-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, WMFWcxuOHvfPYyhlPGc+cNVi4ctUyHlGSArL45tj+qHk8zYvLq9WD9hgsHOzLbTU eO0ple5D09g0WC4rvNZxYw== 0000892569-99-001688.txt : 19990615 0000892569-99-001688.hdr.sgml : 19990615 ACCESSION NUMBER: 0000892569-99-001688 CONFORMED SUBMISSION TYPE: 10-K405/A PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19990127 FILED AS OF DATE: 19990608 FILER: COMPANY DATA: COMPANY CONFORMED NAME: DIEDRICH COFFEE INC CENTRAL INDEX KEY: 0000947661 STANDARD INDUSTRIAL CLASSIFICATION: RETAIL-FOOD STORES [5400] IRS NUMBER: 330086628 STATE OF INCORPORATION: CA FISCAL YEAR END: 0127 FILING VALUES: FORM TYPE: 10-K405/A SEC ACT: SEC FILE NUMBER: 000-21203 FILM NUMBER: 99642077 BUSINESS ADDRESS: STREET 1: 2144 MICHELSON DRIVE STREET 2: STE A CITY: IRVINE STATE: CA ZIP: 9262682612 BUSINESS PHONE: 7142601600 MAIL ADDRESS: STREET 1: 2144 MICHELSON DRIVE CITY: IRVINE STATE: CA ZIP: 92612 10-K405/A 1 AMENDMENT #1 TO FORM 10-K 1 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 ------------------------ AMENDMENT NO. 1 TO FORM 10-K FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (MARK ONE) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED JANUARY 27, 1999 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM __________ TO __________ . COMMISSION FILE NO. 0-21203 DIEDRICH COFFEE, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 33-0086628 (STATE OR OTHER JURISDICTION (I.R.S. EMPLOYER OF INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
2144 MICHELSON DRIVE IRVINE, CALIFORNIA 92612 (949) 260-1600 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE AND TELEPHONE NUMBER, INCLUDING AREA CODE) SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: COMMON STOCK, $0.01 PAR VALUE PER SHARE (TITLE OF CLASS) Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] The aggregate market value of the registrant's common stock held by non-affiliates, based upon the closing sale price of the registrant's common stock on April 7, 1999, as reported on the Nasdaq National Market, was $15,874,826. The number of shares of the registrant's common stock outstanding, as of April 7, 1999, was 6,173,538. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 2 TABLE OF CONTENTS
PAGE ---- A Warning About Forward-Looking Statements.................. 1 PART I Item 1. Business.................................................... 1 Item 2. Properties.................................................. 14 Item 3. Legal Proceedings........................................... 14 Item 4. Submission of Matters to a Vote of Security Holders......... 14 PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters......................................... 15 Item 6. Selected Financial Data..................................... 16 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations................................... 17 Item 7A. Quantitative and Qualitative Disclosures About Market Price....................................................... 23 Item 8. Financial Statements and Supplementary Data................. 23 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.................................... 23 PART III Item 10. Directors and Executive Officers of the Registrant.......... 24 Item 11. Executive Compensation...................................... 27 Item 12. Security Ownership of Certain Beneficial Owners and Management.................................................. 35 Item 13. Certain Relationships and Related Transactions.............. 37 PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K......................................................... 38 Signatures.................................................. 41 Financial Statements........................................ F-1 Index to Exhibits........................................... S-1
i 3 A WARNING ABOUT FORWARD-LOOKING STATEMENTS We make forward-looking statements in this document that are subject to risks and uncertainties. These forward-looking statements include information about possible or assumed future results of the company's financial condition, operations, plans, objectives and performance. Additionally, when we use the words "believe," "expect," "anticipate," "estimate" or similar expressions, we are making forward-looking statements. Many possible events or factors could affect our future financial results and performance. This could cause our results or performance to differ materially from those expressed in our forward-looking statements. You should consider these risks when you review this document, along with the following possible events or factors: - our growth strategy may not be as successful as we expect if we are unable to attract franchise area developers or single store franchisees; - competition within the retail specialty coffee market may intensify; - inclement weather or adverse political changes may significantly increase our coffee costs; and - adverse changes may occur in the securities or financial markets. In addition, this document contains forward-looking statements attributed to third parties relating to their estimates regarding the specialty coffee business. You should not place undue reliance on these forward-looking statements. PART I ITEM 1. BUSINESS. OVERVIEW Diedrich Coffee is a specialty coffee retailer that sells specialty brewed coffee and espresso-based beverages such as cappuccinos, lattes, mochas and espressos and various blended drinks through its 39 company-operated and 2 franchised retail locations in Southern California, Colorado and Texas. To complement beverage sales, we also sell light food items, specialty whole bean coffee and accessories at our retail locations. In addition to our retail locations, we operate a coffee roasting facility located in Southern California that provides high-quality, freshly roasted coffee beans for our retail locations and our wholesale accounts. We have over 300 wholesale accounts with businesses and restaurant chains, such as Ruth's Chris Steakhouses (California/Arizona locations), El Torito, Claim Jumper and Islands Restaurants. Diedrich Coffee believes that as the specialty coffee market has matured, distinct segments have emerged: espresso/coffee bars, coffeehouses and mall coffee stores. Espresso/coffee bars offer limited seating to facilitate quick customer turnover, are generally less than 1,200 square feet in size and are usually located in densely populated urban areas. Coffeehouses are generally greater than 1,200 square feet in size, located in suburban areas, and encourage customers to linger and enjoy a more relaxed, comfortable atmosphere. Mall coffee stores cater to mall consumers and place a heavier emphasis on the sale of flavored whole bean coffee and coffee-related merchandise. Based on the number of domestic retail coffee locations, Starbucks is the leader in the espresso/coffee bar segment, Gloria Jean's is the leader in the mall coffee store segment and there is presently no leader in the coffeehouse segment. Our business objective is to be the leading specialty coffee company in both the coffeehouse and mall coffee store segments. We differentiate ourselves from other specialty coffee producers by roasting our coffee beans in accordance with proprietary recipes developed over three generations by the Diedrich family. Our roasting recipes take into account the specific variety, origin and physical characteristics of each coffee bean to maximize its unique flavor. In addition, we seek to differentiate our coffeehouses by offering our customers a broad line of superior tasting coffee products and a high level of personalized customer service, which generate strong sales and customer loyalty. Diedrich coffeehouses offer a warm, friendly environment specifically designed to encourage guests to linger with friends and business associates or to relax alone in comfort. Ample seating is augmented by cozy sofas and comfortable chairs to create intimate nooks for meeting and relaxing. 1 4 The critical components of our coffeehouse concept include high quality, fresh roasted coffee and superior customer service by knowledgeable employees. COMPANY BACKGROUND The first retail store operating under the name of Diedrich Coffee commenced operations in 1972. Our retail operations grew rapidly until 1997 when we experienced difficulties managing such rapid growth. Diedrich Coffee restructured its operations and, in November 1997, our board of directors retained John Martin as Chairman of the Board and Tim Ryan as President and Chief Executive Officer. Messrs. Martin and Ryan collectively bring more than fifty-five years of multi-unit food service experience to our company. They joined our founder, Martin Diedrich, a recognized expert in sourcing, tasting and roasting coffee, and began the process of building a team of experienced restaurant industry executives to develop the Diedrich Coffee brand. To further our objective to be the leading specialty coffee company in both the coffeehouse and mall coffee store segments, our management team implemented a growth strategy to increase our number of retail locations and the sale of coffee products through other distribution channels. The principal focus of this growth strategy is franchise area development. INDUSTRY OVERVIEW Specialty coffee sales as a percentage of total coffee sales in the United States have been increasing steadily. According to the National Coffee Association, sales of specialty coffee grew from approximately 17% to almost 30% of total coffee sales in the United States from 1989 through 1997. According to the National Coffee Association's 1998 study, 45% of Americans drink coffee. On average they drink 1.4 cups per day. The U.S. coffee market consists of two distinct product categories: (1) commercial ground roast, mass-merchandised coffee and (2) specialty coffees, which include gourmet coffees (premium grade arabica coffees sold in whole bean and ground form) and premium coffees (upscale coffees mass-marketed by the leading coffee companies). Diedrich Coffee believes that several factors have contributed to the increase in demand for gourmet coffee including: - greater consumer awareness of gourmet coffee as a result of its increasing availability; - increased quality differentiation over commercial grade coffees by consumers; - increased demand for all premium food products, including gourmet coffee, where the differential in price from the commercial brands is small compared to the perceived improvement in product quality and taste; - ease of preparation of gourmet coffees resulting from the increased use of automatic drip coffee makers and home espresso machines; and - the decline in alcoholic beverage consumption. The Specialty Coffee Association of America projects the number of specialty coffee beverage outlets in the United States to increase to over 10,000 by the end of 1999. Diedrich Coffee believes that, despite the increase in the number of specialty coffee stores, the market is highly fragmented and, with the exception of Starbucks with less than 20% of the total retail locations, remains relatively unbranded. THE DIEDRICH COFFEEHOUSE CONCEPT Diedrich Coffee's business objective is to be the leading specialty coffee retailer in the coffeehouse segment. To achieve this goal, we must continue to deliver and serve the high quality coffee for which Diedrich Coffee is known by using only the finest quality green coffee beans and ensuring that these beans are freshly roasted using our proprietary recipes. In addition, the friendliness, speed and consistency of the service and the coffee knowledge of our employees are critical to developing Diedrich Coffee's quality brand identity and to building a loyal customer base. Our marketing strategy is to continue developing brand name recognition based upon the quality of our coffee products, education of our customers about our offerings of various coffees and roasts, and the image of our coffeehouses as neighborhood gathering places. 2 5 A Diedrich coffeehouse experience is strongly influenced by three components: ambiance, hospitality and coffee knowledge. Each component is made up of the following elements that are unique to Diedrich Coffee: Ambiance. Diedrich Coffee guest comments indicate taste superiority of our products versus the competition. Moreover, surveys also indicate that customers are not only loyal to a better, specialty cup of coffee, but also to the ambiance provided by the comfortable surroundings designed into every Diedrich coffeehouse. Our coffeehouses are specifically designed to encourage guests to linger with friends and business associates, or to relax alone in comfort. The architectural design of the Diedrich Coffee prototype is a contemporary American interpretation of the European colonial plantation style of the 1800's. Ample seating is augmented with cozy sofas and comfortable chairs to create intimate nooks for meeting and relaxing. A weekly entertainment schedule is provided to encourage patrons to revisit on weekend evenings. Hospitality. Our coffeehouses deliver specific consumer benefits that address a wide range of otherwise unmet needs in the suburban neighborhoods of America. As a neighborhood coffeehouse chain, Diedrich Coffee is the non-alcoholic answer to the corner pub. Coffeehouse employees greet regular customers by name and acknowledge all patrons by name at the point of drink pick-up. While a large percentage of coffeehouse business is quick morning coffee pick-up, the coffeehouse focus on hospitality encourages development of strong afternoon and evening business, complemented by the availability of desserts, pastries and quality, non-caffeinated beverages. Surveys and customer comments indicate that patrons are treated as part of the Diedrich Coffee community and frequently revisit the coffeehouse. Coffee Knowledge. Diedrich Coffee is the only specialty retailer whose founder, Martin Diedrich, comes from three generations of experience in the specialty coffee industry. Mr. Diedrich, currently Chief Coffee Officer, is intimately involved in the daily business of sourcing, tasting and roasting coffees. He is also directly involved in the training of coffeehouse team members. The coffee knowledge and expertise that is transferred from coffeehouse to customer is a competitive advantage, as the interest in specialty coffee continues to develop. Like the wine industry, as customer sophistication grows, so does the customer's desire for more and better information, and for a wider selection of quality coffee varieties. We are able to identify and secure exceptional, rare coffees, roast them to perfection, and then offer these freshly roasted coffees for sale to our customers. GROWTH STRATEGY In order to achieve Diedrich Coffee's objective to be the leading specialty coffee company in the coffeehouse segment, Diedrich Coffee's management team implemented a growth strategy to increase our number of retail locations and the sale of our coffee products through other distribution channels. The growth strategy developed by our management team includes: Franchising through Area Development for Coffeehouses Diedrich Coffee's strategic plan emphasizes franchise area development in markets outside of the core Orange County, California market. Our objective is to expand our operations to 1,200 to 1,500 coffeehouses, as well as additional carts and kiosks, through large area development agreements with experienced multi-unit franchise operators who are interested in opening between 30 and 70 retail outlets within their area over a 5 to 7 year period. Diedrich Coffee has registered, is exempt or is not required to register to sell franchises in 34 states. Since September 1998, we have announced 5 franchise area development agreements that provide for the development of 274 coffeehouses with options to develop an additional 148 coffeehouses. In September 1998, we announced our first franchise area development agreement which calls for the development of at least 44 coffeehouses in the state of North Carolina over the next five years. In November 1998, we announced our second franchise area development agreement which provides for the development of 50 coffeehouses in San Diego, Palm Springs and Temecula, California over the next 5 years. This area development agreement includes a one-year option to begin development of 45 coffeehouses in Arizona. Two more franchise area development agreements were announced in May 1999. One agreement provides for the development of 50 coffeehouses in Northern Florida over the next 6 years. The other agreement provides for the development of 3 6 80 coffeehouses in Los Angeles, California over the next 7 years and the option to develop up to 103 coffeehouses in Northern California. In June 1999, we announced a fifth franchise area development agreement which provides for the development of 50 coffeehouses in the states of Kentucky and Tennessee over the next 5 years. We are currently in various stages of discussion and negotiation with several additional potential area developers. We have recently added two franchise sales organizations to assist in the sales program. These sales organizations receive performance-based compensation for executed franchise area development agreements. We intend to enter into franchise area development agreements covering most major U.S. markets in order to complete the national expansion of Diedrich coffeehouses, carts, and kiosks. We have identified area development franchising with experienced multi-unit franchise operators as our preferred growth vehicle because we believe these operators have: - familiarity with the trade areas and commitment to community businesses; - existing operational, financial, real estate, construction, training, accounting, human resources and management functions that are ready to expand; and - the ability to be better operators in their own markets than a national corporation. The franchisee component of our growth strategy is critical to our success. We believe that our compelling unit level economics are attractive to experienced multi-unit franchise operators who will play an integral role in completing our planned expansion. Developing Company-Operated Retail Locations Diedrich Coffee will continue to develop company-operated coffeehouses, kiosks and carts in our core Southern California market and other strategic markets. We are developing additional coffeehouses in the Phoenix area. Both the Orange County and Phoenix markets have significant capacity for the addition of more coffeehouses. We intend to develop additional retail locations in high visibility, high-traffic locations ranging from 1,200 to 1,800 square feet with an exterior patio area for additional seating. Historically, our most successful coffeehouses are located between our target demographic customer's home and office. The prime locations are generally in a strip mall or center in a neighborhood setting. We are currently in lease negotiations on approximately eight sites in Orange County and Phoenix and recently executed leases for an additional three coffeehouses. Expanding Wholesale Distribution Channel Diedrich Coffee has taken significant steps to build its wholesale sales organization and to grow this business channel. Wholesale sales accounted for approximately 11% of sales in fiscal 1999 and 16% of sales in the first quarter of fiscal 2000. We have added a number of well-known restaurant groups as wholesale customers, including Ruth's Chris Steakhouses (California/Arizona locations), Islands Restaurants, El Torito and Claim Jumper. The sale of Diedrich Coffee products at these restaurant chains helps solidify brand recognition and demand for our coffee. Additionally, we are actively seeking new distribution channels for our products. For example, we now offer our coffee on our website and are seeking to expand this rapidly growing channel of distribution. Pursuing Selected Acquisitions Diedrich Coffee evaluates potential acquisitions that may accelerate our critical mass in existing or new markets. In particular, we look for acquisition targets that may provide: - improved stability of financial and business operations due to increased cash flow and earnings; - greater access to capital, distribution channels and coffee roasting infrastructures; and - decreased supply and distribution costs. 4 7 To this end, we entered into the merger agreement with Coffee People. The acquisition of Coffee People will add 40 new retail locations to the Diedrich Coffee brand. Additionally, it will make Diedrich Coffee the leader in the mall coffee store segment with the acquisition of 280 Gloria Jean's mall coffee stores. We believe that acquisitions will continue to be available at a discount to the cost of constructing new stores, especially where targets may be currently underperforming despite attractive real estate attributes. We believe our unique, high-quality product and efficient operating system can add value to an acquired location. UNIT-LEVEL ECONOMICS Franchised Stores The franchisee of Diedrich coffeehouses is responsible for all of the capital expenditures associated with the store, although we do assist in site selection and help coordinate construction and development to ensure consistency. Our typical franchise development agreement calls for a fixed number of coffeehouses to be built over a five to seven year period. The area development fee is based on $2,000 per coffeehouse and is paid in 5 annual installments. For example, if the area development agreement calls for 50 coffeehouses, the franchisee would pay us a total of $100,000 spread evenly over a 5 year period. In addition, the franchisee pays a fee of $28,000 upon the opening of each coffeehouse. Ongoing charges to franchisees include a royalty fee of 5% of gross sales and an advertising cooperative contribution of 2% of gross sales. The franchisee purchases the whole beans from us at full cost. The franchisee pays the same price for its beans as do our company-operated coffeehouses. Company-Operated Stores In fiscal 1999, our Diedrich coffeehouses located in Orange County generated average store sales of approximately $740,000. During the same fiscal year, these locations generated average cash flow of approximately $190,000 or 26% of total sales. Comparable unit level sales for these coffeehouses increased 4.4% for fiscal 1999. We currently lease most of our locations and plan to lease all of our future locations. We intend to develop coffeehouses that require an initial investment of between $300,000 and $325,000, excluding lease costs. However, individual store investment costs could vary due to a variety of factors, including competition for sites, location, construction costs and unit size. RETAIL LOCATIONS Set forth below is a list of each of the retail locations of Diedrich Coffee as of June 1, 1999, separated by the states in which they are located. COFFEEHOUSES AND CARTS
COMPANY- LOCATION FRANCHISED OPERATED -------- ---------- -------- California...................................... 2 28 Colorado........................................ -- 7 Texas........................................... -- 4 -- -- Total...................................... 2 39 == ==
We currently operate through two retail operating systems: Neighborhood Coffeehouses Neighborhood coffeehouses, located in both urban and suburban neighborhoods and business districts, offer a complete line of coffee products, including beverages, beans and merchandise. As of June 1, 1999, we had 34 neighborhood coffeehouses. 5 8 Specialty Carts or Kiosks Our specialty cart or kiosk format is designed for placement in high-traffic locations such as supermarkets, university campuses, airports and office building lobbies. Kiosks primarily sell coffee beverages and pastries. As of June 1, 1999, we operated 7 carts or kiosks. We intend to expand in this area as opportunities arise. RETAIL OPERATIONS Coffeehouses The typical Diedrich coffeehouse is staffed with 1 or 2 managers and a staff of 10 to 15 part-time hourly employees from which the operating shifts are filled. Additionally, local entertainment is used on the weekends to enhance the neighborhood atmosphere. The hours for each coffeehouse are established based upon location and customer demand, but typically are from 6:00 a.m. to 11:00 p.m., Monday through Saturday, in residential locations and from 6:00 a.m. to 5:00 p.m., Monday through Friday, in commercial locations. In addition to coffee beverages, all Diedrich coffeehouses offer a limited selection of light food items, such as bagels, croissants and pastries and dessert items, such as cookies and cakes, to complement beverage sales. Our coffeehouses also sell more than twenty different selections of regular and decaffeinated roasted whole bean coffees, and they carry select coffee-related merchandise items. The following table sets forth, as percentages, the approximate sales mix by categories of products in fiscal 1999 for Diedrich Coffee company-operated coffeehouses: Beverages................................................... 73% Coffee beans................................................ 6% Food items.................................................. 19% Accessories and clothing.................................... 2% --- Total............................................. 100% ===
