10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-K

(Mark One)

þ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended June 28, 2006

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number 0-21203

DIEDRICH COFFEE, INC.

(Exact Name of Registrant as Specified in Its Charter)

Delaware	33-0086628
(State or Other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification No.)

28 Executive Park, Suite 200

Irvine, California 92614

(Address of Principal Executive Offices)

Registrant’s telephone number, including area code

(949) 260-1600

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 if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes  [    ]  No  [X]

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes  [    ]  No  [X]

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.  [    ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):  Large accelerated filer  [    ]    Accelerated filer  [    ]    Non-accelerated filer  [X]

Indicate by check mark if the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  [    ]  No  [X]

The aggregate market value of the registrant’s common stock held by non-affiliates of the registrant as of December 14, 2005 was $14,462,653.

The number of shares of the registrant’s common stock outstanding, as of September 22, 2006 was 5,346,270.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s proxy statement for its 2006 annual meeting of stockholders, which will be filed with the Securities and Exchange Commission within 120 days of June 28, 2006, are incorporated by reference into Part III of this Report.

TABLE OF CONTENTS

		Page
A Warning About Forward-Looking Statements		1
	PART I
Item 1.	Business	1
Item 1A.	Risk Factors	13
Item 1B.	Unresolved Staff Comments	19
Item 2.	Properties	19
Item 3.	Legal Proceedings	20
Item 4.	Submission of Matters to a Vote of Security Holders	20
	PART II
Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	20
Item 6.	Selected Financial Data	20
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	22
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	37
Item 8.	Financial Statements and Supplementary Data	38
Item 9.	Changes in and Disagreements With Accountants on Accounting and Financial Disclosure	38
Item 9A.	Controls and Procedures	39
Item 9B.	Other Information	39
	PART III
Item 10.	Directors and Executive Officers of the Registrant	39
Item 11.	Executive Compensation	39
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	39
Item 13.	Certain Relationships and Related Transactions	40
Item 14.	Principal Accountant Fees and Services	40
	PART IV
Item 15.	Exhibits and Financial Statement Schedules	40
	Signatures	41
	Financial Statements	F-1
	Index to Exhibits	S-1

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A WARNING ABOUT FORWARD-LOOKING STATEMENTS

We make forward-looking statements in this annual report that are subject to risks and uncertainties. These forward-looking statements include information about possible or assumed future results of our financial condition, operations, plans, objectives and performance. 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:

• the financial and operating performance of our retail operations;

• the timing and success of the pending sale of retail store locations to Starbucks Corporation;

• our ability to maintain profitability over time;

• the successful execution of our growth strategies;

• our franchisees’ adherence to our practices, policies and procedures;

• the impact of competition; and

• the availability of working capital.

Additional risks and uncertainties are described elsewhere in this report and in detail under “Item 1A. Risk Factors. You are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s analysis only as of the date of this annual report. We undertake no obligation to revise or update any forward-looking statements, whether as a result of new information, future events or changed circumstances. Unless the context requires otherwise, the terms “we,” “us,” and “our” refer to Diedrich Coffee, Inc., a Delaware corporation, and its predecessors and subsidiaries.

PART I

Item 1. Business.

Overview

Diedrich Coffee, Inc. is a specialty coffee roaster, wholesaler and retailer. We sell brewed, espresso-based and various blended beverages primarily made from our own fresh roasted premium coffee beans, as well as light food items, whole bean coffee and accessories, through our company operated and franchised retail locations. We also sell whole bean and ground coffee on a wholesale basis through a network of distributors in the Office Coffee Service (“OCS”) market and to other wholesale customers, including restaurant chains and other retailers. Our brands include Diedrich Coffee, Gloria Jean’s, and Coffee People. As of June 28, 2006, we owned and operated 52 retail locations, of which up to 40 retail locations may be sold to Starbucks Corporation (as discussed in “Recent Developments” in the section immediately below and “Item 7 Overview—Recent Developments”), and franchised 148 other retail locations under these brands, for a total of 200 retail coffee outlets. Although the specialty coffee industry is presently dominated by a single company, which operates over eight thousand domestic retail locations, we are one of the nation’s largest specialty coffee retailers with annual system-wide revenues in excess of $116 million. System-wide revenues include sales from company operated and franchise locations. Our retail units are located in 33 states. As of June 28, 2006, we also had over 800 wholesale accounts with OCS distributors, chain and independent restaurants, and others. In addition, we operate a large coffee roasting facility in central California that supplies freshly roasted coffee to our franchise and retail locations and wholesale accounts.

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Our Gloria Jean’s coffee stores offer an extensive variety of the finest quality flavored whole bean coffees, as well as an assortment of coffee related merchandise, accessories, porcelain novelties and gift items, in addition to coffee-based beverages. The critical components for each of our retail locations include high quality, fresh roasted coffee and superior customer service by knowledgeable employees.

Our Diedrich Coffee brand is differentiated from other specialty coffee companies by roasting our coffee beans with the experience we have gained over several decades. 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. Our coffeehouses offer a warm, friendly environment specifically designed to encourage guests to enjoy their favorite beverages while lingering with friends and business associates, or relaxing alone in comfort. Ample seating is augmented by sofas and comfortable chairs to create intimate nooks for meeting and relaxing. Many of our coffeehouses feature local musicians who provide live entertainment from time to time during the week.

Recent Developments

On September 14, 2006, we and Starbucks Corporation, a Washington corporation (“Starbucks”), entered into an asset purchase agreement pursuant to which Starbucks has agreed to purchase our leasehold interests in most of the 47 locations where we operate retail stores under the Diedrich Coffee and Coffee People brands (the “Company Stores”), along with certain related fixtures and equipment, improvements, prepaid items, and ground lease improvements, and to assume certain liabilities as set forth in the asset purchase agreement (collectively, the “Transaction”).

Pursuant to the asset purchase agreement, Starbucks will pay us up to $13,520,000 in cash, which includes payment of $120,000 as consideration for our agreement to a non-compete provision. The actual amount paid by Starbucks under the asset purchase agreement is dependent on which and how many of the Company Stores are ultimately transferred to Starbucks. Ten percent of the amount paid to us upon transfer of the Company Stores will be deposited into an escrow fund to be held in connection with our indemnification obligations. The closing is expected to occur approximately 90 days after the date of the asset purchase agreement (the “Closing”), provided that certain conditions, including that a specified minimum number of Company Stores are transferred to Starbucks at Closing, are met. After the Closing, we and Starbucks have agreed to use commercially reasonable efforts to transfer certain remaining Company Stores until approximately 150 days after the date of the asset purchase agreement or such other longer period as agreed to by us and Starbucks.

We and Starbucks have made certain customary representations, warranties and covenants in the asset purchase agreement. Specifically, we have agreed that, subject to a “fiduciary-out” provision and payment of a break-up fee, we will not (i) take any action to solicit any proposal from, (ii) furnish any information to, or (iii) participate in any discussions with, any entity other than Starbucks regarding any transaction involving the Company Stores. Upon termination of the asset purchase agreement under certain circumstances, including the Company’s entry into an alternative transaction involving the Company Stores, we shall pay Starbucks’ actual fees and expenses incurred in connection with the Transaction up to a maximum amount of $500,000; provided, however, that Starbucks is entitled to a minimum of $250,000, regardless of its actual fees and expenses. The asset purchase agreement also contains customary indemnification provisions for certain claims and provides for a basket of $100,000 and a cap of $2,000,000 for breaches of our representations and warranties contained in the asset purchase agreement.

The consummation of the Transaction is subject to certain customary conditions, including: approval of the Transaction by our stockholders; a specified minimum number of Company Stores transferred to Starbucks at Closing; the receipt by Starbucks of permits and approvals for at least 70% of certain Company Stores that are transferred if the Closing occurs within 90 days of the date of the asset purchase agreement; receipt of lease extensions of at least 10 years for at least 40% of certain Company Stores that are transferred; and, receipt of

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consents to the assignment of the leases for each of the Company Stores that are transferred, with estoppel provisions being agreed to for at least 50% of the Company Stores that are transferred. The asset purchase agreement contains customary termination provisions and may be terminated by either us or Starbucks if the Closing does not occur within 150 days from the date of the asset purchase agreement. We may also terminate the asset purchase agreement if the Closing has not occurred within 90 days, provided that Starbucks has not used commercially reasonable efforts to achieve the Closing.

As part of the asset purchase agreement, we have agreed to a non-compete provision that for three years after the Closing restricts our ability to operate or have any interest in the ownership or operation of any entity operating any retail specialty coffee stores in any city where a Company Store is presently located. The non-compete provision applies only to stores opened after the date of the asset purchase agreement and does not apply to (1) any retail stores operated under the “Gloria Jean’s” brand name, (2) wholesale sales to retail businesses that are not operated by us, or other non-retail businesses, or (3) the conversion of Company-operated stores existing on the date of the asset purchase agreement to franchise stores. We have also agreed that we will not solicit any Starbucks employee to enter our employment for three years after the Closing.

Sale of International Franchise Operations

On February 11, 2005, we completed the sale of our Gloria Jean’s international franchise operations. Proceeds from the sale of the 338 franchised units were a cash payment of $16,000,000 and notes of $7,020,000 payable over the next six years. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Sale of International Franchise Operations.”

Company Background

Our predecessor company, Carl E. Diedrich & Sons, Inc., commenced operations in Orange County, California in 1972 and changed its name to Diedrich Coffee when its first retail store opened. We incorporated in California in 1985. We remained a small, family operated business with only three retail locations until 1992. We grew rapidly from 1992 to 1996 through construction of new Diedrich Coffee coffeehouses in Orange County and the acquisition of coffeehouses operated under other brands in Houston, Denver and San Diego, all of which were converted into Diedrich Coffee coffeehouses. In August 1996, we reincorporated under Delaware law as Diedrich Coffee, Inc., and completed an initial public offering of our common stock in September 1996. On July 7, 1999, we acquired Coffee People, Inc. The Coffee People, Inc. brands included Gloria Jean’s, one of the leaders in the mall coffee store market, Coffee People, based primarily in Portland, Oregon, and Coffee Plantation, based primarily in Phoenix, Arizona. The Coffee Plantation coffeehouses have been sold or closed. We continue to operate three brands: Diedrich Coffee, Gloria Jean’s and Coffee People.

Industry Overview

According to the National Coffee Association of U.S.A., Inc. (the “NCA”), in 2006, 178.3 million adults, or 82% of the population over the age of 18, drank coffee daily or occasionally, which represents a 5.9 million-person increase from the 80% of the population over the age of 18 in 2004. The NCA also reported that daily and occasional consumption of gourmet coffee has increased over the past six years from 9.0% of the adult population in 2000 to over 16.0% of the adult population in 2006.

The United States coffee market consists of two distinct product categories:

n commercial ground roast, mass-merchandised coffee; and

n 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).

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We believe that several factors have contributed to the increase in demand for gourmet coffee including:

n greater consumer awareness of gourmet coffee as a result of its increasing availability;

n increased quality differentiation over commercial grade coffees by consumers;

n 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; and

n ease of preparation of gourmet coffees resulting from the increased use of automatic drip coffee makers and home espresso machines.

Our Business Model

Our business objective is a logical extension of our Mission Statement, which states: “We sell great coffee.” Therefore, our objective is to sell coffee, without compromising our commitment to quality. We buy only the finest quality green coffee beans available, fresh roast them with our proprietary recipes and subject them to a rigorous internal quality control process. We ensure that care is taken at each and every step of the production and distribution process to preserve that quality.

We principally sell our coffee through two distribution channels, and strive to target our resources to increase efficiency and profitability while growing the business within this framework. These two distribution channels are retail outlets and wholesale distribution. While each of these channels have different customers, cost structures, overhead requirements, competitors, and other fundamental differences, we believe our commitment to quality is essential to successful growth in both of these areas. Important financial information for each of our business segments can be found in Note 13 to our consolidated financial statements.

Retail Outlets

Our retail outlet distribution channel can be divided into two sub-channels, each with its own distinct business model, including differences in revenue and cost structure, overhead, and capital requirements. These two retail sub-channels are company operated retail outlets and franchised retail outlets. Despite the differences noted above, we view retail outlets as a single distribution channel primarily because our retail customers do not make any distinction between company and franchise operated locations. The critical success factors are, therefore, the same for each type of retail location, whether company operated or franchised—quality of product, service and atmosphere. The economic model and cost structures are also the same for each type of location at the retail unit level, notwithstanding their different direct financial impacts on us in our roles as both an operator and franchiser of retail outlets. Furthermore, the potential contribution of any given outlet, as measured by the amount of roasted coffee produced through our roasting plant, is the same.

Presently, our largest brand is Gloria Jean’s, which consists of retail units located throughout the United States. Over 97% of Gloria Jean’s retail units are franchised. Our Diedrich Coffee brand has a higher concentration of company operated units, with 76% of retail locations operated by us. Diedrich Coffee stores are located primarily in Orange County, California, although there are a number of Diedrich Coffee locations in Los Angeles, San Diego, Denver, and Houston. We also operate retail coffee outlets under a third brand, Coffee People, all of which except one are currently company operated and located in Oregon.

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The following table summarizes the relative sizes of each of our brands on a unit count basis and changes in unit count for each brand over the past two years.

	Units at June 30, 2004	Opened	Closed/ Sold (E)		Net transfers between the Company and Franchise (A)		Units at June 29, 2005	Opened	Closed/ Sold		Net transfers between the Company and Franchise (B)		Units at June 28, 2006 (F)
Gloria Jean’s Brand
Company Operated	10	1	(1	)	1		11	1	(1	)	(6	)	5
Franchise – Domestic	137	11	(15	)	(1	)	132	16	(15	)	6		139
Franchise – International
Australia	196	46	(242	)	—		—	—	—		—		—
Far East/Asia (C)	19	—	(19	)	—		—	—	—		—		—
Mexico	17	—	(17	)	—		—	—	—		—		—
Other (D)	50	14	(64	)	—		—	—	—		—		—
Total Franchise – International	282	60	(342	)	—		—	—	—		—		—
Subtotal Gloria Jean’s	429	72	(358	)	—		143	17	(16	)	—		144
Diedrich Coffee Brand
Company Operated	23	3	—		—		26	1	—		(1	)	26
Franchise – Domestic	7	1	(1	)	—		7	1	(1	)	1		8
Subtotal Diedrich	30	4	(1	)	—		33	2	(1	)	—		34
Coffee People Brand
Company Operated	23	3	(1	)	—		25	4	(7	)	(1	)	21
Franchise – Domestic	—	—	—		—		—	—	—		1		1
Subtotal Coffee People	23	3	(1	)	—		25	4	(7	)	—		22
Total	482	79	(360	)	—		201	23	(24	)	—		200

(A) Two company operated Gloria Jean’s coffeehouses were transferred to franchisees during fiscal year 2005 and three franchisee operated coffeehouses were transferred from franchisees to the Company.

(B) Six company operated Gloria Jean’s, one company operated Diedrich Coffee, and one company operated Coffee People coffeehouses were transferred to franchisees during fiscal year 2006.

(C) Includes Japan and Korea.

(D) Includes Guam, Indonesia, Ireland, Turkey, Malaysia, New Zealand, Philippines, United Arab Emirates, Romania, South Africa and Thailand.

(E) On February 11, 2005, we sold the international franchise rights to 338 Gloria Jean units in exchange for a cash payment of $16,000,000 and notes of $7,020,000 payable over the next six years, as more fully described in Note 1 to the Consolidated Financial Statements attached herein.

(F) On September 14, 2006, we and Starbucks Corporation entered into an agreement pursuant to which Starbucks has agreed to purchase our leasehold interests in most of the 47 locations where we operate retail stores under the Diedrich Coffee and Coffee People brands. See “Recent Developments” above and “Item 7 Overview—Recent Developments”.

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We recognize the importance of our brands to our success in both the retail and wholesale areas of our business. We therefore devote considerable energy to maintain distinct brand identities. Our brands are differentiated by coffees offered, other product categories offered, format and type of retail location, advertising message, and trade dress.

