Tableof Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

 

----

** **

**FORM 10-Q**

 

x                              **QUARTERLY REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

** **

**FOR THEQUARTERLY PERIOD ENDED SEPTEMBER 30, 2008**

 

**o****                               ****TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**CommissionFile Number 000-29643**

 

**GRANITECITY FOOD & BREWERY LTD.**

(Exact Name ofRegistrant as Specified in Its Charter)

 

| **Minnesota**

(State or Other  Jurisdiction

of Incorporation  or Organization) | ** ** | **41-1883639**

(I.R.S. Employer

Identification  No.) |
|----------------------------------------------------------------------------------|------------|--------------------------------------------------------|

 

| **5402  Parkdale Drive, Suite 101  Minneapolis, Minnesota 55416  (952) 215-0660**(Address of Principal Executive Offices and Issuer’s  Telephone Number, including Area Code) |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

Indicate by check markwhether the registrant:  (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.

 

Yes x     No o

 

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

 

Large accelerated filer o     Acceleratedfiler x                    Non-acceleratedfiler o                    Smallerreporting company o

                                                                                 (Donot check if smaller reporting company)

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

 

Yes o      No x

 

Asof November 5, 2008, the issuer had outstanding 16,197,849****shares of common stock.

 

 

 

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Table of Contents

 

**TABLE OF CONTENTS**

 
| ** **             | ** **                                                                                                                                                                             | **Page**   |
|------------------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **             | ** **                                                                                                                                                                             | ** ** |
| **PART I**        | **FINANCIAL INFORMATION**                                                                                                                                                              | 1          |
| ** **             | ** **                                                                                                                                                                             |       |
| ITEM 1                 | Financial Statements                                                                                                                                                                   | 1          |
|                   |                                                                                                                                                                                   |       |
|                   | Condensed  Consolidated Balance Sheets as of September 30, 2008 and December 25,  2007                                                                                       |       |
|                   |                                                                                                                                                                                   |       |
|                   | Condensed  Consolidated Statements of Operations for the Fourteen and Forty weeks ended  September 30, 2008 and the Thirteen and Thirty-nine weeks ended September 25,  2007 | 2          |
|                   |                                                                                                                                                                                   |       |
|                   | Condensed  Consolidated Statements of Cash Flows for the Forty weeks ended  September 30, 2008 and the Thirty-nine weeks ended September 25,  2007                           | 3          |
|                   |                                                                                                                                                                                   |       |
|                   | Notes  to Condensed Consolidated Financial Statements                                                                                                                                  | 4          |
|                   |                                                                                                                                                                                   |       |
| ITEM 2                 | Management’s  Discussion and Analysis of Financial Condition and Results of Operations.                                                                                           | 15         |
|                   |                                                                                                                                                                                   |       |
| ITEM 3                 | Quantitative  and Qualitative Disclosures about Market Risk                                                                                                                            | 28         |
|                   |                                                                                                                                                                                   |       |
| ITEM 4                 | Controls and Procedures                                                                                                                                                                | 28         |
|                   |                                                                                                                                                                                   |       |
| **PART II**       | **OTHER INFORMATION**                                                                                                                                                                  | 29         |
| ** **             | ** **                                                                                                                                                                             |       |
| ITEM 1                 | Legal Proceedings                                                                                                                                                                      | 29         |
|                   |                                                                                                                                                                                   |       |
| ITEM 1A                | Risk Factors                                                                                                                                                                           | 29         |
|                   |                                                                                                                                                                                   |       |
| ITEM 2                 | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                                                           | 29         |
|                   |                                                                                                                                                                                   |       |
| ITEM 3                 | Defaults upon  Senior Securities                                                                                                                                                       | 29         |
|                   |                                                                                                                                                                                   |       |
| ITEM 4                 | Submission of  Matters to a Vote of Security Holders                                                                                                                                   | 29         |
|                   |                                                                                                                                                                                   |       |
| ITEM 5                 | Other Information                                                                                                                                                                      | 29         |
|                   |                                                                                                                                                                                   |       |
| ITEM 6                 | Exhibits                                                                                                                                                                               | 29         |
|                   |                                                                                                                                                                                   |       |
| **SIGNATURES**         |                                                                                                                                                                                   | 30         |
| ** **             |                                                                                                                                                                                   |       |
| **INDEX TO  EXHIBITS** | 31                                                                                                                                                                                     |

 

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**PART I         FINANCIALINFORMATION**

 

**ITEM1  Financial Statements**

 

**GRANITE CITY FOOD & BREWERY LTD.**

# **CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

** **
| ** **                                                                                                                                                                                  | ** ** | **September 30,  2008** | ** ** | **December 25,  2007** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ASSETS:                                                                                                                                                                                     |       |                         |       |                        |       |
| Current assets:                                                                                                                                                                             |       |                         |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                                  |       | $                            | 2,055,548  |                        | $          | 7,076,835 |   |
| Inventory                                                                                                                                                                                   |       | 820,428                      |       | 827,370                     |       |
| Prepaids and  other                                                                                                                                                                         |       | 1,354,140                    |       | 519,505                     |       |
| Total current  assets                                                                                                                                                                       |       | 4,230,116                    |       | 8,423,710                   |       |
|                                                                                                                                                                                        |       |                         |       |                        |       |
| Prepaid rent,  net of current portion                                                                                                                                                       |       | 471,108                      |       | 514,503                     |       |
| Property and  equipment, net                                                                                                                                                                |       | 77,525,386                   |       | 72,410,886                  |       |
| Intangible and  other assets                                                                                                                                                                |       | 1,269,122                    |       | 1,061,691                   |       |
| Total assets                                                                                                                                                                                |       | $                            | 83,495,732 |                        | $          | 82,410,790 |   |
|                                                                                                                                                                                        |       |                         |       |                        |       |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY:                                                                                                                                                 |       |                         |       |                        |       |
| Current  liabilities:                                                                                                                                                                       |       |                         |       |                        |       |
| Accounts payable                                                                                                                                                                            |       | $                            | 1,941,615  |                        | $          | 3,628,444 |   |
| Accrued expenses                                                                                                                                                                            |       | 4,440,562                    |       | 6,473,894                   |       |
| Accrued exit or  disposal costs, current portion                                                                                                                                            |       | 24,567                       |       | —                      |       |
| Deferred rent,  current portion                                                                                                                                                             |       | 188,716                      |       | 195,707                     |       |
| Long-term debt,  current portion                                                                                                                                                            |       | 308,563                      |       | 284,620                     |       |
| Capital lease  obligations, current portion                                                                                                                                                 |       | 2,610,755                    |       | 1,509,342                   |       |
| Total current  liabilities                                                                                                                                                                  |       | 9,514,778                    |       | 12,092,007                  |       |
|                                                                                                                                                                                        |       |                         |       |                        |       |
| Accrued exit or  disposal costs, net of current portion                                                                                                                                     |       | 827,579                      |       | —                      |       |
| Deferred rent,  net of current portion                                                                                                                                                      |       | 2,649,712                    |       | 2,189,278                   |       |
| Long-term debt,  net of current portion                                                                                                                                                     |       | 1,502,894                    |       | 1,732,416                   |       |
| Capital lease  obligations, net of current portion                                                                                                                                          |       | 62,692,535                   |       | 48,719,728                  |       |
| Total  liabilities                                                                                                                                                                          |       | 77,187,498                   |       | 64,733,429                  |       |
|                                                                                                                                                                                        |       |                         |       |                        |       |
| Commitments and  contingencies                                                                                                                                                              |       |                         |       |                        |       |
| Shareholders’  equity:                                                                                                                                                                 |       |                         |       |                        |       |
| Common stock,  $0.01 par value, 90,000,000 shares authorized; 16,197,849 and 16,158,945  shares issued and outstanding at September 30, 2008 and  December 25, 2007, respectively |       | 161,978                      |       | 161,589                     |       |
| Additional  paid-in capital                                                                                                                                                                 |       | 43,706,816                   |       | 43,264,493                  |       |
| Accumulated  deficit                                                                                                                                                                        |       | (37,560,560                  | )          | (25,748,721                 | )          |
| Total  shareholders’ equity                                                                                                                                                            |       | 6,308,234                    |       | 17,677,361                  |       |
|                                                                                                                                                                                        |       |                         |       |                        |       |
| Total  liabilities and shareholders’ equity                                                                                                                                            |       | $                            | 83,495,732 |                        | $          | 82,410,790 |   |

 

See notes to condensed consolidated financialstatements.

 

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**GRANITE CITY FOOD & BREWERY LTD.**

# **CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

** **
| ** **                                  | ** ** | **Fourteen  Weeks Ended  September 30,  2008** | ** ** | **Thirteen  Weeks Ended  September 25,  2007** | ** ** | **Forty  Weeks Ended  September 30,  2008** | ** ** | **Thirty-nine  Weeks Ended  September 25,  2007** | ** **  |
|---------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|-------------------------------------------------------|------------|-------------------------------------------------------------|-------------|
|                                        |       |                                                     |       |                                                     |       |                                                  |       |                                                        |        |
| Restaurant  revenues                        |       | $                                                        | 25,483,423 |                                                     | $          | 19,584,040                                            |       | $                                                           | 74,601,745  |   | $ | 56,220,186 |   |
|                                        |       |                                                     |       |                                                     |       |                                                  |       |                                                        |        |
| Cost of sales:                              |       |                                                     |       |                                                     |       |                                                  |       |                                                        |        |
| Food, beverage  and retail                  |       | 7,580,660                                                |       | 5,969,981                                                |       | 22,705,868                                            |       | 16,889,600                                                  |        |
| Labor                                       |       | 9,117,270                                                |       | 7,046,217                                                |       | 27,767,400                                            |       | 20,197,394                                                  |        |
| Direct restaurant  operating                |       | 3,817,757                                                |       | 2,835,314                                                |       | 10,913,287                                            |       | 7,720,949                                                   |        |
| Occupancy                                   |       | 1,472,968                                                |       | 1,210,113                                                |       | 4,637,939                                             |       | 3,485,007                                                   |        |
| Total cost of  sales                        |       | 21,988,655                                               |       | 17,061,625                                               |       | 66,024,494                                            |       | 48,292,950                                                  |        |
|                                        |       |                                                     |       |                                                     |       |                                                  |       |                                                        |        |
| Pre-opening                                 |       | 498,744                                                  |       | 732,679                                                  |       | 1,328,812                                             |       | 1,244,861                                                   |        |
| General and  administrative                 |       | 2,735,500                                                |       | 2,055,411                                                |       | 8,206,848                                             |       | 5,699,354                                                   |        |
| Depreciation and  amortization              |       | 1,640,343                                                |       | 1,159,886                                                |       | 4,815,399                                             |       | 3,402,613                                                   |        |
| Exit or disposal  activities                |       | 1,119,545                                                |       | —                                                   |       | 1,119,545                                             |       | —                                                      |        |
| Other                                       |       | 53,768                                                   |       | 10,399                                                   |       | 105,138                                               |       | 58,910                                                      |        |
|                                        |       |                                                     |       |                                                     |       |                                                  |       |                                                        |        |
| Operating loss                              |       | (2,553,132                                               | )          | (1,435,960                                               | )          | (6,998,491                                            | )          | (2,478,502                                                  | )           |
|                                        |       |                                                     |       |                                                     |       |                                                  |       |                                                        |        |
| Interest:                                   |       |                                                     |       |                                                     |       |                                                  |       |                                                        |        |
| Income                                      |       | 3,231                                                    |       | 87,130                                                   |       | 28,477                                                |       | 189,616                                                     |        |
| Expense                                     |       | (1,701,871                                               | )          | (910,637                                                 | )          | (4,841,825                                            | )          | (2,813,915                                                  | )           |
| Net interest  expense                       |       | (1,698,640                                               | )          | (823,507                                                 | )          | (4,813,348                                            | )          | (2,624,299                                                  | )           |
|                                        |       |                                                     |       |                                                     |       |                                                  |       |                                                        |        |
| Net loss                                    |       | $                                                        | (4,251,772 | )                                                        | $          | (2,259,467                                            | )          | $                                                           | (11,811,839 | ) | $ | (5,102,801 | ) |
|                                        |       |                                                     |       |                                                     |       |                                                  |       |                                                        |        |
| Loss per common  share, basic               |       | $                                                        | (0.26      | )                                                        | $          | (0.14                                                 | )          | $                                                           | (0.73       | ) | $ | (0.33 | ) |
|                                        |       |                                                     |       |                                                     |       |                                                  |       |                                                        |        |
| Weighted average  shares outstanding, basic |       | 16,197,849                                               |       | 16,038,302                                               |       | 16,192,844                                            |       | 15,329,517                                                  |        |

 

See notes to condensedconsolidated financial statements.

