of Income:Sales
            
            $
            92,104,000
            
            $
            87,011,000
            
            $
            179,115,000Gross
                Margin
            
            
            53,755,000
            
            
            45,049,000
            
            
            98,804,000Depreciation
                and Amortization
            
            
            1,363,000
            
            
            2,810,000
            
            
            4,173,000Interest
                income
            
            
            (40,000
            )
            
            (4,000
            )
            
            (44,000
            )Interest
                expense
            
            
            463,000
            
            
            513,000
            
            
            976,000Provision
                for income taxes
            
            
            1,225,000
            
            
            1,669,000
            
            
            2,894,000Net
                income
            
            
            2,000,000
            
            
            2,723,000
            
            
            4,723,000Balance
                Sheet:Total
                assets
            
            $
            31,692,000
            
            $
            41,061,000
            
            $
            72,753,000Year
                Ended December 31, 2004Statements
                of Income:Sales
            
            $
            98,771,000
            
            $
            62,587,000
            
            $
            161,358,000Gross
                Margin
            
            
            56,150,000
            
            
            32,475,000
            
            
            88,625,000Depreciation
                and Amortization
            
            
            1,675,000
            
            
            1,991,000
            
            
            3,666,000Interest
                income
            
            
            (2,000
            )
            
            (24,000
            )
            
            (26,000
            )Interest
                expense
            
            
            428,000
            
            
            429,000
            
            
            857,000Provision
                for income taxes
            
            
            973,000
            
            
            1,199,000
            
            
            2,172,000Net
                Income
            
            
            1,654,000
            
            
            2,034,000
            
            
            3,688,000Balance
                Sheet:Total
                assets
            
            $
            35,378,000
            
            $
            23,453,000
            
            $
            58,831,000





Prior
      to
      the acquisition of The Walking Company on March 3, 2004, the Company had only
      one reportable segment.





11.
      EMPLOYEE BENEFIT PLAN





The
      Company has a Retirement Savings Plan (the “Plan”), a defined contribution plan
      adopted pursuant to Section 401(k) of the Internal Revenue Code. The Plan is
      available to substantially all of the Company’s employees. The Company amended
      the Plan in November 2000 to match each dollar deferred up to 3% of
      compensation, which is limited to $1,000 annually, per participant. Participants
      vest in the Company’s contribution at varying rates of 0% to 20% per year over
      six years. The Company contributed approximately $187,000, $156,000 and $124,000
      in 2005, 2004 and 2003, respectively.





F-27





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS (continued)





12.
      RELATED PARTY TRANSACTIONS





Two
      of
      the Company's stockholders and directors have ownership interests in two former
      merchandise vendors to the Company. Merchandise inventory purchased from these
      related vendors totaled $135,000, $324,000 and $75,000 in 2005, 2004 and 2003,
      respectively.





The
      Company engaged a related party to perform retail construction services.
      Construction services provided to the Company totaled $203,000 and $297,000
      in
      2005 and 2004, respectively. No construction services were provided in
      2003.





In
      the
      normal course of business, one of the Company's officers pays for certain
      operating expenses which are reimbursed by the Company.  At December 31,
      2005 and 2004, the related outstanding payable was $654,000 and $176,000,
      respectively.





See
      discussion of related party guarantees in Note 6.





In
      January 2005 the Company made a temporary loan of $4 million to a company where
      a majority stockholder and director is the majority owner of the company. The
      loan was used to facilitate the purchase of an airplane from a third party
      until
      suitable replacement financing could be obtained. Interest on such loan was
      payable at the prime rate plus .05%. The note was fully repaid to the Company
      in
      March 2005 including $34,000 of interest. From time to time, the Company may
      rent the plane for its own corporate travel use. The Company has no obligation
      to use such plane for any minimum amount, and to the extent it does use it,
      the
      Company will pay for such use on terms at least as favorable to the Company
      as
      could be obtained from an independent third party. Costs associated with the
      use
      of such plane totaled $189,000 in 2005.





13.
      SUBSEQUENT EVENT





On
      January 31, 2006, The Walking Company purchased through bankruptcy court
      substantially all of the assets of Steve’s Shoes, Inc. for approximately $4.2
      million. The purchase price was funded through existing working capital. The
      assets include 37 store locations, inventory, trademarks and tangible personal
      property. Pro forma results of operations will not be presented as the
      acquisition is not considered material to the Company’s consolidated financial
      statements. No goodwill was recorded in connection with the acquisition.





