<PAGE>

                                                                    EXHIBIT 10.1

                                 June 6, 2000



Mr. William E. Freeman                  The Statutory Creditors' Committee of
Chief Executive Officer                   Factory Card Outlet Corp. and Factory
Factory Card Outlet Corp.                 Card Outlet of America, Ltd. (the
2727 Diehl Road                           "Committee")
Naperville, IL 60563                      c/o Scott L. Hazan, Esquire
                                          Otterbourg, Steindler, Houston &
                                            Rosen, P.C.
                                          230 Park Avenue, 30th Floor
                                          New York, NY 10169


Dear Messrs. Freeman and Hazan:

     We have discussed with you and legal counsel for Factory Card Outlet Corp.
and its wholly-owned subsidiary, Factory Card Outlet of America, Ltd.
(collectively, "FCO"), a transaction which would enable FCO to emerge from its
existing bankruptcy proceeding and continue in business going forward.  This
letter of intent (the "LOI") sets forth the agreement among Saunders, Karp &
Megrue ("SKM"), FCO and the Committee concerning that transaction (for purposes
hereof, the "Transaction") and will serve as the basis for preparation of the
Definitive Agreement referred to below.  Except as provided in Sections 8 and
12, below, our obligations hereunder will only be binding upon execution of the
Definitive Agreement.  The principal terms of the parties' agreement are as
follows:

     1.  Structure.  FCO is currently a Debtor-in-Possession in Case No.
98-00685 in the United States Bankruptcy Court for the District of Delaware (the
"Court"). SKM, either directly or through an entity it organizes (for purposes
hereof, the "Buyer"), is prepared to contribute $19.5 million in cash in
exchange for a 12% subordinated promissory note payable five and one-half years
after the Closing (the "SKM Note"). Interest on the SKM Note will accrue on the
outstanding principal balance of the SKM Note during its term and will be
payable at maturity. The SKM Note may be prepaid in whole or in part at any time
without premium or penalty. This right to prepayment shall be subject to certain
mandatory prepayments with respect to the Junior Notes (as hereinafter defined)
as described below. The cash will be exchanged for either substantially all of
the assets of FCO or newly issued shares of common stock of Factory Card Outlet
Corp. and Factory Card Outlet of America, Ltd. which represent a 90% ownership
interest in that entity prior to any dilution as a result of stock options or
future issuances of equity in the Buyer's discretion. The final form of the
Transaction will be set forth in the Plan referred to below and will be
determined following completion of SKM's due diligence referred to below.

     While the final use of the proceeds  will be as provided in the Plan, we
understand that the proceeds will be used approximately as follows:
<PAGE>

Mr. William Freeman
Scott L. Hazan, Esquire
June 6, 2000
Page 2


          (a)  An amount equal to approximately $1.25 million will be used to
     pay the fees and expenses of SKM;

          (b)  An amount equal to approximately $3.5 million will be paid for
     administrative and priority claims, including cure amounts, taxes, and
     officer retention bonuses, but excluding professional fees and the fee
     payable to Avalon;

          (c)  An amount not to exceed $1.7 million will be used to pay court
     approved professional fees, including a $680,000 fee payable to Avalon. To
     the extent that fees due to court appointed professionals other than Avalon
     exceed $1.0 million, then the cash portion of the Avalon fee payable as of
     the effective date of the Plan (up to an amount not to exceed $200,000)
     shall be reduced by the amount of such excess, which amount shall be
     applied to the payment of professional fees, and the remaining portion of
     the Avalon fee shall be payable pursuant to a promissory note acceptable to
     SKM;

          (d)  $5.4 million will be distributed to holders of allowed unsecured
     claims as of the effective date of the Plan; and

          (e)  The balance will be used to reduce the Debtor-in-Possession
     financing, the remaining unpaid balance of which shall be repaid pursuant
     to the Exit Financing referred to below.

The amount of unpaid professional fees for services rendered prior to the
effective date of the Plan (including the Avalon fee) in excess of $1.7 million
and any professional fees for court appointed professionals incurred for
services subsequent to the effective date of the Plan (for services such as
avoidance actions (which the parties have no current intention to pursue),
objections to claims, and the like) shall be applied against the amount payable
under clause (d), above.  The Plan shall contain a mutually acceptable procedure
for dealing with the payment of post confirmation fees and the maintenance of
reserves for payment to the creditors consistent with this paragraph.

