Document:

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                                                                    Exhibit 10.1

                                    AGREEMENT

         AGREEMENT, dated as of June 14, 2001, between HANCOCK FABRICS, INC.
("the Company"), a Delaware corporation, and James A. Austin ("the Employee").

         A.       The Employee has been employed by the Company (or
one of its subsidiaries) since June 14, 2001. During the period of such
employment the judgment, skill and efforts of the Employee have contributed
greatly to the growth and success of the Company, and the Company desires to
provide for the continued availability of the services of the Employee. The
Company further recognizes that it would not be to the best interest of the
Company were the Employee to engage in activities competitive with the business
of the Company or any of its subsidiaries.

         B.       The Employee is willing and able to render the services herein
provided for, and is willing to refrain from activities competitive with the
business of the Company and its subsidiaries, on the terms herein set forth.

         IT IS AGREED AS FOLLOWS:

         1.       The payment obligation of the Company under this Agreement is
conditioned upon the occurrence of one of the following: (a) the Employee
remains in the employment of the Company or any of its subsidiaries on a
full-time basis until 12/31/2013 ("said date"); or, (b) the Employee dies prior
to said date while so employed by the Company or any of its subsidiaries.

         2.       If such employment ceases (other than by reason of death) on
or after said date, the Company shall pay to the Employee, if living, Two
Thousand Five Hundred Dollars ($2,500.00) (the "monthly amount") on the first
day of the calendar month following such cessation, and on the first day of

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each and every month thereafter until a total of one hundred eighty (180)
monthly payments shall have been paid.

         3.       (a) If the Employee dies while still so employed by the
Company or any of its subsidiaries, the Company shall pay, as the Employee by
appointment shall have provided pursuant to paragraph 10 hereof, the monthly
amount on the first day of the month following his death, and on the first day
of each and every month thereafter until a total of one hundred eighty (180)
monthly payments shall have been paid.

                  (b) If the Employee dies after said date, and prior to the
time that the payments made to him pursuant to paragraph 2 hereof shall have
totaled Four Hundred Fifty Thousand Dollars ($450,000.00) ("the total amount"),
the Company shall pay, as the Employee by appointment shall have so provided,
the monthly amount on the first day of the month following his death, and on
the first day of each and every month thereafter until the sum of all
payments made under paragraph 2 hereof and under this paragraph shall equal the
total amount.

         4.       So long as the Employee is receiving monthly payments
hereunder, he shall not, without the prior approval of the Board of Directors of
the Company, engage in or be or become interested (as an individual, officer,
principal, agent, employee, trustee, investor, stockholder or creditor, or in
any other relation whatsoever) in any business substantially competitive with
the business of the Company, its successor or subsidiary; provided, that the
Employee shall not be precluded from holding securities of a corporation, which
securities are publicly held, so long as the Employee shall not hold in excess
of one percent (1%) of any class of said securities. The determination of the
Board of Directors of the Company shall be conclusive of the question

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whether any such business is substantially competitive with the business of the
Company.

         5.       So long as the Employee is receiving monthly payments
hereunder, he shall, at the reasonable request of the Company, and to the extent
consistent with his then age and state of health, make available to the Company
at all reasonable times the benefit of his experience and advice. The Company
shall reimburse the Employee for his reasonable travel and other expenses
incurred in the performance of his obligations under this paragraph.

         6.       All obligations of the Company under this Agreement are
conditioned upon the performance by the Employee of his obligations under
paragraphs 4 and 5 hereof. Upon failure of any said condition, this Agreement
shall be of no further effect, and no person shall have any further right to
payments hereunder.

         7.       Nothing in this Agreement shall be construed to affect the
rights and obligations of the Employee, his heirs, successors or personal
representatives, under the Company's Retirement Plan, Extra Compensation Plan,
or employees' stock option plans, as from time to time amended, or under any
other agreement or plan. Payments pursuant to this Agreement are in the nature
of a fee, and do not constitute "compensation" as defined in the Company's
Retirement Plan.

