Document:

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                                                                    Exhibit 10.3

                               SEVERANCE AGREEMENT
                                  June 14, 2001

         THIS AGREEMENT between Hancock Fabrics, Inc., a Delaware corporation
(the "Corporation"), and James A. Austin whose address is 5145 Lackey Lane,
Tupelo, Mississippi (the "Executive"), dated as of June 14, 2001.

                              W I T N E S S E T H :

         WHEREAS, the Corporation wishes to attract and retain well qualified
executive and key personnel and, in the event of any Change of Control (as
defined in Section 2) of the Corporation, to assure both itself and the
Executive of continuity of management; and

         WHEREAS, the Corporation, wishes to enter into this Agreement until
May 4, 2002 ("the Expiration Date"), and to automatically renew the Severance
Agreement for an additional three year period on the Expiration Date and each
subsequent expiration, unless the Incumbent Board elects to cancel the agreement
as of the next Expiration Date; and

         WHEREAS, no benefits shall be payable under this Agreement unless the
Effective Date shall occur and thereafter the Executive's employment is
terminated; and

         WHEREAS, the employment of the Executive is "at will" and may be
terminated by the Corporation without payment of any benefits hereunder until
the occurrence of a Change of Control;

         NOW, THEREFORE, in consideration of the premises and mutual covenants
herein contained, it is hereby agreed by and between the Corporation and the
Executive as follows:

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         1.       Operation of Agreement. No benefits shall be payable hereunder
unless a Change of Control (as defined in Section 2) occurs during the Change of
Control Period (as defined in Section 3). For the purposes of this Agreement the
date on which such a Change of Control occurs is referred to herein as the
"Effective Date."

         2.       Change of Control. For the purposes of this Agreement, a
"Change of Control" shall mean a change of control of a nature that would be
required to be reported by the Corporation 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 (the "Exchange Act");
provided that, without limitation, such 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 Corporation's
outstanding voting securities ordinarily having the right to vote for the
election of directors of the Corporation or (ii) individuals who constitute the
Board of Directors of the Corporation as of the date hereof (the "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 Corporation's stockholders, was
approved by a vote of at least three-quarters of (or if less, all but one of)
the directors comprising 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 Corporation, as such terms are used in Rule
14a-11 of the Regulation 14A promulgated under the

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Exchange Act) shall be, for purposes of this Agreement, considered as though
such person were a member of the Incumbent Board.

         3.       Change of Control Period. The "Change of Control Period" is
the period commencing on the date of this Agreement and ending on the earlier to
occur of (i) the Expiration Date, or (ii) the first day of the month coinciding
with or next following the Executive's 65th birthday. The expiration of the
Change of Control Period shall not limit the Corporation's obligation to
provide, or the Executive's right to collect, payments and benefits pursuant to
Section 5 and Section 10 hereof.

         4.       Certain Definitions.

                  (a)      Death or Disability. The Executive's employment shall
terminate automatically upon the Executive's death ("Death"). The Corporation
will be considered to have terminated the Executive's employment for Disability,
if after having established the Executive's Disability (as defined below), the
Executive receives written notice given in accordance with Section 9(b) of the
Corporation's intention to terminate his employment. The Executive's employment
will terminate for Disability effective on the 90th day after receipt of such
notice if within such 90-day period after such receipt the Executive shall fail
to return to full-time performance of his duties (the "Disability Effective
Date"). For purposes of this Agreement, "Disability" means a disability that,
after the expiration of more than 180 days after its commencement, is determined
to be total and permanent by a physician selected by the Corporation or its
insurers and acceptable to the Executive or his legal representative (such
agreement as to acceptability not to be withheld unreasonably).

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         Consistent with, and not in limitation of, the provisions of Section 6
of this Agreement, neither a termination for, nor a determination of, Disability
pursuant to this Section 4(a) shall be deemed in and of itself a termination for
or determination of disability with respect to the Executive's eligibility to
receive long-term disability benefits, continued medical, dental, or life
insurance coverage, retirement benefits, or benefits under any other plan or
program provided by the Corporation or one of its affiliated companies and for
which the Executive may qualify.

                  (b)      Cause. The Executive's employment will be terminated
for Cause if the majority of the Incumbent Board determines that Cause (as
defined in this Agreement) exists. For purposes of this Agreement, "Cause" means
(i) an act or acts of fraud or misappropriation on the Executive's part that
result in or are intended to result in his personal enrichment at the expense of
the Corporation or one of its affiliated companies or (ii) conviction of a
felony.