 

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**GRANITE CITY FOOD &BREWERY LTD.**

# **CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

** **
| ** **                                                                         | ** ** | **Forty  Weeks Ended  September 30,  2008** | ** **  | **Thirty-nine  Weeks Ended  September 25,  2007** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------------------------------------|-------------|-------------------------------------------------------------|------------|
|                                                                               |       |                                                  |        |                                                        |       |
| Cash flows from  operating activities:                                             |       |                                                  |        |                                                        |       |
| Net loss                                                                           |       | $                                                     | (11,811,839 | )                                                           | $          | (5,102,801 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities:       |       |                                                  |        |                                                        |       |
| Depreciation and  amortization                                                     |       | 4,779,634                                             |        | 3,375,788                                                   |       |
| Other  amortization                                                                |       | 35,765                                                |        | 26,825                                                      |       |
| Stock option  compensation expense                                                 |       | 413,646                                               |        | 786,994                                                     |       |
| Loss on disposal  of property and equipment                                        |       | 105,138                                               |        | 89,525                                                      |       |
| Loss on exit or  disposal activities                                               |       | 986,613                                               |        | —                                                      |       |
| Deferred rent                                                                      |       | 453,443                                               |        | 514,380                                                     |       |
| Changes in  operating assets and liabilities:                                      |       |                                                  |        |                                                        |       |
| Inventory                                                                          |       | 6,942                                                 |        | (25,992                                                     | )          |
| Prepaids and  other                                                                |       | (791,240                                              | )           | (75,502                                                     | )          |
| Accounts payable                                                                   |       | (414,946                                              | )           | (162,028                                                    | )          |
| Accrued expenses                                                                   |       | (2,033,332                                            | )           | (790,806                                                    | )          |
| Net cash used in  operating activities                                             |       | (8,270,176                                            | )           | (1,363,617                                                  | )          |
|                                                                               |       |                                                  |        |                                                        |       |
| Cash flows from  investing activities:                                             |       |                                                  |        |                                                        |       |
| Purchase of:                                                                       |       |                                                  |        |                                                        |       |
| Property and  equipment                                                            |       | (2,862,173                                            | )           | (5,634,505                                                  | )          |
| Intangible and  other assets                                                       |       | (436,096                                              | )           | (16,395                                                     | )          |
| Net cash used in  investing activities                                             |       | (3,298,269                                            | )           | (5,650,900                                                  | )          |
|                                                                               |       |                                                  |        |                                                        |       |
| Cash flows from  financing activities:                                             |       |                                                  |        |                                                        |       |
| Payments on  capital lease obligations                                             |       | (1,276,329                                            | )           | (6,787,174                                                  | )          |
| Proceeds from  capital leases                                                      |       | 8,000,000                                             |        | —                                                      |       |
| Payments on long  term-debt                                                        |       | (205,579                                              | )           | (182,037                                                    | )          |
| Net proceeds  from issuance of stock                                               |       | 29,066                                                |        | 12,795,966                                                  |       |
| Net cash  provided by financing activities                                         |       | 6,547,158                                             |        | 5,826,755                                                   |       |
|                                                                               |       |                                                  |        |                                                        |       |
| Net decrease in  cash                                                              |       | (5,021,287                                            | )           | (1,187,762                                                  | )          |
| Cash and cash  equivalents, beginning                                              |       | 7,076,835                                             |        | 7,671,750                                                   |       |
| Cash and cash  equivalents, ending                                                 |       | $                                                     | 2,055,548   |                                                        | $          | 6,483,988 |   |
|                                                                               |       |                                                  |        |                                                        |       |
| Supplemental  disclosure of non-cash investing and financing activities:           |       |                                                  |        |                                                        |       |
| Land, buildings  and equipment acquired under capital lease agreements             |       | $                                                     | 8,526,868   |                                                        | $          | 2,312,088 |   |
| Property and  equipment and intangibles purchased and included in accounts payable |       | $                                                     | 1,271,883   |                                                        | $          | 2,634,067 |   |

 

See notes to condensed consolidated financialstatements.

 

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**GRANITE CITY FOOD & BREWERY LTD.**

 

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**(Unaudited)**

 

**Fourteen and Forty weeks ended September 30,2008 and**

**Thirteen and Thirty-nine weeks ended September 25,2007**

 

**1.     Summary of significant accounting policies**

 

Background

 

Granite City Food & Brewery Ltd. (the “Company”) develops andoperates Modern American casual dining restaurants known as Granite City Food &Brewery®.   The restaurant theme isupscale casual dining with a wide variety of menu items that are prepared freshdaily, combined with freshly brewed hand-crafted beers finished on-site.  The first Granite City restaurant opened inSt. Cloud, Minnesota in July 1999 and has since expanded to other Midwestmarkets.  As of September 30, 2008,the Company operated 25 restaurants.  TheCompany also operates a beer production facility which is used to provide rawmaterial support to its restaurants to create consistent quality andoperational efficiencies in the production of its proprietary beer.  In 2007, the Company was granted a patent bythe United States Patent Office for its brewing process.

 

TheCompany’s expansion strategy focuses on development of restaurants in marketswhere management believes the Company’s concept will have broad appeal andattractive restaurant-level economics.

 

Principlesof consolidation and presentation

 

The accompanying unaudited condensed consolidated financial statementshave been prepared in accordance with accounting principles generally acceptedin the United States of America and regulations of the Securities and ExchangeCommission.  Accordingly, they do notinclude all the information and footnotes required by U.S. generally acceptedaccounting principles for complete financial statements.  These statements include the accounts andoperations of the Company and its subsidiary corporations under which itsKansas locations are operated.  Fifty-onepercent of the stock of each of the subsidiary corporations is owned by aresident of Kansas and the Company owns the remainder of the stock of eachsubsidiary corporation.  Eachresident-owner of the stock of these entities has entered into a buy-sellagreement with each corporation providing, among other things, that transfer ofthe shares is restricted and that the shareholder must sell his shares to thecorporation upon certain events, including termination of employment (ifemployed by the Company) or any event that disqualifies the resident-owner fromowning the shares under applicable laws and regulations of the state.  The Company has entered into a master agreementwith each separate subsidiary corporation that permits the operation of therestaurants and leases to each corporation the Company’s property andfacilities.  Each corporation pays all ofits operating expenses and obligations, and the Company retains, asconsideration for the operating arrangements and the lease of property andfacilities, all the net profits, as defined, if any, from its operations.  The Company has determined that the foregoingownership structure will cause these separate corporations to be treated asvariable interest entities in which the Company has a controlling financialinterest for the purpose of Financial Accounting Standards Board (“FASB”)Interpretation 46(R), *Consolidation of VariableInterest Entities. *As such,the corporations are consolidated with the Company’s financial statements andthe Company’s financial statements do not reflect a minority ownership in thoseseparate corporations.  Also included inthe Company’s consolidated financial statements are other wholly-ownedsubsidiaries.  All references to theCompany in these notes to the condensed consolidated financial statementsrelate to the consolidated entity.

 

Inthe opinion of management, all adjustments, consisting of normal recurringadjustments, which are necessary for a fair statement of its financial positionas of September 30, 2008 and the results of operations for the interimperiods ended September 30, 2008 and September 25, 2007 have beenincluded.

 

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The balance sheet at December 25, 2007 has been derived from theaudited financial statements at that date, but does not include all of theinformation and notes required by generally accepted accounting principles forcomplete financial statements.  Certaininformation and note disclosures normally included in the Company’s annualfinancial statements have been condensed or omitted.  These condensed financial statements shouldbe read in conjunction with the financial statements and notes thereto includedin the Company’s Annual Report on Form 10-K for the fiscal year ended December 25,2007, filed with the Securities and Exchange Commission on March 10, 2008.

 

The results ofoperations for the fourteen and forty weeks ended September 30, 2008 are not necessarily indicativeof the results to be expected for the entire year.

 

Use of estimates

 

The preparation of financial statements in conformity with generallyaccepted accounting principles in the United States of America and regulationsof the Securities and Exchange Commission requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosures of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenue and expense during the reportingperiod.  Significant estimates includeestimates related to asset lives, lease accounting and revenuerecognition.  Actual results could differfrom these estimates.

 

Reclassifications

 

Certain minor reclassifications have been made to the financialstatements for the third quarter and first three quarters of 2007 in order forthem to conform to the presentation of the financial statements for the thirdquarter and first three quarters of 2008. These reclassifications have no effect on the accumulated deficit or netloss previously reported.

 

Revenue recognition

 

Revenue is derived from the sale of prepared food and beverage andselect retail items.  Revenue isrecognized at the time of sale and is reported on the Company’s statement ofoperations net of sales taxes collected. Revenue derived from gift card sales is recognized at the time the giftcard is redeemed. Until the redemption of gift cards occurs, the outstandingbalances on such cards are included in accrued expenses in the accompanyingconsolidated balance sheets.  The Companyperiodically recognizes gift card breakage which represents the portion of itsgift card obligation for which management believes the likelihood of redemptionby the customer is remote, based upon historical redemption patterns.

 

Cash and cash equivalents

 

The Company considers all highly liquid instruments with originalmaturities of three months or less to be cash equivalents.  The Company maintains its cash at financialinstitutions in Minnesota, South Dakota, Kansas and Indiana.  At times, the bank balances exceed limitsinsured by federal agencies.

 

Stock-based compensation

 

The Company records stock-based compensation in accordance with theprovisions of FASB Statement of Financial Accounting Standard (“SFAS”) No. 123(revised 2004) (“SFAS 123R”), *Share-BasedPayment*, and SEC Staff Accounting Bulletin No. 107, *Share-Based Payment*, requiring themeasurement and recognition of all share-based compensation under the fairvalue method.

 

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The fair value of options at date of grant was estimated using theBlack-Scholes option-pricing model with the following assumptions for the firstthree quarters of 2008 and 2007:

 
| ** **                                | ** ** | **Forty  Weeks Ended  September 30,  2008** | ** ** | **Thirty-nine  Weeks Ended  September 25,  2007** | ** ** |
|-------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                |
| ** **                                |
| Weighted average  risk-free interest rate |       | 3.62% - 4.25%                                    |       | 4.63% - 5.00%                                          |       |
| Expected life of  options                 |       | 10 years                                         |       | 5 - 10 years                                           |       |
| Expected stock  volatility                |       | 40.53% - 47.38%                                  |       | 30.01% - 40.10%                                        |       |
| Expected  dividend yield                  |       | None                                             |       | None                                                   |       |

 

Earnings (loss) per share

 

Basic net income (loss) per share is computed based on the weightedaverage number of shares of common stock outstanding during the interimperiod.  Diluted net loss per share isnot presented since the effect would be anti-dilutive due to the losses.  Calculations of the Company’s net loss percommon share for the fourteen and forty weeks ended September 30, 2008 andthe thirteen and thirty-nine weeks ended September 25, 2007 are set forthin the following table:

 
| ** **                                  | ** ** | **Fourteen**           | ** ** | **Thirteen**           | ** ** | **Forty**              | ** ** | **Thirty-nine**        | ** **  |
|---------------------------------------------|------------|------------------------|------------|------------------------|------------|------------------------|------------|------------------------|-------------|
| ** **                                  | ** ** | **Weeks  Ended**       | ** ** | **Weeks  Ended**       | ** ** | **Weeks  Ended**       | ** ** | **Weeks  Ended**       | ** **  |
|                                        | ** ** | **September 30,** | ** ** | **September 25,** | ** ** | **September 30,** | ** ** | **September 25,** | ** **  |
|                                        | ** ** | **2008**               | ** ** | **2007**               | ** ** | **2008**               | ** ** | **2007**               | ** **  |
|                                        |       |                   |       |                   |       |                   |       |                   |        |
| Net loss                                    |       | $                      | (4,251,772 | )                      | $          | (2,259,467             | )          | $                      | (11,811,839 | ) | $ | (5,102,801 | ) |
| Loss per common  share, basic               |       | $                      | (0.26      | )                      | $          | (0.14                  | )          | $                      | (0.73       | ) | $ | (0.33 | ) |
| Weighted average  shares outstanding, basic |       | 16,197,849             |       | 16,038,302             |       | 16,192,844             |       | 15,329,517             |        |

 

Recentaccounting pronouncements

 

In September 2006, the FASB issued SFAS No. 157, *Fair Value Measurements*(“SFAS 157”),which defines fair value, establishes a framework for measuring fair value andexpands disclosures about fair value measurements.  SFAS No. 157 became effective forfinancial statements issued for the Company’s fiscal year 2008, subject to aone-year delay for nonfinancial assets. In February 2007, the FASB issued SFAS No. 159, *The Fair Value Option for Financial Assets andFinancial Liabilities—Including an amendment of FASB Statement No. 115*(“SFAS 159”),which will permit the option of choosing to measure certain eligible items atfair value at specified election dates and report unrealized gains and lossesin earnings, providing SFAS 157 is also adopted.  In October 2008, FASB issued StaffPosition (FSP) No. FAS 157-3, “Determining the Fair Value of aFinancial Asset When the Market for That Asset Is Not Active” which clarifiesthe application of Statement No. 157 in an inactive market and illustrateshow an entity would determine fair value when the market for a financial assetis not active.  The Staff Position is effective immediatelyand applies to prior periods for which financial statements have not beenissued, including interim or annual periods ending on or before September 30,2008.  The adoption of SFAS 157 and SFAS 159 and implementation ofFAS 157-3 has not had, nor does management expect it to have, a material impacton the Company’s consolidated financial statements.

 

In April 2008, the FASB issued FSP FAS 142-3, “Determination ofthe Useful Life of Intangible Assets” (“FSP 142-3”).  FSP142-3 amends the factors that should be considered in developing renewal orextension assumptions used to determine the useful life of a recognizedintangible asset under SFAS No. 142, 

 

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“Goodwilland Other Intangible Assets” (“SFAS 142”).  Thischange is intended to improve the consistency between the useful life of arecognized intangible asset under SFAS 142 and the period of expected cashflows used to measure the fair value of the asset under SFAS 141R and otherGAAP.  The requirement for determining useful lives must be appliedprospectively to intangible assets acquired after the effective date and thedisclosure requirements must be applied prospectively to all intangible assetsrecognized as of, and subsequent to, the effective date.  FSP142-3 is effective for financial statements issued for fiscal years beginningafter December 15, 2008.  The Companyis currently evaluating the impact of adopting FSP 142-3 on its consolidatedfinancial statements.

 

**2.****             ****Fair value of financialinstruments**

 

At September 30, 2008 and December 25, 2007, the fair valueof cash and accounts payable approximate their carrying value due to theshort-term nature of the instruments. The fair value of the capital lease obligations and long-term debt isestimated at its carrying value based upon current rates available to theCompany.