         8.       This Agreement is not a contract of employment, and shall not
be deemed to affect the right of either the Employee or the Company to terminate
the employment of the Employee by the Company at any time, with or without
cause.

         9. The right to payments pursuant to this Agreement shall not be sold,
transferred, anticipated, assigned, hypothecated, or otherwise disposed

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of, shall not at any time be subject to the claims of creditors, and shall not
be liable to attachment, execution, or other legal process. The Company shall
have no obligation to make any payment hereunder to any person other than the
Employee or his appointee designated pursuant to paragraph 10 hereof.

         10.      Subject to the provisions of paragraph 9 of this Agreement,
the Employee may appoint, by written instrument (other than a will) delivered to
the Secretary of the Company, the permitted appointee or appointees to whom, the
proportions in which, and any contingencies upon which the Company shall make
payments payable under paragraphs 2 and 3 of this Agreement, but not paid prior
to the death of the Employee. "Permitted appointee" includes only the following
persons: spouse, descendant (or spouse thereof), parent, brother or sister of
the Employee (or descendant of such brother or sister); parent, descendant,
brother or sister of the spouse of the Employee (or descendant of such brother
or sister); the trustee or trustees of a trust or trusts (created by the
Employee either during his lifetime or by his will) the purpose of which is
primarily to provide for any of the foregoing persons; or any other natural
person. The determination of the Board of Directors of the Company shall be
conclusive of the question whether such purpose of any such trust is primarily
to provide for such person or persons. To any extent that amounts payable under
paragraphs 2 and 3 of this Agreement are not paid to the Employee prior to his
death and are not the subject of an effective appointment pursuant to this
paragraph, no person shall be entitled to payment thereof, and said amounts
shall remain the property of the Company.

         11.      For purposes of this Agreement, the Employee shall be deemed
to be in the employment of the Company on a full-time basis during any period
for which he is on Company-approved sick leave or disability leave.

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         12.      Notwithstanding any of the provisions of this Agreement, no
payments shall be made hereunder following the death of the Employee in the
event that such death is the result of suicide occurring within three years of
the date of this Agreement.

         13.      This Agreement shall be binding upon the parties hereto, their
heirs, personal representatives and successors. Upon the sale of all or
substantially all of the assets, business and goodwill of the Company, or upon
the merger or consolidation of the Company with another corporation or
corporations, this Agreement shall inure to the benefit of and be binding upon
both the Employee and such purchaser or surviving corporation.

         14.      The purpose of this paragraph is solely to provide for greater
flexibility and convenience in the precise timing of the monthly payments
provided for above, and it shall not be deemed to affect the amount that shall
be payable or the conditions upon which it shall become payable. The Company may
make the payment for any given month upon such day or days and in such manner as
shall be applicable from time to time to executive payroll then being
administered by the disbursing office of the Company that then shall have the
responsibility for the making of payments under this Agreement.

         15.      (a)      Neither Employee nor any other person shall have any
rights under this paragraph 15 until both:

                           (i)      A "Change of Control" (as defined in
                  subparagraph (b) of this paragraph 15) has occurred; and

                           (ii)     Either (A) Employee has satisfied the
                  conditions of paragraph 1 of this Agreement or (B) pursuant to
                  the terms of that certain Severance Agreement, dated as of
                  this date, between the Company and Employee, as hereafter
                  amended, extended or renewed, Employee is deemed to have

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satisfied those conditions. For the purposes of this paragraph 15, the
"Effective Date" shall be the earliest date upon which both of the conditions
described in subparagraph (a) of this paragraph 15 shall have been satisfied.