Gloria Jean’s

Gloria Jean’s is a leader in the specialty grade, flavored coffee market, with 144 coffee stores in 33 states throughout the United States. Many of our Gloria Jean’s coffee stores are located in high traffic shopping malls. The consumer traffic pattern in our mall-based stores is driven by mall hours and dynamics. Our mall-based stores are generally busiest on weekends and during holiday seasons. The typical Gloria Jean’s domestic coffee store is staffed with a manager and a staff of 10 to 15 part-time hourly employees who fill the operating shifts. Gloria Jean’s outlets tend to open earlier than most mall stores, but in general, operating hours coincide with mall hours. In addition to coffee beverages and fresh roasted whole bean coffees, Gloria Jean’s carries a wide selection of gift items, coffee accessories, and a small selection of bakery items to complement beverage sales. The Gloria Jean’s stores currently sell from 32 to 53 varieties of flavored and non-flavored coffees, with beverage sales representing approximately 50% of overall sales.

The success of Gloria Jean’s coffee stores in malls depends on three critical components: product quality, product selection, and service.

Product Quality.    Gloria Jean’s has been a pioneer in developing high quality, flavored, specialty coffees, and continues to be a leader in the sale of flavored coffees. Gloria Jean’s flavored coffees begin with a top quality, single-origin coffee that is roasted and then coated with proprietary flavorings.

Product Selection.    For those stores in a mall environment, the shopping experience is integral to a coffee store, and sales of whole bean coffee and coffee-related merchandise tend to represent a large percentage of sales. Offering as many as 53 varieties of flavored coffees, a wide variety of hot and cold beverages, and a wide selection of gift items is important. A major benefit of mall retailing is its captive consumer base. The primary function of Gloria Jean’s marketing is to entice consumers with eye-catching signage and window displays. A large selection of products helps to attract both new and repeat customers. Once inside a mall, consumers are unlikely to leave to purchase coffee, refreshments or gifts similar to those offered by Gloria Jean’s. Mall employees are also captive consumers and represent an important component of our customer base.

Service.    Friendly and efficient customer service is always critical in any retail setting, and is especially important for those stores in a mall environment, where shoppers are often in a hurry and have many choices. Because of the opportunity for repeat customers, it is essential that customers receive excellent service.

Diedrich Coffee

Our typical Diedrich Coffee neighborhood coffeehouse is staffed with one or two managers and a staff of 12 to 25 part-time hourly employees who fill the operating shifts. Additionally, local entertainment is often offered 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.

In addition to coffee beverages and fresh roasted whole bean coffees, all of our Diedrich Coffee 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 sell more than 25 different selections of regular and decaffeinated roasted whole bean coffees, and they carry select coffee-related merchandise items. The success of a Diedrich Coffee coffeehouse depends upon three critical components: product quality, service and ambiance.

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Product Quality.    Our management team includes a number of coffee experts with years of specialty coffee industry experience in purchasing and roasting coffee and in training our coffeehouse team members. Through these key personnel, we are able to identify and purchase exceptional coffees and roast them to perfection. In addition they share their expertise with our coffeehouse team members in our training program, “Coffee University.”

Service.    Our coffeehouses deliver specific consumer benefits that address a wide range of otherwise unmet needs in suburban neighborhoods in the United States. As a neighborhood coffeehouse, we are the non-alcoholic alternative to the corner pub. Our employees greet regular customers by name and acknowledge all patrons by name at the point of drink pick-up. Although a large percentage of coffeehouse business is quick morning coffee pick-up, where speed is an important aspect of our overall service, our coffeehouses place an emphasis on hospitality and customer interaction to encourage development of strong afternoon and evening business. This is complemented by our selection 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 visit the coffeehouse.

Ambiance.    Our coffeehouses are specifically designed to encourage guests to linger with friends and business associates, or to relax alone in comfort. Ample seating is augmented with 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. A signature element of our full size coffeehouses is a coffee bar, where customers can sit at a barstool and watch the barista prepare espresso-based drinks, similar to the way patrons in traditional pubs and taverns interact with the bartender and other customers at the bar.

Wholesale Distribution

As of June 28, 2006, we had over 800 coffee wholesale accounts not affiliated with our retail locations, which purchase coffee from us under both the Diedrich Coffee and Gloria Jean’s brands. Our current wholesale accounts are in the OCS (Office Coffee Services) market, chain restaurants, independent restaurants and other hospitality industry accounts and specialty retailers. Additionally, our franchise agreements require both Gloria Jean’s and Diedrich Coffee franchisees to purchase substantially all of their coffee from us, and we record a wholesale gross profit on such sales.

OCS Market

During fiscal 2000, we entered into a licensing agreement with Keurig, Inc. whereby we utilize Keurig’s patented single service coffee brewing technology and its extensive distribution channels within the OCS market. In addition to Keurig single-serve K-Cups^®, we sell our premium coffees to OCS distributors in whole bean and ground coffee form for use in traditional coffee brewing equipment found in most office environments. In addition to being a leader in office-based single-cup brewing choices, Keurig is growing in the home-based brewer area. Keurig brewers are currently sold in over 5,000 retail locations including Macy’s, Bloomingdale’s, Target, Linens ’n Things, and Bed, Bath & Beyond. We are actively participating in this retail channel with the sale of K-cups through many of these retailers and the sale of at-home brewers and K-cups in most of our company and franchise stores and internet web stores.

On May 2, 2006, Green Mountain Coffee Roasters, Inc. and Keurig, Inc. announced they had agreed to a transaction in which Green Mountain Coffee would acquire all the outstanding shares of Keurig, Inc. that the Company did not already own. After the acquisition, Keurig would be a wholly-owned subsidiary of Green Mountain Coffee.

We do not anticipate any negative effects to our licensing agreement resulting from Green Mountain’s acquisition of Keurig, Inc. There is, however, no assurance that we will be able to extend or renew our licensing agreement with Keurig, in which case, we would lose revenues from this business.

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Chain Restaurants

As specialty coffee has grown in overall popularity, restaurant customers are demanding a high quality cup of coffee as a supplement to a meal. Our chain accounts include Ruby’s restaurants, Ruth’s Chris Steakhouse (California and Arizona locations), Pat and Oscar’s restaurants, Islands restaurants, and Marie Callender’s restaurants. We not only supply coffee to these customers, but also approve their equipment and train their employees to ensure that the quality of coffee served meets our rigorous quality standards. It is common for our chain restaurant wholesale customers to specify in their menus that they serve Diedrich Coffee or Gloria Jean’s coffee, which provides us with additional exposure to the restaurants’ patrons.

Other Wholesale Accounts

We also supply coffee on a wholesale basis to a number of smaller, often independent, operators in the restaurant and hospitality industries and to specialty retailers. These wholesale accounts are typically located in the same geographic areas where our retail outlets have created brand awareness and demand. We are careful to balance the benefit of new wholesale accounts near our existing retail outlets against the risk of “cannibalization” of these units. We believe that this risk can be successfully managed. Many of our wholesale accounts, such as hotels, restaurants, golf course snack bars and airport concessions have their own “captive” customer base. In such cases, the risk of cannibalization is minimal, since a customer would not likely stop their activity in such locations to visit one of our coffeehouses or mall based coffee stores for a beverage, and then return to their previous activity at those wholesale customer locations. Additionally, if sales conflicts arise as we develop new retail locations in the future, we can cease selling to then-existing wholesale accounts.

Growth Strategy

Retail Segment Growth.    Under a non-compete provision in the asset purchase agreement with Starbucks, we are restricted for a period of three years after the asset sale closes in our ability to open any new company-operated or franchised Diedrich Coffee and Coffee People coffeehouses in any city in which Diedrich Coffee or Coffee People coffeehouses operated on the date that we and Starbucks entered into the asset purchase agreement. The non-compete provision does not restrict our ability to open retail Gloria Jean’s stores and does not apply to wholesale sales to retail businesses that are not operated by us or other non-retail businesses or the conversion of our stores existing on the date of the asset purchase agreement to franchise stores. See “Recent Developments” above and “Item 7 Overview—Recent Developments”.

As a result of the proposed asset sale to Starbucks, we expect any future growth in our retail segment to occur in two ways: via comparable store sales growth in each of our retail brands and from new retail unit growth. We expect that new unit growth in the near term will be achieved through the development of new Gloria Jean’s retail locations, by us and by franchisees. We believe that the resources we recently invested in our Gloria Jean’s franchising infrastructure will allow us to resume net growth in our domestic store count under the Gloria Jean’s brand.

Development of new Gloria Jean’s retail locations by us will be undertaken on a very selective basis. New company store development will be done primarily for the purpose of facilitating new franchise development. Therefore, increased development of new retail units by us will likely be accompanied by increased sales of company operated retail units to franchisees. For a variety of reasons, retail units sold by us to franchisees in any given period may not necessarily coincide precisely with the specific new units developed by us in that same period. Development of new retail units by us is expected to support new franchise development in a number of ways, including opportunistically obtaining control of desirable locations as they become available, increasing awareness of our specialty coffee brands by real estate developers and landlords of prime retail properties as they develop new retail venues, and by prospective retail coffeehouse customers, improving the cost effectiveness of architectural plans for new prototypes, leveraging purchasing efficiencies system-wide for new unit equipment and fixtures packages, and increasing awareness among prospective franchisees and their lenders.

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Gloria Jean’s Franchise Growth.    Since the acquisition of the Gloria Jean’s brand in 1999, we have made a number of modifications to the Gloria Jean’s franchising business model to strengthen the Gloria Jean’s system. A new form of franchise agreement was adopted which incorporated many provisions common in other successful franchise systems. Screening of financial qualifications of franchise candidates has been improved in terms of consistency and accuracy. Franchisees are now encouraged to obtain their own master leases directly from mall owners, rather than subleasing their locations from Gloria Jean’s. Franchisees are required to hire their own architects and contractors to develop new Gloria Jean’s locations to approved specifications. Our training program has been completely redesigned in order to improve the quality of store level operations, product quality, and the consistency of brand standards. Although we believe that these and other changes to the Gloria Jean’s franchising model will ultimately result in a stronger Gloria Jean’s franchise system, they may result in slower domestic franchise growth in the near term.

Another factor we must overcome in the near term to resume domestic unit growth for Gloria Jean’s is a shortage of projects in our new unit development “pipeline,” or inventory of new unit deals in progress. This shortage resulted from our focus on improving the foundation for future franchise development during the past several years since we acquired the Gloria Jean’s brand, rather than on opening new retail units. As part of our efforts to strengthen our existing retail base, it was necessary to allow many of the weaker performing locations to close. Additional gaps in the flow of new franchise units resulted from several periods where our franchise registration status, which is required by law to sell new franchises, was temporarily interrupted during certain periods when our financial position was less stable than it is today, and frequent updates of our registration were required.

Although there were only five “premature” franchise unit closures (closures prior to the natural expiration of the underlying master lease) during the most recent fiscal year, there are an average of approximately 9-12 franchise units which reach their “natural” expiration annually, and it may not make economic sense to renew many of these locations based on changes in the retail tenant mix, desirability of the location, increases in rent relative to sales levels, and various other factors. Therefore, it may be some time before we are able to open enough new domestic retail units to offset the number of closures during the same time period for net growth in domestic retail unit count.

Diedrich Coffee Franchise Growth.     On September 14, 2006, we announced that we had entered into an asset purchase agreement to sell most of our 47 company-owned locations to Starbucks Corporation as part of our plan to narrow the focus of the retail side of the business to our Gloria Jean’s franchise operations. The eight franchisee-owned Diedrich Coffee stores currently opened are not directly affected by the proposed sale transaction or other strategic changes. However, in light of the asset purchase agreement, we have temporarily suspended our franchise growth strategy for the Diedrich and Coffee People brands.

As part of the agreement, we agreed to a non-compete provision that for three years after the transaction closing restricts our ability to franchise any new Diedrich or Coffee People coffeehouses in any city where a company store was previously located. The non-compete provision applies only to stores opened after the date of the asset purchase agreement.

As of June 28, 2006, there were no area development agreements giving any franchisee the right to develop a particular market area. Under the terms of our agreement to sell the Gloria Jean’s international operations, we agreed to not compete internationally with the purchaser using the Diedrich or Coffee People brands. That restriction expires on February 11, 2007.

Wholesale Distribution Growth.    We have taken significant steps to build our wholesale sales organization over the past two years, and we are actively seeking new distribution channels for our products. We intend to pursue continued growth within our OCS wholesale business by expanding the number of distributors that carry our Keurig Premium Coffee Systems^™ lines of coffees and our whole bean and ground coffee product lines. We also offer our coffees on our internet website, and we believe that this channel of distribution has long-term growth potential.

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Franchise Support Programs

We provide a variety of support services to our franchisees. These services include marketing, product sourcing, volume purchasing savings, training and business consultation.

We have established an intensive 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.

Marketing

Our primary marketing strategy is to develop the Gloria Jean’s brand in the U.S. and Puerto Rico through penetration of new and existing markets via franchise growth. Our wholesale sales in the OCS market, to chain restaurants, and to other customers also operate to increase the visibility of our brands. 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 our products. We use word-of-mouth, local store marketing and the inviting atmosphere of our mall coffee stores to drive brand awareness and comparable store sales growth. We also conduct in-store coffee tastings, provide brewed coffee at local neighborhood events, and donate coffee to local charities to increase brand awareness. We also conduct product trials in the communities where our coffeehouses and mall coffee stores are located.

Product Supply and Roasting

Sourcing.    We are committed to selling only the finest whole bean coffees and coffee beverages. Coffee beans are an agricultural product grown in over 50 countries in tropical regions of the world. The supply and price of coffee are subject to significant volatility and we depend upon our relationships with coffee producers, outside trading companies and exporters for our supply of green coffee. Supply and price can be affected by multiple factors in the producing countries, including weather, political and economic conditions. Although the broader coffee market generally treats coffee as a fungible commodity, the specialty coffee industry focuses on the highest grades of coffee. We purchase premium grade Arabica coffee beans that we believe to be the best available from each producing region.

Roasting.    We employ a roasting process that varies based upon the variety, quality, origin and physical characteristics of the coffee beans being roasted. Our master roasters are responsible for the green coffee bean 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 roast master determines and carefully controls the roasting conditions in an effort to maximize the flavor potential of each batch of coffee. The roast master 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.    We are committed to serving our customers beverages and whole bean products from freshly roasted coffee beans. Our coffee is delivered to our retail locations and wholesale customers promptly to guarantee the freshness of each cup of coffee or package of whole coffee beans sold.

Competition

The specialty coffee market is intensely competitive and generally highly fragmented. In most markets in which we do retail business either through company or franchise locations, there are numerous competitors in the specialty coffee beverage business, and we expect this situation to continue. Our whole bean coffee competes

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directly against specialty coffees sold at 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 and convenience and, to a lesser extent, on price.

In our wholesale business, we expect increased competition, both within our primary geographic territory, the Western United States, and in other regions of the United States, as we expand from our current markets. The specialty coffee market is expected to become even more competitive as regional companies expand and attempt to build brand awareness in new markets. We compete primarily by providing high quality coffee, easy access to our products and superior customer service, and we believe we differentiate ourselves from many of our larger competitors, who specialize in one primary channel of distribution. We also believe that our product offering is distinctive because we offer a wide array of coffees, including origins, blends and flavored coffees. Finally, we believe that being an independent roaster allows us to be better focused and react quicker to our wholesale customers’ needs as compared to than larger, multi-product competitors. While we believe we currently compete favorably with respect to these factors, there can be no assurance that we will be able to compete successfully in the future.

Foreign Operations

The international Gloria Jean’s franchise operations were sold on February 11, 2005. In connection with that sale, we agreed that we would not compete internationally with the purchaser using our Diedrich Coffee and Coffee People brands for a period of two years. Since that date, we no longer have foreign operations.

Other Factors

The performance of individual coffeehouses or mall coffee stores may also be affected by factors such as traffic patterns and the type, number and proximity of competing coffeehouses or mall coffee stores. 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 and mall coffee stores in particular.

Seasonality

Historically, we have experienced variations in sales from quarter-to-quarter due to the peak November-December holiday season, as well as from a variety of other factors, including, but not limited to, general economic trends, the cost of green coffee, competition, marketing programs, weather and special or unusual events.