                  (c)      Good Reason. For purposes of this Agreement, "Good
Reason" means

                           (i)      without the express written consent of the
Executive, (A) the assignment to the Executive of any duties inconsistent in any
substantial respect with the Executive's position, authority or responsibilities
as in effect during the 90-day period immediately preceding the Effective Date,
or (B) any other substantial adverse change in such position (including titles
and reporting requirements), authority or responsibilities;

                           (ii)     any failure by the Corporation to furnish
the Executive and/or, where applicable, his family with compensation (including

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annual bonus) and benefits at a level equal to or exceeding those received (on
an annual basis) by the Executive from the Corporation during the 90-day period
preceding the Effective Date, including a failure by the Corporation to maintain
the Corporation's extra compensation plan(s)(Extra Compensation Plan") and
"Officers Incentive Compensation Plan" or any subsequent plans) (including the
right to defer the receipt of payments thereunder) and the Corporation's
supplemental retirement benefit plan ("SERP"), other than an insubstantial and
inadvertent failure remedied by the Corporation promptly after receipt of notice
thereof given by the Executive;

                           (iii)    the Corporation's requiring the Executive to
be based or to perform services at any office or location other than that at
which the Executive is primarily based during the 90-day period preceding the
Effective Date, except for travel reasonably required in the performance of the
Executive's responsibilities; or

                           (iv)     any failure by the Corporation to obtain the
assumption and agreement to perform this Agreement by a successor as
contemplated by Section 8(b).

         For the purposes of this Section 4(c), any good faith determination of
"Good Reason" made by the Executive shall be conclusive.

                  (d)      [Reserved].

                  (e)      Notice of Termination. Any termination by the
Corporation for Cause or by the Executive for Good Reason shall be communicated
by Notice of Termination to the other party hereto given in accordance with
Section 9(b). Any notice of termination by the Corporation for Disability shall
be given in accordance with Section 4(a). For purposes of this Agreement, a
"Notice of Termination" means a written notice that (i) indicates

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the specific termination provision in this Agreement relied upon, (ii) sets
forth in reasonable detail the facts and circumstances claimed to provide a
basis for termination of the Executive's employment under the provision so
indicated and (iii) if the termination date is other than the date of receipt of
such notice, specifies the termination date (which date shall not be more than
15 days after the giving of such notice).

                  (f)      Date of Termination. Date of Termination means the
date of receipt of the Notice of Termination or any later date specified therein
as the termination date, as the case may be, or if the Executive's employment is
terminated by the Corporation for any reason other than Cause, Death or
Disability, the date on which the Corporation notifies the Executive of such
termination. Notwithstanding any contrary provision in this Section 4(f), if the
Executive's employment terminates due to Disability, the Date of Termination
shall be the Disability Effective Date.

         5.       Obligations of the Corporation Upon Termination.

                  (a)      Good Reason Other Than For Cause, Death or
Disability. Regardless of whether the Change of Control Period has expired, if,
within three years of the Effective Date, (i) the Corporation shall terminate
the Executive's employment for any reason other than for Cause, Death or
Disability, or (ii) the Executive shall terminate his employment for Good
Reason:

                           (I)      the Corporation shall pay to the Executive
in a lump sum in cash within 20 days after the Date of Termination the aggregate
of the amounts determined pursuant to the following clauses (A) and (B):

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                                    (A)      if not theretofore paid, the
Executive's base salary through the Date of Termination at the rate in effect at
the time the Notice of Termination was given; and

                                    (B)      the sum of (x) the Executive's
annual base salary at the rate in effect at the time the Notice of Termination
was given, or if higher, at the highest rate in effect at any time within the
90-day period preceding the Effective Date and (y) an amount equal to the
highest bonus paid or payable to the Executive pursuant to the applicable cash
incentive compensations plan(s) within five fiscal years prior to the Effective
Date, provided, however, that in no event shall the Executive be entitled to
receive under this clause (B) more than the product obtained by multiplying the
amount determined as hereinabove provided in this clause (B) by a fraction whose
numerator shall be the number of months (including fractions of a month) that at
the Date of Termination remain until the first day of the month coinciding with
or next following the Executive's 65th birthday and whose denominator shall
equal twelve (12); and

                           (II)     until the earlier to occur of (i) the date
one year following the Date of Termination, or (ii) the first day of the first
month coinciding with or next following the Executive's 65th birthday (the
period of time from the Date of Termination until the earlier of (i) or (ii) is
hereinafter referred to as the "Unexpired Period"), the Corporation shall
continue to provide all benefits that the Executive and/or his family is or
would have been entitled to receive under all medical, dental, vision,
disability, executive life, group life, accidental death and travel accident
insurance plans and programs of the Corporation and its affiliated companies, in
each case on a basis providing the Executive and/or his family with the

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opportunity to receive benefits at least equal to those provided by the
Corporation and its affiliated companies for the Executive under such plans and
programs if and as in effect at any time during the 90-day period preceding the
Effective Date.