 

**3.****             ****Restaurant closing and assetimpairment charges**

 

OnAugust 19, 2008, the Company ceased operations at its Rogers, Arkansasrestaurant.  Since opening in October 2007,the restaurant failed to generate positive cash flow and had approximately $1.4million of net loss.  Management believesthe closure of this restaurant will allow the Company to focus its capital andpersonnel resources on its other restaurants in order to increase futureoperating efficiencies, cash flow and income. The Company is working to find a replacement tenant for the location,for which it is bound by a 20-year net lease. Costs incurred in connection with this closure include one-time benefitsto employees who were involuntarily terminated of approximately $57,700, costsincurred for early contract termination of approximately $4,580 and costs toclose and maintain the facility of approximately $70,652.  Until the Company is able to find areplacement tenant, it will incur ongoing costs such as utilities, landscapeand maintenance and general liability insurance. In accordance with therequirements of SFAS No. 146, *Accounting for CostsAssociated with Exit or Disposal Activities,* the Company recorded anon-cash lease termination liability of $852,146 based on management’s estimateof the fair value of these obligations. This required management to estimate the present value of the futureminimum lease obligations offset by the estimated sublease rentals that couldbe reasonably obtained for the property. During the third quarter of 2008, the Company recorded a non-cash impairmentcharge of $134,467 related to the write-off of the carrying value of therestaurant equipment at the Rogers location. The amount of this write-off is equal to the difference between the netbook value of the equipment and the expected future cash flows generated byleasing the equipment to a replacement tenant. The following is a reconciliation of the beginning and ending balancesof the Rogers exit activity:

 
| Accrued exit or  disposal costs at December 25, 2007  |   | $        | —  | ** ** |
|------------------------------------------------------------|--------|----------|---------|------------|
| Costs incurred  and charged to expense                     |   | 985,078  |    |
| Payments                                                   |   | (132,932 | )       |
| Accrued exit or  disposal costs at September 30, 2008 |   | $        | 852,146 |       |

 

All costs related to the closing of the Rogers restaurant, includingthe asset impairment charge, aggregated $1,119,545 and are reflected on the Company’sincome statement as “exit or disposal activities”.

 

**4.****             ****Non-current assets**

 

Property and equipment

 

Property and equipment are recorded at cost and depreciated over theestimated useful lives of the related assets. The cost of leasehold improvements is depreciated over the initial termof the related lease.  Depreciation iscomputed on the straight-line method for financial reporting purposes andaccelerated methods for income tax purposes. Amortization of assets acquired under capital lease is included in 

 

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depreciation expense.  Thefollowing is a summary of the Company’s property and equipment at September 30,2008 and December 25, 2007:

 
| ** **                     | ** ** | **September 30, 2008** | ** ** | **December 25, 2007** | ** ** |
|--------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| Land                           |       | $                           | 18,000     |                       | $          | 18,000 |   |
| Buildings                      |       | 55,020,656                  |       | 46,238,741                 |       |
| Leasehold  improvements        |       | 9,065,324                   |       | 8,516,291                  |       |
| Equipment and  furniture       |       | 31,866,844                  |       | 26,133,376                 |       |
| Construction in  progress*     |       | 231,919                     |       | 5,540,980                  |       |
|                           |       | 96,202,743                  |       | 86,447,388                 |       |
| Less accumulated  depreciation |       | (18,677,357                 | )          | (14,036,502                | )          |
|                           |       | $                           | 77,525,386 |                       | $          | 72,410,886 |   |

 

----

*Construction inprogress includes the following approximate amounts for items yet to be placed in service:

 
| ** **                                   | ** ** | **September 30, 2008** | ** ** | **December 25, 2007** | ** ** |
|----------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| Leasehold  improvements for future locations |       | $                           | 130,000    |                       | $          | 240,000 |   |
| Building and  equipment at future locations  |       | $                           | 100,000    |                       | $          | 5,300,000 |   |

 

Intangible and other assets

 

Intangible and other assets consisted of the following:

 
| ** **                    | ** ** | **September 30, 2008** | ** ** | **December 25, 2007** | ** ** |
|-------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| Intangible assets:            |       |                        |       |                       |       |
| Liquor licenses               |       | $                           | 510,865    |                       | $          | 331,415 |   |
| Trademarks                    |       | 140,141                     |       | 137,601                    |       |
| Other assets:                 |       |                        |       |                       |       |
| Capitalized loan  costs       |       | 238,421                     |       | 199,912                    |       |
| Security  deposits            |       | 547,600                     |       | 524,903                    |       |
|                          |       | 1,437,027                   |       | 1,193,831                  |       |
|                          |       |                        |       |                       |       |
| Less accumulated amortization |       | (167,905                    | )          | (132,140                   | )          |
|                          |       | $                           | 1,269,122  |                       | $          | 1,061,691 |   |

 

**5.        Accrued expenses**

 

Accrued expenses consisted of the following:

 
| ** **                        | ** ** | **September 30, 2008** | ** ** | **December 25, 2007** | ** ** |
|-----------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| Payroll related                   |       | $                           | 1,146,968  |                       | $          | 2,472,513 |   |
| Deferred revenue  from gift cards |       | 1,058,505                   |       | 2,103,294                  |       |
| Sales taxes                       |       | 768,637                     |       | 692,758                    |       |
| Interest                          |       | 81,503                      |       | 399,387                    |       |
| Real estate  taxes                |       | 703,784                     |       | 212,950                    |       |
| Other                             |       | 681,165                     |       | 592,992                    |       |
|                              |       | $                           | 4,440,562  |                       | $          | 6,473,894 |   |

 

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**6.        Deferred rent payable**

 

The Company leases most of its restaurant properties.  Leases are accounted for under the provisionsof SFAS No. 13 and SFAS No. 98, *Accountingfor Leases,* as well as other subsequent amendments and authoritativeliterature including FASB Staff Position No. FAS 13-1, *Accounting for Rental Costs Incurred During aConstruction Period.*  Forleases that contain rent escalation clauses, the Company records the total rentpayable during the lease term and recognizes expense on a straight-line basisover the initial lease term, including the “build-out” or “rent-holiday” periodwhere no rent payments are typically due under the terms of the lease.  Any difference between minimum rent andstraight-line rent is recorded as deferred rent payable.  Additionally, pursuant to Emerging IssuesTask Force No. 98-09, *Accounting forContingent Rent*, contingent rent expense based on a percentage ofrevenue is accrued and recorded to the extent it is expected to exceed minimumbase rent per the lease agreement, based on estimates of probable levels ofrevenue during the contingency period. Deferred rent payable also includes a tenant improvement allowance theCompany received, which is being amortized as a reduction of rent expense on astraight-line basis over the initial term of the lease.

 

Deferred rent payable

 
| ** **                                              | ** ** | **September 30, 2008** | ** ** | **December 25, 2007** | ** ** |
|---------------------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| Difference  between minimum rent and straight-line rent |       | $                           | 2,458,883  |                       | $          | 1,961,283 |   |
| Contingent rent  expected to exceed minimum rent        |       | 43,156                      |       | 64,813                     |       |
| Tenant  improvement allowance                           |       | 336,389                     |       | 358,889                    |       |
|                                                    |       | $                           | 2,838,428  |                       | $          | 2,384,985 |   |

 

**7.  Long-term debt**

 

As of September 30, 2008, the Company had two outstandinglong-term loans with an independent financial institution, the proceeds ofwhich it used to purchase equipment for its restaurants in Des Moines andDavenport, Iowa.  These loans are securedonly by the personal property and fixtures at the respective locations.  In addition to these two loan agreements, theCompany has a long-term loan outstanding with the same independent financialinstitution secured by the tangible personal property and fixtures at the Fargo,North Dakota restaurant.  Such loan isguaranteed by Steven J. Wagenheim, the Company’s president, chief executiveofficer and one of its directors.  As of September 30,2008 and December 25, 2007, the balances, interest rates and maturitydates of these loans were:

 
| ** **            | ** ** | **September 30, 2008** | ** ** | **December 25, 2007** | ** ** |
|-----------------------|------------|-----------------------------|------------|----------------------------|------------|
| Des Moines            |       |                        |       |                       |       |
| Loan balance          |       | $                           | 257,644    |                       | $          |  345,295 |   |
| Annual interest  rate |       | 10.25                       | %          | 10.25                      | %          |
| Maturity date         |       | August 27, 2010        |       | August 27, 2010       |       |
| Davenport             |       |                        |       |                       |       |
| Loan balance          |       | $                           | 301,053    |                       | $          |  383,330 |   |
| Annual interest  rate |       | 10.25                       | %          | 10.25                      | %          |
| Maturity date         |       | January 6, 2011        |       | January 6, 2011       |       |
| Fargo                 |       |                        |       |                       |       |
| Loan balance          |       | $                           | 1,252,760  |                       | $          |  1,288,411 |   |
| Annual interest  rate |       | 8.75                        | %          | 8.75                       | %          |
| Maturity date         |       | August 15, 2011        |       | August 15, 2011       |       |

 

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Future maturities of long-term debt, exclusive of interest, are asfollows:

 

| **Year  ending:** | ** ** | **Long-term Debt** | ** ** |
|------------------------|------------|--------------------|------------|
| 2008                   |       | $                  | 72,782     |   |
| 2009                   |       | 309,913            |       |
| 2010                   |       | 291,595            |       |
| 2011                   |       | 1,137,167          |       |
|                   |       | $                  | 1,811,457  |   |

 

**8.        Capital leases**

 

Asof September 30, 2008, the Company operated 23 restaurants under capitallease agreements, 21 of which originated with Dunham Capital Management, L.L.C.(“Dunham”), a commercial developer.  Theland portion of these leases is classified as an operating lease while thebuilding portion of these leases is classified as a capital lease because itspresent value was greater than 90% of the estimated fair value at the beginningof the lease and/or the lease term represents 75% or more of the expected lifeof the property.  The Company also has aland and building lease agreement for its beer production facility.  This ten-year lease allows the Company topurchase the facility at any time for $1.00 plus the unamortized constructioncosts.  Because the construction costswill be fully amortized through payment of rent during the base term, if theoption is exercised at or after the end of the initial ten-year period, theoption price will be $1.00.  As such, thelease is classified as a capital lease.

 

OnAugust 19, 2008, the Company ceased operations at its restaurant inRogers, Arkansas (see Note 3).  However,the Company is currently bound by the terms of this 20-year net lease agreemententered into under the terms specified in the development agreement withDunham.  The building portion of thislease is classified as a capital lease while the land portion is classified asan operating lease.

 

Asof September 30, 2008, the Company had entered into two capital leaseagreements related to restaurants which will commence operating subsequent tothe end of the third quarter 2008.  Eachof these leases originated with Dunham.  Theland portion of these leases will be classified as an operating lease while thebuilding portion of these leases will be classified as a capital lease (seeNote 9).

 

Asof September 30, 2008, the Company had capital lease agreements that itused to finance the equipment at 17 of its restaurants.  During the third quarter of 2008, the Companyfinanced the equipment at five of those restaurants, aggregating approximately$5.0 million, under the terms and conditions of the Equipment Lease Commitmentthe Company entered into with DHW Leasing, L.L.C. (“DHW”) in December 2007.

 

Includedin property and equipment are the following assets held under capital leases:

 
| ** **                            | ** ** | **September 30, 2008** | ** ** | **December 25, 2007** | ** ** |
|---------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| Land                                  |       | $                           | 18,000     |                       | $          | 18,000 |   |
| Building                              |       | 52,512,481                  |       | 44,926,945                 |       |
| Equipment and  leasehold improvements |       | 16,588,649                  |       | 7,509,977                  |       |
|                                  |       | 69,119,130                  |       | 52,454,922                 |       |
| Less accumulated  depreciation        |       | (9,842,333                  | )          | (5,438,454                 | )          |
|                                  |       | $                           | 59,276,797 |                       | $          | 47,016,468 |   |

 

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Minimum futurelease payments under all capital leases as of September 30, 2008 are:

 
| **Year  ending:**                            | ** ** | **Capital Leases** | ** ** |
|----------------------------------------------|------------|--------------------|------------|
| 2008                                         |       | $                  | 2,294,358  |   |
| 2009                                         |       | 10,429,342         |       |
| 2010                                         |       | 10,805,903         |       |
| 2011                                         |       | 9,591,725          |       |
| 2012                                         |       | 11,913,159         |       |
| Thereafter                                   |       | 104,571,382        |       |
| Total minimum  lease payments                |       | 149,605,869        |       |
| Less amount  representing interest           |       | 84,302,579         |       |
| Present value of  net minimum lease payments |       | 65,303,290         |       |
| Less current  portion                        |       | 2,610,755          |       |
| Long-term  portion of obligations            |       | $                  | 62,692,535 |   |

 

The foregoingtable considers additional lease commitments commencing after September 30,2008.  Amortization expense related tothe assets held under capital leases is included with depreciation expense onthe Company’s statements of operations.