Intellectual Property

We own several trademarks and service marks that have been registered with the United States Patent and Trademark Office, including Diedrich Coffee^®, Gloria Jean’s^®, Coffee People^®, Motor Moka^®, Aero Moka^®, Wiener Melange Blend^®, Harvest Peak^®, and Flor de Apanas^®, as well as other slogans, product names, design marks and logos. In addition, we have applications pending with the United States Patent and Trademark Office for a number of additional marks. We also own registrations and have applications pending in numerous foreign countries for the protection of the Diedrich Coffee and Coffee People trademark and service mark. These trademark registrations can generally be renewed as long as we continue to use the marks protected by the registrations. The Gloria Jean’s and Diedrich Coffee trademarks are material to our business. On February 11, 2005, we sold Gloria Jean’s international franchise operations to Jireh International Pty. Ltd., formerly the Gloria Jean’s master franchisee for Australia, and certain of its affiliates (collectively, “Jireh”) for $16,000,000 in cash and an additional $7,020,000 payable over the next six years under license, roasting and consulting agreements. After all payments have been made to us under the license, roasting and consulting agreements, all remaining Gloria Jean’s trademarks, including those in the U.S., will be transferred to Jireh. Concurrent with such future transfer, our U.S.-based Gloria Jean’s subsidiary will enter into a perpetual, royalty-free master franchise agreement with Jireh under which we will continue to have exclusive rights to operate, franchise and develop

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Gloria Jean’s locations throughout the U.S. and Puerto Rico and to continue our wholesale operations under the Gloria Jean’s Coffees brand in these same markets. We also own a number of common law service marks and trademarks in the United States including “Gloria Jean’s Coffee Bean.” We have also received trademark and service mark protection for the name Coffee People and related marks in Canada and Japan. 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

At June 28, 2006, we employed 951 people, 570 of whom were employed full-time. None of our employees are represented by a labor union, and no employees are currently covered by collective bargaining agreements. We consider our relations with our employees to be good. We regularly review our employee benefits, training and other aspects of employment to attract and to retain valuable employees and managers. Franchise employees are not employees of the Company. Under the asset purchase agreement with Starbucks, all non-management store employees in good standing at the retail stores that are sold to Starbucks will be offered positions with Starbucks while store managers and assistant managers at those locations will be provided the opportunity to interview for positions with Starbucks.

Government Regulation

In addition to the laws and regulations relating to the food service industry, we are subject to Federal Trade Commission (“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. 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 non-renewal 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 applicable franchise laws may adversely affect us. Any changes to the FTC’s rules, or state franchise laws, or future court or administrative decisions, 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.

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Available Information

Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and other documents that we may file with or furnish to the SEC from time to time are available on our Internet website, free of charge, as soon as reasonably practicable after the reports are electronically filed with or furnished to the United States Securities and Exchange Commission. These reports are available at www.diedrich.com under the heading “Investor Services.” We intend to disclose future amendments to certain provisions of our Code of Conduct, which is available on the www.diedrich.com website, within four business days following the date of such amendment on our website.

Item 1A. Risk factors.

RISK FACTORS AND TRENDS AFFECTING DIEDRICH COFFEE AND ITS BUSINESS

As discussed under “Item 1 Recent Developments,” and “Item 7 Overview—Recent Developments,” on September 14, 2006, we and Starbucks Corporation entered into an asset purchase agreement pursuant to which Starbucks has agreed to purchase our leasehold interests in most of the 47 locations where we operate retail stores under the Diedrich Coffee and Coffee People brands, along with certain related fixtures and equipment, improvements, prepaid items, and ground lease improvements, and to assume certain liabilities as set forth in the asset purchase agreement. The risk factors discussing these retail locations that may be sold to Starbucks are pertinent until such locations are sold to Starbucks. If and when the asset sale to Starbucks is consummated, we will update the risk factors set forth below as necessary in our quarterly reports on Form 10-Q.

The pending sale of certain of our retail stores to Starbucks Corporation may not be consummated.

On September 14, 2006, we and Starbucks Corporation entered into an asset purchase agreement pursuant to which Starbucks has agreed to purchase our leasehold interests in most of the 47 locations where we operate retail stores under the Diedrich Coffee and Coffee People brands, along with certain related fixtures and equipment, improvements, prepaid items, and ground lease improvements, and to assume certain liabilities as set forth in the asset purchase agreement. The asset sale is subject to stockholder approval and certain other closing conditions. We expect to complete the asset sale in December 2006. However, there is no assurance that the conditions to the completion of the asset sale will be satisfied. If the asset sale is not completed, we will be subject to several risks, including the following:

• our cashflow and financial condition could be adversely affected if we are unable to complete the asset sale;

• under certain circumstances, including our entry into an alternative transaction involving the retail store locations that are the subject of the asset sale, we are required to pay Starbucks’ actual fees and expenses incurred in connection with the asset sale up to a maximum amount of $500,000, with a minimum payment of $250,000 regardless of Starbucks’ actual fees and expenses;

• the current stock price of our common stock may reflect a market assumption that the asset sale will occur, and, thus, a failure to complete the asset sale could result in a negative perception by the stock market of us generally and a decline in the market price of our common stock; and

• our retail business could be adversely affected if we are unable to retain key employees, our employees at our retail store locations or attract replacements.

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Historical losses from continuing operations may continue and, as a result, the price of our common stock may be negatively affected.

For the past five fiscal years, we had net income (loss) from continuing operations of $(7,796,000) for the fiscal year ended June 28, 2006, $(3,315,000) for the fiscal year ended June 29, 2005, $(1,647,000) for the fiscal year ended June 30, 2004, $(2,504,000) for the fiscal year ended July 3, 2003 and $272,000 for the fiscal year ended July 3, 2002. We could suffer losses in the future, which may negatively affect our stock price.

If we are not able to grow our business, the results of our operations and our financial condition may be adversely impacted.

As of June 28, 2006, we operated 47 Diedrich Coffee and Coffee People retail locations, which we managed on a day-to-day basis, and had nine franchised Diedrich Coffee and Coffee People coffeehouse locations. We also had 144 Gloria Jean’s retail locations, of which 139 were franchised. To grow, we must:

• attract single and multi-store franchisees for our Gloria Jean’s brand in the United States;

• continue to upgrade Gloria Jean’s products and programs;

• expand Diedrich Coffee and Gloria Jean’s wholesale sales;

• attract franchise area developers for Diedrich Coffee in the United States and internationally after our two-year international non-compete restriction expires;

• 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;

• continue to upgrade 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.

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. Future inability to grow our business resulting from, among other things, failing to execute any of the above factors may adversely affect the results of our operations and our financial condition.

Our franchisees could take actions that could harm our business.

Franchisees are independent contractors and are not our employees. We provide training and support to our franchisees, and the terms of our franchise agreements require our franchisees to maintain certain minimum operating standards; however, the quality of franchised operations may be diminished by any number of factors beyond our control. For example, franchisees may not successfully operate coffeehouses in a manner consistent with our standards and requirements, or may not hire and train qualified managers or other personnel. In other instances, franchisees may operate their units in conformity with our operating standards and specifications, but may fail to meet their financial obligations to us under a franchise agreement or a sublease for a location, or to vendors, lenders or other creditors. While we have certain contractual remedies in such instances of default, enforcing our remedies typically requires litigation, and therefore our image and reputation, and the image and

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reputation of other franchisees, may suffer even if such litigation is successfully concluded. If a significant number of franchisees were to be in default simultaneously, a larger number of franchise units could be terminated in a given time period than we would be able to re-franchise, or absorb into our company operated unit base, and system-wide sales could significantly decline. If this were to occur, we might also be unable to meet our obligations to mall landlords for early termination of the 86 master leases for which we are currently liable.

Our growth through franchise area development may not occur as rapidly as we currently anticipate.

Our ability to recruit, retain and contract with qualified franchise area developers has become, and will continue to be, increasingly important to our operations as we expand. Our franchisees are dependent upon the availability of adequate sources of financing on acceptable terms in order to meet their development obligations, and the credit markets for such franchise financing have historically been somewhat volatile. Prospective franchise lenders have historically been cautious in their approach to financing smaller or newer, less established retail brands vis-à-vis larger and more established franchised systems. Such financing may not be available to our franchised area developers, or only available upon disadvantageous terms. Our franchise development strategy may not enhance our results of operations. Failure to execute on our strategy to grow through franchise area development would 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:

• comparable store sales results;

• the number, timing, mix and cost of coffeehouse and mall coffee store openings, franchises, acquisitions or closings;

• the level of competition from existing or new competitors in the specialty coffee industry;

• labor costs for our hourly and management personnel, including increases in federal or state minimum wage requirements;

• changes in consumer preferences; and

• fluctuations in prices of unroasted coffee.

From time to time in the future, our operating results may fall below the expectations of investors and public market securities analysts. Quarterly fluctuations, for any reason, could cause our stock price to decline. Also, our business is subject to seasonal fluctuations. The November—December holiday season generally experiences the highest sales. In contrast, 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.

In addition, if we were to open additional company owned coffeehouses in the future, we would incur significant pre-opening expenses, and the new coffeehouses would likely experience an initial period of operating losses. As a result, the opening of a significant number of company owned coffeehouses in a single period would have an adverse effect on our results of operations. Accordingly, we believe that period-to-period comparisons of our historical or future operating results are not necessarily meaningful, and such comparisons should not be relied upon as indicators of future performance.

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Because we have only one roasting facility, a significant interruption in the operation of this facility could potentially disrupt our operations.

We have only one coffee roasting and distribution facility. A significant interruption in the operation of this facility, whether as a result of a natural disaster or other causes, could significantly impair our ability to operate our business on a day-to-day basis.

Future changes in minimum wage requirements could adversely affect our business, financial condition, results of operations or cash flows.

A number of our employees are subject to minimum wage requirements. Many of our employees work in retail locations located in California and Oregon, and receive salaries equal to those states’ minimum wage laws, which salaries currently exceed the federal minimum wage. There can be no assurance that further increases will not be implemented in these or other jurisdictions in which we operate or seek to operate. There can be no assurance that we will be able to pass additional increases in labor costs through to our customers in the form of price adjustments and, accordingly, such minimum wage increases could have a material adverse effect on our business, financial condition, results of operations or cash flows.

We or our franchisees may not be able to renew leases or control rent increases at our retail locations.

All of our 52 company operated coffeehouses are presently on leased premises. Gloria Jean’s stores are generally leased by an indirect subsidiary of Coffee People, although in most cases, the franchisees pay their rent directly to their landlord. Upon the expiration of some of these leases, there is no automatic renewal or option to renew. Consequently, these leases may not be renewed. If they are renewed, rents may increase substantially. Either of these events could adversely affect us. Other leases are subject to renewal at fair market value, which could involve substantial rent increases, or are subject to renewal with scheduled rent increases, which could result in rents being above fair market value. In addition, at the time of lease renewal, significant remodeling is typically required. It is possible that we may not have available capital to perform such remodeling.

In addition, franchisees may not renew their franchises at the expiration of the coffeehouse lease term. On average 12 franchise unit lease terms expire annually. Franchisees may choose not to renew their franchises, which could have a material adverse effect on our results of operations.

Our industry is highly competitive and we may not have the resources to compete effectively.

With low barriers to entry, competition in our industry is expected to increase from national and regional chains, franchise operators and local specialty coffee stores. Our whole bean coffees compete directly against specialty coffees sold at specialty retailers, variety and discount stores, and a growing number of specialty coffee stores. Many specialty coffee companies, including Starbucks, Seattle’s Best Coffee, Bucks County, Brothers Gourmet Coffees and Green Mountain Coffee Roasters sell whole bean coffees through these channels. In our sale of coffee beverages and espresso drinks, we compete directly against all other specialty grade 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. Our competition at this level includes a growing number of specialty coffee retailers, including Starbucks, Barnie’s, Coffee Beanery Ltd., Caribou Coffee, Peet’s Coffee, Tully’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 we have. In addition, we compete to draw customers of standard or commercial coffee, and consumers of substitute coffee products manufactured by a number of nationwide coffee manufacturers, such as Kraft Foods, Proctor & Gamble and Nestlé, to specialty grade coffee.

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. The performance of individual coffeehouses

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or mall coffee stores may also be affected by factors such as traffic patterns and the type, number and proximity of competing coffeehouses or mall coffee stores. 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 and mall coffee stores in particular.

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 a number of 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 that establish export quotas or by 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.

Compliance with health, franchising and other government regulations applicable to us could have a material adverse affect on our business, financial condition and results of operations.

Each retail location and roasting facility is and will be subject to licensing and reporting requirements by a number of governmental authorities. These governmental authorities include federal, state and local health, environmental, labor relations, sanitation, building, zoning, fire, safety and other departments that have jurisdiction over the development and operation of our retail locations. Our activities are also subject to the Americans with Disabilities Act and related regulations, which prohibit discrimination on the basis of disability in public accommodations and employment. Changes in any of these laws or regulations could have a material adverse affect on our business, financial condition and results of operations. Delays or failures in obtaining or maintaining required construction and operating licenses, permits or approvals could delay or prevent the opening of new retail locations, or could materially and adversely affect the operation of existing retail locations. In addition, we may not be able to obtain necessary variances or amendments to required licenses, permits or other approvals on a cost-effective or timely basis in order to construct and develop retail locations in the future.

We are also subject to federal regulation and certain state laws that govern the offer and sale of franchises and the franchisor-franchisee relationship. Many state franchise laws impose substantive requirements on

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franchise agreements, including limitations on non-competition provisions and on provisions concerning the termination or non-renewal of a franchise. Some states require companies to register certain materials before franchises can be offered or sold in that state. The failure to obtain or retain licenses or registration approvals to sell franchises could delay or preclude franchise sales and otherwise adversely affect our business, financial condition and results of operations. Additionally, any franchise law violations may give existing and future franchisees a basis to bring claims against us. Franchise law violation claims could include unfair business practices, negligent misrepresentation, fraud, or statutory franchise investment or relationship violations. Remedies may include damages or rescission of the franchise agreement by the franchisee. These claims may already exist and their assertion against us could adversely affect our business, financial condition, and results of operations.

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. The loss of services of these individuals could disrupt operations. Although we have employment agreements with each of our executive officers, any of our executive officers can terminate their employment if he or she chooses 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.

We could be subject to adverse publicity or claims from our customers.

We may be subject to complaints from or litigation by customers who allege beverage or food-related illness, injuries suffered on the premises or other quality, health or operational concerns. Adverse publicity resulting from such allegations may materially adversely affect us, regardless of whether such allegations are true or whether we are ultimately held liable. We may also be the subject of complaints or allegations from current, former or prospective employees from time-to-time. A lawsuit or claim could result in an adverse decision against us that could have a material adverse effect on our business, financial condition and results of operations.

Changes in consumer preferences or discretionary spending could negatively affect our results.

Our retail locations offer specialty coffee beans, brewed coffee beverages, espresso-based beverages, blended drinks and light food items served in a casual setting. Our continued success depends, in part, upon the popularity of these types of coffee-based beverages and this style of casual dining. Shifts in consumer preferences away from our coffee-based beverages or casual setting could materially adversely affect our future profitability. Also, our success depends to a significant extent on a number of factors that affect discretionary consumer spending, including economic conditions, disposable consumer income and consumer confidence. Adverse changes in these factors could reduce guest traffic or impose practical limits on pricing, either of which could adversely affect our business, financial condition, operating results and cash flows.

Our lack of diversification may affect business if demand is reduced.

Our business is primarily centered on one product: fresh specialty grade 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 franchise coffee stores, coffeehouses, and 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.

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Our failure or inability to enforce our trademarks or trade names could adversely affect our efforts to establish brand equity.

Our ability to successfully expand our business will depend in part on our ability to maintain “brand equity” through the use of our trademarks, service marks, trade dress and other proprietary intellectual property, including our name and logos. We currently hold a number of trademarks and service marks related to our brands. Some or all of our rights related to our intellectual property may not be enforceable, even if registered, against any prior users of similar intellectual property or our competitors who seek or intend to utilize similar intellectual property in areas where we operate or intend to conduct operations. If we are unable to successfully enforce our intellectual property rights, we may be unable to capitalize on our efforts to maintain brand equity. It is possible that we will encounter claims from prior users of similar intellectual property in areas where we operate or intend to conduct operations, including foreign countries. Claims from prior users could limit our operations or cause us to pay damages or licensing fees to a prior user or registrant of similar intellectual property.

Item 1B. Unresolved Staff Comments

None.

Item 2. Properties.

Office Space and Plant

We currently lease approximately 17,620 square feet of office space in Irvine, California and approximately 6,192 square feet of warehouse space in Irvine, California. The lease for the office space will expire in January 2011 and the lease for the warehouse space will expire in December 2015. We also lease a 66,237 square foot roasting facility located in Castroville, California. The term of the current lease expires in December 2015, and is renewable, at our option, for a term of 15 additional years. We believe that our facilities are generally adequate for our current needs, and that suitable additional production and administrative space will be available as needed for the foreseeable future.