F-28





**BIG
      DOG HOLDINGS, INC. AND SUBSIDIARIES**





NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS (continued)





14.
      QUARTERLY FINANCIAL DATA (unaudited)





FIRST
              QUARTER
            
            SECOND
              QUARTER
            
            THIRD
              QUARTER
            
            FOURTH
              QUARTER(in
                thousands, except per share)Year
                ended December 31, 2005:Net
                sales
            
            $
            31,345
            
            $
            43,441
            
            $
            44,909
            
            $
            59,420Gross
                profit
            
            
            16,227
            
            
            24,680
            
            
            25,286
            
            
            32,611Selling,
                marketing and distribution expenses
            
            
            18,267
            
            
            19,327
            
            
            20,055
            
            
            22,975General
                and administrative expenses
            
            
            1,743
            
            
            2,286
            
            
            2,207
            
            
            3,395Total
                operating expenses
            
            
            20,010
            
            
            21,613
            
            
            22,262
            
            
            26,370(Loss)
                income from operations
            
            
            (3,783
            )
            
            3,067
            
            
            3,024
            
            
            6,241Net
                (loss) income
            
            
            (2,414
            )
            
            1,718
            
            
            1,770
            
            
            3,649Net
                (loss) income per shareBasic
            
            $
            (0.26
            )
            $
            0.19
            
            $
            0.19
            
            $
            0.40Diluted
            
            $
            (0.26
            )
            $
            0.18
            
            $
            0.18
            
            $
            0.38Weighted
                average shares outstandingBasic
            
            
            9,180
            
            
            9,187
            
            
            9,141
            
            
            9,075Diluted
            
            
            9,180
            
            
            9,760
            
            
            9,680
            
            
            9,664Year
                ended December 31, 2004:Net
                sales
            
            $
            21,880
            
            $
            41,043
            
            $
            42,695
            
            $
            55,740Gross
                profit
            
            
            11,221
            
            
            23,030
            
            
            23,433
            
            
            30,941Selling,
                marketing and distribution expenses
            
            
            14,132
            
            
            18,875
            
            
            19,363
            
            
            21,586General
                and administrative expenses
            
            
            1,797
            
            
            1,936
            
            
            1,811
            
            
            2,516Total
                operating expenses
            
            
            15,929
            
            
            20,811
            
            
            21,174
            
            
            24,102(Loss)
                income from operations
            
            
            (4,708
            )
            
            2,219
            
            
            2,259
            
            
            6,839Net
                (loss) income
            
            
            (2,996
            )
            
            1,251
            
            
            1,284
            
            
            4,149Net
                (loss) income per shareBasic
            
            $
            (0.36
            )
            $
            0.15
            
            $
            0.14
            
            $
            0.45Diluted
            
            $
            (0.36
            )
            $
            0.14
            
            $
            0.13
            
            $
            0.43Weighted
                average shares outstandingBasic
            
            
            8,244
            
            
            8,261
            
            
            9,189
            
            
            9,178Diluted
            
            
            8,244
            
            
            8,907
            
            
            9,633
            
            
            9,732




F-29




INDEX
        TO
        EXHIBITS
 
 Exhibit
                  Number
              Description
 
 2.1
              Second
                  Amended Plan of Reorganization of Shoes Liquidation Co. (formerly
                  The
                  Walking Company) and Alan’s Shoes, Inc., confirmed on March 2, 2004.
                  (1)
 
 2.2
              Order
                  of the United States Bankruptcy Court for the Central District
                  of
                  California confirming the Second Amended Plan of Reorganization
                  of Shoes
                  Liquidation Co. (formerly The Walking Company) and Alan’s Shoes, Inc.,
                  entered on March 2, 2004.(1)
 
 2.3
              Asset
                  Purchase Agreement, dated May 20, 2005, by and among The Walking
                  Company, as buyer, Bianca of Nevada, Inc., a Nevada corporation,
                  as
                  seller, and Sal Palermo, as shareholder.
                  (7)
 
 2.4
              Asset
                  Purchase Agreement, dated January 31, 2006, by and among The Walking
                  Company, as buyer, and Steve’s Shoes, Inc., Debtor in Possession, as
                  seller.
 