 

**9.        Commitments andcontingencies**

 

The Company will need to expend additional capitalin connection with its long-term expansion plans.  Basedon the Company’s September 30, 2008 cash position of $2.1 million, theDecember 2007 $16.0 million DHW Equipment Lease Commitment, of whichapproximately $3.0 million in lease financing remained available as of September 30,2008, and expected cash flows from operations based on the current momentum ofthe Company’s improved operating margins, management believes the Company willhave sufficient funds to complete currently-planned restaurant openings through2009 and maintain sufficient working capital for operations.  However, the Company is evaluating itsdevelopment plans in relation to the current economic environment.  To the extent management determines a moreaggressive store-opening plan is appropriate to brand the company and betterleverage its infrastructure, the Company may require further funding.  The amount of any such required funding woulddepend upon the number of openings, cost of capital, availability of developerfinancing or landlord-tenant improvement funding, adverse sales trends, and theCompany’s ability to generate positive cash flow.  The Company is exploring opportunities toreduce its cash usage per restaurant by utilizing sites that offer lower costsof capital and real estate funding.  Ifsources of liquidity are insufficient to fund expected capital needs, or theCompany’s needs are greater than anticipated, the Company will be required toraise additional funds in the future through the incurrence of indebtedness orpublic or private sales of equity securities. The Company continues to pursue additional debt financing alternativesin order to solidify its expansion plans. If the Company does not generate sufficient cash flow from currentoperations or if financing is not available to the Company, the Company willhave to curtail projected growth, which could materially adversely affect itsbusiness, financial condition, operating results and cash flows.

 

Indianapolis, Indiana and Troy, Michigan lease agreement

 

In April and May 2008, the Company entered into 20-year netlease agreements relating to restaurants it anticipates opening in 2009 inIndianapolis, Indiana and Troy, Michigan, respectively, under the termsspecified in the development agreement with Dunham for the development ofrestaurants.  The restaurants will beconstructed for the Company on a build-to-suit basis.  Basic terms of the leases include annual rentequal to 10.5% of the construction cost plus the land lease and contingent rentbased on a percentage of revenue.  Thebase rent will escalate 10% at the end of each five-year period.  The term of each lease will commence whenoperations begin and the Company will be responsible for any real-estate taxesand all operating costs.  Rental costsassociated with the operating lease incurred during the construction period are

 

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recognized as pre-opening costs and escalated rent will be recognizedas expense on a straight-line basis over the term of each lease.

 

Development agreement with United Properties Investment LLC (“UnitedProperties”)

 

In April 2008, the Company entered into a development agreement withUnited Properties for the development of up to 22 restaurants to be builtbetween 2009 and 2012.  As the Company’snew developer, United Properties will be responsible for all costs related tothe land and building of each restaurant. The annual lease rate for fee-simple land and building developments willbe 9.5% and the Company will have the right of first offer to purchase theserestaurants.  Additionally, in the eventUnited Properties sells one of the buildings that it develops for the Companyat an amount in excess of the threshold agreed to by the parties in theagreement, then the Company will share in the profits of that sale.  The Company assumes no liability in the eventUnited Properties sells a building at a loss. The Company is not bound to authorize the construction ofrestaurants during that time period, but generally cannot use another developerto develop or own a restaurant as long as the development agreement is ineffect.  The Company can, however, use anotherdeveloper if United Properties declines to build a particular restaurant.

 

Litigation

 

From time to time, lawsuits are threatened or filed against the Companyin the ordinary course of business.  Suchlawsuits typically involve claims from customers, former or current employees,and others related to issues common to the restaurant industry.  A number of such claims may exist at anygiven time.  Although there can be noassurance as to the ultimate disposition of these matters, it is management’sopinion, based upon the information available at this time, that the expectedoutcome of these matters, individually or in the aggregate, will not have amaterial adverse effect on the results of operation, liquidity or financialcondition of the Company.

 

**10.****      ****Common stock**

 

Exercise of warrants and options

 

On December 31, 2007, a director of the Company exercised a stockoption for the purchase of 15,000 shares of common stock at an exercise priceof $2.27 per share.  These options wereissued pursuant to the 1997 Director Stock Option Plan and had an expirationdate of January 1, 2008.

 

On January 31, 2008, the Company issued 10,153 shares of commonstock upon the cashless exercise of a warrant for the purchase of 23,996 sharesof common stock originally issued March 20, 2003 to one of the agents forits private placement of Series A Convertible Preferred Stock andwarrants.  The foregoing warrant had anexercise price of $1.58 per share and an expiration date of March 20,2008.

 

On March 5, 2008, the Company issued 7,070 shares of common stockupon the cashless exercise of a warrant for the purchase of 23,996 shares ofcommon stock originally issued March 20, 2003 to one of the agents for itsprivate placement of Series A Convertible Preferred Stock andwarrants.  The foregoing warrant had anexercise price of $1.58 per share and an expiration date of March 20,2008.

 

On March 7, 2008, the Company issued 6,681 shares of common stockupon the cashless exercise of a warrant for the purchase of 25,842 shares ofcommon stock originally issued March 20, 2003 to one of the agents for itsprivate placement of Series A Convertible Preferred Stock andwarrants.  The foregoing warrant had anexercise price of $1.58 per share and an expiration date of March 20,2008.

 

**11.****      ****Stock plans**

 

In July 1997,the Company adopted the 1997 Stock Option Plan for employees and non-employees,including consultants to the Company, to purchase the Company’s common stock atan exercise price that equals or exceeds the fair market value on the date ofgrant.   As of September 30, 2008,options to purchase 306,500 shares of common stock were outstanding under theplan, which expired July 28, 2007. All options outstanding under this plan are fully vested and areexercisable for ten years from the date of grant.

 

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As of September 30,2008, options to purchase 285,000 shares of common stock were outstanding underthe 1997 Director Stock Option Plan (“DSOP”), which expired July 29,2007.  Under this plan, the Companyautomatically granted an option to each outside director on the date suchperson became a director for the purchase of 15,000 shares of common stock andthereafter on each successive anniversary of the grant ofthe first option for the purchase of 15,000 shares.  On May 2, 2007, the Company’s board ofdirectors agreed that until the adoption of any future equity plan fornon-employee directors, awards of stock options for the purchase of 15,000shares of common stock per year should continue to be made to each non-employeedirector on the anniversary of his election to the Board under the 2002 EquityIncentive Plan.  The board further resolved that such awards are to havethe same terms and conditions as those made under the DSOP; provided, however,that they are to be exercisable for a period of ten years rather than fiveyears.

 

In August 2002,the Company adopted the 2002 Equity Incentive Plan for employees, prospectiveemployees, officers and members of the Company’s board of directors, as well asconsultants and advisors to the Company, to purchase shares of the Company’scommon stock at an exercise price that equals or exceeds the fair market valueon the date of grant.  The number ofshares authorized for issuance as of September 30, 2008 was 2,649,743, ofwhich 648,742 shares remained available for future issuance and options topurchase 1,925,301 shares were outstanding. Although vesting schedules may vary, option grants under this plan generallyvest evenly over a three or four-year period and options are exercisable for nomore than ten years from the date of grant.

 

A summary of the status of the Company’s stock options as of September 30, 2008 is presentedbelow:

 
| ** **                                                  | ** ** | ** ** | ** ** | ** **          | ** ** | **Weighted**          | ** ** | ** **    | ** ** |
|-------------------------------------------------------------|------------|------------|------------|---------------------|------------|-----------------------|------------|---------------|------------|
| ** **                                                  | ** ** | ** ** | ** ** | **Weighted**        | ** ** | **Average**           | ** ** | **Aggregate** | ** ** |
|                                                        |       | ** ** | ** ** | **Average**         | ** ** | **Remaining**         | ** ** | **Intrinsic** |       |
| **Fixed  Options**                                          |       | **Shares** | ** ** | **Exercise  Price** | ** ** | **Contractual  Life** | ** ** | **Value**     |       |
| Outstanding at  December 26, 2006                      |       | 1,595,000  |       | $                   | 3.70       |                  | 6.1 years  |          |       |   |
| Granted                                                     |       | 824,000    |       | $                   | 4.82       |                  | 7.3 years  |          |       |   |
| Exercised                                                   |       | (36,200    | )          | $                   | 1.52       |                  |       |          |       |   |
| Forfeited                                                   |       | (110,000   | )          | $                   | 4.63       |                  |       |          |       |   |
| Outstanding at  December 25, 2007                      |       | 2,272,800  |       | $                   | 4.10       |                  | 6.7 years  |          |       |   |
|                                                        |       |       |       |                |       |                  |       |          |       |
| Granted                                                     |       | 570,000    |       | $                   | 2.03       |                  | 9.1 years  |          |       |   |
| Exercised                                                   |       | (15,000    | )          | $                   | 2.27       |                  | —     |          |       |   |
| Forfeited                                                   |       | (265,999   | )          | $                   | 4.14       |                  | —     |          |       |   |
| Outstanding at  September 30, 2008                     |       | 2,561,801  |       | $                   | 3.64       |                  | 6.0 years  |          | $          | — |   |
|                                                        |       |       |       |                |       |                  |       |          |       |
| Options  exercisable at December 25, 2007              |       | 1,507,304  |       | $                   | 3.71       |                  | 5.7 years  |          |       |   |
| Options  exercisable at September 30, 2008             |       | 1,552,139  |       | $                   | 3.87       |                  | 4.6 years  |          | $          | — |   |
|                                                        |       |       |       |                |       |                  |       |          |       |
| Weighted-average  fair value of options granted during 2008 |       | $          | 1.22       |                |       |                  |       |          |       |   |
|                                                             |            |            |            |                     |            |                       |            |               |            |  |  |  |

 

The aggregate intrinsic value in the table above represents the totalpretax intrinsic value (the difference between the closing price of the Company’sstock on September 30,2008 and the exercise price, multiplied by the number of in-the-moneyoptions) that would have been received by the option holders had all optionholders exercised their options on September 30, 2008.  As of September 30, 2008, there was approximately$761,027 of total unrecognized compensation cost related to unvestedshare-based compensation arrangements, of which $150,615 is expected to berecognized during the remainder of fiscal year 2008, $396,332 in fiscal year2009, $134,544 in fiscal year 2010, $62,593 in fiscal year 2011 and $16,943 infiscal year 2012.

 

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The following table summarizes information about stock optionsoutstanding at September 30, 2008:

 
| ** **          | ** ** | **Options  Outstanding** | ** ** | **Options  Exercisable** | ** ** |
|---------------------|------------|--------------------------|------------|--------------------------|------------|
| ** **          | ** ** | **Number  of**           | ** ** | **Weighted**             | ** ** | ** ** | ** ** | **Number  of** | ** ** | ** ** | ** ** |
| ** **          | ** ** | **Options**              | ** ** | **Average**              | ** ** | **Weighted** | ** ** | **Options** | ** ** | **Weighted** |   |
| **Range of**        | ** ** | **Outstanding**          | ** ** | **Remaining**            | ** ** | **Average** | ** ** | **Exercisable** | ** ** | **Average** |   |
| **Exercise Prices** | ** ** | **9/30/2008**            | ** ** | **Contractual  Life**    | ** ** | **Exercise  Price** | ** ** | **9/30/2008** | ** ** | **Exercise  Price** |   |
|                |       |                     |       |                     |       |   |   |   |   |   |   |
| $0.00 - $1.00       |       | 40,000                   |       | 9.9 years                |       | $ | 0.91 |   | — |   | $ | — |   |
| $1.01 - $2.00       |       | 256,500                  |       | 6.7 years                |       | $ | 1.67 |   | 121,500 |   | $ | 1.65 |   |
| $2.01 - $3.00       |       | 529,334                  |       | 7.9 years                |       | $ | 2.32 |   | 166,667 |   | $ | 2.49 |   |
| $3.01 - $4.00       |       | 703,000                  |       | 4.7 years                |       | $ | 3.77 |   | 587,001 |   | $ | 3.81 |   |
| $4.01 - $5.00       |       | 607,300                  |       | 6.2 years                |       | $ | 4.37 |   | 532,300 |   | $ | 4.39 |   |
| $5.01 - $6.00       |       | 309,000                  |       | 3.4 years                |       | $ | 5.21 |   | 94,670 |   | $ | 5.27 |   |
| $6.01 - $7.00       |       | 116,667                  |       | 8.5 years                |       | $ | 6.20 |   | 50,001 |   | $ | 6.20 |   |
|                |       |                     |       |                     |       |   |   |   |   |   |   |   |   |
| Total               |       | 2,561,801                |       | 6.0 years                |       | $ | 3.64 |   | 1,552,139 |   | $ | 3.87 |   |

 

**12.  Common stock warrants**

 

In November 2002, the Company completed a private placement of Series AConvertible Preferred Stock and warrants to purchase common stock.  As part of the agreement between the Companyand its private placement agents, the agents received five-year warrants topurchase an aggregate of 288,604 shares of common stock at an exercise price of$1.58 per share. During the first quarter of fiscal year 2008, the Companyissued an aggregate of 23,904 shares of common stock upon the cashless exerciseof such warrants for the purchase of an aggregate of 73,834 shares of commonstock.  No such agent warrants relatingto this private placement remain outstanding.

 

In May 2003, the Company entered into a two-year financialadvisory services agreement. As part of the agreement between the Company andthe financial consultant, the consultant received five-year warrants topurchase an aggregate of 35,000 shares of common stock at exercise pricesranging from $2.85 to $5.40 per share. On May 12, 2008, all such warrants expired unexercised.

 

In September 2004, the Company entered into a securities purchaseagreement with certain accredited investors for the sale of approximately $8.5million of common stock and warrants. Under this agreement, the Company issued five-year warrants for thepurchase of 1,045,844 shares of common stock at an exercise price of $5.00 pershare.  The Company may call for themandatory exercise of such warrants if certain conditions are met.  As part of this private placement, theCompany sold to its placement agents, for $100, five-year warrants to purchasean aggregate of 130,730 shares of common stock at an exercise price of $5.00per share.  As of September 30, 2008, none of suchwarrants had been exercised.

 

In October 2005, the Company entered into a securities purchaseagreement with certain accredited investors for the sale of approximately $5.34million of common stock and warrants. Under this agreement, the Company issued five-year warrants for thepurchase of 221,762 shares of common stock at an exercise price of $6.50 pershare to such investors and five-year warrants for the purchase of 55,436shares of common stock at an exercise price of $6.50 to the Company’s placementagent. As of September 30,2008, none of such warrants had been exercised.