                           (III)    Within 20 days after the Date of Termination
the Corporation shall pay to the Executive and/or his beneficiary, as the case
may be, a lump sum in cash in the amount of the present value of periodic
payments equal to the excess, if any, of the "Enhanced SERP Benefits" over the
amount of benefits, if any, the Executive and/or his beneficiary, as the case
may be, has actually received (or is then currently entitled to receive) from
the SERP. For purposes of this Section 5(a), the "Enhanced SERP Benefits" shall
equal the amount of benefits under the SERP the Executive and/or his beneficiary
would have received had the benefits under Section 4.1(i) of the SERP been
determined by considering the Executive (a) to have been employed for an
additional period of time equal to the Unexpired Period; (b) to have been a
member of the SERP for an additional period of time equal to the Unexpired
Period; (c) to have retired at the age he would have attained at the end of the
Unexpired Period; (d) to have had compensation for such additional Plan Years
(as such term is defined for purposes of the SERP) equal to the Executive's
earnings for the Plan Year prior to the Effective Date; and (e) to be vested in
a fraction (not to exceed 1) of his benefit under the Hancock Fabrics, Inc.
Consolidated Retirement Plan (the "Retirement Plan") and the SERP equal to the
quotient obtained by dividing (i) the years of service for vesting purposes the
Executive would have had under the Retirement Plan if he had been employed for
an additional period of time equal to the Unexpired Period by (ii) the number of
years of service for vesting purposes that (as of

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the Date of Termination) are required before a participant in the Retirement
Plan is considered to be fully vested under the Retirement Plan (the
determination and payment of the amount payable under this paragraph (III) to be
pursuant to Section 11); and

                           (IV)     for purposes of any written agreement
between the Executive and the Corporation relating to the payment of
compensation to the Executive on a deferred basis, the Executive shall be deemed
to have remained in the employment of the Corporation on a full-time basis until
the Executive's 60th birthday.

         6.       Non-exclusivity of Rights. Nothing in this Agreement shall
prevent or limit the Executive's continuing or future participation in any
benefit, bonus, incentive or other plan or program provided by the Corporation
or any of its affiliated companies and for which the Executive may qualify, nor
shall anything herein limit or otherwise affect such rights as the Executive may
have under any employment, stock option or other agreements with the Corporation
or any of its affiliated companies. Amounts that are vested benefits or that the
Executive is otherwise entitled to receive under any plan or program of the
Corporation or any of its affiliated companies at or subsequent to the Date of
Termination shall be payable in accordance with such plan or program.

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         7.       Full Settlement. The payments provided for in this Agreement
are in full settlement of any claims the Executive may have against the
Corporation arising out of his termination, including, but not limited to, any
claims for wrongful discharge. The Corporation's obligation to make the payments
provided for in this Agreement 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 Corporation may have against the Executive or others; provided, however,
that the Corporation's failure to make any such setoff shall not constitute a
waiver of any claim of the Corporation against the Executive. In no event shall
the Executive be obligated to seek other employment by way of mitigation of the
amounts payable to the Executive under any of the provisions of this Agreement.
The Corporation agrees to pay, to the full extent permitted by law, all legal
fees and expenses the Executive may reasonably incur as a result of any contest
(regardless of the outcome thereof) by the Corporation or others of the validity
or enforceability of, or liability under, any provision of this Agreement or any
guarantee of performance thereof, in each case plus interest, compounded
monthly, on the total unpaid amount determined to be payable under this
Agreement, such interest to be calculated on the basis of the prime commercial
lending rate announced by Morgan Guaranty Trust Company of New York, in effect
from time to time during the period of such non-payment.

         8.       Successors.

                  (a)      This Agreement is personal to the Executive and
without the prior written consent of the Corporation shall not be assignable by
the Executive otherwise than by will or the laws of descent and distribution.

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This Agreement shall inure to the benefit of and be enforceable by the
Executive's legal representatives, executors, heirs and legatees.

                  (b)      This Agreement shall inure to the benefit of and be
binding upon the Corporation and its successors. The Corporation shall require
any successor to all or substantially all of the business and/or assets of the
Corporation, whether directly or indirectly, by purchase, merger, consolidation,
acquisition of stock, or otherwise, by an agreement in form and substance
satisfactory to the Executive, expressly to assume and agree to perform this
Agreement in the same manner and to the same extent as the Corporation would be
required to perform if no such succession had taken place.

         9.       Miscellaneous.

                  (a)      The captions of this Agreement are not part of the
provisions hereof and shall have no force or effect. This Agreement may not be
amended or modified otherwise than by a written agreement executed by the
parties hereto or their respective successors and legal representatives.

                  (b)      All notices and other communications hereunder shall
be in writing and shall be given by hand delivery to the other party or by
registered or certified mail, return receipt requested, postage prepaid,
addressed as follows:

                  If to the Executive:

                  At the address first hereinabove written.

                  If to the Corporation:

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

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or to such other address as either party shall have furnished to the other in
writing in accordance herewith. Notice and communications shall be effective
when actually received by the addressee.