                  (b)      For purposes of this paragraph 15, a "Change of
Control" shall mean a change of control of the Company of a nature that would
be required to be reported in response to Item 1(a) of the Current Report on
Form 8-K (or its successor Item or Form, as the case may be), as in effect on
the date hereof (or from time to time thereafter), pursuant to Section 13
or 15(d) of the Securities Exchange Act of 1934 ("Exchange Act"); provided
that, without limitation, a "Change of Control" shall be deemed to have
occurred if: (i) a third person, including a "group" as defined in
Section 13(d) (3) of the Exchange Act, becomes the beneficial owner, directly
or indirectly, of 20% or more of the combined voting power of the Company's
outstanding voting securities ordinarily having the right to vote for the
election of directors of the Company; or (ii) individuals who constitute the
Board of Directors of the Company as of the date hereof ("Incumbent Board")
cease for any reason to constitute at least two-thirds thereof, provided that
any person becoming a director subsequent to the date hereof whose election, or
nomination for election by the Company's stockholders, was approved by a vote of
at least three-quarters of (or if less, all but one of) the directors
constituting the Incumbent Board (other than an election or nomination in
connection with an actual or threatened election contest relating to the
election of directors of the Company, as such terms are used in Rule 14a-11 of
Regulation 14A promulgated under the Exchange Act) shall be, for purposes of
this paragraph 15, considered as though such person were a member of the
Incumbent Board.

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                  (c)      (i)      Promptly, and in no event more than seven
         (7) days, after the Effective Date, the Company shall establish an
         irrevocable letter of credit (the "Letter of Credit"), as provided in
         subparagraph (c)(iv) of this paragraph 15, in an amount equal to the
         largest sum (calculated as of the Effective Date) of all payments
         provided to be paid in the future under paragraphs 2 and 3 of this
         Agreement, as security for such payments as may become due under this
         Agreement.

                           (ii)     Until such time as all amounts provided to
         be paid to or with respect to Employee under this Agreement have been
         paid in full, the Company shall, no later than thirty (30) days before
         the Letter of Credit would otherwise lapse or expire, renew the Letter
         of Credit or establish a replacement letter of credit in an amount
         equal to the largest sum (calculated as of the date of the renewal or
         replacement) of all payments provided to be paid in the future under
         paragraphs 2 and 3 of this Agreement. Hereinafter, the term "Letter of
         Credit" shall mean the original letter of credit referred to in
         subparagraph (c)(i) of this paragraph 15 and the renewal and
         replacement letters of credit referred to in this subparagraph (c)(ii).

                           (iii)    If the Company fails, within the times
         provided in subparagraph (c)(i) and (c)(ii) of this paragraph 15, to
         establish, renew or replace the Letter of Credit before all amounts
         payable to or with respect to Employee under this Agreement have been
         paid in full, --

                                    (A)      if any payments to or with respect
         to Employee have been made under this Agreement, then the Company shall
         pay in a cash lump sum, without discount, to Employee or to such
         appointee as may have been designated pursuant to paragraph 10 of this
         Agreement (hereinafter Employee and such other person being
         collectively referred to as "Entitled Payee") the

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balance of all payments under this Agreement remaining unpaid, regardless of the
fact that under this Agreement such payments would not otherwise be payable
until some future date or future performance by Employee;

                                       or

                                    (B)      if no payments to or with respect
to Employee have been made under this Agreement, then the Company shall pay in a
cash lump sum, without discount, to Entitled Payee the sum of all payments that
would have been paid to Entitled Payee had Employee ceased employment (x) on the
date by which the Company was required to renew or replace the last Letter of
Credit issued hereunder, or (y) if no Letter of Credit shall have been issued,
on the Effective Date, regardless of the fact that under this Agreement such
payments would not otherwise have been payable until some future date or future
performance by Employee. The cash lump sums required to be paid by clauses (A)
and (B) of this subparagraph (c)(iii) shall be paid within fifteen (15) days
after the date by which the Company was required to establish, renew or replace
the Letter of Credit.