 

During the first three quarters of fiscal year 2008, no warrants wereissued, warrants for the purchase of an aggregate of 73,835 shares wereexercised and warrants for the purchase of an aggregate of 35,000 shares wereforfeited.  As of September 30, 2008, warrants forthe purchase of an aggregate of 1,453,772 shares of common stock wereoutstanding and exercisable.  Theweighted average exercise price of such warrants was $5.29 per share.

 

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**ITEM 2 Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

*This discussion and analysis contains variousnon-historical forward-looking statements within the meaning of Section 21Eof the Exchange Act.  Although we believethat, in making any such statement, our expectations are based on reasonableassumptions, any such statement may be influenced by factors that could causeactual outcomes and results to be materially different from thoseprojected.  When used in the followingdiscussion, the words “anticipates,” “believes,” “expects,” “intends,” “plans,”“estimates” and similar expressions, as they relate to us or our management,are intended to identify such forward-looking statements.  You are cautioned not to attribute unduecertainty to such forward-looking statements, which are qualified in theirentirety by the cautions and risks described herein.  Please refer to the “Risk Factors” section ofour Annual Report on Form 10-K, filed with the Securities and ExchangeCommission on March 10, 2008, for additional factors known to us that maycause actual results to vary.*

 

**Overview**

 

We are a Modern Americanupscale casual restaurant chain. As of September 30, 2008, we operated 25restaurants in 11 Midwestern states featuring on-premises breweries,substantially all of which operate under the name of Granite City Food &Brewery®.  We believe our menu featureshigh quality yet affordable family favorite menu items prepared frommade-from-scratch recipes and served in generous portions.  We believe that the sophisticated yetunpretentious restaurants, proprietary food and beverage products, attractiveprice points and high service standards combine for a great diningexperience.  The location of eachrestaurant in operation and the month and year of its opening appear in thefollowing chart:

 

| **Unit** | ** ** | **Location**               | ** ** | **Opened** |
|----------|------------|----------------------------|------------|------------|
| 1        |       | St. Cloud,  Minnesota      |       | Jun-99     |
| 2        |       | Sioux Falls,  South Dakota |       | Dec-00     |
| 3        |       | Fargo, North  Dakota       |       | Nov-01     |
| 4        |       | Des Moines, Iowa           |       | Sep-03     |
| 5        |       | Cedar Rapids,  Iowa        |       | Nov-03     |
| 6        |       | Davenport, Iowa            |       | Jan-04     |
| 7        |       | Lincoln,  Nebraska         |       | May-04     |
| 8        |       | Maple Grove,  Minnesota    |       | Jun-04     |
| 9        |       | East Wichita,  Kansas      |       | Jul-05     |
| 10       |       | Eagan, Minnesota           |       | Sep-05     |
| 11       |       | Kansas City,  Missouri     |       | Nov-05     |
| 12       |       | Kansas City,  Kansas       |       | Jan-06     |
| 13       |       | Olathe, Kansas             |       | Mar-06     |
| 14       |       | West Wichita,  Kansas      |       | Jul-06     |
| 15       |       | St. Louis Park,  Minnesota |       | Sep-06     |
| 16       |       | Omaha, Nebraska            |       | Oct-06     |
| 17       |       | Roseville,  Minnesota      |       | Nov-06     |
| 18       |       | Madison,  Wisconsin        |       | Dec-06     |
| 19       |       | Rockford,  Illinois        |       | Jul-07     |
| 20       |       | East Peoria,  Illinois     |       | Oct-07     |
| 21       |       | Orland Park,  Illinois     |       | Dec-07     |
| 22       |       | St. Louis,  Missouri       |       | Jan-08     |
| 23       |       | Ft. Wayne,  Indiana        |       | Jan-08     |
| 24       |       | Toledo, Ohio               |       | Feb-08     |
| 25       |       | South Bend,  Indiana       |       | Jul-08     |

 

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We operate acentrally-located beer production facility in Ellsworth, Iowa which facilitatesthe initial stage of our patented brewing process.  We believe that this brewing process improvesthe economics of microbrewing as it eliminates the initial stages of brewingand storage at multiple locations, thereby reducing equipment and developmentcosts at new restaurant locations. Additionally, having a common starting point, the beer productioncreates consistency of taste for our product from unit to unit.  The initial product produced at our beerproduction facility is transported by truck to the fermentation vessels at eachof our restaurants where the brewing process is completed. In 2007, we weregranted a patent by the United States Patent Office for this brewingprocess.  We believe that our currentbeer production facility, which opened in June 2005, has the capacity toservice up to 35 restaurant locations.

 

Our managers are trained under theinstruction of dedicated trainers and veteran managers.  Our seven to fourteen-week training programconsists of both “hands on” as well as classroom training for all aspects ofmanagement.  All salaries of our managersin training and our dedicated trainers as well as all related costs incurredduring the training process are recorded as a component of our general and administrativecosts.

 

We utilize a new store opening team whichconsists of experienced restaurant managers who are dedicated to the opening ofour new restaurants.  This team generallyarrives at a new restaurant site two to three months in advance of therestaurant opening date and coordinates all staffing and training matters forthat new restaurant.  We believe that adedicated team delivers a more disciplined opening process and ensuresadherence to our company’s exacting standards and culture.  In the third quarter of 2008, we initiated agreater involvement of our district operators in our store openings to enhancethe opening process and provide more consistency of training.  Additionally, we are committed to balancestore opening schedules in the future to avoid clustering of store openings ina short period of time.

 

We have developed our restaurants usingproceeds from the sale of our securities, building and equipment financing andcash flow from operations.  We builtunits 4-9, 11-14 and 16-25 based upon the prototype we developed in early2003.  In 2004 and 2005, we retrofittedunits 1-3 to conform to this prototype model. In 2005 and 2006, we developedunits 10 and 15, respectively, which were conversions of existing restaurants.  With the exception of units 1-3 and 15, wedeveloped all of our units under our multi-site development agreement withDunham Capital Management, L.L.C. (“Dunham”), a commercial developer thatprovides us with construction management and financing for newrestaurants.  Under the developmentagreement, we lease the land and building of each restaurant developed byDunham.

 

In April 2008, we enteredinto a development agreement with United Properties Investment LLC (“UnitedProperties”) for the development of up to 22 restaurants to be built between2009 and 2012.  As our new developer,United Properties will be responsible for all costs related to the land andbuilding of each restaurant.  The developmentagreement provides for a cooperative process between United Properties and ourmanagement for the selection of restaurant sites and the development ofrestaurants on those sites and scheduling for the development and constructionof each restaurant once a location is approved. We will lease each restaurant developed under this agreement from UnitedProperties.

 

We believe that ouroperating results will fluctuate significantly because of several factors,including the timing of new restaurant openings and related expenses,profitability of new restaurants, changes in food and labor costs, increases ordecreases in comparable restaurant sales, general economic conditions, consumerconfidence in the economy, changes in consumer preferences, nutritionalconcerns and discretionary spending patterns, competitive factors, the skilland experience of our restaurant-level management teams and weather conditions.

 

We expect the timing of newrestaurant openings to have a significant impact on restaurant revenues andcosts.  We believe we will incur the mostsignificant portion of pre-opening costs associated with a new restaurantwithin the two months immediately preceding, and the month of, the opening ofsuch restaurant.

 

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Weutilize a 52/53-week fiscal year ending the last Tuesday in December forfinancial reporting purposes.  Fiscalyear 2007 had 52 weeks while fiscal year 2008 will have 53 weeks.  The additional week was included in the thirdquarter of 2008.  As such, the quarterended September 30, 2008 included 14 weeks while the quarter ended September 25,2007 included 13 weeks.

 

Thefourteen and forty weeks ended September 30, 2008 included 353 and 988operating weeks, respectively, which is the sum of the actual number of weekseach restaurant operated.  The thirteenand thirty-nine weeks ended September 25, 2007 included 246 and 714operating weeks, respectively.  Becausewe continue to expand our operations and open new restaurants at various timesthroughout the year, we provide this statistical measure to enhance thecomparison of revenues from period to period as changes occur in the number ofunits we are operating.

 

Ourrestaurant revenue is comprised almost entirely of the sales of food andbeverages.  The sale of retail itemstypically represents less than one percent of total revenue.  Product costs include the costs of food,beverages and retail items.  Labor costsinclude direct hourly and management wages, taxes and benefits for restaurantemployees.  Direct and occupancy costsinclude restaurant supplies, marketing costs, rent, utilities, real estatetaxes, repairs and maintenance and other related costs.  Pre-opening costs consist of direct costsrelated to hiring and training the initial restaurant workforce, the salariesand related costs of our dedicated new store opening team, rent expenseincurred during the construction period and other direct costs associated withopening new restaurants.  General andadministrative expenses are comprised of expenses associated with all corporateand administrative functions that support existing operations, which includemanagement and staff salaries, employee benefits, travel, information systems,training, market research, professional fees, supplies and corporate rent.  Depreciation and amortization includesdepreciation on capital expenditures at the restaurant and corporate levels andamortization of intangibles that do not have indefinite lives.  Interest expense represents the cost ofinterest expense on debt and capital leases net of interest income on investedassets.

 

**Resultsof operations as a percentage of sales**

 

Thefollowing table sets forth results of our operations expressed as a percentageof sales for the fourteen and forty weeks ended September 30, 2008 and thethirteen and thirty-nine weeks ended September 25, 2007.

 
| ** **                     | ** ** | **Fourteen**           | ** ** | **Thirteen**           | ** ** | **Forty**              | ** ** | **Thirty-nine**        | ** ** |
|--------------------------------|------------|------------------------|------------|------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                     | ** ** | **Weeks  Ended**       | ** ** | **Weeks  Ended**       | ** ** | **Weeks  Ended**       | ** ** | **Weeks  Ended**       | ** ** |
|                           | ** ** | **September 30,** | ** ** | **September 25,** | ** ** | **September 30,** | ** ** | **September 25,** | ** ** |
|                           | ** ** | **2008**               | ** ** | **2007**               | ** ** | **2008**               | ** ** | **2007**               | ** ** |
|                           |       |                   |       |                   |       |                   |       |                   |       |
| Restaurant  revenues           |       | 100.0                  | %          | 100.0                  | %          | 100.0                  | %          | 100.0                  | %          |
|                           |       |                   |       |                   |       |                   |       |                   |       |
| Cost of sales:                 |       |                   |       |                   |       |                   |       |                   |       |
| Food, beverage  and retail     |       | 29.7                   |       | 30.5                   |       | 30.4                   |       | 30.0                   |       |
| Labor                          |       | 35.8                   |       | 36.0                   |       | 37.2                   |       | 35.9                   |       |
| Direct  restaurant operating   |       | 15.0                   |       | 14.5                   |       | 14.6                   |       | 13.7                   |       |
| Occupancy                      |       | 5.8                    |       | 6.2                    |       | 6.2                    |       | 6.2                    |       |
| Total cost of  sales           |       | 86.3                   |       | 87.1                   |       | 88.5                   |       | 85.9                   |       |
|                           |       |                   |       |                   |       |                   |       |                   |       |
| Pre-opening                    |       | 2.0                    |       | 3.7                    |       | 1.8                    |       | 2.2                    |       |
| General and  administrative    |       | 10.7                   |       | 10.5                   |       | 11.0                   |       | 10.1                   |       |
| Depreciation and  amortization |       | 6.4                    |       | 5.9                    |       | 6.5                    |       | 6.1                    |       |
| Exit or disposal  activities   |       | 4.4                    |       | —                 |       | 1.5                    |       | —                 |       |
| Other                          |       | 0.2                    |       | 0.1                    |       | 0.1                    |       | 0.1                    |       |
|                           |       |                   |       |                   |       |                   |       |                   |       |
| Operating loss                 |       | (10.0                  | )          | (7.3                   | )          | (9.4                   | )          | (4.4                   | )          |
|                           |       |                   |       |                   |       |                   |       |                   |       |
| Interest:                      |       |                   |       |                   |       |                   |       |                   |       |
| Income                         |       | 0.0                    |       | 0.4                    |       | 0.0                    |       | 0.3                    |       |
| Expense                        |       | (6.7                   | )          | (4.6                   | )          | (6.5                   | )          | (5.0                   | )          |
|                           |       |                   |       |                   |       |                   |       |                   |       |
| Net interest  expense          |       | (6.7                   | )          | (4.2                   | )          | (6.5                   | )          | (4.7                   | )          |
|                           |       |                   |       |                   |       |                   |       |                   |       |
| Net loss                       |       | (16.7                  | )%         | (11.5                  | )%         | (15.8                  | )%         | (9.1                   | )%         |

 

Certain percentageamounts do not sum due to rounding.

 

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**Critical Accounting Policies**

 

Our critical accounting policies are those that require significantjudgment.  In addition to thosepreviously reported in our 2007 Annual Report on Form 10-K filed with theSecurities and Exchange Commission on March 10, 2008, the followingcritical accounting policy and related estimates were utilized in thepreparation of our financial statements:

 

*Estimated Liability for Closing Restaurants*

 

Wecontinually evaluate the performance of each of our restaurants.  If a restaurant consistently performs poorly,we consider many factors including the demographics of the location and thelikelihood of being able to improve the performance of the restaurant.  If we determine that the restaurant will not,within a reasonable period of time, perform to our expectations, we may closethe restaurant.