 3.1
              Amended
                  and Restated Certificate of Incorporation (2)
 
 3.1A
              Certificate
                  of Correction (3)
 
 3.2
              Amended
                  and Reinstated Bylaws (3)
 
 4.1
              Reference
                  is hereby made to Exhibits 3.1, 3.1A, and
                  3.2
 
 4.2
              Specimen
                  Stock Certificate (2)
 
 10.1
              Term
                  Loan Note, dated August 31, 2005, among the lenders signatory thereto,
                  Wells Fargo Retail Finance II, LLC, as agent, and Big Dog USA,
                  Inc. and
                  The Walking Company, as borrowers.
                  (8)
 
 10.2
              Promissory
                  Note Secured by Letter of Credit, dated August 31, 2005, among
                  the lenders
                  signatory thereto, Bianca of Nevada, Inc., as payee, and The Walking
                  Company, as maker. (8)
 
 10.10
              Amended
                  and Restated 1997 Performance Award Plan (5)
 
 10.10A
              Form
                  of Employee Nonqualified 1997 Performance Award Plan
                  (2)
 
 10.10B
              Terms
                  and Conditions for Non-Qualified Options Granted under the Amended
                  and
                  Restated 1997 Performance Award Plan
                  (4)
 
 10.10C
              Form
                  of Eligible Director Non-Qualified Stock Option Agreement
                  (4)
 
 10.11
              Lease
                  between Big Dog USA, Inc. and The Prudential Insurance Company
                  of America
                  dated November 4, 1997 (3)
 
 10.12
              Form
                  of Indemnification Agreement (1)
 
 21.1
              List
                  of Subsidiaries of Big Dog Holdings, Inc.
                  (6)
 
 23.1
              Consent
                  of Independent Registered Public Accounting
                  Firm
 
 23.2
              Consent
                  of Independent Registered Public Accounting
                  Firm
 
 24.1
              Power
                  of Attorney (included in signature
                  page)
 31.1
              Certification
                  of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley
                  Act of 2002
 
 31.2
              Certification
                  of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley
                  Act of 2002
 
 32.1
              Certification
                  of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350,as
                  Adopted
                  Pursuant to Section 906 of the Sarbanes-Oxley Act of
                  2002
 
 32.2
              Certification
                  of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350,as
                  Adopted
                  Pursuant to Section 906 of the Sarbanes-Oxley Act of
                  2002
 
 99.1
              Loan
                  and Security Agreement, dated March 3, 2004, among the lenders
                  signatory
                  thereto, Wells Fargo Retail Finance II, LLC, as agent, and The
                  Walking
                  Company (formerly TWC Acquisition Corp.), as
                  borrower.(1)
 
 99.2
              Third
                  Amendment to Loan and Security Agreement, dated March 3, 2004,
                  among the
                  lenders signatory thereto, Wells Fargo Retail Finance II, LLC,
                  as agent,
                  and Big Dog Holdings, Inc., Big Dog USA, Inc. and CSI Acquisition
                  Corporation, as borrowers.(1)
 
 99.3
              First
                  Amended, Restated and Consolidated Loan and Security Agreement,
                  dated July
                  7, 2005, among the lenders signatory thereto, Wells Fargo Retail
                  Finance
                  II, LLC, as agent, and Big Dog Holdings, Inc., Big Dog USA, Inc.,
                  and The
                  Walking Company, as borrowers. (7)
 
 
 (1)
              Incorporated
                  by reference from the Company’s Current Report on Form 8-K filed as of
                  March 3, 2004. The exhibits and schedules to the Plan have been
                  omitted
                  from this filing pursuant to Item 601(b)(2) of Regulation S-K.
                  Big Dog
                  Holdings, Inc. will furnish copies of any of such exhibits and
                  schedules
                  to the Securities and Exchange Commission upon request.
 (2)
              Incorporated
                  by reference from the Company’s S-1 Registration Statement (No. 333-33027)
                  as amended , which became effective September 25,
                  1997.
 (3)
              Incorporated
                  by reference from the Company’s Annual Report on Form 10-K for the year
                  ended December 31, 1997.
 (4)
              Incorporated
                  by reference from the Company’s Schedule TO filed July 31,
                  2000.
 (5)
              Incorporated
                  by reference from the Company’s Annual Report on Form 10-K for the year
                  ended December 31, 1998.
 (6)
              Incorporated
                  by reference from the Company’s Annual Report on Form 10-K for the year
                  ended December 31, 2003.
 (7)
              Incorporated
                  by reference from the Company’s Quarterly Report on Form 10-Q for the
                  period ended June 30, 2005.
 (8)
              Incorporated
                  by reference from the Company’s Quarterly Report on Form 10-Q for the
                  period ended September 30, 2005.