                  (c)      The invalidity or unenforceability of any provision
of this Agreement shall not affect the validity or enforceability of any other
provision of this Agreement.

                  (d)      The Corporation may withhold from any amounts payable
under this Agreement such federal, state or local taxes as shall be required to
be withheld pursuant to any applicable law or regulation, provided, however,
that such withholding shall be consistent with the calculations made by
Accounting Firm under Section 10 of the Agreement.

                  (e)      This Agreement contains the entire understanding with
the Executive with respect to the subject matter hereof.

                  (f)      Whenever used in this Agreement, the masculine gender
shall include the feminine or neuter wherever necessary or appropriate and vice
versa and the singular shall include the plural and vice versa.

                  (g)      The Executive and the Corporation acknowledge that
the employment of the Executive by the Corporation is "at will" and may be
terminated by either the Executive or the Corporation at any time and for any
reason. Nothing contained in the Agreement shall affect such rights to
terminate, it being agreed, however, that nothing in this Section 9(g) shall
prevent the Executive from receiving any amounts payable pursuant to Section
5(a), or 10 of this Agreement in the event of a termination described in such
Section 5(a), or 10 on or after the Effective Date.

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         10.      Penalty Taxes.
                  -------------

                  (a)      Payment. In the event that the Accounting Firm
determines that any payment or other compensation or benefits made or provided
to or for the benefit of the Executive in any way connected with employment of
the Executive by the Corporation will be subject to tax pursuant to section 4999
of the Code or any successor provision or any counterpart provision of state tax
law (the "Penalty Taxes"), the Corporation shall pay to the Executive within 20
days after receipt of a written demand therefor from the Executive an amount
which, after deduction of all additional Federal, state and local taxes
(including, without limitation, income taxes and additional Penalty Taxes)
required to be paid by the Executive in respect of receipt of such amount, shall
be equal to the Penalty Taxes. In calculating the income taxes required to be
paid by the Executive, the Accounting Firm shall assume that the Executive will
pay tax at the maximum marginal Federal, state and local rates and that the
Executive will have no deductions or credits available to reduce such taxes. In
consideration of the payment of such amounts, the Executive shall report and pay
such taxes and promptly provide the Corporation with a written statement that
such filing and payment have occurred executed by the person or firm that signed
as income tax return preparer of the Executive's federal income tax return, or
if prepared by the Executive, executed by the Executive.

                  (b)      Indemnity. If the Executive shall be required to pay
Penalty Taxes in addition to those reimbursed pursuant to paragraph (a) above,
or if based upon failure to receive the opinion of Tax Counsel referred to in
paragraph (d) below the Executive reports and pays greater amounts of Penalty
Taxes than are reimbursed pursuant to paragraph (a) above (any such event
hereafter being referred to as a "Loss"), the Executive shall notify the

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Corporation and the Corporation shall pay to the Executive as an indemnity an
amount which, after deduction of all income taxes and additional Federal, state
and local taxes (including, without limitation, income taxes and additional
Penalty Taxes) required to be paid by the Executive in respect of receipt of
such amount (assuming, for this purpose, that the Executive is subject to the
maximum marginal rates of taxation applicable to individuals at such time as
such amount becomes due and that the Executive will have no deductions or
credits available to reduce such taxes), shall be equal to the sum of (x) the
Penalty Taxes resulting in the Loss and (y) the net amount of any interest,
penalties or additions to tax payable to the United States Government or any
state or local government (after allowing for the deduction of such amounts, to
the extent properly deductible, for Federal, state or local income tax purposes)
as a result of such Loss. Each payment by the Corporation hereunder shall be
made within 30 days after receipt of a written demand therefor from the
Executive accompanied by a written statement describing in reasonable detail the
Loss in question, the amount of additional tax, interest, penalties or additions
to tax and the calculation of the payment due in respect thereof; provided that,
if a contest of the Loss is being conducted pursuant to paragraph (c) below,
payment shall not be required by the Corporation until 30 days after the
completion or termination of such contest.

                  (c)      Contest.

                           (1)      The Executive shall notify the Corporation
within 30 days of receipt from the Internal Revenue Service of a revenue agent's
report, a 30-day letter or a notice of deficiency (as described in Section 6212
of the Code or any successor provision) or of a similar written claim from a
state