     In addition, the Buyer is prepared, either directly or through FCO, to
offer to creditors, subject to the limitations set forth below, (i) a 10%
ownership interest in the Buyer or FCO prior to any dilution as a result of
stock options or future issuances of equity (the "Stock"), and (ii) subordinated
promissory notes, in the aggregate principal amount $7.0 million, plus the
amount (up to a maximum amount of $500,000) by which the amount payable under
clause (d), above, is reduced by virtue of the payment of professional fees as
identified above (the "Junior Notes").  The terms of the Stock and the Junior
Notes are described in more detail below.

     2.  Terms of Stock and Junior Notes.  As you know, SKM requires that upon
completion of the Transaction neither the Buyer nor FCO be or become a public
company with public reporting obligations.  Accordingly, it may require that the
Stock be nontransferable (except in the case of a sale of stock of the company
by SKM in which event the holders of the Stock
<PAGE>

Mr. William Freeman
Scott L. Hazan, Esquire
June 6, 2000
Page 3


would have tag-along rights with SKM and except for any transfers by a holder to
no more than one affiliate or any other exception that may be acceptable to SKM
and described in the Definitive Agreement (described below) and the Plan) and
that there be no more than 300 record holders of the Stock following the Closing
(calculated in accordance with Rule 12g5-1 under the Securities Exchange Act of
1934, as amended). To the extent that there needs to be a convenience class of
unsecured creditors to result in fewer than 300 record holders of the Stock
after the Closing, SKM is prepared to have that class receive cash only, in lieu
of cash, Stock and Junior Notes. The Junior Notes would (i) be subordinate in
payment to payment of all secured debt and payment of the SKM Note, (ii) provide
for cash interest to be paid annually at an annual rate of 12%, (iii) provide
that all unpaid principal would be paid in a lump sum payment on the sixth
anniversary of the Closing except to the extent otherwise provided in this
paragraph, and (iv) be prepayable at any time without premium or penalty. To the
extent that the business achieves earnings before interest, taxes, depreciation,
amortization, and restructuring expenses and reserves (for purposes hereof
"EBITDAR") of at least 90% of $27.2 million (which is the FCO's projected
EBITDAR) for the fiscal year ended January 2005, the payment of the unpaid
principal of the Junior Notes would be accelerated to the end of the fifth year
after the Closing. In addition, the Junior Notes will be subject to certain
limited mandatory prepayments (as hereinafter described) upon prepayment of the
SKM Note. At the time of a prepayment of the SKM Note, the amount the Company
determines available for prepayment will be added to the total amount of
interest payments made on the Junior Notes as of that date (the "Sum"). The Sum
will be allocated pro rata based upon the unpaid principal amount outstanding
under the Junior Notes and the SKM Note. Prepayment will then be made based upon
this allocation after reducing the payment to be made on the Junior Notes by the
amount of interest paid on the Junior Notes through the date of the prepayment.

     3.  Approval of this LOI.  Within two business days from execution of this
LOI, a motion shall be filed by FCO seeking authority for FCO to enter into this
LOI, making the LOI binding and enforceable against FCO and binding on the
Committee, and for approval of Sections 6 and 7 including, specifically, the
Expense Reimbursement Amount and the Break-Up Fee referred to below (the
"Motion"). FCO shall request an expedited hearing on the Motion to be held no
later than June 29, 2000 (the "Approval Hearing"). An order in form and content
reasonably satisfactory to SKM granting the Motion (the "Approval Order") shall
be entered within five days of the Approval Hearing. The Committee shall support
the foregoing.