Franchise Operations Diedrich Coffee's current franchise agreements require franchisees to purchase all of their coffee from us. In addition, we supply franchisees with other non-coffee products, such as cups, bags and napkins. Suppliers of products sold in franchised stores are subject to our approval to ensure that quality standards and product consistency are maintained at all times. We have the first right to purchase any existing franchise store that a franchisee wishes to sell. If we do not choose to purchase the franchise, we have the right to approve the new franchisee before the franchise transfer. Management believes that store profitability and the quality of customer service are maximized when stores are operated by talented and committed management. We have implemented a rigorous screening process for the selection of qualified franchisees and management. Franchise Support Programs We provide a variety of support services to our franchisees. These services include: - training; - business consultation; - marketing; - product sourcing; and - volume purchasing savings. 6 9 We have established an intensive four week training program for our franchisees, which includes training on in-store operations, coffee knowledge, merchandising, buying, controls and accounting. Management works closely with franchisee representatives on issues that affect the operations of stores. Franchisees are surveyed regularly to provide feedback on subjects that affect the operations of their stores. WHOLESALE OPERATIONS Currently, Diedrich Coffee has over 300 wholesale accounts. We previously concentrated on smaller, single store restaurant operators as wholesale clients. With our current management team came a shift in focus to larger, chain customers. As specialty coffee has grown in overall popularity, the restaurant customer has demanded a high quality cup of coffee as a supplement to a fine meal. The shift to chain accounts resulted in several new customers, including Ruth's Chris Steakhouse (California/Arizona locations), Claim Jumper, Islands Restaurants and El Torito Restaurants. Diedrich Coffee not only supplies coffee to these customers, but also approves the equipment and trains the employees of these customers to ensure that the quality of coffee served meets our rigorous standards. These customers specify that Diedrich Coffee products are served in their menus providing Diedrich Coffee with exposure to the restaurants' patrons. MARKETING Our marketing strategy is to differentiate Diedrich Coffee and to build a strong brand identity primarily utilizing the coffeehouse model. The wholesale division and the office coffee service help ensure the visibility of the brand, but the core of this business is the coffeehouse. We implement this strategy at the coffeehouse level by promoting the distinctive qualities of the various Diedrich Coffee products, educating customers about the origins of coffee, including the private estate coffees and roasts and delivering excellent customer service in a cozy, comfortable atmosphere. Our marketing efforts are based upon the belief that the proprietary roast recipes and our commitment to quality and freshness deliver a distinctive advantage in the coffee product. A steady introduction of new coffee and coffee-related drinks is an intrinsic aspect of our marketing strategy. To date, we have relied primarily upon the high visibility of our real estate locations, word-of-mouth, public relations, local store marketing and the inviting atmosphere of our coffeehouses to drive growth. We also conduct in-store coffee tastings, provide brewed coffee at local neighborhood events, donate coffee to local charities and mail periodic announcements to neighborhood residents to announce a store opening or the introduction of a new product. The costs of these promotions do not have a material impact on our operating results. In addition, we seek to develop our brand identity through participation in local and regional community events. As we enter new markets, we plan to tailor our marketing strategy to the overall level of awareness and availability of specialty coffee in that market. Our promotions will focus on the superior proprietary roast recipes and taste of Diedrich Coffee. In markets that are more knowledgeable about specialty coffees, our advertising will focus on the superiority of our guaranteed freshly roasted products versus competitive specialty brands. We plan to utilize print and other mass media advertising to expand brand awareness when Diedrich Coffee has achieved sufficient market penetration, in our judgment, to make such efforts cost-effective. PRODUCT SUPPLY AND ROASTING Sourcing Coffee beans are an agricultural product grown commercially in over fifty countries in tropical regions of the world. The price and supply of coffee are subject to significant volatility. There are many varieties of coffee and a range of quality grades within each variety. Although the broader coffee market generally treats coffee as a fungible commodity, the specialty coffee industry focuses on the highest grades of coffee. Diedrich Coffee purchases only premium grade arabica coffee beans and believes these beans are the best available from each producing region. The premium grade arabica bean is a higher quality variety than the average grade arabica or robusta variety coffee bean, which are typically found in non-specialty or mass-merchandised commercial coffees. We seek to purchase the finest qualities and varieties of coffee by identifying the unique characteris- 7 10 tics and flavor of the varieties available from each region of the world. The background and experience of our personnel allows Diedrich Coffee to maintain its commitment to serve and sell only the highest quality coffee. During the buying season, we may enter into forward commitments for the purchase of more than a dozen different types of coffee, plus specially featured coffees, that may only be available in small quantities. Rotating our coffee selection enables us to provide our customers with a wider variety of coffees, as well as certain coffees that are available only on a seasonal basis. We contract for future delivery of green coffee to help ensure adequacy of supply and typically maintain a minimum six-week supply of each variety of whole beans then available. Roasting Diedrich Coffee employs a roasting process that varies based upon the variety, quality, origin and physical characteristics of the coffee beans being roasted. We utilize recipes and techniques that have been developed over three generations to bring out the best characteristics of the coffee during the roasting process and to develop the optimal flavor conditions that a coffee has to offer. This approach differentiates Diedrich Coffee from commercial coffee producers and other specialty producers employing uniform roasting processes that do not differentiate between the types of coffee being roasted. Diedrich Coffee's master roasters, trained by the company, are responsible for overseeing the roasting process. They are craftsmen who employ our proprietary roasting formulas while adjusting the formula to take into account the specific attributes of each coffee bean being roasted. Each coffee bean contains aromatic oils and flavor characteristics that develop from the soil, climate and environment where the bean is grown. The skilled roastmaster determines and carefully controls the roasting conditions in an effort to maximize the flavor potential of each batch of coffee. The roastmaster hears how the roast pops, smells the developing aroma and identifies the right shades of color. He draws upon experience and knowledge to properly adjust airflow, time and temperature while the roast is in progress in order to optimize each roast. Freshness Diedrich Coffee is committed to serving its customers beverages and whole bean products from freshly roasted coffee beans. Our coffee is delivered to our coffeehouses promptly after roasting to guarantee the freshness of each cup of coffee or package of whole coffee beans sold in our coffeehouses. Serving only freshly roasted coffee is imperative because roasted coffee is a highly perishable product, which steadily loses quality after being roasted at a rate that varies in relation to its exposure to oxygen in storing, packaging and handling. We recently acquired new vacuum pack and nitrogen flush packing equipment that can significantly extend the shelf life of roasted coffee. MANAGEMENT INFORMATION SYSTEMS All of the Diedrich coffeehouses use point-of-sale systems which ensure efficient service to the customers, assist store management in minimizing operating costs and maintain the necessary information to provide management with timely financial and marketing data. The system includes functions to record all customer sales, authorize credit card transactions, forecast labor requirements based on estimated sales activity, manage store inventory and analyze actual versus theoretical food costs. The systems used in Diedrich Coffee's corporate offices provide financial reporting that includes performance comparisons of actual, budget and prior year results by period and year-to-date, statistical recaps and 12 month reports. This information allows management to measure store performance based on sales, cost of sales, labor and store expenses on a timely basis. COMPETITION The specialty coffee market is intensely competitive and highly fragmented. With low barriers to entry, competition in the industry is expected to increase from national and regional chains, franchise operators and local specialty coffee stores. Diedrich Coffee competes directly against all other premium coffee roasters, 8 11 coffeehouses, espresso/coffee bars and mall coffee stores, as well as against restaurant and beverage outlets that serve coffee and a growing number of espresso stands, carts and stores. In addition, we compete to draw consumers of standard or commercial coffee to premium coffee. Our whole bean coffees compete directly against specialty coffees sold at retail through supermarkets, specialty retailers and a growing number of specialty coffee stores. We believe that our customers choose among retailers primarily on the basis of product quality, service, coffeehouse ambiance, convenience and, to a lesser extent, on price. We compete with a growing number of specialty coffee retailers including Starbucks, Coffee Beanery, Caribou, Barnie's, Tully's, New World Coffee & Bagels, Peet's Coffee and many others. The attractiveness of the gourmet specialty coffeehouse market may draw additional competitors with substantially greater financial, marketing and operating resources than us. A number of nationwide coffee manufacturers, such as Kraft General Foods, Proctor & Gamble, and Nestle, distribute coffee products in supermarkets and convenience stores, which may serve as substitutes for our coffees. Other specialty coffee companies including Starbucks, Seattle's Best Coffee, Bucks County, Brothers Gourmet Coffees and Green Mountain Coffee Roasters, sell whole bean coffees in supermarkets and variety and discount stores. The performance of individual coffeehouses may also be affected by factors such as traffic patterns and the type, number and proximity of competing coffeehouses. In addition, factors such as inflation, increased coffee bean, food, labor and employee benefit costs and the availability of experienced management and hourly employees may also adversely affect the specialty coffee retail business in general and our coffeehouses in particular. INTELLECTUAL PROPERTY Diedrich Coffee owns several trademarks and service marks that are registered with the United States Patent and Trademark Office, including Diedrich Coffee,(R) Wiener Melange,(R) Harvest Peak,(R) SCOOP-A-CCINO(R) and Flor de Apanas.(R) In addition, we have applications pending with the United States Patent and Trademark Office for a number of additional marks. The Diedrich Coffee trademark is material to our business. We also own registrations and have applications pending in numerous foreign countries for trademark protection of the Diedrich Coffee trademark and service mark. Trademark registrations can generally be renewed so long as we continue to use the marks. We own copyrights on our promotional materials, coffeehouse graphics and operational and training materials. We do not believe that any of these copyrights, valuable as they are, are material to our business. EMPLOYEES As of June 1, 1999, Diedrich Coffee employed a work force of 800 persons, 117 of whom were employed full-time. None of our employees is represented by a labor union, no employees are currently covered by collective bargaining agreements and we consider our relations with employees to be good. We are improving employee benefits, training and other aspects of employment to attract and retain valuable employees and managers. GOVERNMENT REGULATION In addition to the laws and regulations relating to the food service industry, Diedrich Coffee is subject to Federal Trade Commission, or FTC, regulation and state laws that regulate the offer and sale of franchises as well as the franchise relationship. The FTC's Trade Regulation Rule relating to Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures generally requires us to give prospective franchisees a franchise offering circular containing information prescribed by the rule. 9 12 A number of states have laws that regulate the offer and sale of franchises and the franchisor-franchisee relationship. These laws generally require registration of the franchise offering with state authorities before making offers or sales and regulate the franchise relationship by, for example: - prohibiting interference with the right of free association among franchisees; - prohibiting discrimination in fees and charges; - regulating the termination of the relationship by requiring "good cause" to exist as a basis for the termination, advance notice to the franchisee of the termination, and an opportunity to cure a default; - requiring repurchase of inventories in some circumstances; - restricting nonrenewal by the franchisor; - limiting restrictions on transfers or inheritance of the franchisee's interests; and - regulating placement of competing units that might adversely affect the franchisee's results. Failure to comply with these laws may adversely affect us. Any changes to the FTC rule or state franchise laws, or future court or administrative decisions, however, could affect our franchise business. There are also extensive federal, state and local government regulations relating to the development and operation of food service outlets, including laws and regulations relating to: - building and seating requirements; - the preparation and sale of food; - cleanliness; - safety in the workplace; and - accommodations for the disabled. Our relationship with our employees is also subject to regulation, such as: - minimum wage requirements; - anti-discrimination laws; - overtime and working conditions; and - citizenship requirements. RISK FACTORS AND TRENDS AFFECTING DIEDRICH COFFEE AND ITS BUSINESS If we are not able to successfully manage our growth strategy, our business and results of operations may be adversely impacted As of June 1, 1999, we operated 39 retail locations, which we managed on a day-to-day basis, and had 2 franchised retail locations. Our growth strategy contemplates franchise area development for additional Diedrich coffeehouses as well as opening new company-operated coffeehouses. In addition, we plan to strive to increase wholesale sales. Implementation of our growth strategy may divert management's attention from other aspects of our business and place a strain on management, operational and financial resources, and accounting systems. Our continued growth will require us to: - attract franchise area developers for Diedrich Coffee in the United States and internationally; - expand wholesale sales; - evaluate the potential acquisition of complementary coffee retailers; 10 13 - obtain (or have our franchise area developers obtain) suitable sites at acceptable costs in highly competitive real estate markets; - hire, train and retain qualified personnel; - integrate newly franchised or corporate locations into existing product distribution; - improve inventory control, marketing and information systems; and - impose and maintain strict quality control from green coffee acquisition to the fresh cup of brewed coffee in a customer's hand. Should our franchisees encounter business or operational difficulties, anticipated revenues from franchise fees, including royalties, and product sales to franchisees could be adversely affected. These adverse results could also affect our ability to sell additional franchises. Historical losses may continue and, as a result, the price of our common stock may be negatively affected We had net losses of $2,562,000, $9,113,000, and $986,000 for the fiscal years ended January, 1999, 1998 and 1997, respectively. We expect to sustain net losses for the foreseeable future. Although our revenues have grown in recent quarters, we may not be able to sustain these growth rates. In addition, such growth rates are not necessarily indicative of future growth. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." Our growth through franchise area development may not occur as rapidly as we currently anticipate We must continue to execute new franchise area development agreements with franchisees in order to achieve the objective of our growth strategy to expand our operations to 1,200 to 1,500 coffeehouses over the next 5 to 7 years. On September 16, 1998, we announced our first franchise area development agreement providing for the development of 44 coffeehouses and a number of carts and kiosks over a 5 year period. Since that date, we have entered into 4 additional franchise area development agreements providing for the development of 230 coffeehouses. To date, no coffeehouses have opened under the franchise area development agreements. Our ability to attract, retain and contract with qualified franchise operators will become increasingly important to our operations as we expand. In addition, the coffeehouses contemplated in executed franchise area development agreements may not open on the anticipated development schedule. Our franchise area development strategy may not enhance our results of operations. Failure to execute on our strategy to grow through franchise area development will harm our business, financial condition and results of operations. Our operating results may fluctuate significantly, which could have a negative effect on the price of our common stock Our operating results will fluctuate from quarter to quarter as the result of a number of factors, including: - fluctuations in prices of unroasted coffee; - labor costs for our hourly and management personnel, including increases in federal or state minimum wage requirements; - the number, timing and cost of coffeehouse openings, franchises, acquisitions or closings; - comparable store sales results; - the timing of realizing amortization and other expenses associated with acquisitions; - changes in consumer preferences; and - the level of competition from existing or new competitors in the specialty coffee industry. We incur significant pre-opening expenses associated with our company-owned coffeehouses and new coffeehouses experience an initial period of operating losses. As a result, the opening of a significant number of company-owned coffeehouses in a single period will have an adverse effect on our results of operations. Due to 11 14 the foregoing, we believe that period-to-period comparisons of our operating results are not necessarily meaningful and such comparisons should not be relied upon as indicators of future performance. From time to time in the future, our operating results likely will fall below the expectations of investors and public market securities analysts. Quarterly fluctuations, for any reason, could cause our stock price to decline. In addition, our business is subject to seasonal fluctuations. The December holiday season generally experiences the highest sales. Hot weather tends to depress sales of hot coffee and espresso drinks, especially unseasonably warm weather. Consequently, we will continue to experience significant fluctuations in quarterly results. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Seasonality and Quarterly Results." The loss of key personnel or our inability to attract and retain qualified personnel could significantly disrupt our business Our continued success largely will depend on the efforts and abilities of our executive officers and other key employees, particularly John E. Martin, Chairman of the Board, Timothy J. Ryan, President and Chief Executive Officer, and Martin Diedrich, Chief Coffee Officer. The loss of services of these individuals could disrupt operations. Although Diedrich Coffee has employment agreements with Messrs. Martin, Ryan and Diedrich, any of its executive officers can terminate their employment if they choose to do so. In addition, our success and the success of our franchisees will depend upon our and their ability to attract and retain highly motivated, well-qualified retail operators and other management personnel, as well as a sufficient number of qualified employees. Qualified individuals needed to fill these positions are in short supply in some geographic areas. Our inability to recruit and retain such individuals may delay the planned openings of new retail locations or result in higher employee turnover in existing retail locations, which could have a material adverse effect on our business or results of operations. If we are unable to obtain acceptable financing, it could have a material adverse effect on our growth strategy In order to achieve our anticipated growth and the expansion of our wholesale and retail business, including new coffeehouse construction and franchising, we will need to incur debt or issue additional stock in public or private financings. If additional funds are raised through the issuance of stock, dilution to stockholders may result. If additional funds are raised through the incurrence of debt, these debt instruments will likely contain restrictive financial, maintenance and security covenants, which could have a material adverse effect on our business, financial condition and results of operations. This additional financing may not be available at all or on terms satisfactory to us. Our industry is highly competitive and we may not have the resources to compete effectively The highly competitive nature of the retail specialty coffee market could adversely affect our business and financial condition. With low barriers to entry, competition in the industry is expected to increase from national and regional chains, franchise operators and local specialty coffee stores. We compete directly against all other premium coffee roasters, coffeehouses, espresso/coffee bars and mall coffee stores, as well as against restaurant and beverage outlets that serve coffee and a growing number of espresso stands, carts and stores. In addition, we compete to draw consumers of standard or commercial coffee to premium coffee. Our whole bean coffees compete directly against specialty coffees sold at retail through supermarkets, specialty retailers and a growing number of specialty coffee stores. We believe that our customers choose among retailers primarily on the basis of product quality, service, coffeehouse ambiance, convenience and, to a lesser extent, on price. We compete with a growing number of specialty coffee retailers including Starbucks, Seattle's Best Coffee, Barnie's, Coffee Beanery Ltd., Caribou, Peet's Coffee and many others. The attractiveness of the gourmet specialty coffeehouse market may draw additional competitors with substantially greater financial, marketing and operating resources than us. A number of nationwide coffee manufacturers, such as Kraft General Foods, Proctor & Gamble and Nestle, distribute coffee products in supermarkets and convenience stores, which may serve as substitutes for our coffees. Other specialty coffee companies including Starbucks, 12 15 Seattle's Best Coffee, Bucks County, Brothers Gourmet Coffees and Green Mountain Coffee Roasters, sell whole bean coffees in supermarkets and variety and discount stores. The performance of individual coffeehouses may also be affected by factors such as traffic patterns and the type, number and proximity of competing coffeehouses. In addition, factors such as inflation, increased coffee bean, food, labor and employee benefit costs and the availability of experienced management and hourly employees may also adversely affect the specialty coffee retail business in general and our coffeehouses in particular. Our lack of diversification may affect business if demand is reduced Our business is primarily centered on one product: fresh premium custom-roasted coffee. To date, our operations have been limited to primarily the purchase and roasting of green coffee beans and the sale of whole bean coffee, coffee beverages and espresso drinks through our coffeehouses and our wholesale coffee and mail order businesses. Any decrease in demand for coffee would have a material adverse effect on our business, operating results and financial condition. Our company-operated retail locations are concentrated in the western region of the United States, and therefore our business is subject to fluctuations if adverse business conditions occur in that region Our company-operated retail locations are primarily located in the western region of the United States. Accordingly, we are susceptible to fluctuations in our business caused by adverse economic or other conditions in this region, including natural or other disasters. In addition, some of our competitors have many more retail locations than we do. Consequently, adverse economic or other conditions in a region, a decline in the profitability of several existing retail locations or the introduction of several unsuccessful new retail locations in a geographic area could have a more significant effect on our results of operations than would be the case for a company with a larger number of retail locations or with more geographically dispersed retail locations. Our supply costs may be higher than we expect because of fluctuations in availability and cost of unroasted coffee Increases in the price of green coffee, or the unavailability of adequate supplies of green coffee of the quality we seek, whether due to the failure of our suppliers to perform, conditions in coffee-producing countries, or otherwise, could have a material adverse effect on our results of operations. We depend upon both outside brokers and our direct contacts with exporters and growers in countries of origin for our supply of green coffee. Coffee supply and price are subject to significant volatility beyond our control. Although most coffee trades in the commodity market, coffee of the quality we seek tends to trade on a negotiated basis at a substantial premium above commodity coffee pricing, depending upon the origin, supply and demand at the time of purchase. Supply and price can be affected by multiple factors in the producing countries, including weather, political and economic conditions. In addition, green coffee prices have been affected in the past, and may be affected in the future, by the actions of certain organizations and associations, such as the International Coffee Organization or the Association of Coffee Producing Countries. These organizations have historically attempted to establish commodity price controls of green coffee through agreements establishing export quotas or restricting coffee supplies worldwide. These organizations, or others, may succeed in raising green coffee prices. Should this happen, we may not be able to maintain our gross margins by raising prices without affecting demand. 13 16 RECENT DEVELOPMENTS On March 16, 1999, we agreed to acquire Coffee People, Inc. through a merger in which Coffee People will become a wholly-owned subsidiary of Diedrich Coffee. As a result of the acquisition, Coffee People stockholders will receive from Diedrich Coffee in the aggregate: - $17.75 million in cash; - 1.5 million shares of Diedrich Coffee common stock; and - $5.25 million in cash or shares of Diedrich Coffee common stock, depending on the success of an equity offering or other type of financing by Diedrich Coffee. The acquisition is subject to a number of conditions, including securing financing, obtaining regulatory and stockholder approval and completing the acquisition by July 15, 1999. We expect to complete the acquisition before July 15, 1999. After the completion of the acquisition, we anticipate the combined company will have annual system-wide sales of more than $150 million through 361 retail locations in 38 states and 7 countries. The combined company's brands will include Diedrich Coffee, Coffee People, Coffee Plantation and the Gloria Jean's mall coffee stores. Following the acquisition, Coffee People and Coffee Plantation coffeehouses will be converted into Diedrich coffeehouses. By virtue of the acquisition, we will acquire significant additional roasting capacity, packaging and distribution capabilities and valuable infrastructure and management expertise. We expect to realize some cost savings after the acquisition through greater efficiencies. However, no assurance can be provided as to the extent, if any, of savings. The combined company should facilitate further franchise area development. ITEM 2. PROPERTIES. Diedrich Coffee leases approximately 25,000 square feet of office space for administrative offices, warehousing, roasting and training facilities in Irvine, California. The lease for this facility expires in October 2000, with an option for one additional five-year term. As of January 27, 1999, we were also a party to various leases for a total of 45 retail locations, including 36 operating coffeehouses, 2 subleased units and 7 carts. We converted and subleased two retail locations to a franchisee after the year ended January 27, 1999. This was part of a signed area development agreement that also includes the addition of 48 more locations throughout the San Diego area. We closed 2 retail locations and the Denver warehouse in fiscal 1999 and 11 retail locations in fiscal 1998 of which 9 leases were terminated. All of our operating coffeehouses are on leased premises and are subject to varying arrangements specified in property specific leases. For example, some of the leases require a flat rent, subject to regional cost-of-living increases, while others are based upon a percentage of gross sales. In addition, some of these leases expire in the near future, and there is no automatic renewal or option to renew. ITEM 3. LEGAL PROCEEDINGS. In the ordinary course of our business, we may become involved in legal proceedings from time-to-time. As of January 27, 1999, we were not a party to any material pending legal proceedings. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to a vote of our security holders during the fourth quarter of the year ended January 27, 1999. 14 17 PART II ITEM 5.MARKET FOR DIEDRICH COFFEE'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Diedrich Coffee common stock is reported on the Nasdaq National Market under the symbol "DDRX." The following table sets forth the high and low bid information for the quarterly periods indicated for our common stock as reported on the Nasdaq National Market since January 30, 1997.
PRICE RANGE ---------------- PERIOD HIGH LOW ------ ------ ------ FISCAL YEAR ENDED JANUARY 28, 1998 First Quarter............................................. $8 3/4 $2 3/8 Second Quarter............................................ 4 2 1/2 Third Quarter............................................. 4 1/16 2 7/16 Fourth Quarter............................................ 9 2 3/4 FISCAL YEAR ENDED JANUARY 27, 1999 First Quarter............................................. $8 $5 11/16 Second Quarter............................................ 8 1/4 6 9/16 Third Quarter............................................. 7 1/4 3 3/8 Fourth Quarter............................................ 6 1/2 3 7/8
At April 7, 1999, there were 6,173,538 shares outstanding and 147 stockholders of record of Diedrich Coffee common stock. Diedrich Coffee has not paid dividends on its common stock and does not anticipate paying dividends in the foreseeable future. 15 18 ITEM 6. SELECTED FINANCIAL DATA. The following five-year selected financial data may not be indicative of Diedrich Coffee's future results of operations and should be read in conjunction with "Item 7. Management's Discussion and Results of Operations" and our consolidated financial statements and related notes.