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taxing authority, in which an adjustment is proposed to the federal or state
taxes of the Executive for which the Corporation would be required to indemnify
the Executive hereunder. If the Corporation (i) requests the Executive to do so
within 30 days after such notice, and (ii) furnishes the Executive an opinion of
recognized tax counsel selected by the Corporation and approved by the
Executive, which approval shall not unreasonably be withheld, (hereinafter "Tax
Counsel") to the effect that a reasonable basis exists for contesting such
proposed adjustment, the Executive shall contest the proposed adjustment in good
faith, shall keep the Corporation reasonably informed as to the progress of such
contest, and shall consider in good faith any suggestion made by the Corporation
as to the method of pursuing such contest; provided, however, that the Executive
shall not be obligated to contest such adjustment unless (i) the Corporation
acknowledges in writing its liability under paragraph (b) above to indemnify the
Executive in the event that the Internal Revenue Service or a state taxing
authority prevails in its position regarding the proposed adjustment; (ii) the
Corporation shall have fully performed its prior obligations under this
Agreement; and (iii) the subject matter thereof shall not have been previously
decided pursuant to the contest provisions of this paragraph (c) with respect to
any other executive of the Corporation, unless the Corporation shall have
furnished an opinion of Tax Counsel to the Executive that more likely than not
the Executive will prevail in the contest; provided, further, that the Executive
shall determine, in his sole discretion, the nature of all action to be taken to
contest such proposed adjustment, including (x) whether any action to contest
such proposed adjustment initially shall be by way of judicial or administrative
proceedings, or both, (y) whether any such proposed adjustment shall be
contested by resisting

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payment thereof or by paying the same and seeking a refund thereof, and (z) if
the Executive shall undertake judicial action with respect to such proposed
adjustment, the court or other judicial body before which such action shall be
commenced. The Executive shall, if requested by the Corporation within 30 days
of an adverse determination by any court, and if Tax Counsel is of the opinion
that there is a reasonable basis for a successful appeal of the matter in
question, be obligated to appeal such adverse determination.

                           (2)      The Executive shall not be required to take
any action pursuant to this paragraph (c) unless and until the Corporation shall
have agreed in writing to indemnify the Executive in a manner reasonably
satisfactory to the Executive for any fees, expenses, statutory or regulatory
penalties, interest, additions to tax, or other similar liabilities or losses
which the Executive may incur as a result of contesting the validity of any
proposed adjustment and shall have agreed to pay (or in the Executive's sole
discretion to prepay) to the Executive on demand all costs and expenses which
the Executive may incur in connection with contesting such proposed adjustment
(including without limitation fees and disbursements of counsel). If the
Executive determines to contest any adjustment by paying the additional tax and
suing for a refund, the Corporation shall timely advance to the Executive on an
interest free basis an amount equal to the sum of any tax, interest, penalties
and additions to tax which are required to be paid; provided, however, that, if
the Executive is required to include in income any amount with respect to such
loan or the imputation of interest thereon in any taxable year of the Executive
prior to final determination of the contest, then the Corporation, within 30
days of written notice thereof by the Executive, shall pay to the Executive an
amount which, after deduction of all additional

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Federal, state and local taxes required to be paid by the Executive in respect
of the receipt of such amount (assuming, for this purpose, that the Executive is
subject to the maximum marginal rate of taxation applicable to individuals at
such times as such amount becomes due), shall be equal to the aggregate
additional federal and state income taxes payable by the Executive with respect
to such taxable year as a result of such inclusion. Upon receipt by the
Executive of a refund of any amounts paid by the Executive based on any
adjustment in respect of which amounts the Executive shall have been paid or
advanced an equivalent amount by the Corporation, the Executive shall pay to the
Corporation the amount of such refund (which, in the case of any contest in
which a loan has been advanced pursuant to this paragraph, shall be deemed to be
in repayment of the loan advanced by the Corporation to the extent fairly
attributable thereto), but not in excess of the amount paid or advanced by the
Corporation, together with any interest received by the Executive on such refund
plus any net additional Federal, state or local tax benefits actually realized
by the Executive as the result of such payment, and reduced by the amount of any
Federal, state or local tax actually payable with respect to receipt of such
refund; provided, however, that the Executive may offset the amount of such
refund and benefits against any amount due and owing by the Corporation to the
Executive pursuant to this Agreement. Upon disallowance of any such refund, the
Corporation shall forgive the amount of the advance fairly attributable thereto
and shall pay to the Executive the amount of its indemnity obligation hereunder,
including such amount as, after deduction of all taxes required to be paid by
the Executive in respect of the receipt of such amount under the laws of any
Federal, state or local government or taxing authority of the United States,
shall be equal to the sum on an after-tax

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basis, of any tax, interest, penalties or additions to tax payable with respect
to the forgiveness of such advance.

                           (3)      If any adjustment referred to in this
paragraph (c) shall be proposed and the Corporation shall have requested the
Executive to contest such adjustment as above provided and shall have duly
complied with the terms of this paragraph (c), the Corporation's liability with
respect to such adjustment shall become fixed upon final determination of such
adjustment; provided, however, that if the Corporation shall not deliver the
opinion of Tax Counsel provided in this paragraph (c) to the effect that there
is a reasonable basis for a contest or appeal, then the Corporation's obligation
to pay such indemnity shall become immediately fixed.