 

Inthe event we close a restaurant, we record the liability to cover future leasetermination costs using the fair value of these liabilities as estimated inaccordance with the requirements of Statement of Financial Accounting Standard(“SFAS”) No. 146, *Accounting for CostsAssociated with Exit or Disposal Activities.*  This estimate is generally based on the termof the lease and the lease termination fee we expect to pay.  The amount of the estimated liabilityestablished is generally the present value of these estimated net futurepayments upon exiting the property.

 

Asignificant assumption we use in determining the amount of the estimatedliability for closing a restaurant is the amount of the estimated liability forfuture lease payments on vacant restaurants, determined based on the likelihoodof successfully negotiating an early termination of the lease agreement withour landlord or subleasing the property. If it takes longer than anticipated to terminate or sublease the lease,we may need to record additional estimated liability.  If the lease on the vacant restaurant is notterminated or subleased on the terms we used to estimate the liability, we maybe required to record losses in future periods. Conversely, if the lease on the vacant restaurant is terminated orsubleased on more favorable terms than we used to estimate the liability, wewould reverse previously established estimated liability, resulting in anincrease in operating income.

 

**Resultsof operations****for the fourteen and forty weeks ended September 30, 2008 and thethirteen and thirty-nine weeks ended September 25, 2007**

 

**Revenue**

 

We generated $25,483,423 and $19,584,040 of revenue during the third quarters of2008 and 2007, respectively.  This 30.1%increase was primarily the result of 107 additional operating weeks, which is thesum of the actual number of weeks each restaurant operated.  Such additional operating weeks weregenerated due to the additional fiscal week in the third quarter of fiscal 2008and the five restaurants that opened in late 2007 and early 2008.  Comparablerestaurant revenue, which included restaurants in operation over 18 months,increased 3.8% from the third quarter of 2007 to the third quarter of 2008,primarily due to the additional fiscal week in 2008 and a price increase ofapproximately 4%, partially offset by a decrease in guest traffic, which webelieve was caused primarily by the macroeconomic factors affecting therestaurant industry in general.  Averageweekly revenue per 

 

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comparablerestaurant decreased $2,826 from $78,431 in the third quarter of 2007 to $75,605in the third quarter of 2008.

 

During the first three quarters of fiscal years 2008and 2007, we generated revenue of $74,601,745 and $56,220,186, respectively.  The 32.7% increase in firstthree quarters revenue was primarily the result of the additional fiscal weekin 2008 and the additional restaurants opened during the second half of 2007and first three quarters of 2008.  Thefirst three quarters of 2008 included 988 operating weeks, while the firstthree quarters of 2007 included 714 operating weeks.  Comparable restaurant revenue increased 2.1%in the first three quarters of 2008 over the first three quarters of 2007.  The increase in comparable restaurant revenuewas due primarily to the additional fiscal week and the 4.0% price increase,partially offset by a decrease in guest traffic, which we believe was causedprimarily by the macroeconomic factors affecting the restaurant industry ingeneral.  Average weekly revenue percomparable restaurant decreased $660 from $78,836 in the first three quartersof 2007 to $78,176 in the first three quarters of 2008.

 

We expect that restaurantrevenue will vary from quarter to quarter. We anticipate continued seasonal fluctuations in restaurant revenue duein part to increased outdoor seating and generally favorable weather conditionsat many of our locations during the summer months.  Due to the honeymoon effect that periodicallyoccurs with the opening of a restaurant, we expect the timing of new restaurantopenings to cause fluctuations in restaurant revenue.  Additionally, other factors outside of ourcontrol, such as inclement weather, timing of holidays, consumer confidence inthe economy and changes in consumer preferences may affect our future revenue.  We believe that decreased consumer confidencenegatively impacted the restaurant industry as a whole during the first threequarters of fiscal year 2008.

 

**Restaurant costs**

** **

***Foodand beverage***

** **

Our food and beverage costs, as a percentage of revenue,decreased 0.8% to 29.7% in the third quarter of 2008 from 30.5% in the thirdquarter of 2007.  Such costs increased0.4% as a percentage of revenue to 30.4% in the first three quarters of 2008from 30.0% in the first three quarters of 2007. While the cost of dairy, chicken, beef, bread, general groceries, softdrinks and beer have increased throughout the year, we believe the priceincrease of approximately 4.0% which became effective in March 2008 hascontinued to help address these commodity price increases.  The decrease in food and beverage costs as apercentage of revenue in the third quarter was in part a result of ourincreased oversight of inventory and kitchen management, as well as the menuprice increase.  We will continue tomonitor our prices in an effort to address future commodity price increases.

 

Dueto the number of restaurants we now operate throughout the Midwest, we are ableto contract for many of the food commodities we use in our restaurants forperiods up to one year.  This enables usto eliminate some of the price fluctuations due to market conditions outside ofour control, thereby enabling us to maintain or reduce our food and beveragecosts as a percentage of revenue.  We do,however, expect that our food and beverage costs will continue to vary goingforward due to numerous variables, including seasonal changes in food andbeverage costs for which we do not have contracted pricing, and guestpreferences.  We periodically create newmenu offerings and introduce new craft brewed beers based upon guestpreferences.  Although such menu modificationsmay temporarily result in increased food and beverage cost, we believe we areable to offset such increases with our weekly specials which provide varietyand value to our guests.  Our varietiesof craft brewed beer, which we believe we can produce at lower cost than beerswe purchase for resale, also enable us to keep our food and beverage costs lowwhile fulfilling guest requests and building customer loyalty.  We expect food and beverage costs at our newerrestaurants to be higher initially due to inefficiencies that are part of thestart-up process of a new restaurant. Additionally, as we add new restaurants, we believe our brewing processwill allow us to keep our high quality beer products intact while leveragingour fixed production costs, thereby enhancing overall profitability.

 

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***Labor***

 

Labor expenseconsists of restaurant management salaries, hourly staff payroll costs, otherpayroll-related items including partner and management bonuses, and non-cashstock-based compensation expense.  Ourexperience to date has been that staff labor costs associated with a newlyopened restaurant, for approximately its first four to six months of operation,are greater than what can be expected after that time, both in aggregatedollars and as a percentage of revenue.

 

Our labor costs, as a percentage of revenue, decreased 0.2% to 35.8% inthe third quarter of 2008 from 36.0% in the third quarter of 2007, primarilydue to improved oversight at the management level.  Such costs increased 1.3% as a percentage ofrevenue to 37.2% in the first three quarters of 2008 from 35.9% in the firstthree quarters of 2007.  The increase inthe first three quarters of 2008 was due primarily to new store openings andminimum wage increases, turnover and the addition of a new position at eachrestaurant to oversee inventory and kitchen management in an effort to addressthe increases in commodity costs. Although the immediate effect of these personnel additions was toincrease labor costs, we are beginning to see an overall decrease in costs ofgoods which we believe will continue in the long term.  We believe such decrease will over timeoffset this labor cost increase.

 

We expect that labor costs will vary as we add new restaurants.  Minimum wage laws, local labor laws andpractices, and as unemployment rates vary from state to state and will affectour labor costs, as will hiring and training expenses at our newrestaurants.  We believe that retaininggood employees and more experienced staff ensures high quality guest serviceand may reduce hiring and training costs.

 

***Direct restaurant operating***

 

Operating supplies, repairs and maintenance, utilities, promotions andrestaurant-level administrative expense represent the majority of our directrestaurant operating expense, a substantial portion of which is fixed orindirectly variable.  Our directrestaurant operating expense as a percentage of revenue increased 0.5% to 15.0%in the third quarter of 2008 from 14.5% in the third quarter of 2007.  Such costs increased 0.9% as a percentage ofrevenue to 14.6% in the first three quarters of 2008, from 13.7% in the firstthree quarters of 2007.  These increaseswere due to operating inefficiencies during the first few months at newlyopened restaurants, as well as increased cost of paper products, utilities andexpenses related to repair and maintenance at our mature properties, offset inpart by a decrease in marketing expense.

 

***Occupancy***

 

Our occupancy costs, which include both fixed and variable portions ofrent, common area maintenance charges, property insurance and property taxes,decreased 0.4% as a percentage of revenue to 5.8% in the third quarter of 2008from 6.2% in the third quarter of 2007. Such costs were 6.2% as a percentage of revenue in both the first threequarters of 2008 and 2007.  While rent expenseand property tax costs increased slightly year over year, they were offset by adecrease in property and casualty insurance.

 

**Pre-o****pening**

 

Pre-opening costs, which are expensed as incurred, consist of expensesrelated to hiring and training the initial restaurant workforce, wages andexpenses of our dedicated new store opening teams, rental costs incurred duringthe construction period and certain other direct costs associated with openingnew restaurants.  Pre-opening costs,excluding construction-period rent, are primarily incurred in the month of, andtwo months prior to, restaurant opening.

 

Pre-opening costs decreased $233,935 to $498,744 in the third quarterof 2008 from $732,679 in the third quarter of 2007.  Such costs increased $83,951 to $1,328,812 inthe first three quarters of 2008 from $1,244,861 in the first three quarters of2007.  Included in such expense was$322,085 and $505,149 of non-cash rental costs incurred during constructionperiods in the first three quarters of 2008 and 2007, respectively.

 

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**General and administrative**

 

General and administrative expense includes all salaries and benefits,including non-cash stock-based compensation, associated with our corporatestaff that is responsible for overall restaurant quality, future expansion intonew locations, financial controls and reporting, restaurant managementrecruiting, management training, excess capacity costs related to our beerproduction facility, and salaries and expenses of our new store opening teamwhen it is not dedicated to a particular restaurant opening.  Other general and administrative expenseincludes advertising, professional fees, investor relations, officeadministration, centralized accounting system costs and travel by our corporatemanagement.

 

General and administrative expense increased $680,089 to $2,735,500 inthe third quarter of 2008 from $2,055,411 in the third quarter of 2007.  Such expense increased $2,507,494 to $8,206,848in the first three quarters of 2008 from $5,699,354 in the first three quartersof 2007.  As a percentage of revenue,general and administrative expenses increased 0.2% to 10.7% in the thirdquarter of 2008 and increased 0.9% to 11.0% in the first three quarters of 2008over the respective periods in 2007.  Theprimary sources of such increases were expenses related to recruiting,relocation, training and consulting costs, as well as accounting services andmarketing expense.  We undertook anambitious recruiting plan to upgrade our overall restaurant management teams,particularly in our Kansas/Missouri markets. These increases were partially offset by decreases in insurance,non-cash stock-based compensation and an adjustment of $285,790 for the portionof our gift card obligation for which we believe the likelihood of redemptionis remote.  Non-cash stock basedcompensation included in general and administrative expense was $115,110 and$286,345 in the third quarters of 2008 and 2007, respectively, and was $337,367and $670,736 in the first three quarters of 2008 and 2007, respectively.

 

As we continue to expand our restaurant chain, we will closely monitorour general and administrative expense while seeking to preserve aninfrastructure that remains suitable for our current operations and potentialgrowth.  We may need to recruitadditional personnel to provide continued oversight of operations depending onour turnover ratios.  To the extent ourturnover increases above our expectations, additional costs could be incurredin our recruiting and training expenses. We believe our general and administrative expense as percentage ofrevenue will level off as many of our new recruits complete their training, anddecrease in the long term due to economies of scale.

 

**Depreciation and amortization**

 

Depreciation and amortization expense increased $480,457 to $1,640,343in the third quarter of 2008 from $1,159,886 in the third quarter of 2007.  Such expense increased $1,412,786 to$4,815,399 in the first three quarters of 2008 from $3,402,613 in the prioryear period, due principally to the additional depreciation related to newrestaurants.  As a percentage of revenue,depreciation increased 0.5% in the third quarter of 2008 and increased 0.4% inthe first three quarters of 2008 over the respective periods in 2007.

 

**Exit or disposal activities**

 

On August 19, 2008, we closed our Rogers, Arkansasrestaurant.  Since opening in October 2007,the restaurant failed to generate positive cash flow and had approximately $1.4million of net loss.  We believe theclosure of this restaurant will allow management to focus its capital andpersonnel resources on its other restaurants in order to increase futureoperating efficiencies, cash flow and income. We are working to find a replacement tenant for the location, for whichwe are bound by a 20-year net lease. Costs incurred in connection with this closure include one-time benefitsto employees who were involuntarily terminated of approximately $57,700, costsincurred for early contract termination of approximately $4,580 and costs toclose and maintain the facility of approximately $70,652.  We will incur ongoing costs such asutilities, landscape and maintenance and general liability insurance until weare able to find a replacement tenant. In accordance with the requirements ofSFAS No. 146, *Accounting for CostsAssociated with Exit or Disposal Activities,* we recorded a non-cashlease termination liability of $852,146 based on management’s estimate of thefair value of these obligations.  This requiredmanagement to estimate the present value of the future minimum leaseobligations offset by the estimated sublease rentals that could be reasonablyobtained for the property.  During thethird quarter of 2008, we recorded a non-cash impairment charge of $134,467related to the write-off of the carrying value of the

 

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restaurantequipment at the Rogers location.  Allcosts related to the closing of the Rogers restaurant, including the assetimpairment charge, aggregated $1,119,545 and are reflected in our incomestatement as “exit or disposal activities”.

 

**Interest**

 

Net interest expense consists of interest expense on capital leases andlong-term debt, net of interest earned from cash on hand.  Interest expense increased $791,234 to$1,701,871 in the third quarter of 2008 from $910,637 in the third quarter of2007.  Such expense increased $2,027,910to $4,841,825 in the first three quarters of 2008 from $2,813,915 in the firstthree quarters of 2007.  The increaseswere due to additional capital leases as a result of new restaurants andequipment leases.  Interest incomedecreased $83,899 in the third quarter of 2008 and decreased $161,139 in thefirst three quarters of 2008 over the respective periods in 2007 due to thereduction of cash on hand.