YEAR YEAR YEAR YEAR YEAR ENDED ENDED ENDED ENDED ENDED JANUARY 27, JANUARY 28, JANUARY 29, JANUARY 31, JANUARY 31, 1999 1998 1997 1996 1995 ----------- ----------- ----------- ----------- ----------- (IN THOUSANDS, EXCEPT PER SHARE DATA) STATEMENT OF OPERATIONS DATA: Revenues: Retail............................... $21,248 $20,760 $18,118 $ 8,879 $6,673 Wholesale and other.................. 2,767 2,222 1,694 1,365 918 Franchise revenue.................... 200 -- -- -- -- ------- ------- ------- ------- ------ Total........................... 24,215 22,982 19,812 10,244 7,591 ------- ------- ------- ------- ------ Cost and expenses: Cost of sales and related occupancy costs.............................. 10,955 11,458 9,263 4,409 3,164 Store operating expenses............. 8,936 10,448 8,280 3,520 2,584 Other operating expenses............. 634 290 240 277 282 Depreciation and amortization........ 1,941 1,785 1,054 354 255 Provision for asset impairment and restructuring costs................ -- 3,902 -- -- -- General and administrative expenses........................... 4,014 4,006 2,003 1,335 851 ------- ------- ------- ------- ------ Total........................... 26,480 31,889 20,840 9,895 7,136 ------- ------- ------- ------- ------ Operating income (loss)................... (2,265) (8,907) (1,028) 349 455 Interest expense and other, net........... (293) (205) (86) (34) (78) ------- ------- ------- ------- ------ Income (loss) before income taxes......... (2,558) (9,112) (1,114) 315 377 Income tax provision (benefit)............ 4 1 (128) 129 53 ------- ------- ------- ------- ------ Net income (loss)......................... $(2,562) $(9,113) $ (986) $ 186 $ 324 ======= ======= ======= ======= ====== Basic income (loss) per common share(1)... $ (.43) $ (1.69) $ (.22) ======= ======= ======= Diluted income (loss) per share........... $ (.43) $ (1.69) $ (.22) ======= ======= ======= Pro forma net income per share(2)......... $ .06 ======= BALANCE SHEET DATA: Working capital (deficiency)............ $ (655) $ (959) $ 1,949 $ (53) $ (418) Total assets............................ 12,736 13,948 17,471 5,316 2,503 Long-term debt and long-term obligations, less current portion.... 2,783 2,817 -- 829 471 Total stockholders' equity.............. 6,027 6,835 14,898 3,304 973
- --------------- (1) Net income (loss) per share for periods before the year ended January 31, 1996 is not presented due to the noncomparable capital structure. Net loss per share for fiscal 1999, 1998 and 1997 is presented as basic earnings per share under the provisions of SFAS 128. (2) Pro forma net income per share is computed by dividing net income by the weighted average number of common and common equivalent shares outstanding during the respective period, assuming the conversion of the series A and series B preferred stock into common stock as of the date of issuance. Dividends on the series A and series B preferred stock have been excluded from the computation since the preferred stock has been assumed to have been converted to common stock. 16 19 ITEM 7.MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. GENERAL Effective February 1, 1996, Diedrich Coffee changed its fiscal year end from January 31 to a fiscal year ending on the Wednesday nearest January 31. In connection with the change in fiscal year end, we began reporting quarterly results in thirteen-week periods. Before the change in fiscal year end, our quarterly periods included twelve weeks, except for the fourth quarter, which had approximately sixteen weeks. References to fiscal 1999 refer to the fiscal year ended January 27, 1999, references to fiscal 1998 refer to the fiscal year ended January 28, 1998 and references to fiscal 1997 refer to the fiscal year ended January 29, 1997. Following the merger with Coffee People, Diedrich Coffee intends to change its fiscal year to the 52 or 53 week period ending on the Wednesday closest to June 30 of each year. The first retail store operating under the name of Diedrich Coffee commenced operations in 1972. At the conclusion of fiscal 1999, we operated a total of 36 coffeehouses and seven coffee carts located in California, Colorado and Texas. We sell high quality coffee beverages made with our own freshly roasted coffee. In addition to brewed coffee, we offer a broad range of espresso based beverages such as cappuccino, cafe latte, cafe mocha and espresso machiato. To complement beverage sales, we sell light food items and whole bean coffee through our coffeehouses. In addition, we have a strong wholesale division that markets our products directly to independent and chain food service establishments, as well as to businesses for office coffee systems through brokers and sales representatives. We grew rapidly in fiscal 1997 and experienced difficulties managing that growth in fiscal 1998. In March 1997, we announced the resignation of Steven Lupinacci, President and Chief Executive Officer. We took a restructuring charge of $3.9 million for closing 12 coffeehouses in fiscal 1997. In addition to closing 11 of these 12 coffeehouses, we opened new coffeehouses in Houston, Texas as well as Irvine and Santa Monica, California. We also entered into an agreement to place coffee carts at premium office locations in Orange County, California; seven carts were operating under this agreement at fiscal year-end 1999. Mr. Lawrence Goelman became Chairman of the Board and Interim Chief Executive Officer on March 12, 1997. Kerry Coin was appointed President and Chief Operating Officer on April 25, 1997. Under the board's direction, management developed and executed a turnaround plan intended to return Diedrich Coffee to operating profitability. Underperforming stores were closed, leases assigned, terminated or sublet and new channels of distribution were developed. Experienced professional managers were recruited. The wholesale division was given aggressive growth targets and the resources needed to meet them. New management and training systems were developed and implemented. In the third quarter of fiscal 1998, we raised $3 million of working capital through the private placement of secured debt. On November 17, 1997, the board appointed Mr. John E. Martin as Chairman of the Board and Mr. Timothy J. Ryan as President and Chief Executive Officer. Despite the efforts of the interim management team led by Messrs. Goelman and Coin, Diedrich Coffee did not meet its stated goal of cash-flow positive operating results by the end of the last quarter of fiscal 1998. The reasons for the shortfall were several: the increased one-time general and administrative costs associated with the addition of the new executive management team headed by John Martin and Tim Ryan, inadequate and unsuccessful marketing programs, delays in the installation of coffee carts in Orange County and inadequate management of certain labor costs. Messrs. Martin and Ryan determined that, while the turnaround plan implemented by the interim management team had stabilized Diedrich Coffee operationally, it was not likely to result in profitable growth in the near future. Accordingly, they initiated a business planning process that resulted in a strategic five-year plan directed toward growth through franchise area development agreements combined with focused company unit growth and centralization of production facilities. This plan also built on the interim management strategy of developing new wholesale business channels. New management also reviewed the existing asset base and determined that one coffeehouse designated for closure would remain open and two additional coffeehouses and the Denver warehouse would be closed. Charges for these closures as well as provisions for other 17 20 contingencies resulted in additional operating expenses of approximately $1.7 million in the fourth quarter of fiscal 1998. According to Diedrich Coffee's strategic plan, the roasting facility in Denver, Colorado was closed in the first quarter of fiscal 1999 and roasting was consolidated in Southern California. We also closed an under-performing store in San Diego, California and one in Denver, Colorado. Four coffee cart locations at premium Irvine Office Company locations were opened in the first quarter of fiscal 1999. Additional coffee cart and kiosk locations are under consideration and in discussion with the Irvine Office Company and similar commercial property managers, but no assurances can be given as to when or how many more coffee carts may be installed. We recruited several senior level executives during fiscal 1999 as part of our strategic growth plan in the areas of finance, marketing and franchise development. Management undertook several steps to ensure that the base business was operating well before initiating the franchising sales program. It upgraded the quality of the store management teams and then undertook a program to retrain every Diedrich coffeehouse employee. This program was completed during fiscal 1999. The team also developed, tested and introduced several new product programs, including: - Martin Diedrich Signature Coffee Selections featuring coffee beans that were only available in the United States at Diedrich coffeehouses; - a line of five new Icy Blended drinks to address seasonal softness in the warmer months; - Chai Tea and new mocha products, including white chocolate mocha, were added to the menu; and - a new line of holiday merchandise was introduced in November 1998. FRANCHISE AREA DEVELOPMENT AGREEMENTS Management's franchise area development goal is to enter into franchise area development agreements covering most major U.S. markets. On September 16, 1998, Diedrich Coffee announced its first franchise area development agreement, which calls for the development of 44 coffeehouses and an undisclosed number of carts and kiosks in the state of North Carolina over a five year period. In connection with the signing of this agreement, we recorded and collected area development fee income of $100,000. On November 16, 1998, we announced our second franchise area development agreement, which provides for the development of 50 coffeehouses and an undisclosed number of carts and kiosks in San Diego, Palm Springs and Temecula, California over the next five years. This franchise area development agreement includes a one-year option to begin development of 45 coffeehouses in Arizona. In connection with the signing of this agreement, we recorded area development fee income of $100,000 and a note receivable for $100,000. On May 17, 1999, we announced our third franchise area development agreement, which provides for the development of 50 coffeehouses in the northern portion of Florida. On May 26, 1999, we announced our fourth franchise area development agreement, which calls for the development of 80 coffeehouses in the Los Angeles, California market. This agreement also gives the franchisee an option to develop up to 103 additional stores in the San Francisco Bay Area. In connection with the signing of this agreement, we will record an area development fee of $32,000 in fiscal 2000. On June 1, 1999, we announced our fifth franchise area development agreement, which provides for the development of 50 coffeehouses in the states of Kentucky and Tennessee. In connection with the signing of this agreement, we will record an area development fee of $20,000 in fiscal 2000. Management is currently in various stages of discussion and negotiations with several additional potential area developers. It has recently added two franchise sales organizations to assist in the sales program. These sales organizations are compensated through success-fees based on the execution of area development agreements. Positive sales may not result from these activities. WHOLESALE In fiscal 1998, we took significant steps to build our wholesale sales organization and grow this business channel. A new director of the wholesale division, with substantial experience in the coffee business, was hired and the sales staff was expanded. These efforts proved successful in fiscal 1998, when wholesale sales grew to 18 21 $2,222,000, an increase of 31.1% from the prior year. The new management team focused on continued sales growth in the wholesale sales division in fiscal 1999 and delivered improved results: $2,767,000 in total sales, an increase of 24.5% from fiscal 1998. In fiscal 1999, the wholesale division placed its emphasis on upgrading coffee consumed at chain restaurants. As a result, we added regional divisions of a number of well-known restaurant groups as wholesale customers such as: Islands Restaurants, Inc., Ruth's Chris Steakhouses (California/Arizona locations), El Torito, Claim Jumper and Island Restaurants. RESULTS OF OPERATIONS The following table sets forth the percentage relationship to total sales, unless otherwise indicated, of certain items included in Diedrich Coffee's statements of income for the years indicated:
YEAR YEAR YEAR ENDED ENDED ENDED JANUARY 27, JANUARY 28, JANUARY 29, 1999 1998 1997 ----------- ----------- ----------- Revenues: Retail.................................................. 87.8% 90.3% 91.4% Wholesale and Other..................................... 11.4 9.7 8.6 Franchise revenues...................................... 0.8 -- -- ----- ----- ----- Total........................................... 100.0% 100.0% 100.0% ----- ----- ----- Cost and Expenses: Cost of sales and related occupancy costs............... 45.2% 49.9% 46.8% Store operating expenses(1)............................. 41.7 50.3 45.7 Other operating expenses(2)............................. 22.9 13.0 14.2 Depreciation and amortization........................... 8.0 7.8 5.3 Asset impairment and restructuring costs................ -- 17.0 -- General and administrative expenses..................... 16.6 17.4 10.1 Operating (loss) income................................... (9.4) (38.8) (5.2) Interest expense.......................................... (1.6) (0.8) (1.0) Interest and other (expense) income....................... 0.4 (0.1) 0.5 ----- ----- ----- Loss before income taxes.................................. (10.6) (39.6) (5.6) ----- ----- ----- Income tax provision (benefit)............................ -- -- (0.6) ----- ----- ----- Net (loss) income......................................... (10.6)% (39.7)% (5.0)% ===== ===== =====
- --------------- (1) As a percentage of revenues from retail operations and franchise operations. (2) As a percentage of revenues from wholesale operations. FISCAL YEAR ENDED JANUARY 27, 1999 COMPARED TO FISCAL YEAR ENDED JANUARY 28, 1998 Total Revenues. Total revenues for fiscal 1999 increased 5.4% to $24,215,000 from $22,982,000 for fiscal 1998. Of the total revenues for fiscal 1999, 87.8% were derived from retail sales, 11.4% from wholesale and other revenues and 0.8% from franchise revenues. Retail sales for fiscal 1999 increased 2.4% to $21,248,000 from $20,760,000 for fiscal 1998 as a result of increased customer traffic in our stores, despite closing 2 stores in fiscal 1999. The percentage increase in comparable store sales for stores open during the full year in fiscal 1999 was 1.5%. Wholesale and other revenues for the year ended January 27, 1999 increased 24.5% to $2,767,000 from $2,222,000 for the year ended January 28, 1998 primarily as a result of increased sales to chain restaurant accounts. In addition, we recognized franchise revenues of $200,000 in fiscal 1999 as a result of signing our first two area development agreements. Cost of Sales and Related Occupancy Costs. Cost of sales and related occupancy costs for fiscal 1999 decreased to $10,955,000 from $11,458,000 for fiscal 1998. As a percentage of total revenues, cost of sales and related occupancy costs decreased to 45.2% for fiscal 1999 from 49.9% for fiscal 1998. This decrease resulted from average unit volume efficiencies associated with the closure of low volume locations, lower green coffee 19 22 prices and other efficiencies gained at the coffeehouse level. Interactive training programs were developed during fiscal 1999 covering guest satisfaction and product training. These programs assisted management in scrutinizing and reducing the cost of sales. This reduction more than offset the impact of increased occupancy costs and an increase in the percentage of total revenues contributed by wholesale sales. Store Operating Expenses. For fiscal 1999, store operating expenses, as a percentage of retail and franchise revenues, decreased to 41.7% from 50.3% for fiscal 1998. In fiscal 1998, the company recorded a one-time charge of $1,700,000 associated with the closure of two coffeehouses and the Denver warehouse, which accounted for 8.2% of retail and franchise revenues. Other Operating Expenses. For fiscal 1999, other operating expenses, as a percentage of wholesale and other revenues, increased to 22.9% from 13.0% for fiscal 1998. This increase reflects the costs of additional management and sales staff recruited to further develop the sales of the wholesale division through an emphasis on upgrading the coffee consumed at chain restaurants. In general, as chain accounts are based on negotiated pricing structures, future margins for wholesale sales may not be quite as favorable as they have been in the past. Depreciation and Amortization. Depreciation and amortization increased to $1,941,000 for fiscal 1999 from $1,785,000 for fiscal 1998, principally due to the write-off of $55,000 associated with the remodel of one of the coffeehouses to demonstrate the new Diedrich Coffee prototype. As a percentage of total revenue, depreciation and amortization increased to 8.0% from 7.8% during the prior year. General and Administrative Expenses. General and administrative expenses increased slightly to $4,014,000 in fiscal 1999 from $4,006,000 in fiscal 1998. As a percentage of total revenues, this represents a slight decrease to 16.6% in fiscal 1999 from 17.4% for fiscal 1998. This slight decrease is due to the increase in total revenues. General and administrative expenses have remained at a relatively high percentage of total revenues due to management's commitment to establish the infrastructure necessary to grow the company. Interest Expense. Interest expense increased to $385,000 for fiscal 1999 from $182,000 for fiscal 1998. The increase reflects a full year of interest on the $2,500,000 in long-term debt borrowed in September and October of 1997 and $553,000 in assets under capital leases. Income Taxes. Net operating losses generated in fiscal 1999, fiscal 1998, fiscal 1997, fiscal 1994 and prior were carried back or forward, as the case may be, and utilized to offset the allowable portion of income tax in fiscal 1996. As of January 27, 1999, a net operating loss for federal income tax purposes of $10,655,000 was available to be utilized against future taxable income for years through fiscal 2013, subject to a possible annual limitation due to the change in ownership rules under the Internal Revenue Code. FISCAL YEAR ENDED JANUARY 28, 1998 COMPARED TO FISCAL YEAR ENDED JANUARY 29, 1997 Total Revenues. Total revenues for fiscal 1998 increased 16.0% to $22,982,000 from $19,812,000 for fiscal 1997 primarily due to the increase in retail revenues. Of total revenues for fiscal 1998, 90.3% were derived from retail sales and 9.7% from wholesale and other sales. Retail revenues for fiscal 1998 increased 14.6% to $20,760,000 from $18,118,000 for fiscal 1997 due to a price increase in the second quarter and a nominal increase in comparable store sales. The percentage increase in comparable store sales comparing net sales for stores open during the full year in fiscal 1998 to net sales for the same stores in fiscal 1997 was 0.1%. Wholesale and other revenues for fiscal 1998 increased 31.1% to $2,222,000 from $1,694,000 for fiscal 1997. This increase was principally due to increased focus on wholesale sales by management. Cost of Sales and Related Occupancy Costs. Cost of sales and related occupancy costs for fiscal 1998 increased to $11,458,000 from $9,263,000 for fiscal 1997. As a percentage of total revenues, cost of sales and related occupancy costs increased to 49.9% for fiscal 1998 from 46.8% for fiscal 1997. This increase was primarily the result of increased costs related to higher green coffee prices, increased retail discounting, an increased percentage of wholesale sales as a percentage of total revenues, as well as scheduled rent increases. Store Operating Expenses. For fiscal 1998, store operating expenses, as a percentage of retail revenues, increased to 50.3% from 45.7% for fiscal 1997. The year-end one-time charge of $1,700,000, associated with 20 23 the closure of two coffeehouses and the Denver warehouse, accounted for 8.2% of retail revenues and more than offset decreases achieved during the year primarily as a result of improved labor scheduling methods. Other Operating Expenses. For fiscal 1998, other operating expenses increased to $290,000 from $240,000 in fiscal 1997. This increase is the result of adding management and sales staff to further the growth in wholesale sales. However, other operating expenses, as a percentage of wholesale and other sales, decreased to 13.0% from 14.2% for fiscal 1997 due to the increase in sales for the wholesale division. Depreciation and Amortization. Depreciation and amortization increased to $1,785,000 for fiscal 1998 from $1,054,000 for fiscal 1997, principally due to the addition of depreciable assets related to new coffeehouses added during fiscal 1997 and the conversion costs of the acquired locations being depreciated for the full year. As a percentage of total revenue, depreciation and amortization increased to 7.8% from 5.3% during the prior year. Provision for Store Closings and Restructuring Costs. On March 12, 1997, we announced that we were reviewing the performance of all coffeehouses to determine which units were not meeting management's long-term operational expectations. Subsequently, on April 29, 1997, we recorded an impairment provision and a restructuring charge of approximately $4.6 million in connection with the closure of 12 coffeehouses and other related expenses. Eleven of the original 12 coffeehouses identified for closure were closed in fiscal 1998 with leases terminated in most cases. In January 1998, the new management reviewed the progress of all retail operations and determined that one coffeehouse originally designated for closure would remain open. At year end, most of the lease terminations provided for in the restructuring had been completed at a lower cost than originally anticipated. As a result of these two factors, management determined that the remaining restructuring reserve could be reduced by $648,000. General and Administrative Expenses. General and administrative expenses increased to $4,006,000 in fiscal 1998 from $2,003,000 in fiscal 1997. As a percentage of total revenues, this represented an increase to 17.4% in fiscal 1998 from 10.1% for fiscal 1997, due to the addition of senior executive personnel and other resources required to manage the business more effectively, restructure the company and position it for future growth. Interest Expense. Interest expense decreased to $182,000 for fiscal 1998 from $190,000 for fiscal 1997. Income Taxes. Net operating losses generated in fiscal 1998, fiscal 1997, fiscal 1994 and prior were carried back or forward, as the case may be, and utilized to offset the allowable portion of income tax in fiscal 1996. As of January 28, 1998, a net operating loss for federal income tax purposes of $8,007,000 was available to be utilized against future taxable income for years through fiscal 2013, subject to a possible annual limitation due to the change in ownership rules under the Internal Revenue Code. LIQUIDITY AND CAPITAL RESOURCES Diedrich Coffee had a working capital deficit, as of January 27, 1999, of $655,000 compared to $959,000 at January 28, 1998. Cash used in operating activities totaled $351,000 for fiscal 1999 as compared to $2,489,000 for fiscal 1998. Net cash used in investing activities for fiscal 1999 totaled $1,523,000, which consisted entirely of capital expenditures for property and equipment. Net cash provided by financing activities for fiscal 1999 totaled $1,667,000. This consists of the net proceeds from the issuance of common stock and stock options exercised. On March 30, 1998, we agreed to a private placement of 200,000 shares of our common stock to Franchise Mortgage Acceptance Company, or the FMAC, at a price of $6.375 (the stock's closing sale price for that day on the Nasdaq National Market). In addition, the FMAC also received an option to purchase 100,000 additional shares of our common stock. This option may be exercised in increments of 25,000 shares or more and expires on April 3, 2000. The exercise prices of this option are as follows: 50,000 shares are exercisable at $10.00 per share and $12.50 per share, respectively. We completed this transaction on April 3, 1998. 