                           (iv)     The Letter of Credit is to be issued by a
commercial bank (the "Bank") that is a state or national banking association and
that has a stockholders' equity in excess of one (1) billion dollars. The term
of the Letter of Credit shall be the maximum term then available for commercial
letters of credit. The Letter of Credit shall provide that the Bank shall pay to
Entitled Payee the amount of Entitled Payee's draft, at sight, on presentation
to the Bank of a statement, signed by Entitled Payee or Entitled Payee's
authorized representative, setting forth that Entitled Payee is entitled to
payments of not less than the amount of such draft pursuant to the Agreement and
that such payments are, under the Agreement, due and unpaid.

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         The Letter of Credit shall otherwise be in form and substance
reasonably satisfactory to Entitled Payee and the Company. The Letter of Credit
shall further provide that twenty-five (25) days prior to the expiration of the
Letter of Credit the Bank shall mail by registered mail a written notice to the
Entitled Payee (but only if the Entitled Payee has provided the Bank with
written notice of the Entitled Payee's mailing address), such notice to state
whether or not the Letter of Credit has been renewed or replaced.

         (v)      The payment by the Bank of the amount of Entitled Payee's
draft in accordance with the terms hereof and of the Letter of Credit shall not
constitute a waiver by the Company of, or in any way preclude the Company from
asserting, any claim the Company may have against Entitled Payee that Entitled
Payee is not entitled to some or all of such payment. Drawing upon the Letter of
Credit shall not constitute a waiver by Entitled Payee of, or in any way
preclude Entitled Payee from asserting, any claim the Entitled Payee may have
against the Company that Entitled Payee is entitled to amounts under this
Agreement that were not paid by amounts received under the Letter of Credit.

         (d)      The Company's obligation to make the payments provided for in
this paragraph 15 and otherwise to perform its obligations hereunder shall not
be affected by any circumstances, including, without limitation, any setoff,
counterclaim, recoupment, defense or other right that the Company may have
against the Entitled Payee provided, however, that the Company's failure to make
any such setoff shall not constitute a waiver of any claim of the Company
against the Entitled Payee.

         16.      (a)      If (1) an Employee has made an election pursuant to
the provisions of this paragraph 16 to have his benefits under this Agreement
paid

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in a cash lump sum pursuant to this paragraph 16 and (2) each of the conditions
described in clauses 15(a)(i) and 15(a)(ii) of this Agreement is satisfied with
respect to the Employee, the Company shall pay to the Entitled Payee (as defined
in paragraph 15 of this Agreement) the present value of --

         (i)      if any payments to or with respect to Employee have been made
under this Agreement, the balance of all payments under this Agreement remaining
unpaid, or

         (ii)     if no payments to or with respect to Employee have been made
under this Agreement, the sum of all payments that would have been paid to
Entitled Payee had Employee ceased employment on the Effective Date (as defined
in paragraph 15 of this Agreement).

         Payment shall be made in a single cash lump sum within 20 days after
the Effective Date. If such payment shall not be made in full as provided herein
any unpaid balance shall draw interest at the lesser of: (1) the highest rate of
interest that may legally be chargeable on such amount; and (2) two percent (2%)
over the prime commercial lending rate announced by the Morgan Guaranty Trust
Company of New York in effect from time to time during the period of such
non-payment, compounded monthly.

         (b)      For purposes of this paragraph 16, present value shall be
determined in accordance with the following:

         (i)      Present value shall be determined as of the Effective Date.

         (ii)     The stream of monthly payments for which the present value is
being calculated shall be assumed to run for the following period:

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         (A)    if any payments have been made under this Agreement, a period
beginning one month after the date the most recent payment made was required to
have been made and continuing until the date on which the last of the monthly
payments to be made under this Agreement is required to be made, and

         (B)    if no such payments have been made, a period beginning on the
later of the Effective Date or the date of the, Employee's 60th birthday and
continuing for 180 months.

         (iii)    The interest rate used to determine present value shall be two
percent (2%) below the average of the daily yield (to maturity) quotations
published in the Wall Street Journal on the 30 business days preceding the
Effective Date regarding the obligations (bonds or notes) of the U.S. Treasury
maturing on the date closest to the 15th anniversary of the Effective Date. No
discount factor other than this interest rate shall be used to determine present
value.