     4.  The Plan.  Within a reasonable time after entry of the Approval Order,
FCO will file a plan of reorganization (the "Plan"), approved by SKM and FCO,
which will incorporate the final terms of the Transaction. To the extent SKM
shall request, the Plan shall provide that it shall not be subject to any
amendment which would adversely affect SKM without its express written consent.
SKM reserves the right to be a co-proponent of the Plan if it so elects. The
Plan shall provide that it shall not be subject to any amendment which would
adversely affect unsecured creditors without the express written consent of the
Committee.
<PAGE>

Mr. William Freeman
Scott L. Hazan, Esquire
June 6, 2000
Page 4


     5.  Due Diligence.  Immediately following the entry of the Approval Order,
SKM shall commence its final due diligence investigation of FCO and its business
and assets. In connection therewith, FCO will make available to SKM and the
Buyer all information relating to FCO's business and assets and the identity and
nature of the claims of all third parties who assert claims against FCO, and FCO
will provide reasonable access to the management and facilities of FCO so that
SKM and the Buyer can conduct a business and legal due diligence investigation
as to all matters pertaining to FCO's business, assets and liabilities. All
information provided to SKM under this Section 5 shall be subject to the terms
of the Confidentiality Agreement with FCO. Subject to receiving such documents
and access, SKM is confident that it can complete its due diligence in three
weeks. If, as a result of its due diligence investigation, SKM decides not to
proceed with the Transaction, it shall have the right to terminate this LOI with
no further obligation to FCO; provided, however, that if SKM receives all
necessary cooperation of FCO and the Committee and full and unfettered access to
all information as it requests, SKM may only exercise such right prior to a date
which is 30 business days following entry of the Approval Order. If SKM
terminates this LOI in accordance with the preceding sentence, it shall not be
entitled to the Expense Reimbursement Amount or the Break-up Fee under Section
7, below.

     6.  Buyer's Preferred Status.  FCO acknowledges that it has spent
considerable time and effort in seeking buyers or investors for its business.
Both FCO and the Committee have concluded in their reasonable business judgment
that the proposal set forth herein makes SKM and the Buyer the preferred buyer
of FCO's business. Accordingly, commencing with the execution of this LOI and
continuing until the consummation of the Transaction or the earlier termination
of this LOI, neither the Committee nor FCO shall (and FCO will not permit any of
its officers, directors or controlled affiliates to) solicit any commitments,
agreements or understandings to or from any person, firm or corporation other
than the Buyer or SKM regarding any sale or disposition of any of the assets
(other than sales of inventory in the ordinary course of business), stock or
business or any material portion thereof of FCO or any other transaction such as
a merger involving FCO or proceed with any other proposal; provided, however,
that to the extent either FCO or the Committee receives an unsolicited proposal
from a third party, FCO and the Committee shall have the right to respond to
inquiries regarding any alternative transaction by providing information that
may be requested by any party considering such a transaction, subject to
execution of an appropriate confidentiality agreement and may take such other
action with respect thereto as may be required to satisfy their respective
fiduciary obligations under applicable law. If either FCO or the Committee
receives an unsolicited proposal (whether oral or written) for the purchase of
FCO's assets, business or stock, FCO or the Committee shall promptly notify SKM
of the substance of such unsolicited proposal.

     7.  Expense Reimbursement and Break-up Fee.  FCO and the Committee each
understands that SKM will incur significant expenses in completing its due
diligence and finalizing the Transaction and that SKM would not make this offer
unless it was able to receive a reimbursement of expenses and a Break-up Fee in
the event a third party was to complete a transaction with FCO.  FCO and the
Committee each also acknowledges that SKM has provided
<PAGE>