Company Operated Locations

As of June 28, 2006, we were a party to leases for a total of 52 company operated retail locations. During fiscal year 2006, we closed eight locations. As discussed under “Item 1 Recent Developments,” and “Item 7 Overview—Recent Developments,” we and Starbucks Corporation entered into an asset purchase agreement pursuant to which Starbucks has agreed to purchase our leasehold interests in most of the 47 locations where we operate retail stores under the Diedrich Coffee and Coffee People brands.

Our company operated retail locations on leased premises 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, certain of these leases expire in the near future, and there is no automatic renewal or option to renew. No assurance can be given that leases can be renewed, or if renewed, that rents will not increase substantially, either of which would adversely affect us. Other leases are subject to renewal at fair market value, which could involve substantial increases or are subject to renewal with a scheduled rent increase, which could result in rents being above fair market value. In addition, at the time of lease renewal, significant remodeling is typically required. It is possible that we may not have available capital to perform such remodeling.

Franchised Stores

All of our Gloria Jean’s locations are operated on leased premises, 139 of which are franchised. A majority of the leased premises presently occupied by Gloria Jean’s franchised outlets are leased by us, and we have entered into sublease agreements with the franchisees on a cost pass-through basis. Gloria Jean’s, however,

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remains obligated under the lease in all such cases. As further discussed below under the heading “Financial Condition and Liquidity and Capital Resources—Commitments and Contractual Obligations,” our maximum theoretical future exposure under these leases at June 28, 2006, computed as the sum of all remaining lease payments through the expiration dates of the respective leases, was $20,168,000. In the future, new franchisees will generally be required to enter into master leases directly with the landlord. This will also be the case when current leases are up for renewal. Gloria Jean’s stores are designed to accommodate locations in various sizes, ranging from 170 square foot kiosk outlets (which sell principally coffee drinks and other beverages) to 2,000 square foot full service stores.

Item 3. Legal Proceedings.

In the ordinary course of our business, we may become involved in legal proceedings from time to time. As of September 25, 2006, we were not a party to any material pending legal proceedings.

Item 4. Submission of Matters to a Vote of Security Holders.

None.

PART II

Item 5. Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Our common stock is reported on the Nasdaq Global Market under the symbol “DDRX.” The following table sets forth, for the periods indicated, the high and low trading prices for our common stock as reported on the Nasdaq Global Market.

	Price Range
Period	High		Low
Fiscal Year Ended June 29, 2005
Twelve Weeks Ended September 22, 2004	$	5.60	$	4.72
Twelve Weeks Ended December 15, 2004		5.83		4.24
Twelve Weeks Ended March 9, 2005		6.12		5.11
Sixteen Weeks Ended June 29, 2005		5.32		4.01
Fiscal Year Ended June 28, 2006
Twelve Weeks Ended September 21, 2005		9.11		4.78
Twelve Weeks Ended December 14, 2005		8.55		4.89
Twelve Weeks Ended March 8, 2006		5.20		4.00
Sixteen Weeks Ended June 28, 2006		4.95		3.11

At September 22, 2006, there were 5,346,270 shares of our common stock outstanding and 674 stockholders of record. We have not paid dividends on our common stock and do not anticipate paying dividends in the foreseeable future.

Item 6. Selected Financial Data.

Our fiscal year ends on the Wednesday closest to June 30. This reporting schedule generally results in three 12-week quarters and one 16-week quarter during the fourth fiscal quarter, for a total of 52 weeks. However, due to the alignment of the calendar in 2002, the fiscal year ended July 3, 2002 contains 17 weeks during the fourth fiscal quarter, for a total of 53 weeks. The following selected financial data may not be indicative of our future results of operations and should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” beginning on page 21, and should be read in conjunction with our consolidated financial statements and related notes.

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On February 11, 2005 we completed the sale of our Gloria Jean’s international operations. In accordance with SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”), the financial statements for all periods have been reclassified to report the financial results for those operations as discontinued operations.

The information set forth below should be read in conjunction with the consolidated financial statements and related notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations included elsewhere in this Form 10-K.

	Fiscal Year ended June 28, 2006 (B)			Fiscal Year ended June 29, 2005			Fiscal Year ended June 30, 2004			Fiscal Year ended July 2, 2003			Fiscal Year ended July 3, 2002 (A)
	(in thousands, except per share data)
Statement of Operations Data:
Net revenue:
Retail sales	$	34,428		$	31,890		$	31,617		$	33,034		$	38,658
Wholesale and other		21,244			16,482			14,861			14,788			16,681
Franchise revenue		3,775			4,166			4,407			4,810			5,322
Total net revenue		59,447			52,538			50,885			52,632			60,661
Costs and expenses:
Cost of sales and related occupancy costs		32,440			26,765			24,642			25,862			30,423
Operating expenses		19,947			17,449			16,701			16,954			17,801
Depreciation and amortization		2,601			2,372			2,315			2,169			2,474
General and administrative expenses		13,546			11,178			9,597			9,150			9,398
Provision for asset impairment and restructuring costs		—			—			94			2,176			542
Gain on asset disposals		(58	)		(4	)		(2	)		(868	)		(423	)
Total costs and expenses		68,476			57,760			53,347			55,443			60,215
Operating income (loss) from continuing operations		(9,029	)		(5,222	)		(2,462	)		(2,811	)		446
Interest income (expense) and other, net		432			56			(318	)		(256	)		(537	)
Loss from continuing operations before income tax benefit		(8,597	)		(5,166	)		(2,780	)		(3,067	)		(91	)
Income tax benefit		(801	)		(1,851	)		(1,133	)		(563	)		(363	)
Income (loss) from continuing operations	$	(7,796	)	$	(3,315	)	$	(1,647	)	$	(2,504	)	$	272
Discontinued operations:
Income from discontinued operations, net of income tax		—			2,143			1,898			1,146			680
Gain on sale of discontinued operations, net of income tax		—			15,795			—			—			—
Net income (loss)	$	(7,796	)	$	14,623		$	251		$	(1,358	)	$	952
Basic and diluted net income (loss) per share (B):
Income (loss) from continuing operations	$	(1.47	)	$	(0.64	)	$	(0.32	)	$	(0.49	)	$	0.05
Income from discontinued operations, net	$	—		$	3.44		$	0.37		$	0.22		$	0.13
Net income (loss)	$	(1.47	)	$	2.80		$	0.05		$	(0.26	)	$	0.18
Balance Sheet Data:
Working capital	$	3,618		$	11,203		$	641		$	1,207		$	809
Total assets		34,130			40,313			25,218			26,101			27,806
Long-term debt and obligations under capital leases, less current portion		309			328			1,173			2,033			2,832
Total stockholders’ equity	$	24,267		$	31,522		$	16,475		$	16,202		$	17,492

(A) Includes 53 weeks of operation.

(B) Includes compensation expense of $403,000 due to the adoption of SFAS 123R.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

INTRODUCTION

Management’s discussion and analysis of financial condition and results of operations is provided as a supplement to the accompanying consolidated financial statements and footnotes to help provide an understanding of our financial condition, the changes in our financial condition and the results of operations. Our discussion is organized as follows:

• Overview.    This section provides a general description of our business, as well as recent significant transactions that we believe are important in understanding the results of operations, as well as to anticipate future trends in those operations.

• Results of operations.    This section provides an analysis of our results of operations presented in the accompanying consolidated statements of operations by comparing the results for fiscal 2006 to fiscal 2005 and comparing the results for fiscal 2005 to fiscal 2004.

• Financial condition and liquidity and capital resources.    This section provides an analysis of our cash flows, as well as a discussion of our outstanding debt and commitments, both firm and contingent, that existed as of June 28, 2006. Included in the discussion of outstanding debt is a discussion of the amount of financial capacity available to fund our future commitments, as well as a discussion of other financing arrangements.

• Critical accounting estimates.    This section discusses those accounting policies that both are considered important to our financial condition and results, and require significant judgment and estimates on the part of management in their application. In addition, all of our significant accounting policies, including the critical accounting policies, are summarized in Note 1 to the accompanying consolidated financial statements.

• New accounting pronouncements.    This section discusses new accounting pronouncements, dates of implementation and impact on our accompanying consolidated financial statements, if any.

OVERVIEW

Recent Developments

On September 14, 2006, we and Starbucks Corporation entered into an asset purchase agreement pursuant to which Starbucks has agreed to purchase our leasehold interests in most of the 47 locations where we operate retail stores under the Diedrich Coffee and Coffee People brands, along with certain related fixtures and equipment, improvements, prepaid items, and ground lease improvements, and to assume certain liabilities as set forth in the asset purchase agreement.

Pursuant to the asset purchase agreement, Starbucks will pay us up to $13,520,000 in cash, which includes payment of $120,000 as consideration for our agreement to a non-compete provision. The actual amount paid by Starbucks under the asset purchase agreement is dependent on which and how many of the Company Stores are ultimately transferred to Starbucks. Ten percent of the amount paid to us upon transfer of the Company Stores will be deposited into an escrow fund to be held in connection with our indemnification obligations. The Closing is expected to occur approximately 90 days after the date of the asset purchase agreement, provided that certain conditions, including that a specified minimum number of Company Stores are transferred to Starbucks at Closing, are met. After the Closing, we and Starbucks have agreed to use commercially reasonable efforts to transfer certain remaining Company Stores until approximately 150 days after the date of the asset purchase agreement or such other longer period as agreed to by us and Starbucks.

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We and Starbucks have made certain customary representations, warranties and covenants in the asset purchase agreement. Specifically, we have agreed that, subject to a “fiduciary-out” provision and payment of a break-up fee, we will not (i) take any action to solicit any proposal from, (ii) furnish any information to, or (iii) participate in any discussions with, any entity other than Starbucks regarding any transaction involving the Company Stores. Upon termination of the asset purchase agreement under certain circumstances, including the Company’s entry into an alternative transaction involving the Company Stores, we shall pay Starbucks’ actual fees and expenses incurred in connection with the Transaction up to a maximum amount of $500,000; provided, however, that Starbucks is entitled to a minimum of $250,000, regardless of its actual fees and expenses. The asset purchase agreement also contains customary indemnification provisions for certain claims and provides for a basket of $100,000 and a cap of $2,000,000 for breaches of our representations and warranties contained in the asset purchase agreement.

The consummation of the Transaction is subject to certain customary conditions, including: approval of the Transaction by our stockholders; a specified minimum number of Company Stores transferred to Starbucks at Closing; the receipt by Starbucks of permits and approvals for at least 70% of certain Company Stores that are transferred if the Closing occurs within 90 days of the date of the asset purchase agreement; receipt of lease extensions of at least 10 years for at least 40% of certain Company Stores that are transferred; and, receipt of consents to the assignment of the leases for each of the Company Stores that are transferred, with estoppel provisions being agreed to for at least 50% of the Company Stores that are transferred. The asset purchase agreement contains customary termination provisions and may be terminated by either us or Starbucks if the Closing does not occur within 150 days from the date of the asset purchase agreement. We may also terminate the asset purchase agreement if the Closing has not occurred within 90 days, provided that Starbucks has not used commercially reasonable efforts to achieve the Closing.

As part of the asset purchase agreement, we have agreed to a non-compete provision that for three years after the Closing restricts our ability to operate or have any interest in the ownership or operation of any entity operating any retail specialty coffee stores in any city where a Company Store is presently located. The non-compete provision applies only to stores opened after the date of the asset purchase agreement and does not apply to (1) any retail stores operated under the “Gloria Jean’s” brand name, (2) wholesale sales to retail businesses that are not operated by us, or other non-retail businesses, or (3) the conversion of Company-operated stores existing on the date of the asset purchase agreement to franchise stores. We have also agreed that we will not solicit any Starbucks employee to enter our employment for three years after the Closing.

Business

We are a specialty coffee roaster, wholesaler and retailer. We sell brewed, espresso based and various blended beverages primarily made from our own fresh roasted premium coffee beans, as well as light food items, whole bean coffee and accessories, through our company operated and franchised retail locations. We also sell whole bean and ground coffees on a wholesale basis in the Office Coffee Service market and to other wholesale customers, including restaurant chains and other retailers. We roast coffee at our coffee roasting facility in central California. It supplies freshly roasted coffee to our company operated and franchised retail locations and to our wholesale accounts.

Our brands include Diedrich Coffee, Gloria Jean’s, and Coffee People. The Diedrich Coffee and Coffee People brands are primarily company store operations and the Gloria Jean’s brand is primarily a franchised store operation. As of June 28, 2006, we owned and operated 52 retail locations, of which up to 40 retail locations may be sold to Starbucks Corporation (as discussed in “Item 1 Recent Developments,” and “Overview—Recent Developments” in this Item 7), and franchised 148 other retail locations under these brands, for a total of 200 retail coffee outlets. Our retail units are located in 33 states. As of June 28, 2006, we had over 800 wholesale accounts with Office Coffee Service distributors, chain and independent restaurants, and others. Although the specialty coffee industry is dominated by a single company with over 8,000 domestic locations, we are one of the nation’s largest specialty coffee retailers. Our system-wide revenues are more than $116 million. System-wide revenues include sales from company operated and franchise locations.

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We believe that our company is differentiated from other specialty coffee companies by the quality of our coffee products, the superior personalized customer service provided to our customers and the warm and friendly ambiance offered by our coffeehouses. We serve our distinctively roasted coffee products in all of our brand locations and an extensive variety of fine quality flavored whole bean coffees are offered in our Gloria Jean’s units. Our roasting recipes take into account the specific variety, origin and physical characteristics of each coffee bean to maximize its unique flavor.

Key Performance Indicators

We have several key indicators that we use to evaluate the performance of our business. These include same-store sales growth, the number of company operated and franchised stores opened and closed, and the measured relationship of cost of sales and related occupancy costs, operating expenses and general and administrative expenses to sales.

Same-store sales growth, or comparative sales growth, is a primary statistic used in the retail industry to measure core revenues. This measure compares sales for all units open for one year or more to the comparable prior year period. We use this measure to evaluate single coffeehouse, total brand, and total company sales performance. Until recently, comparable sales of our company operated stores and domestic franchised stores had declined, primarily as a result of aging stores, a lack of capital to fund store improvements, and no new store openings. New stores typically achieve relatively strong comparative sales growth in their early years. Franchised units that are located in malls have also experienced declining sales due to overall declines in mall traffic. Our ability to open new company operated and franchise stores depends on our success in raising capital and selling franchises. Continuing declines in same store sales could result in store closures, make sales of franchises more difficult and have a material adverse impact on our future performance. In addition, under a non-compete provision in the asset purchase agreement with Starbucks, we are restricted for a period of three years after the asset sale closes in our ability to open any new company-operated or franchised Diedrich Coffee and Coffee People coffeehouses in any city in which Diedrich Coffee or Coffee People coffeehouses operated on the date that we and Starbucks entered into the asset purchase agreement. The non-compete provision does not restrict our ability to open retail Gloria Jean’s stores and does not apply to wholesale sales to retail businesses that are not operated by us or other non-retail businesses or the conversion of our stores existing on the date of the asset purchase agreement to franchise stores. See “Item 1 Recent Developments,” and “Overview—Recent Developments” in this Item 7.

The number of operating units opened and closed is also a measure of the health of our brands and our business, although it is affected by a number of factors, including the availability of capital to finance growth. In recent years the number of domestic units has declined because the number of aging units closing exceeded the number of new units opening. Company operated stores have deceased and franchised stores have increased. Unlike new company operated stores, new franchised stores do not require our capital. In addition, franchised stores typically make an immediate profit contribution, whereas company stores generally are not profitable in the first year. Our near-term growth plans focus primarily on franchising new domestic stores. Failure to successfully expand our franchise operations would materially adversely impact our future performance.

We use the relationship between cost of sales and related occupancy costs and operating expenses to sales to measure the operating efficiency of our individual coffeehouses and to measure the relationship between general and administrative expenses to sales to monitor and control the level of corporate overhead. Cost of sales and related occupancy costs increased in the current fiscal year due to the higher percentage of the higher cost Keurig K-cup business. In total, wholesale sales which carry a higher costs of goods sold than retail sales, increased as a percentage of the total retail and wholesale sales mix. Cost of sales and related occupancy costs increased during fiscal 2006 as a result of a higher percentage of higher cost Keurig business in the current year. Operating expenses as a percentage of sales remained relatively flat compared to prior year. General and administrative expenses have increased as a percentage of sales primarily due in part from increases in overhead costs not associated with retail and wholesale operations.