         (iv)     In making such determination, the provisions of paragraphs 4,
5, and 6 of this Agreement shall be disregarded.

         (c)    In order to elect to have his benefits under this Agreement paid
in a cash lump sum pursuant to this paragraph 16 the Employee must give written
notice to the Company as provided in this paragraph (c).

         (i)      The notice must be in writing and be substantially in the form
set forth in Exhibit A to this Agreement.

         The notice, to be valid, must be given before either of the two
conditions described in clauses 15(a)(i) and 15(a)(ii) of this Agreement has
occurred.

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         (ii)     Service of such notice shall be deemed complete when given by
hand delivery to an officer of the Company, or, if given by mail, on the day of
deposit in the United States mail by certified or registered mail, first-class
postage prepaid, addressed as follows:

                  Hancock Fabrics, Inc.
                  3406 W. Main Street
                  P.O. Box 2400
                  Tupelo, Mississippi 38003-2400
                  Attn: Corporate Secretary

or to such other address as the Company shall have furnished to the Employee in
writing in accordance herewith.

         (d)      If Employee elects to receive his benefits pursuant to the
provisions of this paragraph 16, Employee shall have, as of the Effective Date,
no further obligation to the Company under this Agreement, and the Company shall
have no further obligation to the Entitled Payee under this Agreement as of the
date that all payments required to be made to Entitled Payee under this
paragraph 16 have been made.

         (e)      If Entitled Payee incurs any legal fees or expenses as a
result of seeking to obtain or enforce any benefit under this paragraph 16,
Company shall pay or reimburse Entitled Payee for all such reasonable fees and
expenses.

         (f)      The Company's obligation to make the payments provided for in
this paragraph 16 shall not be affected by any circumstances, including, without
limitation, any setoff, counterclaim, recoupment, defense or other right that
the Company may have against the Entitled Payee provided, however, that the
Company's failure to make any such setoff shall not constitute a waiver of any
claim of the Company against the Entitled Payee.

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         IN WITNESS WHEREOF, the parties hereto have executed this Agreement
personally or by officers thereunto duly authorized.

HANCOCK FABRICS, INC.

By
  --------------------------------
  Its
     -----------------------------

----------------------------------
                          Employee

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                               NOTICE OF ELECTION

To:      Hancock Fabrics, Inc.
         3406 W. Main Street
         P.O. Box 2400
         Tupelo, MS 38003-2400
         Attention: Corporate Secretary

         I, James A. Austin ("Employee"), pursuant to paragraph 16 of that
Agreement dated June 14, 2001 to which Hancock Fabrics, Inc. and I are parties
(the Agreement"), hereby elect to have my benefits under the Agreement paid in a
cash lump sum pursuant to the provisions of said paragraph 16.

Dated:
       ---------------------------    ------------------------------------------
                                                                        Employee

                                   EXHIBIT A<PAGE>   1
                                                                    Exhibit 10.2

                            INDEMNIFICATION AGREEMENT

         This Agreement is made as of June 14, 2001, by and between Hancock
Fabrics, Inc., a Delaware corporation (the "Company"), and James A. Austin
("Officer").

                              W I T N E S S E T H :

         WHEREAS, the Company understands that there can be no assurance that
directors' and officers' liability insurance will continue to be available to
the Company and Officer, and believes that it is possible that the cost of such
insurance, if obtainable, may not be acceptable to the Company or the coverage
of such insurance, if obtainable, may be reduced below what has historically
been afforded; and

         WHEREAS, Officer is unwilling to serve, or continue to serve, the
Company as a director without assurances that adequate liability insurance,
indemnification or a combination thereof will be provided; and

         WHEREAS, the Company, in order to induce Officer to continue to serve
the Company, has agreed to provide Officer with the benefits contemplated by
this Agreement, which benefits are intended to supplement or, if necessary,
replace directors' and officers' liability insurance; and

         WHEREAS, as a result of the provision of such benefits Officer has
agreed to serve or to continue to serve as a director of the Company;

         NOW, THEREFORE, in consideration of the promises, conditions,
representations and warranties set forth herein, including Officer's service to
the Company, the Company and Officer hereby agree as follows:

         1.       Definitions. The following terms, as used herein, shall have
the following respective meanings:

                  "Covered Amount" means Loss and Expenses which, in type or
amount, are not insured under directors' and officers' liability insurance
maintained by the Company from time to time.