                  (d)      No Inconsistent Action. The Executive agrees that he
will not take any action, directly or indirectly, or file any returns or other
documents inconsistent with the assumption that the payments to which the
indemnification of paragraph (b) applies do not result in imposition of the tax
under section 4999, and the Executive shall file such returns, take such
actions, maintain such records and execute such documents as may be reasonably
requested by the Corporation; provided, however, that the Executive's
obligations hereunder to file returns or other documents shall apply only if the
Executive receives an opinion of Tax Counsel at least 10 days prior to the due
date of the return (without regard to extensions) required to be made with
respect to the payments to which the indemnification of paragraph (b) applies
that the Executive will not be subject to the penalties described in sections
6651, 6662 or 6663 of the Code, or successor provisions then in effect, as a
result of taking such position.

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                  (e)      Disbursements. Any payments required to be made by
the Corporation pursuant to this Section 10 shall be made directly by the
Corporation to the Executive. Payments made by the Corporation or the Executive
pursuant to this Agreement shall be made by wire transfer of immediately
available funds to such bank and/or account in the continental United States as
specified by the other party in written directions to such payor party, and if
no such direction shall have been given, by check payable to the order of such
other party and mailed to such other party by certified mail, postage prepaid.

                  (f)      No Setoff. No payment required to be made by the
Corporation pursuant to this Section 10 shall be subject to any right of setoff,
counterclaim, defense, abatement, suspension, deferment or reduction, and,
except in accordance with the express terms hereof, the Corporation shall have
no right to terminate the Agreement or to be released, relieved or discharged
from any obligation or liability thereunder for any reason whatsoever.

                  (g)      Late Payment, Interest. Any late payment by any party
hereto of any of its obligations under this Agreement shall bear interest to the
extent permitted by applicable law, at a fluctuating rate per annum equal to the
Prime Rate as announced publicly by Citibank, N.A., in New York, New York from
time to time plus two percentage points, for the period such interest is
payable.

                  (h)      Accounting Firm. The Accounting Firm shall mean the
Memphis, Tennessee Main Office of PricewaterhouseCoopers, or, at the election of
the Executive, the Memphis, Tennessee Main Office of such other national or
regional accounting firm as the Executive shall select subject to the approval

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of the Corporation, which approval shall not unreasonably be withheld.
Compensation of the Accounting Firm with respect to its services hereunder shall
be the responsibility of the Executive.

         11.      Determination of Present Values Under Section 5. The
determination of present values for purposes of Paragraph (a)(III) of Section 5
of this Agreement shall be in accordance with the following:

                  (a)      Present values shall be determined as of the last day
of the calendar quarter ending most recently prior to the Termination Date
("Valuation Date").

                  (b)      The interest rate and other actuarial assumptions
used to determine present values shall be the same as those which would be
required to be used as of the Valuation Date to determine the amount of a lump
sum distribution under the Retirement Plan.

                  (c) The determination of present values shall be made by
Hewitt Associates, or such other actuarial firm as shall, at the time of the
determination, be the actuary for the Retirement Plan ("Actuary Firm"). The
Corporation shall provide to the Actuary Firm all information in its possession
reasonably requested by the Actuary Firm for the purpose of making such present
value determination.

                  (d)      The payment of benefits under Paragraph (a)(III) of
Section 5 shall be made within the time limits set forth in such Paragraph based
upon the present value determinations made by the Actuarial Firm, and such
determinations shall be binding upon the Corporation and the Executive.

                                      -20-
<PAGE>   21

         IN WITNESS WHEREOF, the Executive has hereunto set his hand and,
pursuant to the authorization of its Board of Directors, the Corporation has
caused these presents to be executed in its name on its behalf, and its
corporate seal to be hereunto affixed, all as of the day and year first above
written.

                                            ---------------------------------
                                                                    Executive

                                            HANCOCK FABRICS, INC.

                                            By
                                              -------------------------------

                                      -21-<PAGE>   1
                                                                    Exhibit 10.4

                 AGREEMENT TO SECURE CERTAIN CONTINGENT PAYMENTS

         THIS AGREEMENT TO SECURE CERTAIN CONTINGENT PAYMENTS between Hancock
Fabrics, Inc., a Delaware corporation (the "Company"), and James A. Austin (the
"Executive"), dated as of June 14, 2001.