Mr. William Freeman
Scott L. Hazan, Esquire
June 6, 2000
Page 5


a substantial benefit to the FCO's estate by, among other things, providing the
means to implement a feasible Plan. To encourage SKM to make the offer set forth
in this LOI and to compensate it for its due diligence and other expenses, FCO
shall (a) reimburse SKM for all documented costs and expenses incurred in
connection with this proposal, including without limitation, out-of-pocket
expenses incurred by SKM, and expenses of attorneys, accountants and financial
advisors (the "Expense Reimbursement Amount") in an amount not to exceed $1.0
million, and (b) pay SKM a break-up fee of $1.0 million (the "Break-up Fee");
provided, however, that neither the Expense Reimbursement Amount nor the Break-
up Fee shall be payable in the event (i) SKM terminates this LOI as provided in
Section 5 or (ii) the Transaction does not close as a result of one of the
conditions to the Closing which is outside the control of FCO not having been
satisfied and FCO is otherwise in compliance with the terms of this LOI and the
Definitive Agreement. The Expense Reimbursement Amount and the Break-Up Fee will
each be earned upon the Court's approval of either a Plan of Reorganization
which is not approved by SKM or an offer from a third party to buy substantially
all of the assets, business or stock of FCO which, in either case, has the
effect of precluding SKM or the Buyer from consummating the Transaction
described in this LOI. The Expense Reimbursement Amount and the Break-up Fee
shall be administrative claims allowed pursuant to Section 503(b) of the United
States Bankruptcy Code (the "Code") which will have an administrative priority
under Section 507(a)(1) of the Code, and shall be payable to SKM within 10
business days after the closing of the sale of assets to a third party or, if
there is a plan of reorganization in connection with such third party
transaction, upon the effective date of such plan.

     8.  Definitive Agreement.  Upon the execution of this LOI, FCO and SKM
shall proceed in good faith to negotiate a definitive agreement (the "Definitive
Agreement") and finalize the terms of the Plan, which shall embody the terms and
conditions set forth herein, and the final terms and conditions of the
Transaction.  The Definitive Agreement shall constitute a contractually binding
obligation of SKM and the Buyer and shall contain a mutually acceptable
provision which will bind SKM in the event that SKM breaches the terms of the
Definitive Agreement.  The obligations of SKM, the Buyer and FCO to close this
Transaction shall be subject to the conditions set forth below.

     9.  Conditions to Closing.  In addition to such terms and conditions as are
customary and as may be set forth in the Definitive Agreement, the Definitive
Agreement shall provide that both SKM's and the Buyer's obligation to complete
the Transaction shall be subject to all of the following conditions and that
FCO's obligation to complete the Transaction shall be subject to the conditions
set forth in subsections (a), (b), and (d), below:

          (a)  The parties shall have filed, if required by law, all required
     filings under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as
     amended (the "HSR Act") and the waiting period provided for thereunder
     shall have expired or been terminated without order by the FCC or Justice
     Department and without a second request having been issued with respect
     thereto;
<PAGE>

Mr. William Freeman
Scott L. Hazan, Esquire
June 6, 2000
Page 6


          (b)  At the Closing, all assets of FCO shall be free and clear of any
     and all liens, encumbrances and rights of third parties, other than liens
     granted pursuant to the Exit Financing and other prepetition liens in the
     aggregate amount not to exceed $2.5 million (which amount is exclusive of
     the $3.5 million cash used to pay the claims described in Section 1(b) of
     this LOI);

          (c)  There shall be no material adverse change in FCO's business
     between the date of the Definitive Agreement and the Closing;

          (d)  Orders shall have been entered by the Court in form and content
     reasonably satisfactory to SKM and FCO (i) approving the Definitive
     Agreement, (ii) approving the disclosure statement filed in connection with
     the Plan, and (iii) confirming the Plan and authorizing the consummation of
     the Transaction;

          (e)  SKM and the Buyer shall have completed, to their satisfaction,
     (i) the assumption or in the event of an asset purchase, the assumption and
     assignment, of all store leases which the Buyer intends to assume in their
     entirety and (ii) satisfactory negotiations with respect to any store
     leases which the Buyer intends to modify (which leases shall be set forth
     in a schedule to the Definitive Agreement) and shall have rejected as
     executory contracts any store leases which the Buyer elects not to assume;
     and

          (f)  SKM and the Buyer shall have completed, on terms and conditions
     satisfactory to them, the financing required to repay the unpaid Debtor-in-
     Possession financing and to provide working capital to the Buyer (the "Exit
     Financing").

     10.  Representations and Warranties.  Each of Factory Card Outlet Corp. and
Factory Card Outlet of America, Ltd., by its execution hereof, represents and
warrants to SKM that this LOI and all terms and conditions hereof, has been
approved by the Board of Directors of such entity and upon its execution this
LOI represents a valid and binding obligation of such entity enforceable in
accordance with its terms, subject to approval by the Court.  SKM, by its
execution hereof, represents and warrants to FCO and the Committee that this LOI
and all terms and conditions hereof, have been approved by all necessary action
on the part of SKM and upon its execution this LOI represents a valid and
binding obligation of SKM enforceable in accordance with its terms.