 

**Liquidity and capital resources**

 

As of September 30, 2008, we had $2,055,548 of cash and a workingcapital deficit of $5,284,662 compared to $7,076,835 of cash and a workingcapital deficit of $3,668,297 at December 25, 2007.

 

During the forty weeks ended September 30,2008, we used $8,270,176 of net cash in operating activities and $3,298,269 ofnet cash to purchase equipment and other assets primarily related to therestaurants we opened in the first and third quarters of 2008 and therestaurants we plan to open in Indianapolis, Indiana and Troy, Michigan.  We made payments aggregating $1,481,908 onour debt and capital lease obligations, received $8.0 million in proceeds fromcapital lease obligations and received $29,066 of net cash through the exerciseof stock options.

 

During the thirty-nine weeks ended September 25, 2007, we used$1,363,617 of net cash in operating activities, $5,650,900 of net cash topurchase equipment and other assets primarily related to our new restaurantexpansion, and made payments aggregating $6,969,211 on our debt and capitallease obligations.  Of such capital leasepayments, approximately $6.0 million represented a one-time payment to retiredebt obtained from DHW Leasing, L.L.C. (“DHW”) as detailed below.  Additionally, we received net cash of$12,795,966 from the issuance of our common stock, of which approximately $25,000was received from the exercise of options and warrants while the remainderrepresented the net proceeds from the sale of common stock in March 2007.

 

In April 2008, weentered into a development agreement with United Properties for the developmentof up to 22 restaurants to be built between 2009 and 2012.  As our new developer, United Properties willbe responsible for all costs related to the land and building of eachrestaurant.  The development agreement provides for acooperative process between United Properties and our management for theselection of restaurant sites and the development of restaurants on those sitesand scheduling for the development and construction of each restaurant once alocation is approved.  We will lease eachrestaurant developed under this agreement from United Properties.

 

We intend to continue expansion in markets where we believe our conceptwill have broad appeal and attractive restaurant-level economics.  We plan to continue using our restaurantprototype as we open future restaurants; however, where appropriate, we willconvert existing restaurants to our Granite City concept.  Additionally, we intend to explorealternative restaurant designs to reduce the cost of our initial capitalinvestment and we may alter our prototype to meet various state and localregulatory requirements, including, but not limited to, pollution controlrequirements, liquor license ordinances and smoking regulations.  We have signed lease agreements for alocation in Indianapolis, Indiana which we intend to open in early 2009 and alocation in Troy, Michigan which we anticipate opening in mid-2009.

 

Basedupon our existing prototype, we anticipate that pre-opening costs and theinitial purchase of furniture, fixtures and equipment will require aninvestment by us of approximately $1.1 million for each new restaurant.  We anticipate that our new restaurants willrequire an investment by our developer of approximately $1.8 million to$2.3 million for the building and approximately $1.2 million to$1.5 million for the purchase of the

 

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land.  We expect these costs willvary from one market to another based on real estate values, zoningregulations, labor markets and other variables.

 

Pursuantto the terms of some of our lease agreements, the developer of that sitereceives a construction allowance from the landlord which, in turn, is passedon to us as a reduction in the construction cost of a new restaurant.  Landlord contributions received related torestaurants developed in 2007 and 2008 ranged from $1.0 million to$1.5 million per location.  Our netcapital investment is lower for a restaurant that receives a landlordcontribution.  In some instances weelected to use our own cash for a portion of the building costs, resulting inlower minimum lease payments.

 

Tofinance restaurant openings in 2008, we entered into a master equipment leasewith DHW in December 2007.  Detailsregarding such arrangement appear below under the caption “Commitments—CapitalLeases.”

 

Wewill need to expend additional capital in connection with our long-termexpansion plans.  Based on our September 30,2008 cash position of $2.1 million, the December 2007 $16.0 millionDHW Equipment Lease Commitment, of which approximately $3.0 million inlease financing remained available to us as of September 30, 2008, andexpected cash flows from operations, based on the current momentum of ourimproved operating margins, our management believes we will have sufficientfunds to complete our currently-planned restaurant openings through 2009 andmaintain sufficient working capital for our operations.  However, we are currently evaluating ourdevelopment plans in relation to the current economic conditions.  To the extent our management determines amore aggressive store-opening plan is appropriate to brand our company andbetter leverage our infrastructure, we may require further funding sooner thananticipated.  The amount of any suchrequired funding would depend upon the number of openings, cost of capital,availability of developer financing or landlord-tenant improvement funding,adverse sales trends, and our company’s ability to generate positive cashflow.  We are exploring opportunities toreduce our cash usage per restaurant by utilizing sites that offer lower costsof capital and real estate funding.  Ifour available sources of liquidity are insufficient to fund our expectedcapital needs, or our needs are greater than anticipated, we will be requiredto raise additional funds in the future through the incurrence of indebtednessor public or private sales of equity securities.  We continue to pursue additional debtfinancing alternatives in order to solidify our expansion plans.  If we do not generate sufficient cash flowfrom current operations or if financing is not available to us, we will have tocurtail projected growth, which could materially adversely affect our business,financial condition, operating results and cash flows.

 

Ourability to fund our operations in future periods will depend upon our futureoperating performance, and more broadly, on the availability of equity and debtfinancing, which will be affected by prevailing economic conditions in ourindustry and financial, business and other factors, some of which are beyondour control.  We cannot assure you thatwe will obtain financing on favorable terms or at all.  If we elect to raise additional capitalthrough the issuance and sale of equity securities, the sales may be at pricesbelow the market price of our stock, and our shareholders may suffersignificant dilution.  Debt financing, ifavailable, may involve significant cash payment obligations, covenants and financialratios that restrict our ability to operate and grow our business, and wouldcause us to incur additional interest expense and financing costs.

 

**Commitments**

 

*Capital Leases:*

* *

As of September 30,2008, we operated 23 restaurants under capital lease agreements.  Of these leases, one expires in 2020, two in2023, four in 2024, three in 2025, four in 2026, seven in 2027 and theremaining two in 2028, all with renewable options for additional periods.  Twenty-one of these lease agreementsoriginated with Dunham.  Under 13 of theleases, we may be required to pay additional contingent rent based uponrestaurant sales.  The land portion ofthese leases is classified as an operating lease, while the building portion ofthese leases is classified as a capital lease because its present value wasgreater than 90% of the estimated fair value at the beginning of the leaseand/or the lease term represents 75% or more of the expected life of theproperty.

* *

*23*

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* *

*In December 2004,we entered into a land and building lease agreement for our beer productionfacility.  This ten-year lease, whichcommenced February 1, 2005, allows us to purchase the facility at any timefor $1.00 plus the unamortized construction costs.  Because the construction costs will be fullyamortized through payment of rent during the base term, if the option isexercised at or after the end of the initial ten-year period, the option pricewill be $1.00.  As such, the lease isclassified as a capital lease.*

* *

In August 2006, weentered into a master lease agreement with Carlton Financial Corporation (“Carlton”)pursuant to which we could “finance lease” up to $3.0 million of equipmentpurchases for three restaurant locations. As of September 30, 2008, we had entered into three lease schedulesand amendments to this master lease, pursuant to which we are leasing equipmentfor three locations for an initial lease term ranging from 36 to39 months.  The value of theequipment financed at each of the three locations ranges from approximately$0.8 million to $1.1 million and the annual interest rate on eachranges from 12.9% to 19.6% annually.  Wehave provided Carlton with refundable security deposits aggregating $251,165 aswell as a security interest in certain other equipment.  At the end of each initial lease term, we may(a) purchase Carlton’s interest in all, but not less than all, of theequipment for a purchase price equal to the greater of (1) the fair marketvalue of the equipment, or (2) 15% of the original cost of the equipment,or (b) renew such lease for 12 months at a monthly lease payment ofapproximately one-half of the original monthly payment and take ownership ofthe equipment thereafter for $1.00. Steven J. Wagenheim, our president, chief executive officer and oneof our directors, was required to personally guarantee payments to be made toCarlton under the lease financing and our board of directors agreed tocompensate him for such guarantee.  Theamount of annual compensation is 3% of the balance of such lease and iscalculated and accrued based on the weighted average daily balance of the leaseat the end of each monthly accounting period.

* *

*In December 2007,we entered into an Equipment Lease Commitment with DHW, relating to the leaseof furniture, fixtures and equipment for current and future restaurants.  Under the terms of the Equipment LeaseCommitment, DHW agreed to purchase and lease to us equipment costing up to$16.0 million.  Each five-year leaseis intended to be for equipment costing a minimum of $0.8 million and amaximum of $1.25 million per restaurant. Payments due DHW have an interest rate equal to the DHW bank base rateplus 4.8%.  Principal payments on theamounts borrowed depend upon the repayment schedule specified by the banks thathave provided the financing commitments to DHW. The lease financing is subject to the availability of financingcommitments to DHW from its lenders.  Wehave the option to purchase the leased equipment for $1.00 upon payment in fullof all rent payments due under each lease. We are not obligated to enter into any equipment leases with DHW,although we intend to enter into equipment leases with DHW for the foreseeablefuture.  DHW is not obligated to provideequipment leases for restaurants that are not developed and constructed byDunham.  While Mr. Wagenheim owns a20% membership interest in DHW and has agreed to personally guarantee 20% ofDHW’s indebtedness to its lenders, his participation in the income and profitsof DHW may not exceed 3% of the average principal balance of the amountguarantied for the term of the guarantied debt. Furthermore, Mr. Wagenheim will not receive a guarantee fee orother payment from our company in connection with the equipment lease financingfrom DHW.  As of September 30, 2008,DHW had purchased and leased to us equipment at 13 of our restaurants underthis Equipment Lease Commitment.  Thevalue of the equipment financed at each restaurant is approximately$1.0 million and the current annual interest rate on each lease rangesfrom 10.3% to 12.3%.*

* *

*In June 2007,we entered into a lease for an energy optimization system at our Maple Groverestaurant for approximately $30,000. This five-year lease commenced June 28, 2007, carries an annualinterest rate of approximately 11.9% and contains a bargain purchase option.*

* *

On August 19, 2008, we ceased operations at our restaurant inRogers, Arkansas.  However, we arecurrently bound by the terms of the 20-year net lease agreement entered into in2007 under the terms specified in the development agreement with Dunham.  The building portion of this lease isclassified as a capital lease, while the land portion is classified as an operatinglease (see Note 3).

 

As of September 30, 2008, we had entered into two 20-year netlease agreements under the terms specified in the development agreement withDunham relating to restaurant properties in Indianapolis, Indiana 

 

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and Troy, Michigan.  The land portion of these leases will beclassified as an operating lease while the building portion of these leaseswill be classified as a capital lease. Basic terms of the leases include annual rent equal to 10.5% of theconstruction cost plus the land lease and contingent rent based on a percentageof revenue.  The base rent will escalate10% at the end of each five-year period. The term of each lease will commence when operations begin we will beresponsible for any real-estate taxes and all operating costs.  Rental costs associated with the operatinglease incurred during the construction period are recognized as pre-openingcosts and escalated rent will be recognized as expense on a straight-line basisover the term of each lease.

 

*Operating Leases*:

 

The land portions of the 23 property leases referencedabove, as well as the land portion of the Rogers lease, are classified asoperating leases because the fair value of the land was 25% or more of theleased property at the inception of each lease. All scheduled rent increases for the land during the initial term of eachlease are recognized on a straight-line basis. In addition to such property leases, we have obligations under thefollowing operating leases:

 

In January 2001, weentered into a 20-year operating lease for the land upon which we built ourFargo restaurant.  Under the lease terms, we are obligated toannual rent of $72,000 plus contingent rent based upon restaurant sales.

 

In August 2005, weentered into a 38-month lease agreement for office space for our corporateoffices.  The lease commenced October 1, 2005.  In November 2007, we entered into anamendment to such lease to include additional space commencing December 1,2007.  Pursuant to the amended lease, which expires in November 2011, annual rent is $96,613 withscheduled annual increases throughout the term of the lease.  Suchscheduled rent increases are recognized on a straight-line basis over the termof the lease.

 

In November 2005, weentered into a lease agreement for a facility in Minneapolis, Minnesota whichwe use as a test kitchen.  This three-year lease agreement includes anoption for a three-year renewal which we have exercised.  Annual rent is $42,000.

 

In March 2006, weentered into a lease agreement for the land and building for our St. LouisPark, Minnesota restaurant.  Rental payments for this lease are $148,625annually.  This operating lease expires in 2016 with renewal options foradditional periods.

 

In April and May 2008,we entered into 20-year net lease agreements relating to restaurants weanticipate opening in 2009 in Indianapolis, Indiana and Troy, Michigan, respectively.  Each leaseagreement was entered into under the terms specified in the developmentagreement with Dunham.  The restaurantswill be constructed for us on a build-to-suit basis.  Basic terms ofthe leases include annual rent equal to 10.5% of the construction cost plus theland lease and contingent rent.  The baserent will escalate 10% at the end of each five-year period.  The term ofeach lease will commence when operations begin and we are responsible for anyreal-estate taxes and all operating costs.  Rental costsassociated with each operating lease incurred during the construction period are recognized as pre-openingcosts and escalating rent will be recognized as expense on a straight-linebasis over the term of each lease.