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RESULTS OF OPERATIONS

The following table sets forth the percentage relationship to total revenue of certain items included in our statements of income for the years indicated:

	Year Ended June 28, 2006		Year Ended June 29, 2005		Year Ended June 30, 2004
Net revenue:
Retail sales	57.9	%	60.7	%	62.1	%
Wholesale and other	35.7		31.4		29.2
Franchise revenue	6.4		7.9		8.7
Total revenue	100.0	%	100.0	%	100.0	%
Costs and expenses:
Cost of sales and related occupancy costs	54.6	%	50.9	%	48.4	%
Operating expenses	33.5		33.2		32.8
Depreciation and amortization	4.4		4.5		4.5
General and administrative expenses	22.8		21.3		18.9
Provision for asset impairment and restructuring costs	—		—		0.2
Gain on asset disposals	(0.1	)	—		—
Total costs and expenses	115.2	%	109.9	%	104.8	%
Operating loss from continuing operations	(15.2	)%	(9.9	)%	(4.8	)%
Interest income (expense) and other, net	0.7		0.1		(0.6	)
Loss from continuing operations before income tax provision	(14.5	)	(9.8	)	(5.4	)
Income tax benefit	(1.4	)	(3.5	)	(2.2	)
Loss from continuing operations	(13.1	)%	(6.3	)%	(3.2	)%
Discontinued operations:
Income from discontinued operations, net of income tax	—		4.1	%	3.7	%
Gain on sale of discontinued operations, net of income tax	—		30.0		—
Net income (loss)	(13.1	)%	27.8	%	0.5	%

Sale of International Franchise Operations

On February 11, 2005, we completed the sale of our Gloria Jean’s international franchise operations to Jireh International Pty. Ltd., formerly the Gloria Jean’s master franchisee for Australia, and certain of its affiliates (collectively, “Jireh”) for $16,000,000 in cash and an additional $7,020,000 payable over the next six years under license, roasting and consulting agreements. The sale resulted in a gain on the disposal of discontinued operations of $15,795,000, net of $3,139,000 in taxes. The tax expense associated with the discontinued operations differed from the statutory federal effective tax rate primarily due to changes in the valuation allowance and permanently nondeductible goodwill associated with the discontinued operations.

The sale included immediate transfer of franchise rights to Jireh of 338 Gloria Jean’s retail locations outside the U.S. and Puerto Rico, including 242 in Australia. After all payments have been made to us under the license, roasting and consulting agreements, all remaining Gloria Jean’s trademarks, including those in the U.S., will be transferred to Jireh. Concurrent with such future transfer, our U.S.-based Gloria Jean’s subsidiary will enter into a perpetual, royalty-free master franchise agreement with Jireh under which we will continue to have exclusive rights to operate, franchise and develop Gloria Jean’s locations throughout the U.S. and Puerto Rico and to continue our wholesale operations under the Gloria Jean’s Coffees brand in these same markets.

We agreed to not compete internationally through our Diedrich Coffee and Coffee People brands for a period of two years from the date of sale. Other than that restriction, our domestic Gloria Jean’s outlets, our

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Castroville roasting operations, our wholesale operations and our company operated Diedrich Coffee and Coffee People retail outlets were not significantly affected by this transaction.

In accordance with SFAS No. 144, the financial results of Gloria Jean’s international franchise operations are reported as discontinued operations for all periods presented.

Results of Operations

Year Ended June 28, 2006 Compared To Year Ended June 29, 2005

Total Revenue.    Our revenue from continuing operations for the year ended June 28, 2006 increased by $6,909,000, to $59,447,000 from $52,538,000 for the year ended June 29, 2005. This result was the net effect of a 8.0% increase in retail sales, a 28.9% increase in wholesale sales and a 9.4% decrease in domestic franchise revenue. Each component of total revenue is discussed below.

Retail Sales.    Our retail sales revenue for the year ended June 28, 2006 increased by $2,538,000, or 8.0%, to $34,428,000 from $31,890,000 for the year ended June 29, 2005. This increase was primarily due to a company-operated same store sales increase of 3.6%. Retail sales from our internet website also increased by $295,000 from $596,000 in fiscal 2005 to $891,000 in fiscal 2006.

Wholesale Revenue.    Our wholesale sales for the year ended June 28, 2006 increased by $4,762,000, or 28.9%, to $21,244,000 from $16,482,000 for the year ended June 29, 2005. This increase was primarily the net result of the following factors:

Keurig “K-cup” and other Third Party Wholesale sales.    Third party wholesale sales increased $4,890,000, or 46.0% to $15,514,000 led by strong growth in the Keurig “K-cup” sales which increased by 55.3%.

Roasted coffee sales to franchisees.    Sales of roasted coffee to our franchisees decreased $129,000 for the year ended June 28, 2006 primarily because of a net decrease of 2.1% same store sales in fiscal 2006 for the Gloria Jean’s domestic system which reduced roasted coffee usage.

Franchise Revenue.    Our domestic franchise revenue decreased by $391,000, or 9.4%, to $3,775,000 for the year ended June 28, 2006 from $4,166,000 for the year ended June 29, 2005. Our franchise revenue consists of initial franchise fees, franchise renewal fees, area development fees and royalties received on sales at franchised locations. Of the decrease in domestic franchise revenue, $341,000 resulted from a reclassification of certain fees as a reduction of general and administrative marketing expenses. The balance of the decrease in franchise revenue of $50,000 resulted primarily from a 2.1% negative same stores sales for the Gloria Jean’s brand in the current year compared to fiscal 2005.

Cost of Sales and Related Occupancy Costs.    As a percentage of total revenue, these costs increased from 50.9% in fiscal 2005 to 54.6% in fiscal 2006. Because none of these costs relate to franchise revenue, the most relevant benchmark of these costs is their relationship to total retail and wholesale sales. Using that measure, cost of sales and related occupancy costs increased as a percentage of total retail and wholesale sales from 55.3% in fiscal 2005 to 58.3% in fiscal 2006. Retail cost of sales increased from 34.8% to 35.5% in the current year whereas wholesale cost of sales increased from 72.2% to 73.4% of wholesale sales in fiscal 2006 due to a higher percentage of higher cost Keurig business in the current year. Wholesale sales that carry a higher cost of goods sold than retail sales, also increased as a percentage of the retail and wholesale sales mix from 34.1% to 38.2%.

Operating Expenses.    Operating expenses for the year ended June 28, 2006, as a percentage of retail and wholesale sales, decreased modestly, from 36.1% of retail and wholesale sales in fiscal 2005 to 35.8% in the current year. Retail operating expenses increased from 47.7% of retail sales in fiscal 2005 to 49.5% in the current year primarily due to increased labor and supervision costs.

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Depreciation and Amortization.    Depreciation and amortization increased $229,000, or 9.7% to $2,601,000 for the year ended June 28, 2006 from $2,372,000 for the year ended June 29, 2005 and resulted from an increase in capital improvements in the current year and toward the second half of the previous fiscal year.

General and Administrative Expenses.    Our general and administrative expense increased by $2,368,000, or 21.2%, to $13,546,000 for the year ended June 28, 2006. As a percentage of revenue, general and administrative expenses increased to 22.8% for the year ended June 28, 2006 from 21.3% for the year ended June 29, 2005. This increase resulted from $1,189,000 of salaries, consulting, and related costs, including $701,000 of salaries resulting from the departures of our former chief executive officer and vice president of information systems along with the realignment of those respective departments, as well as $263,000 of increase in salaries and consulting related to the company’s review of its purchasing and distribution process. In addition, the Company incurred $225,000 in salaries associated with store supervision, training, and marketing, $121,000 in salaries associated with training and franchise development primarily in an effort to grow our Gloria Jean’s brand, $268,000 in accounting and finance consulting fees primarily related to strategic planning projects and the restatement of the Company’s prior year financial statements, all of which was offset by $389,000 from the elimination of the current year corporate bonus accruals. We also incurred $403,000 of compensation expense for the current year due to the adoption of SFAS 123R “Share Based Payment” (“SFAS 123R”), in the first quarter of the fiscal 2006 along with a net $581,000 increase in legal fees. In addition, the Company incurred $243,000 of additional workers compensation charges from an increase in expected losses, outside services increased by $122,000 primarily from audit and tax fees expensed in the current fiscal year, but which were related to the 2005 fiscal year end audit and tax returns, and other costs of $138,000 net primarily associated with an increase in credit card processing fees. These increases were offset by, $131,000 savings in travel due to timing of the Gloria Jean’s annual conference and a reduction in overall advertising spending of $177,000 resulting from a change in the classification for coordination fees previously reflected in franchise income.

Interest Expense and Interest and Other Income, Net.    Interest and other income, net less Interest Expense totaled $432,000 for the year ended June 28, 2006 while Interest and other income, net les Interest Expense totaled $56,000 for the year ended June 29, 2005. The increase of $376,000 was primarily due to interest income on the notes receivables from the sale of our international Gloria Jean’s franchise operations.

Income Tax Benefit.    We had losses from continuing operations for the years ended June 28, 2006 and June 29, 2005. In accordance with SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”), the income tax benefit generated by the loss from continuing operations were $801,000 and $1,851,000 for the years ended June 28, 2006 and June 29, 2005, respectively. Due to the utilization of net operating loss carryforwards in the sale of the Gloria Jean’s international franchise operations and following an Internal Revenue Code Section 382 analysis, as of June 28, 2006, net operating loss carryforwards of $8,721,000 and $7,883,000 for federal and state income tax purposes, respectively are available to be utilized against future taxable income for years through fiscal 2026, subject to possible annual limitation pertaining to change in ownership rules under the Internal Revenue Code. Due to the uncertainty of future taxable income, deferred tax assets resulting from the net operating loss carryforwards have been fully reserved.

Results of Discontinued Operations    As a result of the sale of the international Gloria Jean’s franchise operations on February 11, 2005 the results from this component of our business are presented as discontinued operations for the fiscal year ended June 29, 2005 in accordance with SFAS 144. In the year ended June 29, 2005 net income from discontinued operations was $17,938,000, net of $3,457,000 in taxes, including a gain of $15,795,000, net of $3,139,000 in taxes. The tax expense associated with the discontinued operations differed from the statutory federal effective tax rate primarily due to changes in the valuation allowance and permanently nondeductible goodwill associated with the discontinued operations.

Year Ended June 29, 2005 Compared To Year Ended June 30, 2004

Total Revenue.    Our revenue from continuing operations for the year ended June 29, 2005 increased by $1,653,000, to $52,538,000 from $50,885,000 for the year ended June 30, 2004. This result was the net effect of

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a 0.9% increase in retail sales, a 10.9% increase in wholesale sales and a 5.5% decrease in domestic franchise revenue. Each component of total revenue is discussed below.

Retail Sales.    Our retail sales revenue for the year ended June 29, 2005 increased by $273,000, or 0.9%, to $31,890,000 from $31,617,000 for the year ended June 30, 2004. This increase was primarily due to a company-operated same store sales increase of 4.7%, and a net increase of four company stores since the beginning of the prior year. Retail sales from our internet website also increased by $139,000 from $457,000 in fiscal 2004 to $596,000 in fiscal 2005.

Wholesale Revenue.    Our wholesale sales for the year ended June 29, 2005 increased by $1,621,000, or 10.9%, to $16,482,000 from $14,861,000 for the year ended June 30, 2004. This increase was primarily the net result of the following factors:

Keurig “K-cup” and other Third Party Wholesale sales.    Third party wholesale sales increased $1,878,000, or 21.5% to $10,624,000 led by strong growth in the Keurig “K-cup” sales which increased by 27.6%.

Roasted coffee sales to franchisees.    Sales of roasted coffee to our franchisees decreased $219,000 for the year ended June 29, 2005 because of a net decrease of 14 domestic franchise stores since the beginning of the 2004 fiscal year and compounded by negative 3.0% same store sales in fiscal 2005 for the Gloria Jean’s domestic system which reduced roasted coffee usage.

Franchise Revenue.    Our domestic franchise revenue decreased by $241,000, or 5.5%, to $4,166,000 for the year ended June 29, 2005 from $4,407,000 for the year ended June 30, 2004. Our franchise revenue consists of initial franchise fees, franchise renewal fees, area development fees, royalties received on sales at franchised locations, and miscellaneous other franchise revenue, including coordination fees received from product suppliers. The decrease in domestic franchise revenue was primarily due to the net impact of a 14 store decrease in units as 22 new units opened but 36 closed during the past two fiscal years, and also due to 3.0% negative same store sales which affected royalties.

Cost of Sales and Related Occupancy Costs.    As a percentage of total revenue, these costs increased from 48.4% in fiscal 2004 to 50.9% in fiscal 2005. Because none of these costs relate to franchise revenue, the most relevant benchmark of these costs is their relationship to total retail and wholesale sales. Using that measure, cost of sales and related occupancy costs increased as a percentage of total retail and wholesale sales from 53.0% in fiscal 2004 to 55.3% in fiscal 2005. Retail cost of sales remained relatively stable, but wholesale cost of sales increased from 69.8% to 72.2% of wholesale sales in fiscal 2005 due to a higher percentage of higher cost Keurig business in the current year. Wholesale sales that carry a higher cost of goods sold than retail sales, also increased as a percentage of the retail and wholesale sales mix from 32.0% to 34.1%.

Operating Expenses.    Operating expenses for the year ended June 29, 2005, as a percentage of retail and wholesale sales, increased modestly, increasing from 35.9% of retail and wholesale sales in fiscal 2004 to 36.1% in the current year. Retail operating expenses increased from 47.0% of retail sales in fiscal 2004 to 47.7% in the current year primarily due to increased labor and supervision costs.

Depreciation and Amortization.    Depreciation and amortization was relatively stable increasing $57,000, or 2.5% to $2,372,000 for the year ended June 29, 2005.

General and Administrative Expenses.    Our general and administrative expense increased by $1,581,000, or 16.5%, to $11,178,000 for the year ended June 29, 2005. On a margin basis, general and administrative expenses increased to 21.3% of total revenue for the year ended June 29, 2005 from 18.9% of total revenue for the year ended June 30, 2004. This unfavorable 2.4% change for the current year was primarily the result of a $614,000 increase in costs related to actual and planned store growths in areas such as marketing, franchise sales, real estate, technology and development, $292,000 in increased independent audit and financial staffing costs,

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increased cost of Gloria Jean’s franchisee meetings of $211,000, and a $260,000 workers compensation refund received in the prior fiscal year period.

Provision for Asset Impairment and Restructuring Costs.    No provision was required in fiscal 2005. A provision of $94,000 was recorded in the prior year.

Interest Expense and Interest and Other Income, Net.    Interest and other income, net less Interest Expense was an expense of $318,000 in the year ended June 30, 2004, while Interest and other income, net less Interest Expense totaled $56,000 in the year ended June 29, 2005. This change was due to a lower level of outstanding debt in the current year and interest income on our increased cash generated from the proceeds on the sale of the international franchise operations.

Income Tax Benefit.    We had losses from continuing operations and income from discontinued operations for the years ended June 30, 2005 and June 30, 2004. In accordance with SFAS No. 109, the income tax benefits generated by the losses from continuing operations were $1,851,000 and $1,133,000 for the years ended June 29, 2005 and June 30, 2004, respectively. Due to the utilization of net operating loss carryforwards in the sale of the Gloria Jean’s international franchise operations and following an Internal Revenue Code Section 382 analysis, as of June 29, 2005, net operating loss carryforwards for federal income tax purposes of $3,615,000 are available to be utilized against future taxable income for years through fiscal 2024, subject to possible annual limitation pertaining to change in ownership rules under the Internal Revenue Code. Due to the uncertainty of future taxable income, deferred tax assets resulting from the net operating loss carryforwards have been fully reserved. As of June 29, 2005, there were no net operating loss carryforwards available for state income tax purposes.

Results of Discontinued Operations    As a result of the sale of the international Gloria Jean’s franchise operations on February 11, 2005 the results from this component of our business are presented as discontinued operations for the fiscal years ended June 29, 2005 and June 30, 2004 in accordance with SFAS 144. In the year ended June 29, 2005 net income from discontinued operations was $17,938,000, net of $3,457,000 in taxes, including a gain of $15,795,000, net of $3,139,000 in taxes. The tax expense associated with the discontinued operations differed from the statutory federal effective tax rate primarily due to changes in the valuation allowance and permanently nondeductible goodwill associated with the discontinued operations. In the year ended June 30, 2004 income from discontinued operations was $1,898,000, net of taxes of $1,161,000.