     11.  Management Options.  The Buyer will establish an option pool of 7% of
the stock of the Buyer or FCO, which will be available to management of the
Buyer. The options will have a five-year vesting schedule and a portion of the
options will be retained for issuance after the Closing.

     12.  Expenses.  Except as set forth in Section 7 with regard to the Expense
Reimbursement Amount and the Break-up Fee, each party hereto shall bear its own
legal and accounting fees and other expenses, incurred by it in connection with
the Transactions
<PAGE>

Mr. William Freeman
Scott L. Hazan, Esquire
June 6, 2000
Page 7


contemplated hereby; provided, that either SKM or the Buyer shall pay the filing
fee required under the HSR Act. Except for Avalon, which has been retained by
FCO, each party represents to the other that it has not utilized the services of
any broker or agent in connection with the Transaction and agrees to indemnify
and hold harmless the other parties from and against any and all claims,
actions, liabilities, expenses and losses, relating to any finders' or brokers'
fees or other claims by any finder or broker engaged or purported to be engaged
by the indemnifying party in connection with the Transaction.

     13.  Timing.  The terms of this LOI shall expire and be deemed void if (i)
a signed copy of this LOI is not received by the SKM on or before 8:00 p.m.,
Eastern daylight time, on June 6, 2000, and (ii) the Approval Order is not
entered within five business days of the Approval Hearing.

     14.  Governing Law.  To the extent that any matter set forth in this LOI is
to be governed by state law, this LOI shall be governed by and construed in
accordance with the internal laws of the State of New York, without reference to
choice of law provisions thereof.

     15.  Counterparts.  This LOI may be executed in any number of counterparts,
each of which when executed and delivered shall be an original, and all of which
shall together constitute one and the same instrument.  Facsimile signatures are
acceptable.

     16.  Notices.  Any notices to be given to FCO hereunder shall be in writing
and shall be deemed delivered when sent by facsimile to FCO at 2727 Diehl Road,
Naperville, Illinois 60163-2371, Attention: William Freeman, facsimile number
(630) 579-2501, with a copy to Richard Krasnow, Esq., Weil, Gotshal & Manges,
LLP 767 Fifth Avenue, New York, New York 10153, facsimile number (212) 310-8007.
Any notices to be given to the Buyer and/or SKM hereunder shall be in writing
and shall be deemed delivered when sent by facsimile to Sanders, Karp & Megrue,
262 Harbor Drive, Stamford, Connecticut 06902, Attention: Conor Bastable,
facsimile number (203) 708-6677, with a copy to Howard A. Schoenfeld, Esq.,
Godfrey & Kahn, S.C., 780 North Water Street, Milwaukee, Wisconsin 53202,
facsimile number (414) 273-5198. Copies of any notices given to FCO, the Buyer
and/or SKM hereunder shall be delivered contemporaneously to Scott L. Hazan,
Esq., Otterbourg, Steindler, Houston & Rosen, P.C., 230 Park Avenue, 30th Floor,
New York, New York 10169, facsimile number (212) 682-6104.
<PAGE>

Mr. William Freeman
Scott L. Hazan, Esquire
June 6, 2000
Page 8


     If the foregoing correctly sets forth our agreement, please evidence your
approval by signing a copy of this LOI and returning it to the undersigned.  We
look forward to completing the Transaction outlined herein.

                                        Very truly yours,

                                        SAUNDERS, KARP & MEGRUE


                                        By: _______________________________
                                            Allan W. Karp

The foregoing terms and conditions are
accepted and agreed to this ____ day of
_____________, 2000.

FACTORY CARD OUTLET CORP.



By: ______________________
                   (Title)

FACTORY CARD OUTLET OF
AMERICA, LTD.



By: ______________________
                   (Title)

THE STATUTORY COMMITTEE OF
UNSECURED CREDITORS OF
FACTORY CARD OUTLET CORP. AND
FACTORY CARD OUTLET OF
AMERICA, LTD.



By: ______________________
                   (Title)