21 24 We announced on April 14, 1998 that we were in the process of obtaining a financing from FMAC to meet its expected capital requirements. After extensive discussions, we determined that the structure required by FMAC was not in our best interest. In anticipation of this possible outcome, we engaged an investment banker in November 1998 to seek alternative sources of capital. On April 6, 1999, Diedrich Coffee entered into a $1,000,000 loan agreement and security agreement with Amre Youness, a former director of Diedrich Coffee. All outstanding principal and interest is due and payable on April 6, 2000. The loan is secured by our assets with interest accruing and paid monthly at the prime rate plus 3%. In connection with the loan agreement, we issued warrants to Mr. Youness to purchase 70,000 shares of our common stock at a price of $5.625 per share. We believe that cash from operations and the additional loan described above will be sufficient to satisfy our working capital needs at the anticipated operating levels for the next twelve months. However, if the proposed merger with Coffee People is completed, additional capital will be required to finance the cash portion of the payment to the Coffee People stockholders and to pay related fees and expenses. See "Item 1. Business -- Recent Developments." SEASONALITY AND QUARTERLY RESULTS Our business is subject to seasonal fluctuations as well as economic trends that affect retailers in general. Historically, our net sales have not been realized proportionately in each quarter, with net sales being the highest during the last fiscal quarter which includes the December holiday season. Hot weather tends to reduce sales. Quarterly results are affected by the timing of the opening of new stores, which may not occur as anticipated due to events outside our control. As a result of these factors, and of the other contingencies and risk factors described elsewhere in this report, the financial results for any individual quarter may not be indicative of the results that may be achieved in a full fiscal year. EFFECT OF NEW ACCOUNTING PRONOUNCEMENTS In June 1998, FASB issues SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" was issued. This statement established standards for derivative instruments and for hedging activities and requires that an entity recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value. We have no instruments or transactions subject to this statement. YEAR 2000 We are currently working to resolve the potential impact of the year 2000 on the processing of data-sensitive information by our computerized information systems. The year 2000 problem is the result of computer programs being written using two digits rather than four to define the applicable year. Any of our programs that have time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000, which could result in miscalculations or system failures. We are investigating the impact of the year 2000 problem on our business, including our operational, information and financial systems. Based on the preliminary review of our existing businesses, we do not expect the year 2000 problem, including the cost of making our computerized information systems year 2000 compliant, to have a material adverse impact on our financial position or results of operations in future periods. However, our inability to resolve all potential year 2000 problems in a timely manner could have a material adverse impact on Diedrich Coffee. We have also initiated communications with significant suppliers and key business partners on which we rely in an effort to determine the extent to which our business is vulnerable to the failure by these third parties' to remediate their year 2000 problems. Although we have not been informed of any material risks associated with the year 2000 problem on these entities, there can be no assurance that the computerized information systems of these third parties' will be year 2000 compliant on a timely basis. The inability of these third parties to remediate their year 2000 problems could have a material adverse impact on Diedrich Coffee. We will have to modify certain applications and replace some of the hardware used in the processing of financial information. In conjunction with these upgrades, which are expected to be completed by the end of September 1999, we believe we will have addressed any potential significant year 2000 issues. Total 22 25 expenditures related to the upgrade of the information systems are expected to cost less than $20,000. As of January 27, 1999, we had incurred and expensed approximately $34,000 of expenditures consisting of internal staff costs, outside consulting and other expenditures related to this upgrade process. These costs are being funded through operating cash flows. To the extent possible, we will be developing and executing contingency plans designed to allow continued operation in the event of failure of our or third parties' computer information systems. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. DERIVATIVE INSTRUMENTS Diedrich Coffee does not and did not invest in market risk sensitive instruments in fiscal 1999. From time to time, we enter into agreements to purchase green coffee in the future at prices to be determined within two to twelve months of the time of actual purchase. At January 27, 1999, these commitments totaled $1,135,000. These agreements are tied to specific market prices, defined by both the origin of the coffee and the month of delivery, but we have significant flexibility in selecting the date of the market price to be used in each contract. We do not use commodity based financial instruments to hedge coffee or any other commodity, as we believe there will continue to be a high probability of maintaining a strong correlation between increases in green coffee prices and the final selling prices of our products. We do not and have not used derivative financial instruments for any purpose, including hedging or mitigating interest rate risk. MARKET RISK Diedrich Coffee's market risk exposure with regard to financial instruments is to changes in the "prime rate" in the United States. We borrowed $2,500,000 at the prime rate plus 3 1/2% and $1,000,000 at the prime rate plus 3%. At January 27, 1999, a hypothetical 100 basis point increase in the prime rate would result in additional interest expense of $25,000 on an annualized basis. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The financial statements and supplementary data required by this item are set forth at the end of this annual report on Form 10-K beginning on page F-1. ITEM 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. 23 26 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Diedrich Coffee's directors, executive officers and other key employees, and their ages as of January 27, 1999, are as follows:
NAME AGE POSITION(S) HELD ---- --- ---------------- John E. Martin.......... 53 Chairman of the Board and Director Timothy J. Ryan......... 59 President, and Chief Executive Officer and Director Martin R. Diedrich...... 40 Vice Chairman of the Board, Secretary, Chief Coffee Officer and Director Peter Churm(1)(2)....... 73 Director Lawrence 58 Director Goelman(1)(2)......... Paul C. 42 Director Heeschen(1)(2)........ Ann Wride............... 37 Vice President and Chief Financial Officer Dolf Berle.............. 36 Vice President of Franchise Development and Operations Catherine Saar.......... 39 Vice President of Marketing and Wholesale Sales
- --------------- (1) Audit committee member. (2) Compensation committee member. The principal occupation for the last five years of each director and executive officer, as well as some other information, is set forth below. John E. Martin was appointed Chairman of the Board of Directors by the board as of November 17, 1997. From 1983 to 1996, Mr. Martin was Chairman and Chief Executive Officer of Taco Bell Worldwide. From October 1996 to June 1997, Mr. Martin was Chairman of PepsiCo's Casual Dining Division. Mr. Martin is also Chairman of publicly held Easyriders, Inc., a publishing company, and Chairman of Culinary Adventures, a privately held company that owns and operates several restaurants in Southern California. In addition, Mr. Martin serves on the boards of directors of: Williams-Sonoma, Inc., Franchise Mortgage Acceptance Company and The Good Guys! Inc. Timothy J. Ryan was appointed as President and Chief Executive Officer by the board effective November 1997. From December 1995 until his retirement in December 1996, Mr. Ryan was president of Sizzler U.S.A., a division of Sizzler International, Inc. of which he was also Senior Vice President. Sizzler International, Inc. filed for bankruptcy protection in June 1996. From November 1988 to December 1993, Mr. Ryan was Senior Vice President of Marketing at Taco Bell Worldwide, and from December 1993 to December 1995, he was Senior Vice President of Taco Bell's Casual Dining Division. In addition, Mr. Ryan serves on the board of directors of Rubio's Restaurants, Inc. Martin R. Diedrich has served as an officer and director of Diedrich Coffee since 1985. In April 1997, he became Vice Chairman of the Board and Chief Coffee Officer, as well as continuing as Diedrich Coffee's Corporate Secretary. Before that time, Mr. Diedrich served as Director of Coffee. In addition, he served as Chairman of the Board from January 1996 to April 1997. Mr. Diedrich is an internationally recognized specialty coffee expert who is a frequent speaker at industry and trade association functions. Peter Churm joined the board of directors in October 1996. He has been Chairman Emeritus of Furon Company since 1992. He served as Chairman of the Board of Furon Company from May 1980 through February 1992 and was President of that company for more than 16 years before that time. He also serves on the boards of directors of Furon Company and CKE Restaurants, Inc. Lawrence Goelman was the interim Chief Executive Officer of Diedrich Coffee from March 1997 to November 1997 and has served as a member of the board since October 1996. He assumed the position of Chairman of the Board in March 1997 until he was replaced by John E. Martin on November 17, 1997. Most recently, Mr. Goelman served as President and Chief Executive Officer of Pinnacle Micro, Inc. from May 24 27 1996 to December 1996. Mr. Goelman has also been a Managing Partner of Tremont Partners, Inc. since June 1995. Before that, he served as Chairman, President and Chief Executive Officer of CostCare, Inc. for 14 years. Mr. Goelman also serves on the board of Imagyn Medical Technologies, Inc. Paul C. Heeschen became a director of Diedrich Coffee in January 1996. For the past eight years, Mr. Heeschen has been a Principal of Heeschen & Associates, a private investment firm. He is also the sole general partner of D.C.H., L.P. and Redwood Enterprises VII, L.P., and a trustee of the Palm Trust, each of which are stockholders of Diedrich Coffee. Ann Wride joined Diedrich Coffee in April 1998 as Vice President and Chief Financial Officer. Previously, Ms. Wride was Vice President and Chief Financial Officer of Advantica Restaurant Group Inc.'s Coco's/Carrows Division from May 1996 to March 1998. Before joining Advantica, Ms. Wride served as Vice President, Finance of Family Restaurants Inc., where she worked in various capacities since 1989. Dolf A. Berle was appointed Vice President of Franchise Development in May 1998. Additionally, Mr. Berle assumed responsibility for Company Operations in June 1998. Before joining Diedrich Coffee, Mr. Berle was Senior Director of Operations for Pepsi Restaurants International from July 1997 to May 1998. From September 1996 to June 1997, Mr. Berle was Director of Operations for Taco Bell International. Before joining the international division, Mr. Berle served as Market Manager for Taco Bell in Nashville, Tennessee between June 1994 and August 1996. Catherine A. Saar was appointed Vice President of Marketing and Wholesale Sales in July 1998. Ms. Saar was Vice President Marketing and Merchandising for Frame-N-Lens from January 1998 to June 1998. From May 1993 to December 1997, Ms. Saar was Director of Corporate Marketing for Smart and Final, Inc. Before this, Ms. Saar held various marketing positions at Taco Bell Corporation. BOARD COMMITTEES AND MEETINGS Diedrich Coffee's board of directors has standing compensation and audit committees. We do not have a standing nominating committee. Instead, the board acts as a committee of the whole with respect to nominations for membership on the board. The members of each committee and the functions performed thereby are described below: Audit Committee. The audit committee of the board currently consists of Mr. Churm, Mr. Heeschen and Mr. Goelman, each of whom have been a member of the audit committee since its formation. The audit committee reviews the results and scope of the audit and other services provided by our independent auditors, reviews and evaluates our internal control functions and monitors transactions between Diedrich Coffee and its employees, officers and directors. Compensation Committee. The compensation committee of the board consists of Messrs. Churm, Goelman and Heeschen. The compensation committee administers our stock option plans and sets compensation levels for our executive officers. During our fiscal year ended January 27, 1999, there were five meetings of the board of directors, one meeting of the audit committee and one meeting of the compensation committee. While a director, each of the current board members attended 100% of the meetings of the board of directors and meetings of the committees on which he served during such period. DIRECTORS' COMPENSATION Directors who are also employees of Diedrich Coffee receive no extra compensation for their service on the board. Non-employee directors receive reimbursement for out-of-pocket expenses incurred in attending board meetings and receive stock option grants under our 1996 Non-Employee Directors Stock Option Plan. Under our non-employee directors plan, each non-employee director automatically receives, upon becoming a director, a one-time grant of an option to purchase up to 10,000 shares of Diedrich Coffee common stock. These initial options will vest and become exercisable with respect to 50% of the underlying shares upon the earlier of (1) the first anniversary of the grant date or (2) immediately before the first annual 25 28 meeting of stockholders following the grant date, if the recipient has remained a non-employee director for the entire period from the grant date to such earlier date, and with respect to the remaining 50% of the underlying shares upon the earlier of (1) the second anniversary of the grant date or (2) immediately before the second annual meeting of stockholders following the grant date, if the recipient has remained a non-employee director for the entire period from the grant date to such earlier date. In addition to an initial grant, each non-employee director will also receive, upon re-election to the board, an automatic grant of an option to purchase up to 5,000 additional shares of our common stock. These additional options will vest and become exercisable upon the earlier of (1) the first anniversary of the grant date or (2) immediately before the annual meeting of stockholders following the grant date, if the recipient has remained a non-employee director for the entire period from the grant date to such earlier date. All non-employee director options have a term of ten years and an exercise price equal to the fair market value of Diedrich Coffee common stock on the date of grant. The non-employee directors plan provides that the exercise price may be paid by company loan or withholding of underlying stock, or deferred until completion of broker-assisted exercise and sale transactions. Vesting of non-employee director options accelerates if the recipient of the option ceases to be a director of Diedrich Coffee in connection with a change-in-control. During the fiscal year ended January 27, 1999, options to purchase an aggregate of 15,000 shares of our common stock were issued to non-employee directors according to the terms of the non-employee directors plan. SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE Under the securities laws of the United States, the directors and officers of Diedrich Coffee and persons who own more than 10% of our equity securities are required to report their initial ownership of our equity securities and any subsequent changes in that ownership to the Commission and the Nasdaq National Market. Specific due dates for these reports have been established, and we are required to disclose in this document any late filings during the fiscal year ended January 27, 1999. To our knowledge, based solely on our review of the copies of such reports required to be furnished to the company during the fiscal year ended January 27, 1999, all of these reports were timely filed. 26 29 ITEM 11. EXECUTIVE COMPENSATION. SUMMARY COMPENSATION TABLE The following table sets forth certain information with respect to compensation earned during the last three fiscal years by our Chief Executive Officer and our next most highly compensated persons who were serving as executive officers of Diedrich Coffee on January 27, 1999 and whose total annual salary and bonus for fiscal 1999 exceeded $100,000.
LONG-TERM ANNUAL COMPENSATION COMPENSATION AWARDS FISCAL ------------ ------------ YEAR SECURITIES ENDED UNDERLYING NAME AND PRINCIPAL POSITION JANUARY SALARY($) OPTIONS(#) --------------------------- ------- ------------ ------------ John E. Martin(1)........................................... 1999 $100,000 -- Chairman of the Board 1998 20,385 850,000 1997 -- -- Timothy J. Ryan(2).......................................... 1999 $200,000 -- Chief Executive Officer and President 1998 33,035 600,000 1997 -- -- Martin R. Diedrich.......................................... 1999 $111,692 4,000 Vice Chairman of the Board, Secretary and Chief Coffee Officer 1998 100,000 -- 1997 100,000 -- Ann Wride(3)................................................ 1999 $122,808 54,000 Vice President and Chief Financial Officer 1998 -- -- 1997 -- -- Dolf Berle(4)............................................... 1999 $105,519 54,000 Vice President of Franchise Development and Operations 1998 -- -- 1997 -- --
- --------------- (1) Mr. Martin was appointed Chairman of the Board on November 17, 1997. Accordingly, he did not earn or receive any compensation from Diedrich Coffee before fiscal 1998. (2) Mr. Ryan was appointed President and Chief Executive Officer on November 17, 1997. Accordingly, he did not earn or receive any compensation from Diedrich Coffee before fiscal 1998. (3) Ms. Wride joined Diedrich Coffee as Vice President and Chief Financial Officer in April 1998. Accordingly, she did not earn or receive any compensation from Diedrich Coffee until fiscal 1999. (4) Mr. Berle joined Diedrich Coffee as Vice President of Franchise Development in May 1998. Accordingly, he did not earn or receive any compensation from Diedrich Coffee until fiscal 1999. 27 30 STOCK OPTION GRANTS IN LAST FISCAL YEAR The following table sets forth information regarding stock options granted to the following executive officers during the fiscal year ended January 27, 1999.
POTENTIAL PERCENT OF REALIZABLE VALUE AT TOTAL ASSUMED ANNUAL RATES NUMBER OF OPTIONS OF STOCK PRICE SECURITIES GRANTED TO APPRECIATION FOR OPTION UNDERLYING EMPLOYEES EXERCISE TERM(1) OPTIONS IN FISCAL PRICE EXPIRATION ----------------------- NAME GRANTED(#) YEAR ($/SHARE) DATE 5%($) 10%($) ---- ---------- ---------- --------- ---------- ---------- ---------- John E. Martin..................... -- -- -- -- -- -- Timothy J. Ryan.................... -- -- -- -- -- -- Martin R. Diedrich(2).............. 4,000 2.1% $7.00 6/23/08 $ 16,209 $ 41,825 Ann Wride(3)....................... 50,000 25.9 5.81 3/25/08 168,169 433,932 4,000 2.1 7.00 6/23/08 16,209 41,825 Dolf Berle(4)...................... 50,000 25.9 6.25 3/23/08 180,905 466,795 4,000 2.1 7.00 6/23/08 16,209 41,825
- --------------- (1) The potential realizable values listed are based on an assumption that the market price of Diedrich Coffee common stock appreciates at the stated rate, compounded annually, from the date of grant to the expiration date. The 5% and 10% assumed rates of appreciation are determined by the rules of the Commission and do not represent our estimate of the future market price of our common stock. (2) All of Mr. Diedrich's options were granted pursuant to the 1996 Stock Incentive Option Plan, which was approved by our board of directors on June 23, 1998. (3) 50,000 of Ms. Wride's options were granted pursuant to her employment letter dated April 8, 1998, the terms of which are described under "-- Employment Agreements and Compensatory Arrangements." 4,000 of Ms. Wride's options were granted pursuant to the 1996 Stock Incentive Option Plan. (4) 50,000 of Mr. Berle's options were granted pursuant to her employment letter dated April 8, 1998, the terms of which are described under "-- Employment Agreements and Compensatory Arrangements." 4,000 of Mr. Berle's options were granted pursuant to the 1996 Stock Incentive Option Plan. AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION VALUES The following table sets forth information concerning the number and value of unexercisable options held by the following executive officers on January 27, 1999. None of these executive officers exercised any stock options during fiscal year 1999.