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FINANCIAL CONDITION AND LIQUIDITY AND CAPITAL RESOURCES

Current Financial Condition

At June 28, 2006, we had working capital of $3,618,000, total capital lease obligations, deferred rent and deferred compensation of $1,334,000 and $24,267,000 of stockholders’ equity, compared to a working capital of $11,203,000, total capital lease obligations, deferred rent and deferred compensation of $780,000 and $31,522,000 of stockholders’ equity at June 29, 2005. As a result of the restructuring of our credit agreements as described in “Outstanding Debt and Financing Arrangements” below, available credit under our credit agreements were $5,000,000 and $5,250,000 as of June 28, 2006 and June 29, 2005, respectively.

Cash Flows

The following is a summary of our cash flows for the three years ended June 28, 2006:

	Fiscal Years Ended
	June 28, 2006			June 29, 2005			June 30, 2004
Cash flows provided by operating activities:
Net income (loss)	$	(7,796,000	)	$	14,623,000		$	251,000
Less: Income from discontinued operations, net		—			(2,143,000	)		(1,898,000	)
Gain on disposal of discontinued operations, net		—			(15,795,000	)		—
Loss from continuing operations		(7,796,000	)		(3,315,000	)		(1,647,000	)
Net non-cash charges to income		3,191,000			908,000			1,812,000
Net (increase) decrease in operating assets		(916,000	)		(2,241,000	)		173,000
Net increase in operating liabilities		814,000			1,942,000			541,000
Cash flows provided by (used in) continuing operating activities	$	(4,707,000	)	$	(2,706,000	)	$	879,000
Cash flows provided by (used in) discontinued operations		—			(201,000	)		2,877,000
Cash flows provided by (used in) investing activities		(3,246,000	)		12,353,000			(2,438,000	)
Cash flows used in financing activities		53,000			(752,000	)		(2,144,000	)
Net increase (decrease) in cash		(7,900,000	)		8,694,000			(826,000	)
Cash at beginning of year		10,493,000			1,799,000			2,625,000
Cash at end of year	$	2,593,000		$	10,493,000		$	1,799,000
Capital commitments at end of year	$	2,018,000		$	2,065,000		$	514,000

The decrease in cash from continuing operations in fiscal year 2006 as compared to fiscal years 2005 and 2004 is more fully enumerated in the consolidated statements of cash flows in the accompanying consolidated financial statements.

Working capital requirements tend to be seasonal, with inventories and receivables increasing before the holiday season and declining in the post holiday period. Planned new store growth will initially have the effect of increasing working capital requirements and decreasing cash flows provided by operating activities.

Cash flow provided by discontinued operating activities is primarily the results of international franchise operations before the sale in February 2005.

Cash provided by investing activities for the fiscal year ended June 29, 2005 increased $14,791,000 from cash used of $2,438,000 in fiscal 2004 to cash provided of $12,353,000 in fiscal 2005. The increase is primarily the result of the sale of international operations for $16,000,000 in cash offset by capital expenditures of $3,665,000.

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The decrease in cash flows used in financing activities is the result of a net reduction of long-term debt and capital lease obligations from fiscal 2004 to fiscal 2005.

We had capital commitments at the end of the fiscal year 2006 totaling $2,018,000, of which $1,177,000 relates to opening new stores and $841,000 for remodeling, equipment and software upgrades for company operated retail units. We had capital commitments at the end of the fiscal year 2005 totaling $2,065,000, of which $1,228,000 relates to opening new stores and $837,000 for remodeling, equipment and software upgrades for company operated retail units and the Castroville roasting facility. Capital commitments at the end of the fiscal year 2004 totaled $514,000 of which $406,000 relates to opening a new store and $108,000 for remodeling and equipment for company operated retail units.

Outstanding Debt and Financing Arrangements

On May 10, 2004, we entered into a $5,000,000 Contingent Convertible Note Purchase Agreement. The agreement provides for us to, at our election, issue notes with up to an aggregate principal amount of $5,000,000. The notes are to be amortized on a monthly basis at a rate that will repay 60% of the principal amount of the note by June 30, 2008. The remaining 40% will mature on that date. Interest is payable at three-month LIBOR plus 5.30%, and a facility fee of 1.00% annually is payable on the unused portion of the facility. The agreement contains covenants among others that limit the amount of indebtedness that we may have outstanding in relation to its tangible net worth. As of June 28, 2006, we were in compliance with all the covenants in the agreement. Notes are convertible into our common stock only upon certain changes of control. For notes issued and repaid, warrants to purchase shares are to be issued with the same rights and restrictions for exercise as existed for convertibility of the notes at the time of their issuance. Warrants are exercisable only in the event of a change of control and expire on June 30, 2010. The fair value of warrants issued with respect to notes repaid will be recorded as a discount to debt, at the date of issuance, which will then be amortized using the effective interest method. Warrants to purchase our common stock will be issued only upon a change in control. The lender under this agreement is a limited partnership of which the chairman of our board of directors serves as the sole general partner. On May 10, 2004, upon entering into the agreement, we immediately issued a $1,000,000 note under the facility, and used the proceeds of the note and other available cash to repay all outstanding debt with Bank of the West (“BOW”). On September 15, 2004, we issued a second note for $1,000,000 under this facility. Both the notes were fully repaid in fiscal year 2005, and thus a total of 455,184 warrants are issuable upon a change in control. We have issued 4,219 warrants as of June 28, 2006. As of June 28, 2006, we had no borrowings outstanding under the facility and the full amounts are available for borrowing at that date.

On June 30, 2004, we entered into Amendment No. 1 to Contingent Convertible Note Purchase Agreement (“Amendment No. 1”), which revised the definition of “Availability” to mean, on any date, the loan amount less the sum of the principal amounts then outstanding under the Note Purchase Agreement. Under the original Note Purchase Agreement, availability was calculated using a formula that reduced availability over time.

On November 4, 2005, we entered into a new Credit Agreement with Bank of the West. The agreement provides for a $750,000 letter of credit facility that expires on October 15, 2006. The letter of credit facility is secured by a deposit account at Bank of the West. As of June 28, 2006, this deposit account had a balance of $583,000, which is shown as restricted cash on the consolidated balance sheets. As of June 28, 2006, $651,000 of letters of credit was outstanding under the letter of credit facility. The agreement contains covenants that, among other matters, require us to submit financial statements to the bank within specified time periods. As of June 28, 2006, we were in compliance with all Bank of the West agreement covenants.

On March 31, 2006, we entered into Amendment No. 2 to Contingent Convertible Note Purchase Agreement (“Amendment No. 2”). Amendment No. 2: (i) contains a waiver with respect to the default of the Minimum EBITDA Covenant as of March 8, 2006 and removes the Minimum EBITDA from the Note Purchase Agreement; (ii) clarifies that warrants to purchase our common stock will be issued with respect to repaid principal amounts only upon a change in control; (iii) increases the interest rate applicable to outstanding

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amounts under the credit facility by 2%, to LIBOR plus 5.30%; and (iv) extended the exercise date of all warrants issued or to be issued under the Note Purchase Agreement by one year, to May 10, 2009 which was subsequently extended as discussed below. The maturity date for any notes issued in the future was unaffected by Amendment No. 2. We were in compliance with all agreement covenants as amended by Amendment No. 2 as of June 28, 2006.

Subsequent to the fiscal year-end 2006, we issued a note with a principal amount of $1,000,000 on August 23, 2006, pursuant to the $5,000,000 Contingent Convertible Note Purchase Agreement. The interest rate was 10.63% at the time of the note issuance.

On September 22, 2006, we entered into Amendment No. 3 to Contingent Convertible Note Purchase Agreement (“Amendment No. 3”). Amendment No. 3 (i) changes the date specified in the definition of “Maturity Date” from May 10, 2007 to June 30, 2008; (ii) adjusts the calculation of monthly payments to reflect the extended maturity date; (iii) removes a condition precedent to each loan that previously required there to be no material adverse effect or event reasonably likely to result in a material adverse effect before the obligation of the lender to purchase any note arose; (iv) amends the events of default so that an event that has, or is reasonably likely to have, a material adverse effect will not be considered such an event of default; (v) amends the notice requirements so that the Company is not required to give notice to the lender of any event that is reasonably likely to have a material adverse effect; and (vi) extends the exercise date of all warrants issued or to be issued under the Note Purchase Agreement to June 30, 2010.

In recent years, we have experienced recurring operating losses and negative cash flows from operations. We have taken steps to reduce future losses and with positive revenue trends, the cost control measures initiated by us should result in improved financial performance in the near term. We have announced our plans to strengthen our two core business segments by focusing the resources dedicated to our expanding wholesale business and by narrowing our retail focus to our franchise stores without significant capital investment. We also announced that we would exit our company operated Diedrich and Coffee People retail locations through the previously disclosed transaction with Starbucks Corporation.

While our management fully expects that the transaction with Starbucks Corporation will be completed, there are no absolute assurances that this will occur. In the unlikely event that the transaction is not fully completed, the anticipated improvement in our cash flow and financial condition would reflect only the cost control measures initiated by us and any portion of the transaction that is completed.

Based on the terms of our credit agreements, as amended, our management’s expectations that the transaction to exit the company operated Diedrich and Coffee People retail locations will be completed, the focus on growing the wholesale and franchise business segments, the status of our balance sheet and the overall business outlook for us and the specialty coffee market, our management believes that cash from ongoing operations, the anticipated proceeds from the sale transaction and funds available to us from our current credit agreements will be sufficient to satisfy our working capital needs at the anticipated operating levels for at least the next twelve months.

Off-Balance Sheet Arrangements

As of June 28, 2006, we did not have any off-balance sheet arrangements, as defined in Item 303 (a)(4)(ii) of Regulation S-K.

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Commitments and Contractual Obligations

The following is a summary of our contractual obligations and commitments as of June 28, 2006:

	Payments Due By Period
	Total		Less than 1 year		1-3 years		3-5 years		More than 5 years
	(In thousands)
Capital leases (including interest)	$	504	$	44	$	88	$	88	$	284
Company operated retail locations and other operating leases		27,463		4,112		7,421		5,924		10,006
Franchise operated retail locations operating leases		20,168		4,203		6,037		4,250		5,678
Green coffee commitments		1,874		1,874		—		—		—
	$	50,009	$	10,233	$	13,546	$	10,262	$	15,968

We have also entered into employment agreements with two senior executive officers that provide for severance payments in the event that these individuals are terminated without cause or that they terminate their employment as a result of a constructive termination. These severance payments range from six months to one year’s salary. Our Company’s maximum liability for severance under the contracts is currently $368,000. Because such amounts are contingent they have not been included in the above table.

We have obligations under non-cancelable operating leases for our coffee houses, roasting facility and administrative offices. Lease terms are generally for 10 to 20 years with renewal options and generally require us to pay a proportionate share of real estate taxes, insurance, common area and other operating costs. Some retail leases provide for contingent rental payments based on sales thresholds. In addition, we are liable on the master leases for 79 Gloria Jean’s franchise locations. Under our historical franchising business model, we executed the master leases for these locations, and entered into subleases on the same terms with our franchisees, which typically pay their rent directly to the landlords. Should any of these franchisees default on their subleases, we would be responsible for making payments thereunder. Our maximum theoretical future exposure at June 28, 2006, computed as the sum of all remaining lease payments through the expiration dates of the respective leases, was $20,168,000. This amount does not take into consideration any mitigating measures that we could take to reduce this exposure in the event of default, including re-leasing the locations or terminating the master lease by negotiating a lump sum payment to the landlord that is less than the sum of all remaining future rents and other amounts payable.

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CRITICAL ACCOUNTING ESTIMATES

The preparation of our consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts. The estimates and assumptions are evaluated on an ongoing basis and are based on historical experience and on various other factors that are believed to be reasonable. Accounts significantly impacted by estimates and assumptions include, but are not limited to, franchise receivables, allowance for bad debt reserves, fixed asset lives, goodwill, intangible assets, income taxes, self-insurance and workers’ compensation reserves, store closure reserves, stock-based compensation, the valuation allowance for net deferred tax assets and contingencies. We believe that the following represent our critical accounting policies and estimates used in the preparation of our condensed consolidated financial statements. The following discussion, however, does not list all of our accounting policies and estimates.

Impairment of Property and Equipment and Other Amortizable Long-Lived Assets Held and Used

Each quarter, or upon the occurrence of a triggering event as defined in SFAS No. 144, we evaluate the carrying value of individual stores when the operating results have reasonably progressed to a point to adequately evaluate the probability of continuing operating losses or a current expectation that a store will be sold or otherwise disposed of before the end of its previously estimated useful life. In making these judgments, we consider the period of time since the store was opened or remodeled, and the trend of operations and expectations for future sales growth. For stores selected for review, we estimate the future cash flows from operating the store over its estimated useful life. We make judgments about future same-store sales and the operating expenses and estimated useful life that we would expect with such level of same-store sales.

The most significant assumptions in our analysis are those used when we estimate a unit’s future cash flows. We generally use the assumptions in our strategic plan and modify them as necessary based on unit specific information. If our assumptions are incorrect, the carrying value of our operating unit assets may be overstated or understated.

Impairment of Goodwill

At the reporting unit level, goodwill is tested for impairment annually or whenever an event or circumstance indicates that impairment has likely occurred. We consider the reporting unit level to be the segment level since the components within each segment have similar economic characteristics, including products and services, production processes, types or classes of customers and distribution methods. The impairment, if any, is measured based on the estimated fair value of the segment. Fair value can be determined based on discounted cash flows or valuations of similar businesses. Impairment occurs when the carrying amount of goodwill exceeds its estimated fair value.

The most significant assumptions we use in this analysis are those made in estimating future net cash flows. In estimating future cash flows, we consider historical results as well as the assumptions utilized in our strategic plan for items such as same-store sales, store count growth rates, and the discount rate we consider to be the market discount rate used for acquisitions of similar businesses.

If our assumptions used in performing the impairment test prove inaccurate, the fair value of the segments may ultimately prove to be significantly higher or lower, thereby causing the carrying value to be less than or to exceed the fair value and indicating impairment has or has not occurred. If our assumptions are incorrect, the carrying value of our goodwill may be understated or overstated. Our annual impairment measurement date is our fiscal year end.

Estimated Liability for Closing Stores

We make decisions to close stores based on prospects for estimated future profitability and sometimes we are forced to close stores due to circumstances beyond our control (e.g., a landlord’s refusal to negotiate a new

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lease). Our management team evaluates each store’s performance every period. When stores continue to perform poorly, we consider the demographics of the location, as well as the likelihood of being able to improve the performance of an unprofitable store. Based on the management team’s judgment, we estimate the future net cash flows. If we determine that the store will not, within a reasonable period of time, operate at break-even cash flow or be profitable, and we are not contractually obligated to continue operating the store, we may close the store. Additionally, franchisees may close stores for which we are the primary lessee. If the franchisee cannot make payments on the lease, we continue making the lease payments and establish an estimated liability for the closed store if we decide not to operate it as a company operated store. Effective January 1, 2003, we establish the estimated liability on the actual closure date which is generally the date on which we cease to receive economic benefit from the unit. Prior to the adoption of SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”), on January 1, 2003, we established the estimated liability when we identified a store for closure, which may or may not have been the actual closure date. We also review the net cash flows to determine the need to provide for asset impairment.

The estimated liability for closing stores on properties vacated is generally based on the term of the lease and the lease termination fee that we expect to pay, as well as the estimated maintenance costs that we expect to pay until the lease has been abated. The amount of the estimated liability is generally the present value of the estimated future payments. The interest rate used to calculate the present value of these liabilities is based on our incremental borrowing rate at the time the liability is established. The related discount is amortized and shown in provision for asset impairment and restructuring costs or cost of sales and related occupancy, net in our consolidated statements of operations.

A significant assumption used in determining the amount of the estimated liability for closing stores is the amount of the estimated liability for future lease payments on vacant stores, which we determine based on our assessment of our ability to successfully negotiate early terminations of our lease agreements with the lessors or to sublease the property. Additionally, we estimate the cost to maintain leased and owned vacant properties until the lease has been abated. If the costs to maintain properties increase, or it takes longer than anticipated to sell properties or sublease or terminate leases, we may need to record additional estimated liabilities. If the leases on the vacant stores are not terminated or subleased on the terms we used to estimate the liabilities, we may be required to record losses in future periods. Conversely, if the leases on the vacant stores are terminated or subleased on more favorable terms than we used to estimate the liabilities, we reverse previously established estimated liabilities through the line item in which it was originally recorded, resulting in an increase in operating income.