                  "Covered Act" means any breach of duty, neglect, error,
misstatement, misleading statement, omission or other act done or wrongfully
attempted by Officer or any of the foregoing alleged by any claimant or any
claim against Officer by reason of Officer's serving as or being a director,
officer, employee, or agent of the Company, or by reason of Officer's serving at
the request of the Company as a director, officer, partner, member, trustee,
employee or agent of another corporation, partnership, joint venture, trust or
other enterprise.

                  "D&O Insurance" means a policy or policies of the directors'
and officers' liability insurance issued to the Company and its directors and
officers.

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         "Determination" means a determination, based on the facts known at the
time, made by:

                  (i)      A majority of the directors who are not parties to
the action, suit or proceeding for which indemnification is considered or being
considered, even though less than a quorum; or

                  (ii)     Independent legal counsel in a written opinion if
there be no such directors, or if such directors so direct; or

                  (iii)    A majority of the shareholders of the Company; or

                  (iv)     A final adjudication by a court of competent
jurisdiction.

         "Determined" shall have a correlative meaning.

         "Excluded Claim" means any payment for Losses or Expenses in connection
with any claim:

                  (i)      Based upon or attributable to Officer gaining in fact
any personal profit or advantage to which Officer is not entitled; or

                  (ii)     For the return by Officer of any remuneration, for
which prior approval of the shareholders of the Company was required but not
obtained; or

                  (iii)    For an accounting of profits in fact made from the
purchase or sale by Officer of securities of the Company within the meaning of
Section 16 of the Securities Exchange Act of 1934 as amended, or similar
provisions of any state law; or

                  (iv)     Resulting from Officer's knowingly fraudulent,
dishonest or willful misconduct; or

                  (v)      The payment of which by the Company under this
Agreement is not permitted by applicable law; or

                  (vi)     Which are not within the Covered Amount.

         "Expenses" means any reasonable expenses incurred by Officer as a
result of a claim or claims made against Officer for Covered Acts including,
without limitation, counsel fees and costs of investigative, judicial or
administrative proceedings or appeals, but, where prohibited by law or public
policy, shall not include fines.

         "Loss" means any amount which Officer is legally obligated to pay as a
result of a claim or claims made against Officer for Covered Acts including,
without limitation, damages and judgments and sums paid in settlement of a claim
or claims, but, where prohibited by law or public policy, shall not include
fines.

         2.       Maintenance of D&O Insurance.

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                  (a)      The Company represents that it presently has in force
and effect policies of D&O Insurance. The Company hereby covenants that it will
use its best efforts to maintain a policy or policies no less beneficial to the
Company and Officer than the policies in effect on the date hereof. The Company
shall not be required, however, to maintain such policy or policies if such
insurance is not reasonably available or if, in the reasonable business judgment
of the then directors of the Company, either (i) the premium cost for such
insurance is disproportionate to the amount of coverage, or (ii) the coverage
provided by such insurance is so limited by exclusions that there is
insufficient benefit from such insurance.

                  (b)      In all policies of D&O Insurance, Officer shall be
named as an insured in such a manner as to provide Officer the same rights and
benefits, subject to the same limitations, as are accorded to the Company's
directors or officers most favorably insured by such policy.

         3.       Indemnification. The Company shall indemnify Officer against,
and hold Officer harmless from, the Covered Amount of any and all Losses and
Expenses subject, in each case, to the further provisions of this Agreement.

         4.       Excluded Coverage.

                  (a)      The Company shall have no obligation to indemnify
Officer against, and hold Officer harmless from, any Loss or Expense which has
been Determined to constitute an Excluded Claim.