NUMBER OF SECURITIES UNDERLYING VALUE OF UNEXERCISED UNEXERCISED OPTIONS AT IN-THE-MONEY OPTIONS AT FISCAL YEAR END(#) FISCAL YEAR END($)(1) ------------------------------- ------------------------------- NAME EXERCISABLE UNEXERCISABLE(2) EXERCISABLE UNEXERCISABLE(2) ---- ----------- ---------------- ----------- ---------------- John E. Martin........................ 550,000 300,000 $198,000 -- Timothy J. Ryan....................... 250,000 350,000 47,000 -- Martin Diedrich....................... -- 4,000 -- -- Ann Wride............................. -- 54,000 -- -- Dolf Berle............................ -- 54,000 -- --
- --------------- (1) These amounts represent the difference between the exercise price of the in-the-money options and the market price of Diedrich Coffee common stock on January 27, 1999. The closing price of our common stock on that day on the Nasdaq National Market was $4.44. Options are in-the-money if the market value of the shares covered thereby is greater than the option exercise price. (2) Future exercisability is subject to a number of factors, including, but not limited to, the optionee remaining employed by Diedrich Coffee. 28 31 1996 STOCK INCENTIVE PLAN In July 1996, we adopted the 1996 Stock Incentive Plan, which authorized the granting of a variety of stock-based incentive awards, including incentive and nonstatutory stock options. Our stockholders approved the plan in September 1996. The purpose of the incentive plan is to promote the interests of Diedrich Coffee and our stockholders by using investment interests in Diedrich Coffee to attract, retain and motivate its management and other persons, to encourage and reward their contributions to the performance of Diedrich Coffee and to align their interests with the interests of our stockholders. A total of 475,000 shares were initially authorized under the plan. On June 26, 1997, the stockholders increased the number of shares authorized by 300,000, to a total of 775,000 authorized shares. The incentive plan is administered by the compensation committee of the board, who determine the recipients and terms of the awards granted. The compensation committee is comprised of disinterested directors. The disinterested directors are eligible only to receive automatic nondiscretionary awards under the 1996 Non-Employee Directors Stock Option Plan described below. Under the incentive plan, options to purchase common stock may be granted with an exercise price below market value of such stock on the grant date. No such below market options have been granted. The board or the compensation committee may amend, suspend or terminate the incentive plan at any time. In addition, the maximum number of shares that may be sold or issued under the incentive plan may be increased and the class of persons eligible to participate in the incentive plan may be altered only with the approval of our stockholders. With respect to all other amendments to the incentive plan, the board may, in its discretion, determine that the amendment shall only become effective upon approval by our stockholders. The board or compensation committee may allow award recipients to pay for the exercise of options with a promissory note issued by the company or in a broker-assisted type transaction with the company. In the event of a change in control of Diedrich Coffee, awards outstanding under this plan terminate without contrary agreement or action by the board of directors. In such a case, the board has the ability to accelerate the vesting of the outstanding awards or provide for the creation of new awards to replace those awards that would terminate. 1996 NON-EMPLOYEE DIRECTORS STOCK OPTION PLAN In July 1996, we adopted the 1996 Non-Employee Directors Stock Option Plan, which authorizes the granting of non-qualified stock options to disinterested directors. Our stockholders approved the plan in September 1996. The purpose of the directors plan is to promote the interests of Diedrich Coffee and our stockholders by using investment interests in Diedrich Coffee to attract and retain highly qualified independent directors. A total of 125,000 shares have been reserved for issuance under the directors plan. Pursuant to the directors plan, each non-employee director automatically receives an initial, one-time grant of an option to purchase up to 10,000 shares of Diedrich Coffee common stock. In addition to the initial grant, each non-employee director will also receive, upon each re-election to our board, an automatic grant of an option to purchase up to 5,000 additional shares of our common stock. The initial grant vests over two years. The automatic re-election grant vests immediately before the next annual meeting of stockholders. All disinterested employee director options have a term of ten years and an exercise price equal to the fair market value of our common stock on the date of grant. We may allow award recipients to pay for the exercise of options in a broker-assisted type transaction with the company. In the event of a change in control of Diedrich Coffee and the subsequent termination of a director, the vesting of all options accelerates. Upon such an acceleration, the initial option grants are exercisable for a period of one year following the director's termination, while additional option grants are exercisable for 90 days following the termination. 1997 NON-EMPLOYEE DIRECTORS STOCK OPTION PLAN AND AGREEMENT In April 1997, the disinterested directors on the board adopted and approved the 1997 Non-Employee Directors' Stock Option Plan and Agreement to recognize and compensate the disinterested directors for their service to Diedrich Coffee above and beyond normal requirements. Pursuant to that plan, one-time grants of options to purchase up to 10,000 shares of our common stock were granted to each of Mr. Churm and Mr. Heeschen. These options vested on April 25, 1998, twelve months after they were granted and will expire on the earlier of April 25, 2007, or 180 days after the termination of the director. We may allow 29 32 Messrs. Churm and Heeschen to pay for the exercise of the options in a broker-assisted type transaction with the company. In the event of a change in control of Diedrich Coffee and the subsequent termination of either director, the terminated director has 180 days to exercise his options. No additional options are available for grant under the 1997 Non-Employee Directors Stock Option Plan and Agreement. EMPLOYMENT AGREEMENTS AND COMPENSATORY ARRANGEMENTS John E. Martin On November 17, 1997, John E. Martin entered into a letter agreement with Diedrich Coffee appointing him as a director and as Chairman of the Board. The agreement provides for a base salary of $100,000 per year for so long as Mr. Martin continues as Chairman of the Board. Mr. Martin is not to receive employee benefits nor any other compensation to which he would otherwise be entitled for serving on the board and the board may terminate him in its discretion at any time with or without reason. We have agreed to employ a full-time executive assistant on his behalf with an annual salary not to exceed $72,000 per year. Diedrich Coffee also agreed (1) to reimburse Mr. Martin for all reasonable and necessary travel and other business expenses incurred in connection with the performance of services under the agreement; (2) to enter into an indemnification agreement with Mr. Martin in the form provided to each of the other directors and executive officers of Diedrich Coffee; and (3) to reimburse Mr. Martin for reasonable legal and accounting fees incurred in connection with the negotiation and execution of the agreement in an amount not to exceed $10,000. Finally, the agreement recognizes that Mr. Martin's other business interests relate to restaurants and provides that we waive any rights or claims to other business opportunities involving the restaurant business which may become available to Mr. Martin, other than opportunities involving the coffeehouse business or other businesses in which the principal activity involves the sale of coffee and coffee beverages. On November 17, 1997, Mr. Martin also entered into a stock option plan and agreement with Diedrich Coffee. Our stockholders approved Mr. Martin's option agreement at a special meeting held on January 22, 1998. We granted Mr. Martin options to purchase an aggregate of 850,000 shares of common stock for the purpose of encouraging and rewarding Mr. Martin's contributions to the performance of Diedrich Coffee and to align Mr. Martin's interests with the interests of our stockholders. The options granted to Mr. Martin are exercisable, at the following exercise prices: (1) 450,000 shares of common stock at an exercise price of $4.00 per share; (2) 100,000 shares of common stock at an exercise price of $5.00 per share; (3) 150,000 shares of common stock at an exercise price of $8.00 per share; and (4) 150,000 shares of common stock at an exercise price of $10.00 per share. All of the options granted to Mr. Martin become exercisable on the earlier of May 15, 2002 or as soon as the closing price of our common stock on the Nasdaq National Market exceeds the respective exercise price for at least seven trading days in any period of ten consecutive trading days. All options are to terminate if unexercised on November 17, 2002 or, if Mr. Martin resigns from Diedrich Coffee or we terminate Mr. Martin's employment for cause, the options will become unexercisable within sixty days. Only Mr. Martin is eligible to receive options under his option agreement and the options are not transferable or assignable. Subject to the discretion of the compensation committee of the board, Mr. Martin may pay the exercise price for his options with cash or by delivery of shares of our common stock with a value equal to the exercise price or through a combination of cash and shares. Timothy J. Ryan On November 17, 1997, Timothy J. Ryan entered into a two-year employment agreement with Diedrich Coffee as our President and Chief Executive Officer. The agreement provides for an annual salary of $200,000 per year, a discretionary performance bonus which may be awarded by the compensation committee after twelve months of employment (not to initially exceed 25% of Mr. Ryan's base salary), and employee benefits that include three weeks annual vacation leave, reimbursement for all reasonable and necessary travel and 30 33 other business expenses incurred in connection with the performance of services under the agreement, and the payment of a monthly car allowance of $600. The employment agreement may be terminated before the completion of two years in the event of Mr. Ryan's sustained incapacity as defined in the agreement or by Diedrich Coffee for cause as defined in the agreement. We may also terminate Mr. Ryan for any other reason, however, in such event, Mr. Ryan will be entitled to receive a severance payment equal to fifty percent of his base salary. On November 17, 1997, Mr. Ryan also entered into a stock option plan and agreement with Diedrich Coffee. Our stockholders approved Mr. Ryan's option agreement at a special meeting held on January 22, 1998. We granted Mr. Ryan options to purchase an aggregate of 600,000 shares of our common stock for the purpose of encouraging and rewarding Mr. Ryan's contributions to the performance of Diedrich Coffee and to align Mr. Ryan's interests with the interests of our stockholders. The options granted to Mr. Ryan are exercisable, at the following exercise prices: (1) 50,000 shares of common stock at an exercise price of $3.50 per share; (2) 75,000 shares of common stock at an exercise price of $4.50 per share; (3) 125,000 shares of common stock at an exercise price of $5.00 per share; (4) 175,000 shares of common stock at an exercise price of $8.00 per share; and (5) 175,000 shares of common stock at an exercise price of $10.00 per share. The options become exercisable on the earlier of May 15, 2002 or upon the satisfaction of two conditions: (1) the options having vested pursuant to a vesting schedule set forth in the agreement and (2) after the date of the agreement, the closing price of the common stock on the Nasdaq National Market shall have exceeded the option price per share for at least seven trading days in any period of ten consecutive trading days. All options are to terminate if unexercised on November 17, 2002 or, if Mr. Ryan resigns from Diedrich Coffee without good cause or we terminate Mr. Ryan's employment for cause, the options will become unexercisable within sixty days. Only Mr. Ryan is eligible to receive options under the his option agreement and the options are not transferable or assignable. Subject to the discretion of the compensation committee of the board, Mr. Ryan may pay the exercise price for his options with cash or by delivery of shares of our common stock with a value equal to the exercise price or through a combination of cash and shares. Martin R. Diedrich Martin R. Diedrich entered into a new employment agreement with Diedrich Coffee, which appointed him as Diedrich Coffee's Chief Coffee Officer beginning as of June 29, 1998. The term of the agreement is three years. The agreement provides for a base salary of $120,000 per annum, increasing to $140,000 per annum beginning in the second year of the agreement, and to $160,000 in the third year. Mr. Diedrich receives employee benefits consistent with our policies for other senior executives. Ann Wride In April 1998, Ann Wride entered into an employment agreement with Diedrich Coffee appointing her Vice President and Chief Financial Officer. The term of the agreement is two years. The agreement provides for a base salary of $155,000 per annum and an annual incentive bonus of up to 25% of base salary based on the company's performance and Ms. Wride's performance against objectives approved by the board. If terminated without cause, Ms. Wride is entitled to six months salary as severance compensation. Ms. Wride also received options to purchase up to 50,000 shares of common stock at an exercise price of $5.8125, vesting over two years. Ms. Wride receives employee benefits consistent with Diedrich Coffee's policies from other senior executives. Dolf Berle In April 1998, Dolf Berle entered into an employment agreement with Diedrich Coffee appointing him Vice President of Franchise Development. The agreement provides for a base salary of $155,000 per annum 31 34 and an annual incentive bonus of up to 25% of base salary based on the company's performance and Mr. Berle's performance against objectives approved by the board. If terminated without cause, Mr. Berle is entitled to six months salary as severance compensation. Mr. Berle also received options to purchase up to 50,000 shares of our common stock at an exercise price of $6.25 vesting over two years. According to the terms of the employment agreement, Mr. Berle was also granted 10,000 stock options annually for each of the five years following the end of the two-year vesting period of the initial grant. The exercise price of those options will be the date of the annual grant. Mr. Berle receives employee benefits consistent with Diedrich Coffee's policies from other senior executives. Catherine Saar On June 11, 1998, Catherine Saar entered into an employment agreement with Diedrich Coffee appointing her Vice President, Marketing. The agreement provides for a base salary of $120,000 per annum and an annual incentive bonus of up to 25% of base salary based on the company's performance and Ms. Saar's performance against objectives approved by the board. If terminated without cause, Ms. Saar is entitled to four months salary as severance compensation. Ms. Saar also received options to purchase up to 20,000 shares of our common stock at an exercise price of $7.75, vesting over two years. Ms. Saar receives employee benefits consistent with Diedrich Coffee's policies for other senior executives. REPORT OF THE COMPENSATION COMMITTEE The compensation committee consists of Messrs. Churm, Goelman and Heeschen. The compensation committee administers Diedrich Coffee's stock option plans and sets compensation levels for our executive officers. Our executive compensation policies and programs are designed to: - provide competitive levels of overall compensation that will attract and retain the best executive talent in the industry; - motivate executive officers to perform at their highest level; - align executive officer and stockholder interests to create stockholder value; and - reward executive officers for achievement of corporate and individual objectives. To achieve these goals, the compensation committee and the board of directors have established an executive compensation program consisting primarily of three integrated components: base salary, annual bonus and stock options. Base Salary. Base salaries for executive officers are set by the compensation committee after considering factors such as competitive environment, experience level, position, responsibility and overall contribution of the executive. Base salaries for the executive officers were established in their respective employment agreements. Annual Bonus. All executive officers, including the Chief Executive Officer, are eligible to receive an annual bonus. The employment agreements for the executive officers provide for discretionary performance bonuses based upon Diedrich Coffee's performance and the respective executive officer's contribution to this performance. The board awarded annual bonuses to sixteen employees, including three of the executive officers, for the fiscal year ended January 27, 1999 because of outstanding performance by such persons during the year. These bonuses were paid after the fiscal year ended January 27, 1999 but related to performance during the fiscal year. Stock Options. The third component of the compensation program for executive officers is in the form of stock option awards. Diedrich Coffee's 1996 Stock Incentive Plan provides for long-term incentive compensation for Diedrich Coffee employees, including executive officers. Stock option awards align the interests of executive officers with those of stockholders by providing an equity interest in Diedrich Coffee, thereby providing incentive for the executive officers to maximize stockholder value. Option awards directly tie executive compensation to the value of our stock. The compensation committee is responsible for determining, subject to the terms of the 1996 Stock Incentive Plan, the individuals to whom grants are made, the timing of 32 35 grants and the number of shares per grant. The number of shares are determined based upon the individual's position in Diedrich Coffee, competitive company practices and the number of unvested shares already held by the individual. Stock options are generally granted with an exercise price equal to the fair market value of Diedrich Coffee common stock on the date of grant. During fiscal 1999, the compensation committee granted stock options to approximately 76 employees. This was a wider employee base than in past years. The goal of the compensation committee was to ensure employees were focused on increasing stockholder value. The group included the majority of corporate office employees as well as general managers and assistant managers at the coffeehouse level. Chief Executive Officer. In November 1997, Diedrich Coffee entered into an employment agreement as well as a stock option plan and agreement with Mr. Ryan. The stockholders of Diedrich Coffee approved the Stock Option Plan and Agreement at a special meeting called for that purpose on January 22, 1998. The terms of Mr. Ryan's employment agreement and stock option plan and agreement are described under "-- Employment Agreements and Compensation Arrangements." The process of establishing the Chief Executive Officer's compensation parallels the process and criteria used in establishing compensation levels for other executive officers. There were no changes made during the fiscal year ended January 27, 1999 to Mr. Ryan's employment agreement or his compensation package. Policy with Respect to Internal Revenue Code Section 162(m). In 1993, the Internal Revenue Code was amended to add Section 162(m). Section 162(m) and the regulations thereunder place a limit of $1 million on the amount of compensation that may be deducted by Diedrich Coffee in any year with respect to certain of our most highly compensated officers. Section 162(m) does not, however, disallow a deduction for qualified "performance-based compensation," the material terms of which are disclosed to and approved by stockholders. At the present time, our executive officer compensation levels, other than "perform once-based compensation," do not exceed $1 million. The compensation committee and the board of directors plan to take such actions in the future to minimize the loss of tax deductions related to compensation as they deem necessary and appropriate in light of specific compensation objectives. Respectfully submitted, Peter Churm Paul C. Heeschen Lawrence Goelman COMPENSATION COMMITTEE INTERLOCKS During the fiscal year ended January 27, 1999, the compensation committee of Diedrich Coffee's board of directors consisted of Mr. Churm, Mr. Goelman and Mr. Heeschen. No member of the compensation committee was, at any time during the fiscal year ended January 27, 1999 or at any other time, an officer or employee of Diedrich Coffee. There are no compensation committee interlocks between Diedrich Coffee and other entities involving our executive officers and board members who serve as executive officers or board members of such other entities. 33 36 STOCK PERFORMANCE GRAPH The following graph shows a comparison of the cumulative total returns for the period beginning on September 12, 1996, the date Diedrich Coffee common stock was first publicly traded, and ending on January 27, 1999 for: - Diedrich Coffee common stock; - the Total Return Index for the Nasdaq National Market (U.S. companies); and - the Total Return Index for Nasdaq Retail Trade Stocks. Each of the above assumes an initial value of $100 and reinvestment of dividends. Although the graph would normally cover a five-year period, our common stock has been publicly traded only since September 12, 1996, so the graph begins on that date. The comparisons in the graph are required by the Commission and are not intended to forecast or be indicative of possible future performance of our common stock.
RETAIL NASDAQ DDRX ------ ------ ---- '9/12/96' 100.00 100.00 100.00 '10/30/96' 98.41 102.88 97.62 '1/29/97' 97.34 116.09 80.95 '4/30/97' 88.70 107.83 25.00 '7/30/97' 107.69 136.25 27.38 '10/29/97' 111.49 137.99 26.79 '1/28/98' 114.79 139.16 59.52 '4/29/98' 134.05 159.67 76.19 '7/29/98' 131.19 161.73 64.89 '10/28/98' 108.69 150.99 40.48 '1/27/99' 136.62 209.69 42.27
34 37 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The following table sets forth information regarding the beneficial ownership of our common stock as of June 1, 1999, by: - each person or group of affiliated persons who we know owns beneficially 5% or more of our common stock; - each of our directors; - each of our executive officers listed in the summary compensation table; and - all of our directors and executive officers as a group. Percentage of ownership is calculated as required by Commission Rule 13d-3(d)(1). Except as indicated in the footnotes to this table, the persons named in the table have sole voting and investment power with respect to all shares of common stock shown as beneficially owned by them, subject to community property laws. The table below includes the number of shares underlying options that are exercisable within 60 days from June 1, 1999.
NAME AND ADDRESS AMOUNT AND NATURE PERCENT OF OF BENEFICIAL OWNER(1) OF BENEFICIAL OWNERSHIP(2) CLASS ---------------------- -------------------------- ---------- D.C.H., L.P................................................. 1,473,197(3) 23.9% 450 Newport Center Drive Suite 450 Newport Beach, CA 92660 Amre A. Youness............................................. 500,958(4) 7.6% 301 North Lake Avenue Suite 910 Pasadena, CA 91101 Cosleno, Inc................................................ 340,000(5) 5.2% 3753 Howard Hughes Parkway Suite 200 Las Vegas, NV 89109 Steven A. Lupinacci......................................... 309,061(6) 5.0% Dolf A. Berle............................................... 26,000(7) * Peter Churm................................................. 50,000(8) * Martin Diedrich............................................. 656,107(9) 10.6% Lawrence Goelman............................................ 117,700(10) 1.9% Paul C. Heeschen............................................ 1,796,480(11) 29.0% John E. Martin.............................................. 1,258,533(12) 17.9% Timothy J. Ryan............................................. 629,367(13) 9.3% Catherine Saar.............................................. 11,000(14) * Ann Wride................................................... 26,000(15) * All directors and executive officers as a group (9 persons).................................... 4,571,187(16) 58.1%
- --------------- * Less than 1% (1) Unless otherwise indicated, the address of each person in this table is c/o Diedrich Coffee, 2144 Michelson Dr., Irvine, California 92612. (2) Calculated pursuant to Rule 13d-3(d) under the Securities Exchange Act. Shares not outstanding that are subject to options or warrants exercisable by the holder thereof within 60 days of June 1, 1999 are deemed outstanding for the purposes of calculating the number and percentage owned by such stockholder, but not deemed outstanding for the purpose of calculating the percentage owned by each other stockholder listed. Unless otherwise noted, all shares listed as beneficially owned by a stockholder are actually outstanding. 35 38 (3) Paul C. Heeschen, a director of Diedrich Coffee, is the sole general partner of this limited partnership with voting and investment power as to all shares beneficially owned by the limited partnership. (4) Pursuant to Schedule 13D filed with the Commission and dated as of October 14, 1997, includes 70,000 shares that are subject to warrants exercisable within 60 days and 340,000 shares that are subject to warrants exercisable within 60 days of which he has shared voting and dispositive power with Cosleno, Inc. (5) Pursuant to Schedule 13D as filed with the Commission and dated as of October 14, 1997, Cosleno, Inc. and Amre A. Youness, who is the sole stockholder of Cosleno, Inc., have shared voting and dispositive power of the 340,000 shares that are subject to warrants exercisable within 60 days. (6) Mr. Lupinacci resigned as Chief Executive Officer, President and Chief Financial Officer effective March 12, 1997. (7) Includes 26,000 shares subject to options that are exercisable within 60 days. (8) Includes 30,000 shares subject to options that are exercisable within 60 days. (9) Includes 1,000 shares subject to options that are exercisable within 60 days. (10) Includes 105,000 shares subject to options that are exercisable within 60 days. This number does not include the 85,000 shares subject to warrants held by the Virginia R. Cirica Trust. Ms. Cirica is Mr. Goelman's wife. Mr. Goelman disclaims any beneficial interest in the Virginia R. Cirica Trust, except to the extent to which Mr. Goelman is a contingent beneficiary under the terms of that trust. (11) Includes 1,473,197 shares beneficially owned by D.C.H., L.P. and 255,914 shares beneficially owned by Redwood Enterprises VII, L.P. Mr. Heeschen is the sole general partner of each of these partnerships with voting and investment power as to all of such shares. Also includes 7,369 shares owned personally by Mr. Heeschen and 30,000 shares held personally by Mr. Heeschen subject to options that are exercisable within 60 days and 25,000 shares purchased on the open market by the Palm Trust, of which Mr. Heeschen is a trustee with shared voting and investment power as to all of such shares. (12) Includes 850,000 shares subject to options that are exercisable within 60 days. (13) Includes 600,000 shares subject to options that are exercisable within 60 days. (14) Includes 11,000 shares subject to options that are exercisable within 60 days. (15) Includes 26,000 shares subject to options that are exercisable within 60 days. (16) Includes 1,679,000 shares subject to options that are exercisable within 60 days. 36 39 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. On April 6, 1999, we entered into a $1,000,000 loan agreement and security agreement with Amre Youness, a former director of Diedrich Coffee and the beneficial owner of approximately 6.6% of the outstanding shares of our common stock. Under the loan agreement, all outstanding principal and interest is due and payable on April 6, 2000. The loan is secured by the assets of Diedrich Coffee with interest accruing and paid monthly at the prime rate plus 3%. In connection with the loan agreement, we issued warrants to Mr. Youness to purchase 70,000 shares of Diedrich Coffee common stock at a price of $5.625 per share. On August 19, 1997, the company entered into a promissory note, term loan agreement and security agreement with the Virginia R. Cirica Trust. The trust is controlled by Ms. Cirica, who is the spouse of Lawrence Goelman, then Chairman and Interim Chief Executive Officer and currently a director of Diedrich Coffee. Shortly before the trust entered into the loan documents, Mr. Goelman loaned Ms. Cirica approximately $250,000. Some of those funds were transferred by Ms. Cirica to the trust and advanced to Diedrich Coffee pursuant to the loan documents. The loan was secured by the assets of Diedrich Coffee and provided for borrowings up to $500,000 with interest accruing at the prime rate plus 3 1/2%. This note was fully paid and discharged on December 17, 1997. In connection with the loan documents with the Cirica Trust, Diedrich Coffee issued a warrant to the trust to purchase up to 85,000 shares of Diedrich Coffee's common stock if the loan were repaid in full within 120 days of closing, or up to 170,000 shares of Diedrich Coffee's common stock if the loan was not repaid within 120 days, all at a price of $2.25 a share. The warrants were reduced to 85,000 shares of Diedrich Coffee's common stock by virtue of the December repayment of the note in full. The warrants were exercised in December 1998. Mr. Goelman disclaims any pecuniary interest in the loan to Diedrich Coffee and any beneficial interest in the trust, except to the extent to which Mr. Goelman is a contingent beneficiary under the terms of the trust. 37 40 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) 1. FINANCIAL STATEMENTS. The financial statements required to be filed hereunder are set forth at the end of this document beginning on page F-1. 2. EXHIBITS. 2.1 Form of Agreement and Plan of Merger by and between Diedrich Coffee, a California corporation, and Diedrich Coffee, Inc., a Delaware corporation(1) 2.2 Agreement and Plan of Merger dated as of March 16, 1999, by and among Diedrich Coffee, CP Acquisition Corp., a wholly owned subsidiary of Diedrich Coffee, and Coffee People(2) 3.1 Certificate of Incorporation of the company(1) 3.2 Bylaws of the company(1) 4.1 Purchase Agreement for Series A Preferred Stock dated as of December 11, 1992 by and among Diedrich Coffee, Martin R. Diedrich, Donald M. Holly, SNV Enterprises and D.C.H., L.P.(1) 4.2 Purchase Agreement for Series B Preferred Stock dated as of June 29, 1995 by and among Diedrich Coffee, Martin R. Diedrich, Steven A. Lupinacci, Redwood Enterprises VII, L.P. and Diedrich Partners I, L.P.(1) 4.3 Specimen Stock Certificate(1) 4.4 Form of Conversion Agreement in connection with the conversion of Series A and Series B Preferred Stock into Common Stock(1) 4.5 Form of Lock-up Letter Agreement among The Second Cup, Ltd. and Diedrich Coffee, Inc.(3) 4.6 Voting Agreement and Irrevocable Proxy dated as of March 16, 1999 by and among Diedrich Coffee, Inc., D.C.H., L.P., Peter Churm, Martin R. Diedrich, Lawrence Goelman, Paul C. Heeschen, John E. Martin, Timothy J. Ryan, and Second Cup USA Holdings Ltd.(3) 10.1 Form of Indemnification Agreement(1) 10.2 Diedrich Coffee 1996 Stock Incentive Plan(1) 10.3 Diedrich Coffee 1996 Non-Employee Directors Stock Option Plan(1) 10.4 Agreement of Sale dated as of February 23, 1996 by and among Diedrich Coffee (as purchaser) and Brothers Coffee Bars, Inc. and Brothers Gourmet Coffees, Inc. (as sellers)(1) 10.5 Separation agreement dated May 13, 1997 between Steven A. Lupinacci and Diedrich Coffee, Inc.(4) 10.6 Letter agreement by and between the Company and John E. Martin appointing Mr. Martin Chairman of the Board, dated as of November 17, 1997(5) 10.7 Stock Option Plan and Agreement by and between the Company and John E. Martin granting Mr. Martin the option to purchase up to 850,000 shares of the Common Stock of the Company, dated as of November 17, 1997(5) 10.8 Common Stock Purchase Agreement by and between the Company and John E. Martin under which Mr. Martin agrees to purchase 333,333 shares of the Common Stock of the Company, dated as of November 17, 1997(5)
38 41 10.9 Employment Agreement by and between the Company and Timothy J. Ryan retaining Mr. Ryan as Chief Executive Officer, dated as of November 17, 1997(5) 10.10 Stock Option Plan and Agreement by and between the Company and Timothy J. Ryan granting Mr. Ryan the option to purchase up to 600,000 shares of the Common Stock of the Company, dated as of November 17, 1997(5) 10.11 Common Stock Purchase Agreement by and between the Company and Timothy J. Ryan under which Mr. Ryan agrees to purchase 16,667 shares of the Common Stock of the Company, dated as of November 17, 1997(5) 10.12 Form of Promissory Note made in favor of Nuvrty, Inc., the Ocean Trust and the Grandview Trust(6) 10.13 Form of Term Loan Agreement made in favor of Nuvrty, Inc., the Ocean Trust and the Grandview Trust(6) 10.14 Form of Security Agreement made in favor of Nuvrty, Inc., the Ocean Trust and the Grandview Trust(6) 10.15 Form of Warrant Agreement made in favor of Nuvrty, Inc., the Ocean Trust and the Grandview Trust(6) 10.16 Form of Intercreditor Agreement made in favor of Nuvrty, Inc., the Ocean Trust and the Grandview Trust(6) 10.17 Form of Common Stock and Option Purchase Agreement with Franchise Mortgage Acceptance Company dated as of April 3, 1998(7) 10.18 Separation and Release Agreement dated January 28, 1998 with Kerry W. Coin(7) 10.19 Employment Agreement with Ann Wride dated April 8, 1998(8) 10.20 Employment Agreement with Dolf Berle dated April 8, 1998(9) 10.21 Employment Agreement with Catherine Saar dated June 11, 1998(9) 10.22 Form of Franchise Agreement(10) 10.23 Form of Area Development Agreement(10) 10.24 Employment Agreement with Martin Diedrich dated June 29, 1998(3) 10.25 1997 Non-Employee Director Stock Option Plan and Agreement* 11.1 Statement re: Computation of Per Share Earnings(11) 21.1 List of Subsidiaries(3) 24.1 Power of Attorney(11) 27.1 Financial Data Schedule(11)
- --------------- * Filed herewith (1) Previously filed as an exhibit to Diedrich Coffee's Registration Statement on Form S-1(No. 333-08633), as amended, as declared effective by the Securities and Exchange Commission on September 11, 1996. (2) Previously filed as Appendix A to Amendment No. 1 to Diedrich Coffee's Registration Statement on Form S-4, filed with the Securities and Exchange Commission on June 7, 1999. (3) Previously filed as an exhibit to Diedrich Coffee's Registration Statement on Form S-4, filed with the Securities and Exchange Commission on April 23, 1999. (4) Previously filed as an exhibit to Diedrich Coffee's Quarterly Report on Form 10-Q, for the period ended April 30, 1997, filed with the Securities and Exchange Commission on June 13, 1997. (5) Previously filed as an exhibit to Diedrich Coffee's Current Report on Form 8-K, filed with the Securities and Exchange Commission on November 25, 1997. 39 42 (6) Previously filed as an exhibit to Diedrich Coffee's Quarterly Report on Form 10-Q, for the period ended October 29, 1997, filed with the Securities and Exchange Commission on December 11, 1997. (7) Previously filed as an exhibit to Diedrich Coffee's annual report on Form 10-K for the fiscal year ended January 28, 1998. (8) Previously filed as an exhibit to Diedrich Coffee's Quarterly Report on Form 10-Q, for the period ended April 29, 1998, filed with the Securities and Exchange Commission on June 11, 1998. (9) Previously filed as an exhibit to Diedrich Coffee's Quarterly Report on Form 10-Q, for the period ended July 29, 1998, filed with the Securities and Exchange Commission on September 10, 1998. (10) Previously filed as an exhibit to Diedrich Coffee's Quarterly Report on Form 10-Q, for the period ended October 28, 1998, filed with the Securities and Exchange Commission on December 11, 1998. (11) Previously filed as an exhibit to Diedrich Coffee's Annual Report on Form 10-K for the fiscal year ended January 27, 1999, as filed with the Securities and Exchange Commission on April 27, 1999. (b) REPORTS ON FORM 8-K. None. 40 43 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, Diedrich Coffee has duly caused this Amendment No. 1 to the Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Irvine, State of California, on the 7th day of June 1999. DIEDRICH COFFEE, INC. By: /s/ TIMOTHY J. RYAN ------------------------------------ Timothy J. Ryan President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Amendment No. 1 to the Annual Report on Form 10-K has been signed by the following persons in the capacities and on the dates indicated.