Estimated Liability for Self-Insurance and Workers’ Compensation

We are self-insured for a portion of our current year’s losses related to workers’ compensation insurance. We have obtained stop loss insurance for individual workers’ compensation claims with a $250,000 deductible per occurrence and a program maximum for all claims of $750,000. Insurance liabilities and reserves are accounted for based on the present value of actuarial estimates of the amount of incurred and unpaid losses, based approximately on a risk-free interest rate. These estimates rely on actuarial observations of historical claim loss development. Management, in determining the estimated liability, bases the assumptions on the average historical losses on claims we have incurred. The actual loss development may be better or worse than the development we estimated in conjunction with the actuary. In that event, we will modify the reserve. As a result, if we experience a higher than expected number of claims or the costs of claims are greater than expected, then we may adjust the expected losses upward and our future self-insurance expenses will rise.

Franchised Operations

We monitor the financial condition of certain franchisees and record provisions for estimated losses on receivables when we believe that our franchisees are unable to make their required payments to us. Each period we perform an analysis to develop estimated bad debts for each franchisee. We then compare the aggregate result

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of that analysis to the amount recorded in our consolidated financial statements as the allowance for doubtful accounts and adjust the allowance as appropriate. Over time, our assessment of individual franchisees may change. For instance, we have had franchisees for whom we had estimated a loss equal to the total amount of their receivable, who have paid us in full or established a consistent record of payments (generally one year) such that we determined an allowance was no longer required.

Depending on the facts and circumstances, there are a number of different actions we or our franchisees may take to resolve franchise collections issues. These actions may include the purchase of franchise stores by us or by other franchisees, a modification to the franchise agreement, which may include a provision to defer certain royalty payments or reduce royalty rates in the future, a restructuring of the franchisee’s business or finances (including the restructuring of leases for which we are the primary or secondary obligee) or, if necessary, the termination of the franchise agreement. The allowance established is based on our assessment of the most probable course of action that will occur.

In accordance with SFAS No. 146, which we adopted on January 1, 2003, an estimated liability for future lease obligations on stores operated by franchisees for which we are the primary or secondary obligee is established on the date the franchisee closes the store. Also, we record an estimated liability for subsidized lease payments when we sign a sublease agreement committing us to the subsidy.

The amount of the estimated liability is established using the methodology described in “Estimated Liability for Closing Stores” above. Consistent with SFAS No. 146, we have not established an additional estimated liability for potential losses not yet incurred. If sales trends or economic conditions worsen for our franchisees, their financial health may worsen, our collection rates may decline and we may be required to assume the responsibility for additional lease payments on franchised stores. In addition, entering into restructured franchise agreements may result in reduced franchise royalty rates in the future.

Stock-Based Compensation

As discussed in the notes to consolidated financial statements, we have various stock-based compensation plans that provide options for certain employees and outside directors to purchase common shares of stock. Prior to June 30, 2005, we elected to account for stock-based compensation in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” which utilizes the intrinsic value method of accounting for stock-based compensation, as opposed to using the fair-value method prescribed in SFAS No. 123, “Accounting for Stock-Based Compensation.” Because of this election, we were required to make certain disclosures of pro forma net income assuming we had adopted SFAS No. 123. Starting June 30, 2005, we adopted the provisions of SFAS 123R, which sets accounting requirements for “share-based” compensation to employees and non-employee directors, including employee stock purchase plans, and requires companies to recognize in the statement of operations the grant-date fair value of stock options and other equity-based compensation.

We determine the estimated fair value of stock-based compensation on the date of the grant using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model requires us to apply highly subjective assumptions, including our historical stock price volatility, expected life of the option and the risk-free interest rate. A change in one or more of the assumptions used in the Black-Scholes option-pricing model may result in a material change to the estimated fair value of the stock-based compensation. See Note 1 of Notes to Consolidated Financial Statements for analysis of the effect of certain changes in assumptions used to determine the fair value of stock-based compensation.

Valuation Allowance for Net Deferred Tax Assets and Contingencies

As discussed above, we have recorded a 100% valuation allowance against our net deferred tax assets. If we have been profitable for a number of years and our prospects for the realization of our deferred tax assets are

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more likely than not, we would then reverse our valuation allowance and credit income tax expense. In assessing the prospects for future profitability, many of the assessments of same-store sales and cash flows discussed above become relevant. When circumstances warrant, we assess the likelihood that our net deferred tax assets will more likely than not be realized from future taxable income. As of June 28, 2006, our net deferred tax assets and related valuation allowance totaled approximately $5,094,000.

NEW ACCOUNTING PRONOUNCEMENTS

Accounting Pronouncements Not Yet Adopted

In July 2006, the FASB issued Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109,” which seeks to reduce the diversity in practice associated with the accounting and reporting for uncertainty in income tax positions. This Interpretation prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. FIN 48 is effective for fiscal years beginning after December 15, 2006. We will adopt the new requirements in our fiscal first quarter of 2008. The cumulative effects, if any, of adopting FIN 48 will be recorded as an adjustment to retained earnings as of the beginning of the period of adoption. We have not yet determined the impact, if any, of adopting FIN 48 on our consolidated financial statements.

OTHER MATTERS

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 second fiscal quarter, which includes the November-December holiday season. Hot weather tends to negatively impact sales. Quarterly results are also 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.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk.

Market Risk Sensitive Items Entered Into for Trading Purposes

None.

Market Risk Sensitive Items Entered Into for Other Than Trading Purposes

We have exposure to market risk from two primary sources—interest rate risk and commodity price risk.

Interest Rate Risk

We are exposed to market risk from changes in interest rates on our outstanding bank debt. At June 28, 2006, we had a $5,000,000 note facility with no outstanding balance, which could be affected by changes in short term interest rates. At fiscal year-end, the interest rate was 10.81%.

Commodity Price Risk

Green coffee, the principal raw material for our products, is subject to significant price fluctuations caused by a number of factors, including weather, political, and economic conditions. To date, we have not used

37

commodity-based financial instruments to hedge against fluctuations in the price of green coffee. To ensure that we have an adequate supply of green coffee, however, we enter into agreements to purchase green coffee in the future that may or may not be fixed as to price. At June 28, 2006, we had commitments to purchase coffee through fiscal year 2007, totaling $1,874,000 for 1,215,000 pounds of green coffee, the majority of which were fixed as to price. The coffee scheduled to be delivered to us in fiscal year 2007 pursuant to these commitments will satisfy approximately 25% of our anticipated green coffee requirements for the fiscal year. Assuming we require approximately 3,364,000 additional pounds of green coffee during fiscal 2007 for which no price has yet been fixed, each $0.01 per pound increase in the price of green coffee could result in $34,000 of additional cost. However, because the price we pay for green coffee is negotiated with suppliers, we believe that the commodity market price for green coffee would have to increase significantly, by as much as $0.25 per pound, before suppliers would increase the price they charge us.

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.

We have agreed to indemnify and hold KPMG LLP harmless against and from any and all legal costs and expenses incurred by KPMG LLP in successful defense of any legal action or proceeding that arises as a result of KPMG LLP’s consent to the incorporation by reference of its audit report on our past financial statements incorporated by reference herein.

Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.

KPMG LLP (KPMG) was previously our principal accountants. On October 26, 2004, the Audit Committee approved the dismissal of KPMG as our principal accountants upon the acceptance by BDO Seidman, LLP of its appointment to serve in such capacity. The decision to change auditors was recommended and approved by the Audit Committee.

The audit report of KPMG on our consolidated financial statements as of and for the fiscal year ended June 30, 2004 did not contain any adverse opinion or disclaimer of opinion, nor were they qualified or modified as to uncertainty, audit scope or accounting principles.

In connection with the audit of the fiscal year ended June 30, 2004 and the subsequent interim period through October 26, 2004, there were no disagreements or reportable events with KPMG on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedures, which disagreements if not resolved to KPMG’s satisfaction would have caused KPMG to make reference in connection with its opinion to the subject matter of the disagreement or reportable event, except as described below:

In performing its audit of our consolidated financial statements for the year ended June 30, 2004, KPMG noted a matter involving our internal controls that it considered to be a reportable condition. A “reportable condition,” which may or may not be determined to be a material weakness, involves matters relating to significant deficiencies in the design or operation of internal controls that, in KPMG’s judgment, could adversely affect our ability to record, process, summarize and report financial data consistent with the assertions of management in the financial statements. The reportable conditions, which were not considered by us to be material weaknesses, noted that we do not have adequate internal controls over the application of new accounting principles or the application of existing accounting principles to new transactions. Specifically, KPMG noted that in the fourth quarter of fiscal year 2004 we recognized $113,000 in franchise revenue related to a terminated area development agreement when it should have been recognized in the first fiscal quarter, which resulted in the

38

restatement of our first fiscal quarter results. It also noted that we had not fully addressed the impact of accounting for the warrants associated with the convertible debt issued in May 2004, and had not timely completed the assessment necessary to implement Financial Accounting Standards Board Interpretation No. 46 (revised December 2003), “Consolidation of Variable Interest Entities.” We authorized KPMG to respond fully to the inquiries of BDO Seidman, LLP regarding the events described above.

For the fiscal year ended June 30, 2004 and the subsequent interim period through October 26, 2004, we did not consult with BDO Seidman, LLP regarding the application of accounting principles to a specified transaction, type of audit opinion that might be rendered on our financial statements, or any other accounting, auditing or reporting matters.

Item 9A. Controls and Procedures.

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), in connection with the preparation of this Annual Report on Form 10-K, as of June 28, 2006. Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, also conducted an evaluation of our internal control over financial reporting to determine whether any changes occurred during the fourth quarter of fiscal 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Based on the review described above, our Chief Executive Officer and Chief Financial Officer determined that our disclosure controls and procedures were effective as of the end of the period covered by this report. There were no changes in our internal control over financial reporting that occurred during the fourth quarter ended June 28, 2006, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Item 9B. Other Information.

None.

PART III

Item 10. Directors and Executive Officers of the Registrant.

The information required by this item is incorporated herein by reference to our definitive proxy statement for our 2006 annual meeting of stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended June 28, 2006.

Item 11. Executive Compensation.

The information required by this item is incorporated herein by reference to our definitive proxy statement for our 2006 annual meeting of stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended June 28, 2006.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.

The information required by this item is incorporated herein by reference to our definitive proxy statement for our 2006 annual meeting of stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended June 28, 2006.

39

Equity Compensation Plan Information

The following table summarizes the equity compensation plans under which our common stock may be issued as of June 28, 2006.

	(a)	(b)	(c)
Plan category	Number of securities to be issued upon exercise of outstanding options, warrants and rights	Weighted-average exercise price of outstanding options, warrants and rights	Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))
Equity compensation plans approved by security holders	941,333 (1)	$4.94	387,001 (2)
Total	941,333	$4.94	387,001

(1) Represents options to purchase shares of our common stock issued under: the Diedrich Coffee, Inc. 2000 Equity Incentive Plan; the Stock Option Plan and Agreement with Roger M. Laverty; the Diedrich Coffee, Inc. 2000 Non-Employee Directors Stock Option Plan; and the Amended and Restated Diedrich Coffee, Inc. 1996 Stock Incentive Plan.

(2) Represents securities available for issuance under the Diedrich Coffee, Inc. 2000 Equity Incentive Plan.

Item 13. Certain Relationships and Related Transactions.

The information required by this item is incorporated herein by reference to our definitive proxy statement for our 2006 annual meeting of stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended June 28, 2006.

Item 14. Principal Accountant Fees and Services.

The information required by this item is incorporated herein by reference to our definitive proxy statement for our 2006 annual meeting of stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended June 28, 2006.

PART IV

Item 15. Exhibits and Financial Statement Schedules

Financial Statements and Schedules.

The financial statements and schedules required to be filed hereunder are set forth at the end of this Annual Report on Form 10-K beginning on page F-1.

Exhibits.

The Exhibit Index attached hereto is incorporated herein by reference.

40

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	DIEDRICH COFFEE, INC.
September 26, 2006	By:	/s/ STEPHEN V. COFFEY
		Stephen V. Coffey
		Chief Executive Officer
		(on behalf of the registrant)

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

Signature	Title	Date
/s/ PAUL HEESCHEN Paul Heeschen	Chairman of the Board of Directors	September 26, 2006
/s/ STEPHEN V. COFFEY Stephen V. Coffey	Chief Executive Officer	September 26, 2006
/s/ SEAN M. MCCARTHY Sean M. McCarthy	Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)	September 26, 2006
/s/ LAWRENCE GOELMAN Lawrence Goelman	Director	September 26, 2006
/s/ RICHARD SPENCER Richard Spencer	Director	September 26, 2006
/s/ TIMOTHY J. RYAN Timothy J. Ryan	Director	September 26, 2006
/s/ GREG PALMER Greg Palmer	Director	September 26, 2006

41

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

	Page
Report of Independent Registered Public Accounting Firms
BDO Seidman, LLP	F-2
KPMG LLP	F-3
Consolidated Balance Sheets	F-4
Consolidated Statements of Operations	F-5
Consolidated Statements of Stockholders’ Equity	F-6
Consolidated Statements of Cash Flows	F-7
Notes to Consolidated Financial Statements	F-9
Schedule II – Valuation and Qualifying Accounts	F-32

F-1

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders

Diedrich Coffee, Inc.:

We have audited the accompanying consolidated balance sheets of Diedrich Coffee, Inc. and subsidiaries (the “Company”) as of June 28, 2006 and June 29, 2005 and the related consolidated statements of operations, shareholders’ equity and cash flows for the years then ended. In connection with our audits of the consolidated financial statements, we also have audited the supplementary information included in Schedule II. These consolidated financial statements and the financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also 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.

As more fully described in Note 1 to the consolidated financial statements, effective June 30, 2005, the Company adopted the provisions of SFAS 123(R), “Share-Based Payment.”

As described in Note 2, the Company has suffered continuing losses from operations resulting in decreased working capital availability and the Company management has implemented certain actions and plans including the potential sale of its retail operations to address its financial condition and liquidity.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Diedrich Coffee, Inc. and subsidiaries as of June 28, 2006 and June 29, 2005, and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States. Also in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.

/s/ BDO Seidman, LLP

Costa Mesa, California

August 18, 2006, except as to Note 16,

which is as of September 14, 2006

and Note 2 and last paragraphs

of Notes 7 and 9, which are as of

September 22, 2006

F-2

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders

Diedrich Coffee, Inc.:

We have audited the accompanying consolidated statements of operations, stockholders’ equity and cash flows of Diedrich Coffee, Inc. and subsidiaries for the year ended June 30, 2004. In connection with our audit of the consolidated financial statements, we have also audited the accompanying financial statement schedule. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). 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 audit provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of Diedrich Coffee, Inc. and subsidiaries for the year ended June 30, 2004, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

/s/ KPMG LLP

Costa Mesa, California

August 20, 2004, except as to paragraphs 3, 4, 5, 6 and 7 of note 1,

which are as of September 22, 2005

F-3

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

	June 28, 2006			June 29, 2005
Assets
Current assets:
Cash	$	2,593,000		$	10,493,000
Restricted cash		583,000			—
Accounts receivable, less allowance for doubtful accounts of $1,863,000 at June 28, 2006 and $1,392,000 at June 29, 2005		2,829,000			2,203,000
Inventories		3,846,000			3,426,000
Income tax refund		516,000			1,220,000
Current portion of notes receivable		1,137,000			1,165,000
Advertising fund assets, restricted		217,000			218,000
Prepaid expenses		426,000			489,000
Total current assets		12,147,000			19,214,000
Property and equipment, net		9,088,000			7,974,000
Goodwill		8,179,000			8,179,000
Notes receivable		3,972,000			4,554,000
Cash surrender value of life insurance policy		391,000			—
Other assets		353,000			392,000
Total assets	$	34,130,000		$	40,313,000
Liabilities and Stockholders’ Equity
Current liabilities:
Current installments of obligations under capital leases	$	19,000		$	85,000
Accounts payable		2,929,000			2,642,000
Accrued compensation		2,481,000			2,886,000
Accrued expenses		1,779,000			1,366,000
Franchisee deposits		599,000			632,000
Deferred franchise fee income		104,000			91,000
Advertising fund liabilities		217,000			218,000
Accrued provision for store closure		401,000			91,000
Total current liabilities		8,529,000			8,011,000
Obligations under capital leases, excluding current installments		309,000			328,000
Deferred rent		603,000			452,000
Deferred compensation		422,000			—
Total liabilities		9,863,000			8,791,000
Commitments and contingencies (Notes 7 and 8)
Stockholders’ equity:
Common stock, $.01 par value; authorized 8,750,000 shares; issued and outstanding 5,308,000 shares at June 28, 2006 and 5,273,000 shares at June 29, 2005		53,000			53,000
Additional paid-in capital		59,022,000			58,481,000
Accumulated deficit		(34,808,000	)		(27,012,000	)
Total stockholders’ equity		24,267,000			31,522,000
Total liabilities and stockholders’ equity	$	34,130,000		$	40,313,000

See accompanying notes to consolidated financial statements.