 

*Personal Guaranties*

* *

*Two of ourdirectors and one former director have personally guaranteed certain of ourleases and loan agreements.  Inconnection with the $1.5 million loan we obtained in July 2001 tofinance our Fargo restaurant, we entered into an agreement concerning guarantywhich provides, among other things, that such guarantors will be indemnifiedfrom any liabilities they may incur by reason of their guaranties of ourindebtedness.  Our board of directors hasagreed to compensate Steven J. Wagenheim, our president, chief executiveofficer and one of our directors, for his personal guaranties of equipmentloans entered into in August 2003 and January 2004.  In August 2006, we entered into a leaseagreement with Carlton pursuant to which we may finance lease up to$3.0 million of equipment.  Mr. Wagenheimwas required to personally guarantee payments to be made to Carlton*

* *

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* *

*under thislease financing agreement, for which our board of directors agreed tocompensate him.  The amount of annualcompensation for each of these guarantees is 3% of the balance of theobligation and is calculated and accrued based on the weighted average dailybalance of the obligation at the end of each monthly accounting period.  During the first three quarters of 2008 and2007, we recorded $71,716 and $34,361 of such compensation in general andadministrative expense, respectively.  Wepaid $40,000 and $50,000 of such compensation in the first three quarters of2008 and 2007, respectively.*

* *

*In December 2007,we entered into an Equipment Lease Commitment and Master Equipment Lease withDHW, relating to the lease of furniture, fixtures and equipment for current andfuture restaurants.  Under the terms ofthe Equipment Lease Commitment, DHW has agreed to purchase and lease to usequipment costing up to $16.0 million. While Mr. Wagenheim owns a 20% membership interest in DHW and hasagreed to personally guarantee 20% of DHW’s indebtedness to its lenders, hisparticipation in the income and profits of DHW may not exceed 3% of the averageprincipal balance of the amount guarantied for the term of the guarantieddebt.  Furthermore, Mr. Wagenheimwill not receive a guarantee fee or other payment from our company inconnection with the equipment lease financing from DHW.*

* *

*Employment Agreements:*

* *

*In June 2005,we entered into a three-year employment agreement with Steven J. Wagenheim, ourpresident and chief executive officer, who also is one of our directors.  In April 2007, we amended thecompensatory arrangements under the agreement to provide for an annual basesalary of $300,000, commencing April 1, 2007; cash incentive compensationfor 2007 ranging from $0 to $197,400 based on performance; and a stock optionfor the purchase of 100,000 shares of common stock.  In addition to annual compensation terms andother provisions, the agreement includes change in control provisions thatwould entitle Mr. Wagenheim to receive severance pay equal to18 months of salary if there is a change in control of our company and hisemployment terminates.  Our company and Mr. Wagenheimhave agreed to continue operating under the terms of this agreement until suchtime as a new agreement becomes effective.*

* *

*In November 2007,we entered into an employment agreement with James G. Gilbertson providing forhis employment as our chief financial officer on an at-will basis at an annualbase salary of $225,000.  He is entitledto participate in performance-based cash bonus or equity award plans for seniorexecutives based upon goals established by our board or compensation committeeafter reasonable consultation with Mr. Gilbertson.  He may be eligible to receive a bonus of upto 50% of his base salary.  We alsogranted to Mr. Gilbertson a stock option for the purchase of 175,000shares of common stock, vesting over a two-year period, upon the commencementof his employment.  The employmentagreement provides for provisions for termination with and without cause by usand for good reason by Mr. Gilbertson and for the payment of a severancepayment equal to 12 months of base salary upon termination of employmentresulting from a change of control of our company, or if Mr. Gilbertson isterminated without cause.  The employmentagreement contains other customary terms and conditions.*

* *

*Development Agreements:*

 

In October 2002, we entered into a development agreement withDunham for the development of restaurants. Dunham is controlled by Donald A. Dunham, Jr., who is a member ofDHW and an affiliate of Granite Partners, LLC, a beneficial owner ofapproximately one percent of our securities. The agreement gave Dunham the right to develop, construct and lease upto 22 restaurants for us prior to December 31, 2012.  As of July 29, 2008, 22 restaurants hadbeen constructed for us under this development agreement and we had signed twoadditional lease agreements for restaurants we plan to open in 2009.  Dunham also has the right to sell the underlyingland and building to third parties or assign these leases.  As of September 30, 2008, Dunham hadsold six of our restaurant sites to third parties.  The assignment or sale of a lease by Dunhamhas had no material impact on our company.

 

In April 2008, we entered into a development agreement with UnitedProperties for the development of up to 22 restaurants to be built between 2009and 2012.  As our new developer, UnitedProperties will be responsible for all costs related to the land and buildingof each restaurant.  The development agreement provides for a 

 

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cooperative process between United Properties and our management forthe selection of restaurant sites and the development of restaurants on thosesites and scheduling for the development and construction of each restaurantonce a location is approved.  The annual lease rate for fee-simple land andbuilding developments will be 9.5% and we will have the right of first offer topurchase these restaurants. Additionally, in the event United Properties sells one of the buildingsthat it develops for us at an amount in excess of the threshold agreed to bythe parties in the agreement, then we will share in the profits of thatsale.  We assume no liability in theevent United Properties sells a building at a loss.  We are not bound to authorize theconstruction of restaurants during that time period, but generally cannot useanother developer to develop or own a restaurant as long as the developmentagreement is in effect.  We can, however,use another developer if United Properties declines to build a particularrestaurant.

 

*Off- balance sheet arrangements:*

 

It is not our business practice to enter intooff-balance sheet arrangements.

 

*Summary of contractual obligations:*

 

Thefollowing table summarizes our obligations under contractual agreements as of September 30,2008 and the time frame within which payments on such obligations are due.  This table does not include amounts relatedto contingent rent as such future amounts are not determinable.  In addition, whether we would incur any additionalexpense on our employment agreements depends upon the existence of a change incontrol of the company or other unforeseeable events.  Therefore, neither contingent rent norseverance expense has been included in the following table.

 
| ** **                                       | ** ** | **Payments due by period** | ** **  |
|--------------------------------------------------|------------|-------------------------------------------|-------------|
| **Contractual Obligations**                 | ** ** | **Total**                                 | ** **  | **Fiscal Year  2008** | ** ** | **Fiscal Years  2009-2010** | ** ** | **Fiscal Years  2011-2012** | ** ** | **Fiscal Years  Thereafter** | ** ** |
| Long-term debt,  principal                       |       | $                                         | 1,811,457   |   | $ | 72,782 |   | $ | 601,509 |   | $ | 1,137,166 |   | $ | — |   |
| Interest on  long-term debt                      |       | 370,402                                   |        | 43,788 |   | 258,494 |   | 68,120 |   | — |   |
| Capital lease  obligations, including interest   |       | 149,605,869                               |        | 2,294,358 |   | 21,235,245 |   | 21,504,883 |   | 104,571,382 |   |
| Operating lease  obligations, including interest |       | 73,492,277                                |        | 935,934 |   | 7,910,765 |   | 7,891,185 |   | 56,754,394 |   |
| Loan guarantee                                   |       | 179,077                                   |        | 99,570 |   | 58,363 |   | 21,144 |   | — |   |
| Total obligations                                |       | $                                         | 225,459,081 |   | $ | 3,446,431 |   | $ | 30,064,375 |   | $ | 30,622,498 |   | $ | 161,325,776 |   |

 

Certain amounts do not sum due to rounding.

 

Based on our cash position at September 30,2008, the December 2007 $16.0 million DHW Equipment LeaseCommitment, of which approximately $3.0 million in lease financingremained available to us as of September 30, 2008, as well as cashgenerated from operations, we believe that we will have sufficient capital to meet our current obligations.

 

*Recent accounting pronouncements:*

 

Seethe “Recent accounting pronouncements” section of Note 1 to our condensedconsolidated financial statements for a summary of recent accounting standards.

 

**Seasonality**

 

We expect that our sales and earnings willfluctuate based on seasonal patterns.  Weanticipate that our highest sales and earnings will occur in the second andthird quarters due to the milder climate and availability of outdoor seatingduring those quarters in our existing and proposed markets.

** **

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**Inflation**

** **

Theprimary inflationary factors affecting our operations are food, supplies andlabor costs.  A large percentage of ourrestaurant personnel is paid at rates based on the applicable minimum wage, andincreases in the minimum wage directly affect our labor costs.  In the past, we have been able to minimizethe effect of these increases through menu price increases and otherstrategies.  To date, inflation has nothad a material impact on our operating results.

 

**ITEM 3****                  ****Quantitative andQualitative Disclosures about Market Risk**

 

Our company is exposed tomarket risk from changes in interest rates on debt and changes in commodityprices.

 

*Changesin interest rates:*

 

Pursuantto the terms of our capital leases and long-term debt, we will have balloonpayments due over the next two to five years. If it becomes necessary to refinance such balloon balances, we may notbe able to secure financing at the same interest rate.  The effect of a higher interest rate woulddepend upon the negotiated financing terms.

 

*Changes in commodity prices:*

 

Manyof the food products and other commodities we use in our operations are subjectto price volatility due to market supply and demand factors outside of ourcontrol.  Extreme fluctuations incommodity prices and/or long-term changes could have an adverse effect onus.  These commodities are generallypurchased based upon market prices established with vendors.  To manage this risk in part, we attempt toenter into fixed price purchase commitments, with terms typically up to oneyear, for many of our commodity requirements. Although a large national distributor is our primary supplier of food,substantially all of our food and supplies is available from several sources,which helps to control commodity price risks. Additionally, we have the ability to increase menu prices, or vary themenu items offered, in response to food product price increases.  If, however, competitive circumstances limitour menu price flexibility, margins could be negatively impacted.

 

Our company does notenter into derivative contracts either to hedge existing risks or forspeculative purposes.

 

**ITEM 4****                  ****Controls and Procedures**

 

*Evaluationof disclosure controls and procedures*

 

We maintain a system of disclosure controlsand procedures that is designed to ensure that information required to bedisclosed in our Exchange Act reports is recorded, processed, summarized andreported within the time periods specified in the SEC’s rules and forms,and that such information is accumulated and communicated to our management,including our Chief Executive Officer and Chief Financial Officer, asappropriate, to allow timely decisions regarding disclosures.

 

Under the supervision and with theparticipation of our management, including our Chief Executive Officer andChief Financial Officer, we conducted an evaluation of our disclosure controlsand procedures (as defined in Exchange Act Rules 13a-15(e) and15d-15(e)).  Based on this evaluation,our Chief Executive Officer and our Chief Financial Officer concluded that, asof September 30, 2008, our disclosure controls and procedures wereeffective.

 

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*Changes in internal control over financial reporting*

 

There were no changes in our internal controlover financial reporting that occurred during the quarter ended September 30,2008, that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

**PART II****              ****OTHER INFORMATION**

 

**ITEM 1****                 ****Legal Proceedings**

 

Not applicable.

 

**ITEM 1A****              ****Risk Factors**

 

Please refer to the “Risk Factors” section of our Annual Report on Form 10-Kfor the fiscal year ended December 25, 2007, filed with the Securities andExchange Commission on March 10, 2008.

 

**ITEM 2****                 ****Unregistered Sales of EquitySecurities and Use of Proceeds**

 

Not applicable.

 

**ITEM 3****                  Defaultsupon Senior Securities**

 

Not applicable.

 

**ITEM 4****                 ****Submission of Matters to a Voteof Security Holders**

 

Not applicable.

 

**ITEM 5****                 ****Other Information**

 

Not applicable.

 

**ITEM 6****                 ****Exhibits**

 

See “Index to Exhibits.”

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

 
|                                                       | GRANITE CITY FOOD & BREWERY LTD.                                                                   |
|------------------------------------------------------------|-------------------------------------------------------------------------------------------------------------|
|                                                       |                                                                                                        |
| Date:     November 10,  2008 | By:                                                                                                         |  /s/ James G. Gilbertson |
|                                                       | James G. Gilbertson                                                                                         |
|                                                       | Chief Financial Officer                                                                                     |
|                                                       | (As Principal Financial Officer and Duly  Authorized Officer of Granite City Food &  Brewery Ltd.) |
|                                                            |                                                                                                             |  |  |

 

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**INDEX TO EXHIBITS**

 
| **Exhibit** | ** ** | ** **                                                                                                                                                                                                             |
|-------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Number**  | ** ** | **Description**                                                                                                                                                                                                        |
| ** **  | ** ** | ** **                                                                                                                                                                                                             |
| 3.1         |       | Articles of Incorporation of the Company, as amended (incorporated by  reference to our Quarterly Report on Form 10-QSB, filed on  November 13, 2002 (File No. 000-29643)).                             |
|        |       |                                                                                                                                                                                                                   |
| 3.2         |       | Amended and Restated Bylaws of the Company, dated May 2, 2007  (incorporated by reference to our Current Report on Form 8-K, filed on  May 4, 2007 (File No. 000-29643)).                          |
|        |       |                                                                                                                                                                                                                   |
| 4.1         |       | Reference is made to Exhibits 3.1 and 3.2.                                                                                                                                                                             |
|        |       |                                                                                                                                                                                                                   |
| 4.2         |       | Specimen common stock certificate (incorporated by reference to our  Current Report on Form 8-K, filed on September 20, 2002 (File  No. 000-29643)).                                                    |
|        |       |                                                                                                                                                                                                                   |
| 31.1        |       | Certification by Steven J. Wagenheim, President and Chief Executive  Officer of the Company, pursuant to Exchange Act Rule 13a-14(a), as  adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
|        |       |                                                                                                                                                                                                                   |
| 31.2        |       | Certification by James G. Gilbertson, Chief Financial Officer of the  Company, pursuant to Exchange Act Rule 13a-14(a), as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.               |
|        |       |                                                                                                                                                                                                                   |
| 32.1        |       | Certification by Steven J. Wagenheim, President and Chief Executive  Officer of the Company, pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.      |
|        |       |                                                                                                                                                                                                                   |
| 32.2        |       | Certification  by James G. Gilbertson, Chief Financial Officer of the Company, pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                   |

 

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