SIGNATURE TITLE DATE --------- ----- ---- * Chairman of the Board June 7, 1999 - --------------------------------------------- John E. Martin /s/ TIMOTHY J. RYAN President, Chief Executive Officer June 7, 1999 - --------------------------------------------- and Director (Principal Executive Timothy J. Ryan Officer) * Vice President and Chief Financial June 7, 1999 - --------------------------------------------- Officer (Principal Financial and Ann Wride Accounting Officer) * Chief Coffee Officer, Vice Chairman June 7, 1999 - --------------------------------------------- of the Board of Directors and Martin R. Diedrich Secretary * Director June 7, 1999 - --------------------------------------------- Lawrence Goelman * Director June 7, 1999 - --------------------------------------------- Peter Churm * Director June 7, 1999 - --------------------------------------------- Paul C. Heeschen
*By: /s/ TIMOTHY J. RYAN --------------------------- Timothy J. Ryan Attorney-in-fact 41 44 DIEDRICH COFFEE, INC. INDEX TO FINANCIAL STATEMENTS
PAGE ---- Independent Auditors' Report................................ F-1 Balance Sheets.............................................. F-2 Statements of Operations.................................... F-3 Statements of Stockholders' Equity.......................... F-4 Statements of Cash Flows.................................... F-5 Notes to Financial Statements............................... F-6
45 INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders' Diedrich Coffee, Inc.: We have audited the accompanying balance sheets of Diedrich Coffee, Inc. as of January 27, 1999 and January 28, 1998, and the related statements of operations, stockholders' equity, and cash flows for the years ended January 27, 1999, January 28, 1998 and January 29, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Diedrich Coffee, Inc. as of January 27, 1999 and January 28, 1998, and the results of its operations and its cash flows for the years ended January 27, 1999, January 28, 1998 and January 29, 1997, in conformity with generally accepted accounting principles. /s/ KPMG LLP Orange County, California March 26, 1999, except the second paragraph of note 13 which is April 6, 1999 F-1 46 DIEDRICH COFFEE, INC. BALANCE SHEETS JANUARY 28, 1998 AND JANUARY 27, 1999
1998 1999 ------------ ------------ ASSETS (NOTE 5) Current Assets: Cash...................................................... $ 1,408,161 $ 1,200,861 Accounts receivable, less allowance for doubtful accounts of $29,438 and $22,134................................. 181,628 263,651 Note receivable........................................... -- 100,000 Inventories (Note 2)...................................... 1,375,119 1,279,436 Prepaid expenses.......................................... 157,393 188,993 Income taxes receivable................................... 42,528 17,686 ------------ ------------ Total current assets................................. 3,164,829 3,050,627 Property and equipment, net (Note 3)........................ 10,104,843 9,119,859 Costs in excess of net assets acquired, net (Note 4)........ 389,651 329,086 Other assets................................................ 289,103 236,880 ------------ ------------ Total assets......................................... $ 13,948,426 $ 12,736,452 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Current installments of obligations under capital leases (Note 6)............................................... $ 168,139 $ 169,488 Accounts payable.......................................... 1,204,366 1,415,067 Accrued compensation...................................... 716,742 970,034 Accrued expenses (Note 7)................................. 1,796,869 1,039,097 Restructuring charge (Note 10)............................ 237,320 112,400 ------------ ------------ Total current liabilities............................ 4,123,436 3,706,086 Obligations under capital lease -- long-term (Note 6)....... 317,292 283,106 Long term debt (Note 5)..................................... 2,500,000 2,500,000 Deferred rent............................................... 172,231 219,865 ------------ ------------ Total liabilities.................................... 7,112,959 6,709,057 ------------ ------------ Stockholders' Equity: Common stock, $.01 par value; authorized 25,000,000 shares; issued and outstanding 6,167,313 shares at January 27, 1999 and 5,741,650 at January 28, 1998..... 57,417 61,674 Additional paid-in capital................................ 16,928,546 18,708,032 Accumulated deficit....................................... (10,150,496) (12,742,311) ------------ ------------ Total stockholders' equity........................... 6,835,467 6,027,395 Commitments and contingencies (Note 6) ------------ ------------ Total liabilities and stockholders' equity........... $ 13,948,426 $ 12,736,452 ============ ============
See accompanying notes to financial statements. F-2 47 DIEDRICH COFFEE, INC. STATEMENTS OF OPERATIONS YEARS ENDED JANUARY 29, 1997, JANUARY 28, 1998 AND JANUARY 27, 1999
1997 1998 1999 ----------- ----------- ----------- Revenues: Retail............................................ $18,117,720 $20,759,993 $21,248,462 Wholesale and other............................... 1,694,686 2,221,704 2,766,741 Franchise revenue................................. -- -- 200,000 ----------- ----------- ----------- Total revenues............................... 19,812,406 22,981,697 24,215,203 ----------- ----------- ----------- Cost and Expenses: Cost of sales and related occupancy costs......... 9,263,286 11,457,612 10,955,197 Store operating expenses.......................... 8,279,621 10,447,349 8,935,644 Other operating expenses.......................... 240,227 289,867 634,124 Depreciation and amortization..................... 1,053,770 1,785,271 1,941,020 Provision for asset impairment and restructuring costs.......................................... -- 3,902,332 -- General and administrative expenses............... 2,003,483 4,005,853 4,013,809 ----------- ----------- ----------- Total........................................ 20,840,387 31,888,284 26,479,794 ----------- ----------- ----------- Operating (loss) income............................. (1,027,981) (8,906,587) (2,264,591) Interest expense.................................... (189,549) (182,135) (384,544) Interest and other (expense) income................. 103,718 (23,239) 90,517 ----------- ----------- ----------- Loss before income taxes............................ (1,113,812) (9,111,961) (2,558,618) Income tax provision (benefit)...................... (128,107) 800 3,690 ----------- ----------- ----------- Net loss............................................ $ (985,705) $(9,112,761) $(2,562,308) =========== =========== =========== Net loss per share -- basic & diluted:.............. $ (0.22) $ (1.69) $ (0.43) =========== =========== =========== Weighted average shares outstanding............... 4,414,000 5,392,609 5,934,287 =========== =========== ===========
See accompanying notes to financial statements. F-3 48 DIEDRICH COFFEE, INC. STATEMENTS OF STOCKHOLDERS' EQUITY YEARS ENDED JANUARY 29, 1997, JANUARY 28, 1998 AND JANUARY 27, 1999
SERIES A PREFERRED SERIES B PREFERRED STOCK STOCK COMMON STOCK ---------------------- ------------------------ ------------------- ADDITIONAL ACCUMULATED SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT PAID IN CAPITAL DEFICIT ---------- --------- ---------- ----------- --------- ------- --------------- ------------ Balance, January 31, 1996................... 1,000,000 $ 800,000 1,608,568 $ 2,225,813 1,183,082 $11,831 $ 318,867 $ (52,030) Initial public offering, net.................... -- -- -- -- 1,600,000 16,000 12,563,452 -- Conversion of Series A and B preferred stock.................. (1,000,000) (800,000) (1,608,568) (2,225,813) 2,608,568 26,086 2,999,727 -- Net loss for the year.... -- -- -- -- -- -- -- (985,705) ---------- --------- ---------- ----------- --------- ------- ----------- ------------ Balance, January 29, 1997................... -- -- -- -- 5,391,650 53,917 15,882,046 (1,037,735) Common stock issued...... -- -- -- -- 350,000 3,500 1,046,500 -- Net loss for the year.... -- -- -- -- -- -- -- (9,112,761) ---------- --------- ---------- ----------- --------- ------- ----------- ------------ Balance, January 28, 1998................... -- -- -- -- 5,741,650 57,417 16,928,546 (10,150,496) Common stock issued...... -- -- -- -- 200,000 2,000 1,273,000 -- Exercise of options and warrants............... -- -- -- -- 225,663 2,257 476,979 -- Amortization of options................ -- -- -- -- -- -- 29,507 (29,507) Net loss for the year.... -- -- -- -- -- -- -- (2,562,308) ---------- --------- ---------- ----------- --------- ------- ----------- ------------ Balance, January 27, 1999................... -- $ -- -- $ -- 6,167,313 $61,674 $18,708,032 $(12,742,311) ========== ========= ========== =========== ========= ======= =========== ============ TOTAL ----------- Balance, January 31, 1996................... $ 3,304,481 Initial public offering, net.................... 12,579,452 Conversion of Series A and B preferred stock.................. -- Net loss for the year.... (985,705) ----------- Balance, January 29, 1997................... 14,898,228 Common stock issued...... 1,050,000 Net loss for the year.... (9,112,761) ----------- Balance, January 28, 1998................... 6,835,467 Common stock issued...... 1,275,000 Exercise of options and warrants............... 479,236 Amortization of options................ -- Net loss for the year.... (2,562,308) ----------- Balance, January 27, 1999................... $ 6,027,395 ===========
See accompanying notes to financial statements. F-4 49 DIEDRICH COFFEE, INC. STATEMENTS OF CASH FLOWS YEARS ENDED JANUARY 29, 1997, JANUARY 28, 1998 AND JANUARY 27, 1999
1997 1998 1999 ----------- ----------- ----------- Cash flows from operating activities: Net (loss) income......................................... $ (985,705) $(9,112,761) $(2,562,308) Adjustments to reconcile net (loss) income to cash (used in) provided by operating activities: Depreciation and amortization........................... 1,053,770 1,785,271 1,941,020 Deferred income taxes................................... 48,192 -- -- Restructuring charge.................................... -- 987,590 -- Impairment on long-lived assets......................... -- 2,203,217 -- Changes in operating assets and liabilities: Accounts and notes receivable......................... (75,790) 28,735 (182,023) Inventories........................................... (969,652) 150,804 95,683 Prepaid expenses...................................... (78,696) 27,670 (31,600) Income taxes receivable............................... (272,182) 242,544 24,842 Other assets.......................................... (121,881) 26,637 12,392 Accounts payable...................................... 1,164,864 (595,926) 210,701 Accrued compensation.................................. 232,137 186,971 165,614 Accrued expenses...................................... 136,250 1,562,055 (73,236) Income taxes payable.................................. (51,235) -- -- Deferred rent......................................... 33,240 17,847 47,634 ----------- ----------- ----------- Net cash (used in) provided by operating activities....... 113,312 (2,489,346) (351,281) ----------- ----------- ----------- Cash flows from investing activities: Capital expenditures for property and equipment......... (7,813,263) (1,724,397) (1,672,076) Disposal of property and equipment...................... 148,785 Acquisition of coffeehouses............................. (1,916,000) -- -- ----------- ----------- ----------- Net cash (used in) investing activities................. (9,729,263) (1,724,397) (1,523,291) ----------- ----------- ----------- Cash flows from financing activities: Proceeds from notes payable............................. 10,000 -- -- Payments on notes payable............................... (49,398) -- -- Proceeds from line of credit............................ 4,100,000 -- -- Payments on line of credit.............................. (4,100,000) -- -- Proceeds from long-term debt............................ 1,622,520 4,500,000 -- Principal payments on long-term debt.................... (2,569,378) (2,000,000) -- Payments on capital lease obligations................... -- -- (86,964) Proceeds from issuance of common stock, net of fees paid.................................................. 12,579,452 1,050,000 1,275,000 Proceeds from stock options exercised................... -- -- 479,236 ----------- ----------- ----------- Net cash provided by financing activities................. 11,593,196 3,550,000 1,667,272 ----------- ----------- ----------- Net (decrease) increase in cash........................... 1,977,245 (663,743) (207,300) Cash at beginning of year................................. 94,659 2,071,904 1,408,161 ----------- ----------- ----------- Cash at end of year....................................... $ 2,071,904 $ 1,408,161 $ 1,200,861 =========== =========== =========== Supplemental Disclosure of Cash Flow Information: Cash paid during the period for: Interest.............................................. $ 164,140 $ 154,999 $ 299,670 =========== =========== =========== Income taxes.......................................... $ 108,773 $ 800 $ 3,690 =========== =========== =========== Non-cash Transactions Equipment Purchased under Capital Leases.............. -- $ 498,513 $ 54,127 =========== =========== ===========
See accompanying notes to financial statements. F-5 50 DIEDRICH COFFEE, INC. NOTES TO FINANCIAL STATEMENTS YEARS ENDED JANUARY 29, 1997, JANUARY 28, 1998 AND JANUARY 27, 1999 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND PRACTICES Business Diedrich Coffee, Inc. (the "Company") operates coffeehouses in Southern California, Colorado and Texas, which sell coffee beverages made with its own freshly roasted coffee. In addition, the Company sells light food items and whole bean coffee through its coffeehouses. The Company also operates a wholesale and mail order business in Southern California, which sells whole bean coffee and related supplies and equipment. Fiscal Year The Company's fiscal year ends on the Wednesday closest to January 31. Inventories Inventories are stated at the lower of cost or market. The cost for inventories is determined using the first-in, first-out method. Property and Depreciation Property and equipment, including assets under capital leases are recorded at cost. Depreciation is calculated using the straight-line method over estimated useful lives of five to seven years. Property and equipment held under capital leases and leasehold improvements are amortized straight-line over the shorter of their estimated useful lives or the term of the related leases. Major renewals and improvements are capitalized. Maintenance and repairs that do not improve or extend the life of the respective assets are charged to expense. Store Pre-opening Costs Direct and incremental costs prior to the opening of a coffeehouse location are expensed as incurred. Fair Value of Financial Instruments The carrying amounts of cash, accounts receivable, accounts payable and accrued expenses approximate fair value because of the short-term maturity of these financial instruments. The Company believes the carrying amounts of the Company's notes payable and long-term debt approximate fair value because the interest rates on these instruments are subject to change with, or approximate, market interest rates. Rent Expense Certain lease agreements provide for scheduled rent increases during the lease terms or for rental payments commencing on a date other than the date of initial occupancy. Rent expense is recorded on a straight-line basis over the respective terms of the leases. Income Taxes Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. F-6 51 DIEDRICH COFFEE, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED JANUARY 29, 1997, JANUARY 28, 1998 AND JANUARY 27, 1999 The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Net Income (Loss) per Common Share The Company adopted Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings per Share" in fiscal 1998. SFAS 128 requires the presentation of "basic" earnings per share which represents net earnings divided by the weighted average shares outstanding excluding all common stock equivalents. Dual presentation of "diluted" earnings per-share reflecting the dilutive effect of all common stock equivalents is also required. Costs in Excess of Net Assets Acquired Costs in excess of net assets acquired is amortized on a straight-line basis over the expected periods to be benefited. The Company assesses the recoverability of this intangible asset by determining whether the amortization of the goodwill balance over its remaining life can be recovered through undiscounted future operating cash flows of the acquired operations. The amount of goodwill impairment, if any, is measured based on projected discounted future operating cash flows using a discount rate reflecting the Company's average cost of funds. The assessment of the recoverability of goodwill will be impacted if estimated future operating cash flows are not achieved. Stock Option Plans Prior to February 1, 1996, the Company accounted for its stock option plans in accordance with the provisions of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. As such, compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. On February 1, 1996, the Company adopted SFAS No. 123, "Accounting for Stock-Based Compensation," which permits entities to recognize as expense over the vesting period the fair value of all stock-based awards on the date of the grant. Alternatively, SFAS No. 123 also allows entities to continue to apply the provisions of APB Opinion No. 25 and provide pro forma net income and pro forma earnings per share disclosures for employee stock option grants made in fiscal 1996 and future years as if the fair-value-based method defined in SFAS No. 123 had been applied. The Company has elected to continue to apply the provisions of APB Opinion No. 25 and provide the pro forma disclosure provisions of SFAS No. 123. Long-Lived Assets It is the Company's policy to account for long-lived assets, including intangibles, at the lower of amortized cost or fair value, less disposition costs. Long-lived assets and certain identifiable intangibles are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If this assessment indicates that the intangibles will not be recoverable, as determined by a non-discounted cash flow generated by the asset, the carrying value of the Company's long- lived assets will be reduced to its estimated fair market value based on the discounted cash flows. Advertising and Promotion Costs Advertising costs are expensed as incurred. Promotion costs are charged to income in the period of the promotional event. During fiscal 1999, the retail stores were charged approximately $427,000, which was included in store operating expenses and wholesale was charged $56,000, which was included in other operating expenses, with the remaining amount to general and administrative expenses. General and F-7 52 DIEDRICH COFFEE, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED JANUARY 29, 1997, JANUARY 28, 1998 AND JANUARY 27, 1999 administrative expenses included approximately $98,000 for the year ended January 27, 1999, $377,000 for the year ended January 28, 1998 and $157,000 for the year ended January 29, 1997. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Business Segment Reporting The Company adopted SFAS No. 131 "Disclosures About Segments of an Enterprise and Related Information," effective in 1999. SFAS No. 131 establishes new standards for reporting information about business segments and related disclosures about products and services, geographic areas and major customers. The business segments of the Company are wholesale and retail. Information regarding these segments are in Note 11. Revenue Recognition Sales are recorded when payment is tendered at point of sale for retail and upon shipment of product for wholesale. 2. INVENTORIES Inventories consist of the following:
JANUARY 28, JANUARY 27, 1998 1999 ----------- ----------- Unroasted coffee............................................ $ 535,885 $ 412,103 Roasted coffee.............................................. 67,965 115,979 Accessory and specialty items............................... 230,502 275,386 Other food, beverage and supplies........................... 540,767 475,968 ---------- ---------- $1,375,119 $1,279,436 ========== ==========
3. PROPERTY AND EQUIPMENT Property and equipment is summarized as follows:
JANUARY 28, JANUARY 27, 1998 1999 ----------- ----------- Leasehold improvements.................................... $ 7,017,125 $ 6,475,369 Equipment................................................. 4,047,109 4,555,017 Furniture and fixtures.................................... 2,022,252 1,948,423 Construction in progress.................................. 250,716 504,279 Assets under capital lease................................ 498,513 552,640 ----------- ----------- 13,835,715 14,035,728 Accumulated depreciation and amortization................. (3,730,872) (4,915,869) ----------- ----------- $10,104,843 $ 9,119,859 =========== ===========
F-8 53 DIEDRICH COFFEE, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED JANUARY 29, 1997, JANUARY 28, 1998 AND JANUARY 27, 1999 4. ACQUISITIONS During fiscal 1997, the Company purchased substantially all assets of twelve coffeehouses previously owned by Brothers Gourmet Coffees, Inc., seven bakery-espresso cafes from an unrelated third party and another coffeehouse from an unrelated third party for total cash consideration of $1,916,000. These acquisitions have been accounted for using the purchase method of accounting and, accordingly, the results of operations of the coffeehouses acquired have been included with those of the Company as of their respective acquisition date. The costs in excess of net assets acquired related to these acquisitions was $874,000 and is being amortized over 15 years. The Company has expensed or reserved these costs in connection with store closures. (See Note 7 and 10). 5. DEBT Long-term debt consists of the following:
JANUARY 28, JANUARY 27, 1998 1999 ----------- ----------- NUVRTY, INC. Note payable bearing interest at prime rate plus 3 1/2%, interest payable monthly. Note is secured by the assets of the Company. Due September 30, 2002....................... $1,000,000 $1,000,000 GRANDVIEW TRUST Note payable bearing interest at prime rate plus 3 1/2%, interest payable monthly. Note is secured by the assets of the Company. Due October 15, 2002......................... 750,000 750,000 OCEAN TRUST Note payable bearing interest at prime rate plus 3 1/2%, interest payable monthly. Note is secured by the assets of the Company. Due October 16, 2002......................... 750,000 750,000 ---------- ---------- $2,500,000 $2,500,000 ========== ==========