                                R E C I T A L S :

         WHEREAS, Executive and the Company have entered into that certain
Severance Agreement dated this date (in its present form or as it may hereafter
be amended, extended or renewed, the "Severance Agreement") and that certain
Agreement dated this date ("Deferred Compensation Agreement"); and

         WHEREAS, under such Agreements, certain payments are to be made at
times which are contingent upon a change in control of the Company, and in
certain instances also contingent upon a termination of Executive's employment,
all of which contingencies are set forth in such Agreements; and

         WHEREAS, the Company wishes to make additional provision for the
security of the payment of certain of the contingent amounts under such
Agreements in order to assure itself of continuity of management and to assure
the Executive of payment of the amounts in question,

         NOW, THEREFORE, in consideration of the foregoing and the mutual
covenants contained herein, it is hereby agreed by and between the Company and
the Executive as follows:

         1.       Letter of Credit Required.

                  The Company shall, no later than the date of a change in
control as defined in the Severance Agreement ("Change in Control"), provide
Executive with an irrevocable letter of credit ("Letter of Credit"), under which
Executive shall be the beneficiary, to pay the following amounts:

                                      -1-
<PAGE>   2

                  a.       Severance benefits to be paid by the Company as
provided in Section (5)(a)(I) of the Severance Agreement.

                  b.       "Penalty Taxes" (as defined in Section 10 of the
Severance Agreement) and all other amounts to be paid by the Company as provided
in Section 10 of the Severance Agreement.

                  c.       Payments to be made by the Company under Section 16
of the Deferred Compensation Agreement.

         2.       Amount of Letter of Credit.

                  a. The Letter of Credit shall be in an amount equal to the sum
determined by the Accounting Firm identified in Section 9 (the "Accounting
Firm"), as follows (both initially and recalculated as provided in Section 7)
plus ten percent (10%) of said sum.

                  b.       The Accounting Firm shall determine the sum of:

                           (i)      The amount which would be payable to the
Executive under Section 5(a)(I) of the Severance Agreement assuming a Change of
Control has occurred and that the Executive terminates employment for Good
Reason (as defined in the Severance Agreement) at the time the determination is
made;

                           (ii)     The amount of "Penalty Taxes" and income
taxes, if any, that the Accounting Firm has determined as the total amount
payable by the Company to the Executive under Section 10(a) of the Severance
Agreement; and

                           (iii)    The amount which would be payable to the
Executive under Section 16 of the Deferred Compensation Agreement if he had made
the election to receive benefits under that Section and was in all other

                                      -2-
<PAGE>   3

respects eligible to receive benefits thereunder at the time the determination
is made.

                  c.       The amount so determined shall be stated in a written
notice by the Accounting Firm to the Company; and such notice shall thereupon be
marked "Attachment A" and be attached to and become a part of this Agreement.

                                      -3-
<PAGE>   4

         3.       Form of Letter of Credit.

                  The Letter of Credit shall be in a form agreed to by the
Company and the issuing bank (the "Bank") consistent with the terms of this
Agreement. The Executive shall be entitled to draw on the Letter of Credit by
presenting to the Bank a draft and a certificate in which the Executive
certifies in writing that the requisite events have occurred under the Severance
Agreement and/or the Deferred Compensation Agreement for payment to the
Executive of amounts specified in Section 1.

         4.       Issuer.

                  The Letter of Credit shall be issued by a commercial bank that
is a state or national banking association and which has a stockholders' equity
in excess of $1 billion.

         5.       Single Letter of Credit with Multiple Beneficiaries.

                  At the Company's discretion, the Letter of Credit may provide
for payment of similar compensation and benefits to other executives of the
Company who are parties to agreements similar to this Agreement as long as the
total amount of the Letter of Credit, for all such other executives and for the
Executive, is, at all times, no less than the sum of the required amounts of the
Letter of Credit and of the letters of credit required under the agreements with
such other executives (initially or after recalculation pursuant to Section 7).

         6.       Term of Letter of Credit.

                  The Letter of Credit to be provided as required by Section 1
shall be issued for a term which shall be the maximum term then available for
commercial letters of credit. Until such time as all amounts described in
Sections 1(a), 1(b) and 1(c) have been paid in full, the Company shall, not

                                      -4-
<PAGE>   5

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
with terms at least as favorable as the initial Letter of Credit. The term
"Letter of Credit" shall mean both the original letter of credit and the renewal
and replacement letters of credit referred to in this Section 6. The period of
time during which a Letter of Credit is required to remain in effect under this
Agreement is herein called the "Secured Period." If the Company does not
establish or renew a Letter of Credit as required by Section 1 and this Section
6, the payment of all amounts described in Section 1 shall be accelerated in
accordance with Section 8 hereof.

         7.       Calculation and Recalculation of Amounts Secured by Letter of
                  Credit and Increase in Amount of Letter of Credit.

                  During the Secured Period, the Accounting Firm shall, no later
than the end of each calendar quarter in the Secured Period, recalculate the
amounts listed on Attachment A and give prompt written notice of such
recalculations to the Executive, the Company and the Bank. Any such recalculated
amounts shall thereafter be deemed to be the amounts listed on Attachment A. If
such recalculated amounts plus ten percent (10%) thereof exceed the amounts
payable under the Letter of Credit then in effect, no later than seven (7) days
after receipt of such written notice of recalculation, the Company shall cause
the amounts payable under the Letter of Credit to be increased to the
recalculated amounts plus 10%.