                  (b)      The Company shall have no obligation to indemnify
Officer against, and hold Officer harmless from, any Loss or Expenses to the
extent that Officer is indemnified by the Company pursuant to the provisions of
the Company's Certificate of Incorporation or is otherwise in fact indemnified.

         5.       Indemnification Procedures.

                  (a)      Promptly after receipt by Officer of notice of the
commencement or the threat of commencement of any action, suit or proceeding,
Officer shall notify the Company of the commencement thereof if indemnification
with respect thereto may be sought from the Company under this Agreement; but
the omission so to notify the Company shall not relieve it from any liability
that it may have to Officer otherwise than under this Agreement. Such notice may
be given by mailing the same by United States mail, registered or certified,
return receipt requested, postage prepaid, addressed to the Company at: P.O. Box
2400, Tupelo, Mississippi 38803-2400, Attention: Secretary (or to such other
address as the Company may from time to time designate by written notice to
Officer).

                  (b)      If, at the time of the receipt of such notice, the
Company has D&O Insurance in effect, the Company shall give prompt notice of the
commencement of such action, suit or proceeding to the insurers in accordance
with the procedures set forth in the respective policies in favor of Officer.
The Company shall thereafter take all necessary or desirable action to cause
such insurers to pay, on behalf of Officer, all Losses and Expenses payable as a
result of such action, suit or proceeding in accordance with the terms of such
policies.

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<PAGE>   4

                  (c)      To the extent the Company does not, at the time of
the commencement or the threat of commencement of such action, suit or
proceeding, have applicable D&O Insurance, or if a Determination is made that
any Expenses arising out of such action, suit or proceeding will not be payable
under the D&O Insurance then in effect, or if for any reason a D&O insurer does
not timely pay such Expenses, the Company shall be obligated to pay the Expenses
of any such action, suit or proceeding in advance of the final disposition
thereof and the Company, if appropriate, shall be entitled to assume the defense
of such action, suit or proceeding, with counsel satisfactory to Officer, upon
the delivery to Officer of written notice of its election so to do. After
delivery of such notice, the Company will not be liable to Officer under this
Agreement for any legal or other Expenses subsequently incurred by Officer in
connection with such defense other than reasonable Expenses incurred at the
request of the Company provided that Officer shall have the right to employ its
counsel in any such action, suit or proceeding but the fees and expenses of such
counsel incurred after delivery of notice from the Company of its assumption of
such defense shall be at Officer's expense, provided further that if (i) the
employment of counsel by Officer has been previously authorized by the Company,
(ii) Officer shall have reasonably concluded that there may be a conflict of
interest between the Company and Officer in the conduct of any such defense or
(iii) the Company shall not, in fact, have employed counsel to assume the
defense of such action, the fees and expenses of counsel shall be at the expense
of the Company.

                  (d)      All payments on account of the Company's
indemnification obligations under this Agreement shall be made within thirty
(30) days of Officer's written request therefor unless a Determination is made
that the claims giving rise to Officer's request are Excluded Claims or
otherwise not payable under this Agreement, provided that all payments on
account of the Company's obligations under Paragraph 5(c) of this Agreement
prior to the final disposition of any action, suit or proceeding shall be made
within twenty (20) days of Officer's written request therefor and such
obligation shall not be subject to any such Determination but shall be subject
to Paragraph 5(e) of this Agreement.

                  (e)      Officer agrees to reimburse the Company for all
Losses and Expenses paid by the Company in connection with any action, suit or
proceeding against Officer in the event and only to the extent that a
Determination shall have been made that Officer is not entitled to be
indemnified by the Company because the claim is an Excluded Claim or because
Officer is otherwise not entitled to payment under this Agreement.

         6.       Settlement. The Company shall have no obligation to indemnify
Officer under this Agreement for any amounts paid in settlement of any action,
suit or proceeding effected without the Company's prior written consent. The
Company shall not settle any claim in any manner which would impose any fine or
any obligation on Officer without Officer's written consent. Neither the Company
nor Officer shall unreasonably withhold consent to any proposed settlement.