On September 30, 1997 the Company entered into a promissory note, term loan agreement and security agreement with Nuvrty, Inc., a Colorado corporation and predecessor-in-interest to Cosleno, Inc. controlled by Amre Youness, a former director of the Company (the "Nuvrty Loan Documents"). All outstanding principal and accrued interest is due and payable on September 30, 2002. The loan is secured by the assets of the Company and provides for borrowings up to $1,000,000 with interest accruing and paid monthly at the prime rate plus 3 1/2%. The Company borrowed the full amount under the loan. In connection with the Nuvrty Loan Documents, the Company issued a warrant to Nuvrty to purchase 340,000 shares of the Company's common stock at a price of $2.25 per share. The warrants are exercisable immediately and expire on the later of September 30, 2003 or one year following payment in full of the loan. On October 16, 1997 the Company entered into parallel promissory notes, term loan agreements and security agreements with the Ocean and Grandview Trusts on terms identical to those entered into with Nuvrty, Inc. (the "Ocean Trust Loan Documents" and the "Grandview Trust Loan Documents," respectively). The Ocean Trust Loan Documents and the Grandview Trust Loan Documents provide for borrowing up to $750,000 from each Trust. Each loan is secured by the assets of the Company. Interest on advances is accrued and payable monthly at the prime rate plus 3 1/2%. The Company borrowed $750,000 under each facility. All outstanding principal and accrued interest is due and payable to each of the Ocean and Grandview Trusts on October 16, 2002. F-9 54 DIEDRICH COFFEE, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED JANUARY 29, 1997, JANUARY 28, 1998 AND JANUARY 27, 1999 In connection with the Ocean Trust Loan Documents and the Grandview Trust Loan Documents the Company issued warrants to each Trust respectively to purchase 255,000 shares of the Company's common stock at a price of $2.25 per share. The warrants are exercisable immediately and expire on the later of October 16, 2003 or one year following payment in full of the respective loans. The warrants associated with all the above debt were accounted for in accordance with the provisions of APB 14, "Accounting for Convertible Debt and Debt Issued Stock Purchase Warrants." In accordance with APB 14, none of the proceeds from issuance of the debt was allocated to the warrants based on their relative fair value, which is insignificant, calculated using both a Cost of Replacement Model and the Monte Carlo simulation of possible warrant exercise and no expense was recognized. At January 27, 1999 the prime rate was 7.75%. 6. COMMITMENTS AND CONTINGENCIES Lease Commitments As of January 27, 1999, the Company leases warehouse and office space in Irvine, California, warehouse space in Denver, Colorado, and thirty-six coffeehouse locations in Southern California, Colorado and Texas expiring through February 2009. The leases for five of the coffeehouse locations are guaranteed by an officer/ director of the Company. Certain of the coffeehouse leases require the payment of property taxes, normal maintenance and insurance on the properties and additional rents based on percentages of sales in excess of various specified retail sales levels. Contingent rent expense was insignificant for all periods presented. Future minimum lease payments under non-cancelable operating leases as of January 27, 1999 are as follows:
NON-CANCELABLE YEAR ENDING JANUARY OPERATING LEASES CAPITAL LEASES ------------------- ---------------- -------------- 2000.................................................... $1,842,000 $169,488 2001.................................................... 1,711,000 169,488 2002.................................................... 1,413,000 165,672 2003.................................................... 1,172,000 95,179 2004.................................................... 974,000 1,389 Thereafter.............................................. 1,957,000 -- ---------- -------- $9,069,000 $601,216 ========== ======== Less amount representing interest....................... 148,622 -------- Present value of minimum lease payments................. 452,594 Less current portion.................................... 169,488 -------- Long-term portion....................................... $283,106 ========
Rent expense under operating leases approximated $2,070,000, $2,232,000, and $1,772,000 for the years ended January 27, 1999, January 28, 1998 and January 29, 1997, respectively. Purchase Commitments As of January 27, 1999 and January 28, 1998, the Company had entered into fixed price purchase contracts for unroasted coffee aggregating approximately $1,135,000 and $451,500, respectively. Such F-10 55 DIEDRICH COFFEE, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED JANUARY 29, 1997, JANUARY 28, 1998 AND JANUARY 27, 1999 contracts are generally short-term in nature and the Company believes that their cost approximates fair market value. Contingencies In the ordinary course of its business, the Company may become involved in legal proceedings from time to time. As of March 26, 1999, the Company was not aware of any pending legal proceedings which in the opinion of management would adversely affect continuing operations. 7. ACCRUED EXPENSES The following table sets forth details of accrued expenses:
JANUARY 28, JANUARY 27, 1998 1999 ----------- ----------- Accrued costs for store/warehouse closures.................. $ 986,000 $ 471,915 Other accrued taxes......................................... 331,224 113,664 Accrued worker's compensation insurance..................... 147,532 159,872 Other accrued expenses...................................... 332,113 293,646 ---------- ---------- Total accrued expenses...................................... $1,796,869 $1,039,097 ========== ==========
8. STOCKHOLDERS' EQUITY In June 1995, one executive officer was granted options to purchase 131,350 shares of the Company's common stock at $1.45 per share, the estimated fair value of the common stock on the grant date. The options were to become exercisable on the eighth anniversary of the date of grant or earlier upon the occurrence of certain events, including an IPO or a change in control (as defined). If not exercised earlier, the options were to expire 10 years from the date of grant. In May 1997, in connection with the termination of the executive's employment agreement, the Company and the executive agreed to terms under which 52,167 options were forfeited and the expiration date for the remaining 79,183 options was changed to March 12, 1999. During Fiscal 1999, the options to purchase 79,183 shares were exercised. In July 1996, the Company adopted the 1996 Stock Incentive Plan (the "Incentive Plan"), which authorized the granting of a variety of stock-based incentive awards, including incentive and nonstatutory stock options. A total of 475,000 shares were reserved for issuance under the Incentive Plan. The stockholders approved at the 1997 annual meeting of stockholders, an increase of 300,000 shares for a total of 775,000 shares reserved for issuance pursuant to the Incentive Plan. The Incentive Plan is administered by a committee of the Board of Directors, who determine the recipients and terms of the awards granted. Under the Incentive Plan, options to purchase common stock may be granted with an exercise price below market value of such stock on the grant date. In July 1996, the Company adopted the 1996 Non-Employee Directors Stock Option Plan (the "Directors Plan"), which authorizes the granting of non-qualified stock options to independent directors. A total of 125,000 shares have been reserved for issuance under the Directors Plan. Pursuant to the Directors Plan, each non-employee director receives certain automatic grants of options, which generally vest over two years. All non-employee director options have a term of ten years and an exercise price equal to the fair market value of the Company's common stock on the date of grant. In August 1996, one executive officer was granted options to purchase 120,000 shares of the Company's common stock, subject to a specified vesting schedule, at an exercise price equal to the public offering price per share in the Company's initial public offering. On September 24, 1997 the Company and the executive F-11 56 DIEDRICH COFFEE, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED JANUARY 29, 1997, JANUARY 28, 1998 AND JANUARY 27, 1999 agreed to revise the exercise price of these options to $3.00 per share (the closing price of the Company's stock on that date). In January 1998, in connection with the termination of executive's employment agreement, the Company and the executive agreed to terms under which the employee retained options to purchase 80,000 shares. The remaining 40,000 options were canceled. Options to purchase 62,500 shares were exercised in fiscal 1999 and options to purchase 17,500 shares were exercised in fiscal 2000. In September 1996, the holders of the Series A and Series B Preferred Shares converted their shares into shares of common stock on a one-for-one basis. On September 11, 1996, the Company completed an initial public offering of 2,530,000 shares (including an over-allotment option). The offering consisted of 1,600,000 shares of common stock sold on behalf of the Company and 930,000 shares of common stock sold on behalf of certain selling stockholders. The net proceeds of the offering to the Company, after deducting approximately $2,621,000 in related expenses, were approximately $12,579,000. In connection with the IPO, the managing underwriter received warrants exercisable for 160,000 shares of the Company's common stock at $11.50 per share. The warrants were exercisable commencing September 1997 and were to expire in September 1999. The warrants were repriced to $5.25 and the exercise period was shortened to provide for expiration in December 1998 pursuant to written agreement on December 10, 1997. During fiscal 1999, 28,960 warrants were exercised and the remaining 131,040 expired. On April 25, 1997, the Company's Board of Directors approved the 1997 Non-Employee Director's Stock Option Plan which granted options to purchase 10,000 shares each to two non-employee directors. These options have an exercise price of $2.75, became vested on April 25, 1998 and expire on April 25, 2007. On November 18, 1997, Mr. John E. Martin joined the Company's Board of Directors as Chairman. The Company and Mr. Martin entered into an agreement under which Mr. Martin was granted the option to purchase 850,000 shares of the common stock of the Company. Mr. Martin and the Company also agreed to terms under which Mr. Martin purchased 333,333 shares of the Company's common stock at $3.00 per share. On November 18, 1997, Mr. Timothy J. Ryan joined the Company as Diedrich Coffee's President and Chief Executive Officer. The Company entered into a performance based Stock Option Plan and Agreement under which Mr. Ryan was granted the option to purchase up to 600,000 shares of the common stock of the Company. In addition, Mr. Ryan purchased 16,667 shares of common stock at $3.00 per share pursuant to a private sale of restricted stock. On January 22, 1998 the stockholders of the Company approved the stock option plans and agreements with John Martin and Timothy Ryan. On January 28, 1998 Messrs. Martin and Ryan completed their respective private purchases of Company stock of $1,000,000 and $50,000, respectively. On March 30, 1998 the Company agreed to a private placement of 200,000 shares of the Company's common stock to Franchise Mortgage Acceptance Company ("FMAC") at a price of $6.375 (the stock's closing sale price for that day on the Nasdaq National Market). In addition, FMAC also received an option to purchase 100,000 additional shares of the Company's common stock; this option may be exercised in increments of 25,000 shares or more and expires on April 3, 2000. 50,000 shares are exercisable at $10.00 per share and 50,000 shares are exercisable at $12.50 per share. This transaction was completed on April 3, 1998. Mr. John E. Martin, Chairman of Diedrich Coffee, Inc., serves on the Board of Directors of FMAC. F-12 57 DIEDRICH COFFEE, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED JANUARY 29, 1997, JANUARY 28, 1998 AND JANUARY 27, 1999 Information regarding the Company's stock options plans is summarized below:
WEIGHTED AVERAGE OPTIONS EXERCISE PRICE --------- -------------- Shares authorized...................................... 2,601,350 Shares under option Outstanding at: January 31, 1996....................... 161,250 $3.04 Granted........................................... 140,000 $9.61 Exercised......................................... -- -- Forfeited......................................... -- -- Outstanding at: January 29, 1997....................... 301,350 $6.09 Granted........................................... 1,885,000 $5.60 Exercised......................................... -- -- Forfeited......................................... 202,167 $7.53 Outstanding at: January 28, 1998....................... 1,984,183 $5.48 Granted........................................... 308,100 $7.81 Exercised......................................... 164,999 $2.26 Forfeited......................................... 70,017 $3.20 Outstanding at: January 27, 1999....................... 2,057,267 $6.17 Weighted-average fair value of options granted during the fiscal year: 1997.............................................. $5.01 1998.............................................. $2.56 1999.............................................. $4.29 Options exercisable: At January 29, 1997.................................. 110,850 At January 28, 1998.................................. 1,125,683 At January 27, 1999.................................. 1,169,152
In connection with debt (Note 5) the Company issued warrants to purchase common stock at a price of $2.25 expiring at various times. As of January 27, 1999, January 28, 1998 and January 29, 1997, warrants of 850,000, 1,095,000 and 160,000 are outstanding and vested. The following table summarizes information about stock options outstanding on January 27, 1999:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE ------------------------------------------ ------------------------------ NUMBER WEIGHTED WEIGHTED NUMBER WEIGHTED OUTSTANDING AVERAGE AVERAGE EXERCISABLE AVERAGE AT REMAINING EXERCISE AT EXERCISE JANUARY 27, 1999 LIFE (YEARS) PRICE JANUARY 27, 1999 PRICE ---------------- ------------ -------- ---------------- ----------- $2.75 - $4.00...................... 779,167 5.97 $ 3.54 749,152 $ 3.57 $4.01 - $6.00...................... 376,500 7.02 $ 4.97 300,000 $ 4.88 $6.01 - $9.00...................... 456,600 6.58 $ 7.66 -- -- $9.01 - $10.50..................... 445,000 7.04 $10.22 120,000 $10.81
F-13 58 DIEDRICH COFFEE, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED JANUARY 29, 1997, JANUARY 28, 1998 AND JANUARY 27, 1999 Pro forma income and pro forma income per share, as if the fair value-based method has been applied in measuring compensation cost for stock-based awards:
1998 1999 ------------ ----------- REPORTED Net Loss............................................. $ (9,112,761) $(2,562,308) Basic loss per share................................. $ (1.69) $ (0.43) PRO FORMA Net Loss............................................. $(13,588,746) $(3,082,569) Basic loss per share................................. $ (2.52) $ (0.52)
The pro forma net income (loss) and net income (loss) per share calculated pursuant to the provisions of SFAS No. 123 for the year ended January 29, 1997 would not be significantly different from amounts reported and therefore are not included herein. The fair values of the options granted were estimated using the Black-Scholes option-pricing model based on the following weighted average assumptions:
1998 1999 ------- ------- Risk free interest rate..................................... 5.5% 4.5% Expected Life............................................... 6 years 6 years Expected volatility......................................... 128% 53% Expected dividend yield..................................... 0% 0%
9. INCOME TAXES The components of the income tax provision (benefit) are as follows:
YEAR ENDED YEAR ENDED YEAR ENDED JANUARY 29, JANUARY 28, JANUARY 27, 1997 1998 1999 ----------- ----------- ----------- Current: Federal........................................ $(171,284) $ -- $ -- State.......................................... (5,015) 800 3,690 --------- ---- ------ (176,299) 800 3,690 --------- ---- ------ Deferred: Federal........................................ 40,542 -- -- State.......................................... 7,650 -- -- --------- ---- ------ 48,192 ------ $(128,107) $800 $3,690 ========= ==== ======
F-14 59 DIEDRICH COFFEE, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED JANUARY 29, 1997, JANUARY 28, 1998 AND JANUARY 27, 1999 Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting and income tax purposes. The significant components of deferred tax assets and liabilities are as follows:
JANUARY 28, JANUARY 27, 1998 1999 ----------- ----------- Deferred tax assets: Net operating loss carryforwards.......................... $ 2,965,213 $ 3,900,495 Accrued expenses.......................................... 456,844 457,872 Restructure and Store closure Reserves.................... 410,933 98,179 AMT credit................................................ 1,069 1,069 ----------- ----------- Total deferred tax assets................................... 3,834,059 4,457,615 ----------- ----------- Deferred tax liabilities: Depreciation and amortization............................. (199,432) 164,543 State income taxes........................................ -- -- ----------- ----------- Total deferred tax liabilities.............................. (199,432) 164,543 ----------- ----------- Total deferred tax assets................................... 3,634,627 4,622,158 Less: Valuation allowance................................... (3,634,627) (4,622,158) ----------- ----------- Net deferred tax assets..................................... $ -- $ -- =========== ===========
A reconciliation of the statutory Federal income tax rate with the Company's effective income tax provision (benefit) rate is as follows:
YEAR ENDED YEAR ENDED YEAR ENDED JANUARY 29, JANUARY 28, JANUARY 27, 1997 1998 1999 ----------- ----------- ----------- Federal statutory rate................................... (34.0)% (34.0)% (34.0)% State income taxes, net of Federal benefit............... 2.6 (3.3) (1.6) Other.................................................... (1.0) (0.1) (2.8) Valuation allowance...................................... 20.9 37.4 38.6 ----- ----- ----- (11.5)% -- 0.2% ----- ----- -----
As of January 27, 1999, the Company had net operating loss (NOL) carryforwards of approximately $10,655,000 and $4,760,000 for Federal and state purposes, respectively. The Federal NOL is available to offset future federal taxable income through 2013, and the state NOL is available to offset future state taxable income through 2003. The utilization of certain NOL carryforwards could be limited due to restriction imposed under Federal and state laws upon a change in ownership. A valuation allowance against deferred tax assets of $4,622,158 was recorded in fiscal 1999 to fully offset NOL carryforwards and other net deferred tax assets at January 27, 1999. 10. RESTRUCTURING CHARGE On March 12, 1997, the Company announced that it was reviewing the performance of all of the Company's coffeehouses to determine which units were not meeting management's long-term operational expectations. As a result of this review, twelve stores were identified to be closed. In connection with the store closures and other related expenses, the Company recorded an impairment provision and restructuring charge totaling approximately $4.6 million in the first quarter of fiscal 1998. Eleven of the twelve stores were closed with eight leases terminated and three locations subleased. In January, the new management reviewed the progress of all retail operations and determined that one coffeehouse originally designated for closure would F-15 60 DIEDRICH COFFEE, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED JANUARY 29, 1997, JANUARY 28, 1998 AND JANUARY 27, 1999 remain open. During fiscal 1998, most of the lease terminations provided for in the restructuring had been completed at less cost than originally anticipated. As a result of these two factors, management determined that the remaining restructuring reserve could be reduced by $648,000 to $237,000. The remaining balance of $112,000 at the end of fiscal 1999 is designated for costs related to two closed locations currently under sublease. 11. EARNINGS PER SHARE The following table sets forth the computation of basic and diluted earnings per share:
JANUARY 29, JANUARY 28, JANUARY 27, 1997 1998 1999 ----------- ----------- ----------- NUMERATOR: Net (loss) income..................................... (985,705) (9,112,761) (2,562,308) DENOMINATOR: Basic and diluted weighted average common shares outstanding........................................ 4,414,000 5,392,609 5,934,287 Basic and diluted loss per share...................... (0.22) (1.69) (0.43)
For the years ended January 27, 1999, January 28, 1998 and January 29, 1997, stock options of 2,057,267, 1,984,183 and 301,350 respectively, and warrants of 850,000, 1,095,000 and 160,000 respectively, were not included in the computation of diluted earnings per share as losses were incurred in those years. 12. SEGMENT INFORMATION In accordance with the requirements of SFAS 131, "Disclosures about Segments of an Enterprise and Related Information," the Company reportable business segments and respective accounting policies, policies of the segments are the same as those described in Note 1. Management evaluates segment performance based primarily on revenue and earnings from operations. Interest income and expenses is evaluated on a consolidated basis and not allocated to the Company's business segments. Segment information is summarized as follows for the years ended January 27, 1999, January 28, 1998 and January 29, 1997:
1997 1998 1999 ----------- ----------- ----------- Net Revenues: Retail operations................................. $18,117,720 $20,759,993 $21,248,462 Wholesale operations.............................. 1,694,686 2,221,704 2,766,741 ----------- ----------- ----------- 19,812,406 22,981,697 24,015,203 ----------- ----------- ----------- Earnings (loss) from operations: Retail operations................................. 821,511 (5,160,947) 1,476,140 Wholesale operations.............................. 291,689 512,313 392,467 ----------- ----------- ----------- Total.......................................... $ 1,113,200 $(4,648,634) $ 1,868,607 =========== =========== ===========
13. SUBSEQUENT EVENT On March 16, 1999, the Company signed a definitive agreement to acquire Coffee People, Inc. Under the terms of the agreement, Coffee People stockholders will receive $17.75 million in cash, 1,500,000 shares of Diedrich Coffee common stock, and $5.25 million in cash or stock depending on the success of Diedrich F-16 61 DIEDRICH COFFEE, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED JANUARY 29, 1997, JANUARY 28, 1998 AND JANUARY 27, 1999 Coffee's financing efforts. The transaction is expected to close during the Summer 1999, subject to a number of conditions including the securing of financing and stockholder and regulatory approval. On April 6, 1999, the Company entered into a $1,000,000 loan agreement and security agreement with Amre Youness, a former director of the Company. All outstanding principal and interest is due and payable on April 6, 2000. The loan is secured by the assets of the Company with interest accruing and paid monthly at the prime rate plus 3%. In connection with the loan agreement, the Company issued warrants to Mr. Youness to purchase 70,000 shares of the Company's common stock at a price of $5.625 per share. The fair value of the warrants is estimated to be $100,000. This estimated fair value will be charged to interest expense and amortized ratably over the life of the loan. 14. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) The results of operations for fiscal 1999 and 1998 were as follows:
FIRST SECOND THIRD FOURTH QUARTER QUARTER QUARTER QUARTER ------- ------- ------- ------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Fiscal 1999: Net sales................................................. $ 5,923 $6,030 $6,043 $ 6,219 Operating (loss).......................................... (649) (677) (521) (418) Net (loss)................................................ (746) (761) (609) (446) Net (loss) per share...................................... (.13) (.13) (.10) (.07) Fiscal 1998: Net sales................................................. $ 5,868 $5,811 $5,563 $ 5,740 Operating (loss).......................................... (5,390) (661) (654) (2,202) Net (loss)................................................ (5,383) (698) (739) (2,293) Net (loss) per share...................................... (1.00) (.13) (.14) (.42)
F-17 62 DIEDRICH COFFEE, INC. INDEX TO EXHIBITS