         8.       Acceleration Under Letter of Credit.

                  If at least 30 days prior to the expiration of a Letter of
Credit established hereunder, which expiration would occur before the end of the
Secured Period, the Executive shall not have received written notice from the
Company that an extension or renewal of the expiring Letter of Credit has

                                      -5-
<PAGE>   6

occurred or a new Letter of Credit has been obtained with the terms and
conditions at least as favorable as the predecessor Letter of Credit, then,
notwithstanding any other provisions of the Severance Agreement, the Deferred
Compensation Agreement, or this Agreement, all amounts which are described in
Section 1 shall be due and payable immediately without regard to any
contingencies or future events and Executive, his beneficiaries or estate shall
be entitled to immediately draw on the Letter of Credit for all such amounts.

         9.       Accounting Firm.

                  The Accounting Firm shall mean the same Accounting Firm as
determined under the provisions of Section 10(h) of the Severance Agreement. All
calculations by the Accounting Firm shall be binding on the Company, the
Executive and the Bank in the absence of wilful misconduct or gross negligence
by the Accounting Firm.

         10.      Expenses.

                  The Company shall pay all expenses and fees of the Accounting
Firm.

         11.      Information.

                  The Company shall provide the Accounting Firm with such
information as the Company has in its possession that the Accounting Firm
believes necessary, in its discretion, to make its calculations and
recalculations under this Agreement.

         12.      Obligation of Executive.

                  Subject to the provisions of Section 8, if Executive receives
payments under the Letter of Credit for any amount in excess of that to which he
is entitled under the Severance Agreement, the Deferred Compensation

                                      -6-
<PAGE>   7

Agreement, or this Agreement, Executive shall immediately repay such amount to
Company.

         13.      Legal Fees, Etc.

                  If Executive incurs any legal fees and expenses as a result of
seeking to obtain or enforce any right or benefit provided by this Agreement,
Company shall pay or reimburse Executive for all such reasonable fees and
expenses.

                                      -7-
<PAGE>   8

         14.      No Waivers.

                  The payment by a Bank on a Letter of Credit established in
accordance with the terms hereof 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 Executive that Executive is not entitled to some or all of such
payment. Drawing upon the Letter of Credit shall not constitute a waiver by
Executive of, or in any way preclude Executive from asserting, any claim
Executive may have against the Company that Executive is entitled to amounts
under this Agreement or the Severance Agreement or the Deferred Compensation
Agreement (except to the extent that such amounts have been paid in full by the
Bank under the Letter of Credit).

         15.      Enforceability.

                  Subject to Section 19, this Agreement shall inure to the
benefit of and be enforceable by Executive's personal or legal representatives,
executors, administrators, successors, heirs, distributees, devisees and
legatees.

         16.      No Change to Agreements.

                  Except as expressly modified by this Agreement, Executive's
rights under the Severance Agreement and the Deferred Compensation Agreement are
unchanged by this Agreement.

         17.      Modification in Writing.

                  No provision of this Agreement may be modified or waived
unless in writing and signed by Executive and such officer of Company as may be
designated or authorized by its Board of Directors.

                                      -8-
<PAGE>   9

         18.      Severability.

                  The invalidity or unenforceability of any provision of this
Agreement shall not affect the validity or enforceability of any other provision
of this Agreement, which shall remain in full force and effect.

         19.      Assignment.

                  Executive's rights under this Agreement and the Letter of
Credit are not assignable.

         20.      Notices.

                  Any notice, report, demand or waiver required or permitted
hereunder shall be in writing and shall be given personally or by prepaid
registered or certified mail, return receipt requested, addressed as follows:

         If to the Company:                 Hancock Fabrics, Inc.
                                            3406 West Main Street
                                            P.O. Box 2400
                                            Tupelo, Mississippi 38003-2400

                                            Attention: Corporate Secretary

         If to the Executive:               James A. Austin
                                            5145 Lackey Lane
                                            Tupelo, Mississippi 38801

A notice shall be effective upon the receipt thereof. The above addresses can be
changed by notice in writing delivered as provided above.

         21.      Additional Benefits.

                  The security provided under this Agreement is in addition to
and not by way of limitation of any rights or benefits to which Executive is
entitled under the Severance Agreement and the Deferred Compensation Agreement.

         IN WITNESS WHEREOF Executive and, pursuant to authorization from its
Board of Directors, Company have executed this Agreement to Secure Certain
Contingent Payments effective as of the date first above written.

                                    --------------------------------------------
                                                                      Executive

                                    HANCOCK FABRICS, INC.

                                    By
                                      ------------------------------------------

                                    Its
                                       -----------------------------------------

                                      -9-

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