         7.       Subrogation. To the extent of any payment under this
Agreement, the Company shall be subrogated to all of the rights of recovery of
Officer. Officer shall execute all papers required and shall do everything that
may be

                                      -4-
<PAGE>   5

necessary to secure such rights, including the execution of such documents as
are necessary to enable the Company effectively to bring suit to enforce such
rights.

         8.       Rights Not Exclusive. The rights provided hereunder shall not
be deemed exclusive of any other rights to which Officer may be entitled under
any provision of the Delaware General Corporation Law or any other provisions of
law, the Company's Certificate of Incorporation, its by-laws, or any agreement,
vote of shareholders or of disinterested directors or otherwise, both as to
action in an official capacity and as to action in any other capacity by holding
such office, and shall continue after Officer ceases to serve the Company as a
director.

                                      -5-
<PAGE>   6

         9.       Enforcement.

                  (a)      An adverse Determination shall not foreclose an
action to enforce Officer's rights under this Agreement to the extent allowed by
law. If a prior adverse Determination has been made, the burden of proving that
indemnification is required under this Agreement shall be on Officer. The
Company shall have the burden of proving that indemnification is not required
under this Agreement if no prior adverse Determination shall have been made.

                  (b)      In the event that any action is instituted by Officer
under this Agreement, or to enforce or interpret any of the terms of this
Agreement, Officer shall be entitled to be paid all court costs and expenses,
including reasonable counsel fees, incurred by Officer with respect to such
action, unless the court determines that each of the material assertions made by
Officer as a basis for such action was not made in good faith or was frivolous.

         10.      Continuation of Agreement. All agreements and obligations of
the Company contained herein shall continue during the period Officer is a
director, officer, employee or agent of the Company (or serving at the request
of the Company as a director, officer, partner, member, trustee, employee or
agent of another corporation, partnership, joint venture, trust or other
enterprise) and shall continue thereafter so long as Officer shall be subject to
any possible demand, claim or threatened, pending or completed proceeding,
whether civil, criminal, administrative or investigative, by reason of the fact
that Officer was a director of the Company or serving in any other capacity
referred to in this paragraph.

         11.      Severability. In the event that any provision of this
Agreement is determined by a court to require the Company to do or to fail to do
an act which is in violation of applicable law, such provision shall be limited
or modified in its application to the minimum extent necessary to avoid a
violation of law, and such provision, as so limited or modified, and the balance
of this Agreement shall be enforceable in accordance with their terms.

         12.      Choice of Law. This Agreement shall be governed by and
construed and enforced in accordance with the laws of the State of Delaware.

         13.      Consent to Jurisdiction. The Company and Officer each hereby
irrevocably consents to the jurisdiction of the courts of the State of Delaware
for all purposes in connection with any action or proceeding which arises out of
or relates to this Agreement and agrees that any action instituted under this
Agreement shall be brought only in the state courts of the State of Delaware.

         14.      Successor and Assigns. This Agreement shall be (i) binding
upon all successors and assigns of the Company (including any transferee of all
or substantially all of its assets and any successor by, merger or otherwise by
operation of law) and (ii) shall be binding on and inure to the benefit of the
heirs, personal representatives and estate of Officer.

                                      -6-
<PAGE>   7

         15.      Amendment. No amendment, modification, termination or
cancellation of this Agreement shall be effective unless made in a writing
signed by each of the parties hereto.

         IN WITNESS WHEREOF, the Company and Officer have executed this
agreement as of the day and year first above written.

                                    HANCOCK FABRICS, INC.,
                                    a Delaware corporation

                                    By:
                                       ----------------------------------------

                                    Its:
                                        ---------------------------------------

                                                                      "Company"

                                    -------------------------------------------
                                    James A. Austin
                                                                      "Officer"

                                      -7-

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