SEQUENTIALLY EXHIBIT NUMBERED NUMBER DESCRIPTION PAGES - ------- ----------- ------------ 2.1 Form of Agreement and Plan of Merger by and between Diedrich Coffee, a California corporation, and Diedrich Coffee, Inc., a Delaware corporation(1) 2.2 Agreement and Plan of Merger dated as of March 16, 1999, by and among Diedrich Coffee, CP Acquisition Corp., a wholly owned subsidiary of Diedrich Coffee, and Coffee People(2) 3.1 Certificate of Incorporation of the company(1) 3.2 Bylaws of the company(1) 4.1 Purchase Agreement for Series A Preferred Stock dated as of December 11, 1992 by and among Diedrich Coffee, Martin R. Diedrich, Donald M. Holly, SNV Enterprises and D.C.H., L.P.(1) 4.2 Purchase Agreement for Series B Preferred Stock dated as of June 29, 1995 by and among Diedrich Coffee, Martin R. Diedrich, Steven A. Lupinacci, Redwood Enterprises VII, L.P. and Diedrich Partners I, L.P.(1) 4.3 Specimen Stock Certificate(1) 4.4 Form of Conversion Agreement in connection with the conversion of Series A and Series B Preferred Stock into Common Stock(1) 4.5 Form of Lock-up Letter Agreement among The Second Cup, Ltd. and Diedrich Coffee, Inc.(3) 4.6 Voting Agreement and Irrevocable Proxy dated as of March 16, 1999 by and among Diedrich Coffee, Inc., D.C.H., L.P., Peter Churm, Martin R. Diedrich, Lawrence Goelman, Paul C. Heeschen, John E. Martin, Timothy J. Ryan, and Second Cup USA Holdings Ltd.(3) 10.1 Form of Indemnification Agreement(1) 10.2 Diedrich Coffee 1996 Stock Incentive Plan(1) 10.3 Diedrich Coffee 1996 Non-Employee Directors Stock Option Plan(1) 10.4 Agreement of Sale dated as of February 23, 1996 by and among Diedrich Coffee (as purchaser) and Brothers Coffee Bars, Inc. and Brothers Gourmet Coffees, Inc. (as sellers)(1) 10.5 Separation agreement dated May 13, 1997 between Steven A. Lupinacci and Diedrich Coffee, Inc.(4) 10.6 Letter agreement by and between the Company and John E. Martin appointing Mr. Martin Chairman of the Board, dated as of November 17, 1997(5) 10.7 Stock Option Plan and Agreement by and between the Company and John E. Martin granting Mr. Martin the option to purchase up to 850,000 shares of the Common Stock of the Company, dated as of November 17, 1997(5)
63
SEQUENTIALLY EXHIBIT NUMBERED NUMBER DESCRIPTION PAGES - ------- ----------- ------------ 10.8 Common Stock Purchase Agreement by and between the Company and John E. Martin under which Mr. Martin agrees to purchase 333,333 shares of the Common Stock of the Company, dated as of November 17, 1997(5) 10.9 Employment Agreement by and between the Company and Timothy J. Ryan retaining Mr. Ryan as Chief Executive Officer, dated as of November 17, 1997(5) 10.10 Stock Option Plan and Agreement by and between the Company and Timothy J. Ryan granting Mr. Ryan the option to purchase up to 600,000 shares of the Common Stock of the Company, dated as of November 17, 1997(5) 10.11 Common Stock Purchase Agreement by and between the Company and Timothy J. Ryan under which Mr. Ryan agrees to purchase 16,667 shares of the Common Stock of the Company, dated as of November 17, 1997(5) 10.12 Form of Promissory Note made in favor of Nuvrty, Inc., the Ocean Trust and the Grandview Trust(6) 10.13 Form of Term Loan Agreement made in favor of Nuvrty, Inc., the Ocean Trust and the Grandview Trust(6) 10.14 Form of Security Agreement made in favor of Nuvrty, Inc., the Ocean Trust and the Grandview Trust(6) 10.15 Form of Warrant Agreement made in favor of Nuvrty, Inc., the Ocean Trust and the Grandview Trust(6) 10.16 Form of Intercreditor Agreement made in favor of Nuvrty, Inc., the Ocean Trust and the Grandview Trust(6) 10.17 Form of Common Stock and Option Purchase Agreement with Franchise Mortgage Acceptance Company dated as of April 3, 1998(7) 10.18 Separation and Release Agreement dated January 28, 1998 with Kerry W. Coin(7) 10.19 Employment Agreement with Ann Wride dated April 8, 1998(8) 10.20 Employment Agreement with Dolf Berle dated April 8, 1998(9) 10.21 Employment Agreement with Catherine Saar dated June 11, 1998(9) 10.22 Form of Franchise Agreement(10) 10.23 Form of Area Development Agreement(10) 10.24 Employment Agreement with Martin Diedrich dated June 29, 1998(3) 10.25 1997 Non-Employee Director Stock Option Plan and Agreement* 11.1 Statement re: Computation of Per Share Earnings(11) 21.1 List of Subsidiaries(3) 24.1 Power of Attorney(11) 27.1 Financial Data Schedule(11)
64 - --------------- * Filed herewith (1) Previously filed as an exhibit to Diedrich Coffee's Registration Statement on Form S-1(No. 333-08633), as amended, as declared effective by the Securities and Exchange Commission on September 11, 1996. (2) Previously filed as Appendix A to Diedrich Coffee's Registration Statement on Form S-4, filed with the Securities and Exchange Commission on April 23, 1999. (3) Previously filed as an exhibit to Diedrich Coffee's Registration Statement on Form S-4, filed with the Securities and Exchange Commission on April 23, 1999. (4) Previously filed as an exhibit to Diedrich Coffee's Quarterly Report on Form 10-Q, for the period ended April 30, 1997, filed with the Securities and Exchange Commission on June 13, 1997. (5) Previously filed as an exhibit to Diedrich Coffee's Current Report on Form 8-K, filed with the Securities and Exchange Commission on November 25, 1997. (6) Previously filed as an exhibit to Diedrich Coffee's Quarterly Report on Form 10-Q, for the period ended October 29, 1997, filed with the Securities and Exchange Commission on December 11, 1997. (7) Previously filed as an exhibit to Diedrich Coffee's annual report on Form 10-K for the fiscal year ended January 28, 1998. (8) Previously filed as an exhibit to Diedrich Coffee's Quarterly Report on Form 10-Q, for the period ended April 29, 1998, filed with the Securities and Exchange Commission on June 11, 1998. (9) Previously filed as an exhibit to Diedrich Coffee's Quarterly Report on Form 10-Q, for the period ended July 29, 1998, filed with the Securities and Exchange Commission on September 10, 1998. (10) Previously filed as an exhibit to Diedrich Coffee's Quarterly Report on Form 10-Q, for the period ended October 28, 1998, filed with the Securities and Exchange Commission on December 11, 1998. (11) Previously filed as an exhibit to Diedrich Coffee's Annual Report on Form 10-K for the fiscal year ended January 27, 1999, as filed with the Securities and Exchange Commission on April 27, 1999. EX-10.25 2 1997 NON-EMPOLYEE DIRECTOR STOCK OPTION PLAN 1 EXHIBIT 10.25 1997 NON-EMPLOYEE DIRECTOR STOCK OPTION PLAN AND AGREEMENT This 1997 Non-Employee Director Stock Option Plan and Agreement, dated as of April 25, 1997 (the "AGREEMENT") is entered into by and among Diedrich Coffee, Inc., a Delaware corporation (the "COMPANY"), on the one hand, and Peter Churm and Paul C. Heeschen (individually, the "GRANTEE" and collectively, the "GRANTEES") on the other hand. RECITALS A. Messrs. Churm and Heeschen have served as independent directors of the Company since the Company's initial public offering in September 1996. In light of the operational challenges and management transition that the Company has experienced this year, the independent directors have been called upon to work closely with the Company's officers providing invaluable advice and direction beyond that which would ordinarily be expected from members of the Board of Directors. B. In appreciation of the service rendered by the independent directors and for the purpose of encouraging and rewarding their continuing contributions to the performance of the Company and further aligning their interests with the interests of the Company's stockholders, the Company believes that it is in the best interests of the Company and its stockholders to grant to each of the Grantees options to purchase 10,000 shares of common stock, $0.01 par value per share (the "COMMON STOCK"), of the Company . AGREEMENT NOW, THEREFORE, to evidence the grant of options by the Company and to set forth the terms and conditions of the grant of options, the Company and Grantees hereby agree as follows: 1. DEFINITIONS. The following terms, as used in this Agreement, have the meanings ascribed to them in this Section 1. (a) "BOARD" means the Board of Directors of the Company. (b) "CLOSING PRICE" means the closing price on any given trading day of the Common Stock on the Nasdaq National Market (or any subsequent exchange or market system upon which the Company's Common Stock is principally traded) as reported in the Transaction Index of the Wall Street Journal. (c) "EXCHANGE ACT" means the Securities Exchange Act of 1934, as amended. (d) "EXERCISE DATE" means any date on which Grantee exercises Options. 2 (e) "EXERCISE DATE VALUE" means the product of: (i) the number of shares of Common Stock delivered to the Company and (ii) the Closing Price of the Common Stock on the Exercise Date. (f) "EXERCISE SHARES" means those shares of Common Stock with respect to which Options are being exercised. (g) "NON-EMPLOYEE DIRECTOR" means a duly elected or appointed member of the Company's Board of Directors who is not and has not since the beginning of the Company's most recently completed fiscal year been an employee of or a compensated consultant to the Company or any of its affiliates. (h) "OPTIONS" means options to purchase shares of Common Stock granted under this Agreement. (i) "SECURITIES ACT" means the Securities Act of 1933, as amended. 2. GRANT OF OPTIONS. The Company hereby grants options to Grantees as follows: (a) The Company grants to Mr. Churm, effective as of the date hereof, Options to purchase up to 10,000 shares of Common Stock on the terms and subject to the conditions set forth herein; and (b) The Company grants to Mr. Heeschen, effective as of the date hereof, Options to purchase up to 10,000 shares of Common Stock on the terms and subject to the conditions set forth herein. 3. EXERCISABILITY AND EXERCISE PRICES. The Options will become exercisable at an option exercise price of $2.75 per share of Common Stock on April 25, 1998, if the Grantee has remained a Non-Employee Director for the entire period from the date hereof to April 25, 1998. Any Options that have not become exercisable at the time the Grantee ceases to be a Non-Employee Director shall terminate. 4. TERMINATION OF OPTIONS. (a) Unless an earlier termination date occurs as specified in Section 4(b), the Options will expire and become unexercisable (whether or not then exercisable) on the tenth (10th) anniversary of the date hereof ("EXPIRATION DATE"). (b) If a Grantee ceases to be a Non-Employee Director for any reason prior to the Expiration Date: (i) all Options that have not otherwise become exercisable, as of the date Grantee ceases to be a Non-Employee Director, will immediately terminate and become unexercisable; and (ii) all Options that have become exercisable will terminate and become unexercisable on and after the date one hundred eighty (180) days following the date of Grantee's termination of employment. 2 3 5. REGISTRATION OF OPTIONS. After execution of this Agreement, the Company, at its expense, shall file a registration statement on Form S-8 to register the issuance and exercise of the Options. 6. RESTRICTIONS ON EXERCISE. All options granted under the Plan shall be subject to the requirement that, if at any time the Company shall determine, in its discretion, that the listing, registration or qualification of the shares subject to options granted under the Plan upon any securities exchange or under any state or federal law, or the consent or approval of any government or regulatory body or authority, is necessary or desirable as a condition of, or in connection with, the granting of such an option or the issuance, if any, or purchase of shares in connection therewith, such option may not be exercised in whole or in part unless such listing, registration, qualification, consent or approval shall have been effected or obtained free of any conditions not acceptable to the Company. Unless the shares of stock to be issued upon exercise of an option granted under the Plan have been effectively registered under the Securities Act of 1933, as amended (the "Securities Act") as now in force or hereafter amended, the Company shall be under no obligation to issue any shares of stock covered by any option unless the person who exercises such option, in whole or in part, shall give a written representation and undertaking to the Company satisfactory in form and scope to counsel to the Company and upon which, in the opinion of such counsel, the Company may reasonably rely, that he or she is acquiring the shares of stock issued to him or her pursuant to such exercise of the option for his or her own account as an investment and not with a view to, or for sale in connection with, the distribution of any such shares of stock, and that he or she will make no transfer of the same except in compliance with any rules and regulations in force at the time of such transfer under the Securities Act, or any other applicable law or regulation, and that if shares of stock are issued without such registration, a legend to this effect may be endorsed upon the securities so issued and the Company may order its transfer agent to stop transfer of such shares. 7. NON-TRANSFERABILITY OF OPTIONS. None of the Options are assignable or transferable, in whole or in part, and may not, directly or indirectly, be offered, transferred, sold, pledged, assigned, alienated, hypothecated or otherwise disposed of or encumbered (including without limitation by gift, operation of law or otherwise) other than by will or by the laws of descent and distribution to the estate of Grantee upon his death, provided that the deceased Grantee's beneficiary or the representative of his estate acknowledge and agree in writing, in a form reasonably acceptable to the Board of Directors to be bound by this Agreement as if such beneficiary or the estate were Grantee. 8. WITHHOLDING. Whenever shares of Common Stock are to be issued pursuant to the exercise of Options, the Board of Directors may require the recipient of the shares of Common Stock to remit to the Company an amount sufficient to satisfy any applicable federal, state and local tax withholding requirements. Upon request by Grantee, the Company may also withhold shares of Common Stock to satisfy applicable withholding requirements, subject to any rules adopted by the Board of Directors regarding compliance with applicable law, including, but not limited to, Section 16(b) of the Exchange Act. 3 4 9. MANNER OF EXERCISE. (a) To the extent that the Options have become and remain exercisable as provided in Sections 3 and 4, and subject to such reasonable administrative regulations as the Board of Directors may adopt, the Options may be exercised, by written notice to the Board of Directors, specifying the number of Exercise Shares and the Exercise Date. On or before the Exercise Date, Grantee shall deliver to the Company full payment for the Options being exercised in cash, or cash equivalent satisfactory to the Board of Directors, and in an amount equal to the aggregate purchase price for the Exercise Shares. (b) Subject to the discretion of the Board of Directors, Grantee may, in lieu of cash, either: (i) deliver shares of Common Stock having an Exercise Date Value equal to the purchase price of the Exercise Shares; or (ii) deliver a combination of cash and shares of Common Stock with an aggregate value and Exercise Date Value equal to the purchase price of the Exercise Shares, subject to such rules and regulations as may be adopted by the Board of Directors to provide for the compliance of such payment procedure with applicable law, including Section 16(b) of the Exchange Act. (c) The Board of Directors may require Grantee to furnish or execute such other documents as the Board of Directors reasonably deems necessary: (i) to evidence such exercise and (ii) to comply with or satisfy the requirements of the Securities Act, applicable state securities laws or any other law. 10. NO RIGHTS AS STOCKHOLDER. Grantee will have no voting or other rights as a stockholder of the Company with respect to any shares of Common Stock covered by the Options until the exercise of such Options and the issuance of a certificate or certificates to him for such shares of Common Stock. No adjustment will be made for dividends or other rights for which the record date is prior to the issuance of such certificate or certificates. 11. CAPITAL ADJUSTMENTS. The number and any applicable option price of the shares of Common Stock covered by the Options will be proportionately and appropriately adjusted by the Board of Directors to reflect any stock dividend, stock split or share combination of the Common Stock or any recapitalization of the Company. Subject to any required action by the stockholders of the Company, in any merger, consolidation, reorganization, exchange of shares, liquidation or dissolution, the Options will pertain to the securities and other property, if any, that a holder of the number of shares of Common Stock covered by the Options would have been entitled to receive in connection with such event. 12. REORGANIZATIONS; MERGERS; CHANGES IN CONTROL. Subject to the other provisions of this Section 12, if the Company shall consummate any reorganization or merger or consolidation in which holders of shares of the Company's Common Stock are entitled to receive in respect of such shares any other consideration (including, without limitation, a different number of such shares), each option outstanding under this Agreement shall thereafter be exercisable, in accordance with the Agreement, only for the kind and amount of securities, cash and/or other property receivable upon such reorganization or merger or consolidation by a holder of the same number of shares of Common Stock as are subject to that option immediately prior to 4 5 such reorganization or merger or consolidation, and any appropriate adjustments will be made to the exercise price thereof. In addition, if a Change in Control occurs and in connection with such Change in Control any recipient of an option granted under the Plan ceases to be a director of the Company, then such recipient shall have the right to exercise his or her options granted under the Plan in whole or in part during the applicable time period provided in Section 4 without regard to any vesting requirements. For purposes hereof, but without limitation, a director will be deemed to have ceased to be a director of the Company in connection with a Change in Control if such director (i) is removed by or resigns upon request of a Person (as defined in paragraph (a) below) exercising practical voting control over the Company following the Change in Control, or a person acting upon authority or at the instruction of such Person, or (ii) is willing and able to continue as a director of the Company but is not re-elected to or retained on the Company's Board of Directors by the Company's stockholders through the stockholder vote or consent action for election of directors that precedes and is taken in connection with, or next follows, the Change of Control. For purposes hereof, a "Change in Control" means the following and shall be deemed to occur if any of the following events occur: (a) Any person, entity or group, within the meaning of Section 13(d) or 14(d) of the Exchange Act, but excluding the Company and its subsidiaries and any employee benefit or stock ownership plan of the Company or its subsidiaries and also excluding an underwriter or underwriting syndicate that has acquired the Company's securities solely in connection with a public offering thereof (such person, entity or group being referred to herein as a "Person"), becomes the beneficial owner (within the meaning of Rule 13d-3 promulgated under the Exchange Act) of 50% or more of either the then outstanding shares of Common Stock or the combined voting power of the Company's then outstanding securities entitled to vote generally in the election of directors; or (b) Individuals who, as of the effective date hereof, constitute the Board of Directors of the Company (the "Incumbent Board") cease for any reason to constitute at least a majority of the Board of Directors of the Company, provided that any individual who becomes a director after the effective date hereof whose election, or nomination for election by the Company's stockholders, is approved by a vote of at least a majority of the directors then comprising the Incumbent Board shall be considered to be a member of the Incumbent Board unless that individual was nominated or elected by any Person having the power to exercise, through beneficial ownership, voting agreement and/or proxy, 20% or more of either the then outstanding shares of Common Stock or the combined voting power of the Company's then outstanding voting securities entitled to vote generally in the election of directors, in which case that individual shall not be considered to be a member of the Incumbent Board unless such individual's election or nomination for election by the Company's stockholders is approved by a vote of at least two-thirds of the directors then comprising the Incumbent Board; or (c) Consummation by the Company of the sale or other disposition by the Company of all or substantially all of the Company's assets or a reorganization or merger or consolidation of the Company with any other person, entity or corporation, other than 5 6 (i) a reorganization or merger or consolidation that would result in the voting securities of the Company outstanding immediately prior thereto (or, in the case of a reorganization or merger or consolidation that is preceded or accomplished by an acquisition or series of related acquisitions by any Person, by tender or exchange offer or otherwise, of voting securities representing 5% or more of the combined voting power of all securities of the Company, immediately prior to such acquisition or the first acquisition in such series of acquisitions) continuing to represent, either by remaining outstanding or by being converted into voting securities of another entity, more than 50% of the combined voting power of the voting securities of the Company or such other entity outstanding immediately after such reorganization or merger or consolidation (or series of related transactions involving such a reorganization or merger or consolidation), or (ii) a reorganization or merger or consolidation effected to implement a recapitalization or reincorporation of the Company (or similar transaction) that does not result in a material change in beneficial ownership of the voting securities of the Company or its successor; or (d) Approval by the stockholders of the Company or an order by a court of competent jurisdiction of a plan of liquidation of the Company. 13. NOTICES. All notices and other communications required or permitted to be given under this Agreement shall be in writing and shall be deemed to have been given if delivered personally or sent by certified or express mail, return receipt requested, postage prepaid, or by any recognized international equivalent of such delivery, to the Company, or Grantee, as the case may be, at the address of the Company's principal executive office. All such notices and communications shall be deemed to have been received on the date of delivery or on the third business day after the mailing thereof. 14. BINDING EFFECT; BENEFITS. This Agreement shall be binding upon and inure to the benefit of the parties to this Agreement and their respective successors and assigns. Nothing in this Agreement, express or implied, is intended or shall be construed to give any person other than the parties to this Agreement or their respective successors or assigns any legal or equitable right, remedy or claim under or in respect of any agreement or any provision contained herein. 15. AMENDMENT. This Agreement may be amended, modified or supplemented only by a written instrument executed by Grantees and the Company. 16. APPLICABLE LAW. This Agreement shall be governed by and construed in accordance with the law of the State of Delaware, regardless of the law that might be applied under principles of conflict of laws. 17. SECTION AND OTHER HEADINGS. The section and other headings contained in this Agreement are for reference purposes only and shall not affect the meaning or interpretation of this Agreement. 6 7 \ 18. COUNTERPARTS. This Agreement may be executed in any number of counterparts, each of which shall be deemed to be an original and all of which together shall constitute one and the same instrument. IN WITNESS WHEREOF, the Company and Grantees have executed this Agreement as of the date first above written. DIEDRICH COFFEE, INC., a Delaware corporation BY: /s/ MARTIN DIEDRICH ------------------------------- NAME: MARTIN DIEDRICH TITLE: VICE CHAIRMAN THE GRANTEES /s/ PETER CHURM ----------------------------------- PETER CHURM /s/ PAUL C. HEESCHEN ----------------------------------- PAUL C. HEESCHEN 7 -----END PRIVACY-ENHANCED MESSAGE-----