F-4

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

	Year Ended June 28, 2006			Year Ended June 29, 2005			Year Ended June 30, 2004
Net revenue:
Retail sales	$	34,428,000		$	31,890,000		$	31,617,000
Wholesale and other		21,244,000			16,482,000			14,861,000
Franchise revenue		3,775,000			4,166,000			4,407,000
Total revenue		59,447,000			52,538,000			50,885,000
Costs and expenses:
Cost of sales and related occupancy costs		32,440,000			26,765,000			24,642,000
Operating expenses		19,947,000			17,449,000			16,701,000
Depreciation and amortization		2,601,000			2,372,000			2,315,000
General and administrative expenses		13,546,000			11,178,000			9,597,000
Provision for asset impairment and restructuring costs		—			—			94,000
Gain on asset disposals		(58,000	)		(4,000	)		(2,000	)
Total costs and expenses		68,476,000			57,760,000			53,347,000
Operating loss from continuing operations		(9,029,000	)		(5,222,000	)		(2,462,000	)
Interest expense		(116,000	)		(223,000	)		(348,000	)
Interest and other income, net		548,000			279,000			30,000
Loss from continuing operations before income tax benefit		(8,597,000	)		(5,166,000	)		(2,780,000	)
Income tax benefit		(801,000	)		(1,851,000	)		(1,133,000	)
Loss from continuing operations		(7,796,000	)		(3,315,000	)		(1,647,000	)
Discontinued operations:
Income from discontinued operations, net of $0, $318,000 and $1,161,000 taxes, respectively		—			2,143,000			1,898,000
Gain on sale of discontinued operations, net of $3,139,000 taxes		—			15,795,000			—
Net income (loss)	$	(7,796,000	)	$	14,623,000		$	251,000
Basic and diluted net income (loss) per share:
Loss from continuing operations	$	(1.47	)	$	(0.64	)	$	(0.32	)
Income from discontinued operations, net	$	—		$	3.44		$	0.37
Net income (loss)	$	(1.47	)	$	2.80		$	0.05
Weighted average and equivalent shares outstanding:
Basic and diluted		5,303,000			5,218,000			5,161,000

See accompanying notes to consolidated financial statements.

F-5

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

	Common Stock
	Shares	Amount		Additional Paid-In Capital		Accumulated Deficit			Total Stockholders’ Equity
Balance, July 2, 2003	5,161,000	$	52,000	$	58,036,000	$	(41,886,000	)	$	16,202,000
Stock compensation expense	—		—		22,000		—			22,000
Net income	—		—		—		251,000			251,000
Balance, June 30, 2004	5,161,000		52,000		58,058,000		(41,635,000	)		16,475,000
Exercise of stock options	112,000		1,000		367,000		—			368,000
Stock compensation expense	—		—		47,000		—			47,000
Common Stock warrants	—		—		9,000		—			9,000
Net income	—		—		—		14,623,000			14,623,000
Balance, June 29, 2005	5,273,000		53,000		58,481,000		(27,012,000	)		31,522,000
Exercise of stock options	35,000		—		138,000		—			138,000
Stock compensation expense	—		—		403,000		—			403,000
Net loss	—		—		—		(7,796,000	)		(7,796,000	)
Balance, June 28, 2006	5,308,000	$	53,000	$	59,022,000	$	(34,808,000	)	$	24,267,000

See accompanying notes to consolidated financial statements.

F-6

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

	Year Ended June 28, 2006			Year Ended June 29, 2005			Year Ended June 30, 2004
Cash flows from operating activities:
Net income (loss)	$	(7,796,000	)	$	14,623,000		$	251,000
Income from discontinued operations		—			(2,143,000	)		(1,898,000	)
Gain on disposal of discontinued operations, net		—			(15,795,000	)		—
Loss from continuing operations:		(7,796,000	)		(3,315,000	)		(1,647,000	)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Depreciation and amortization		2,601,000			2,372,000			2,315,000
Amortization and write off of loan fees		32,000			35,000			152,000
Amortization of note payable discount		—			7,000			—
Provision for bad debt		589,000			213,000			246,000
Income tax benefit		(801,000	)		(1,851,000	)		(1,133,000	)
Provision for inventory obsolescence		86,000			89,000			210,000
Provision for asset impairment and restructuring		—			—			94,000
Provision for (reversal of) store closure		401,000			—			(70,000	)
Stock compensation expense		403,000			47,000			22,000
Notes receivable issued for franchise fees		(62,000	)		—			(22,000	)
Gain on disposal of assets		(58,000	)		(4,000	)		(2,000	)
Changes in operating assets and liabilities:
Accounts receivable		(1,215,000	)		(866,000	)		172,000
Inventories		(506,000	)		(714,000	)		(414,000	)
Notes receivable		(373,000	)		(139,000	)		—
Prepaid expenses		63,000			(158,000	)		560,000
Income tax refund		1,505,000			—			—
Other assets		(390,000	)		(364,000	)		(145,000	)
Accounts payable		286,000			498,000			36,000
Accrued compensation		16,000			812,000			767,000
Accrued expenses		435,000			619,000			6,000
Deferred franchise fees income and franchisee deposits		(20,000	)		47,000			(66,000	)
Accrued provision for store closure		(91,000	)		(18,000	)		(246,000	)
Deferred rent		188,000			(16,000	)		44,000
Net cash provided by (used in) continuing operations		(4,707,000	)		(2,706,000	)		879,000
Net cash provided by (used in) discontinued operations		—			(201,000	)		2,877,000
Net cash provided by (used in) operating activities:		(4,707,000	)		(2,907,000	)		3,756,000
Cash flows from investing activities:
Capital expenditures for property and equipment		(3,826,000	)		(3,665,000	)		(2,530,000	)
Proceeds from sale of discontinued operations		—			16,000,000			—
Proceeds from disposal of property and equipment		93,000			31,000			64,000
Acquisition of retail store		—			(80,000	)		—
Issuance of notes receivable		—			—			(20,000	)
Payments received on notes receivable		1,070,000			67,000			48,000
Investment in restricted money market account		(583,000	)		—			—
Net cash provided by (used in) investing activities		(3,246,000	)		12,353,000			(2,438,000	)

See accompanying notes to consolidated financial statements.

F-7

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS—(Continued)

	Year Ended June 28, 2006			Year Ended June 29, 2005			Year Ended June 30, 2004
Cash flows from financing activities:
Payments on long-term debt		—			(1,983,000	)		(2,967,000	)
Payments on capital lease obligations		(85,000	)		(137,000	)		(177,000	)
Exercise of stock options		138,000			368,000			—
Borrowings under credit agreement		—			1,000,000			1,000,000
Net cash provided by (used in) financing activities		53,000			(752,000	)		(2,144,000	)
Net increase (decrease) in cash		(7,900,000	)		8,694,000			(826,000	)
Cash at beginning of year		10,493,000			1,799,000			2,625,000
Cash at end of year	$	2,593,000		$	10,493,000		$	1,799,000
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest	$	83,000		$	357,000		$	153,000
Income taxes	$	50,000		$	2,828,000		$	37,000
Non-cash transactions:
Issuance of notes receivable	$	66,000		$	7,020,000		$	42,000

See accompanying notes to consolidated financial statements.

F-8

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.    Summary of Significant Accounting Policies and Practices

Business

Diedrich Coffee, Inc. is a specialty coffee roaster, wholesaler, retailer and franchiser whose brands include Diedrich Coffee, Gloria Jean’s, and Coffee People. The Company owns and operates 52 retail locations and is the franchiser of 148 retail locations as of June 28, 2006, all of which are located in 33 states. The Company also has over 800 wholesale accounts with businesses and restaurant chains. In addition, the Company operates a coffee roasting facility in central California that supplies freshly roasted coffee beans to its retail locations and to its wholesale customers.

Basis of Presentation and Fiscal Year End

The consolidated financial statements include the accounts of Diedrich Coffee, Inc. and its wholly owned subsidiaries (the “Company”). All significant intercompany transactions are eliminated. The Company’s fiscal year end is the Wednesday closest to June 30. In fiscal years 2004, 2005 and 2006, this resulted in a 52-week year.

Discontinued Operations

On February 11, 2005, the Company completed the sale of its Gloria Jean’s international franchise operations to Jireh International Pty. Ltd., formerly the Gloria Jean’s master franchisee for Australia, and certain of its affiliates (collectively, “Jireh”) for $16,000,000 in cash and an additional $7,020,000 payable over the next six years under license, roasting and consulting agreements. The sale resulted in a gain on the disposal of discontinued operations of $15,795,000, net of $3,139,000 of taxes. The tax expense associated with the discontinued operations differed from the statutory federal effective tax rate primarily due to changes in the valuation allowance and permanently nondeductible goodwill associated with the discontinued operations.

The sale included the immediate transfer of related franchise rights to Jireh of 338 Gloria Jean’s retail locations outside the U.S. and Puerto Rico, including 242 located in Australia.

The Company was not required to defer any of the gain on the disposal of Gloria Jean’s international franchise operations because all future payments are irrevocable, non-interest bearing and require no ongoing obligation or performance by the Company to receive them.

In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”), the financial results of Gloria Jean’s international franchise operations are reported as discontinued operations for all periods presented.

The following accounts are reflected in Discontinued Operations:

• International franchise royalties, new store fees and roasting fees

• Wholesale revenue and cost of goods sold associated with the sale of coffee to international franchisees

• Bad debt expense related to international franchisees

• General and administrative costs related to international operations and audit, tax and legal fees relating to the transaction.

• Gain on sale of the international franchise operations, net of the related tax provision, and

• Provision for foreign taxes paid on international revenues

F-9

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

The financial results included in discontinued operations were as follows:

	Fiscal years ended
	June 28, 2006	June 29, 2005		June 30, 2004
Net revenue	—	$	3,935,000	$	3,740,000
Earnings from discontinued operations before income taxes	—	$	2,461,000		3,059,000
Earnings from discontinued operations, net of $318,000 and $1,161,000 taxes, respectively	—	$	2,143,000		1,898,000
Gain on sale of discontinued operations, net of $3,139,000 of taxes	—		15,795,000		—
Total income from discontinued operations, net of tax	—	$	17,938,000	$	1,898,000

Cash and Cash Equivalents

The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. The Company had $0 and $9,500,000 of invested cash at June 28, 2006 and June 29, 2005, respectively.

Accounts Receivable

Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts is based on management’s best estimate of the amount of probable credit losses in existing accounts receivable. The Company evaluates its allowance for doubtful accounts based upon knowledge of its customers and their compliance with credit terms. The evaluation process includes a review of customers’ accounts on a regular basis. The review process evaluates all account balances with amounts outstanding 90 days and other specific amounts for which information obtained indicates that the balance may be uncollectible. The allowance for doubtful accounts is adjusted based on such evaluation, with a corresponding provision included in operating expenses. Account balances are charged off against the allowance when management believes it is probable the receivable will not be recovered. The Company does not have any off-balance-sheet credit exposure related to its customers.

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 for property and equipment is calculated using the straight-line method over estimated useful lives of three to seven years. Property and equipment held under capital leases and leasehold improvements are generally amortized using the straight-line method. Property and equipment held under capital leases are generally amortized over the shorter of their estimated useful lives or the term of the related leases. Leasehold improvements are generally amortized over the shorter of 9 years or the term of the related leases.

Major remodels and improvements are capitalized. Maintenance and repairs that do not improve or extend the life of the respective assets are charged to expense as incurred.

F-10

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Deferred Financing Costs

Costs related to the issuance of debt are deferred and amortized using a method that approximates the effective interest method as a component of interest expense over the terms of the respective debt issues.

Store Pre-opening Costs

Direct and incremental costs incurred prior to the opening of a retail coffeehouse location are expensed as incurred.

Fair Value of Financial Instruments

The carrying amounts of cash, accounts receivable, inventories, prepaid expenses, other assets, notes receivable, accounts payable, accrued compensation, accrued expenses, and franchisee deposits approximate fair value because of the short-term maturity of these financial instruments. The Company believes the carrying amounts of the Company’s long-term debt approximates fair value because the interest rate on these instrument are subject to change with market interest rates and other terms and conditions are consistent with terms currently available to the Company.

Cost of Sales and Related Occupancy Costs

Cost of sales and related occupancy costs include cost of purchased products, inbound freight charges, purchasing and receiving costs, inspection costs, warehousing costs, internal transfer costs and all other costs of our distribution network and retail store occupancy costs.

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.

Operating Expenses

Operating expenses include compensation costs that account for over 70% of the total. Other operating expenses include utilities, advertising and marketing, business insurance, taxes, licenses, fees and bank charges.

General and Administrative Expenses

General and administrative expenses include compensation costs that represent approximately 60% of the total. Other costs include legal, office rent, telephone, consulting and outside services, and Director’s and Officer’s insurance.

Income Taxes

The Company accounts for income taxes under SFAS No. 109, “Accounting for Income Taxes” (“SFAS No. 109”). This statement requires the recognition of deferred tax assets and liabilities for the future consequences of events that have been recognized in the Company’s financial statements or tax returns. The measurement of the deferred items is based on enacted tax laws. In the event the future consequences of differences between financial reporting bases and the tax bases of the Company’s assets and liabilities result in a deferred tax asset, SFAS No. 109 requires an evaluation of the probability of being able to realize the future benefits indicated by such asset. A valuation allowance related to a deferred tax asset is recorded when it is more likely than not that some portion or all of the deferred tax asset will not be realized.

F-11

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Net Income (Loss) Per Common Share

“Basic” earnings per share represents net earnings divided by the weighted average shares outstanding, excluding all potentially dilutive common shares. “Diluted” earnings per-share reflects the dilutive effect of all potentially dilutive common shares.

Goodwill

In July 2001, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 141, “Business Combinations,” (“SFAS No. 141”) and SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”). SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. SFAS No. 141 also specifies criteria intangible assets acquired in a purchase method business combination must meet to be recognized and reported apart from goodwill. SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead are tested for impairment annually or whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors the Company considers important which could trigger an impairment review include significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of use of acquired assets or the strategy for the overall business, and significant negative industry or economic trends. The Company has performed annual evaluations of its goodwill since June 30, 2001 in order to properly state its goodwill (see Notes 6 and 11). No provision for impairment was recorded in fiscal 2004, 2005 and 2006.

Stock Option Plans

On June 30, 2005, the Company adopted the provisions of SFAS No. 123R, “Share-Based Payment” (“SFAS No. 123R”). SFAS 123R sets accounting requirements for “share-based” compensation to employees and non-employee directors, including employee stock purchase plans, and requires companies to recognize in the statement of operations the grant-date fair value of stock options and other equity-based compensation.

The Company chose the modified-prospective transition alternatives in adopting SFAS No. 123R. Under the modified-prospective transition method, compensation cost is recognized in financial statements issued subsequent to the date of adoption for all stock-based payments granted, modified or settled after the date of adoption, as well as for any unvested awards that were granted prior to the date of adoption. Because the Company previously adopted only the pro forma disclosure provisions of SFAS No. 123 “Accounting for Stock-Based Compensation” (“SFAS No. 123”), it will recognize compensation cost relating to the unvested portion of awards granted prior to the date of adoption using the same estimate of the grant-date fair value and the same attribution method used to determine the pro forma disclosures under SFAS No. 123, except that forfeitures rate will be estimated for all options, as required by SFAS No. 123R.

Awards granted prior to the Company’s implementation of SFAS No. 123R were accounted for under the recognition and measurement principles of APB Opinion 25, Accounting for Stock Issued to Employees, and related interpretations. Accordingly, no stock-based employee compensation cost is reflected in net loss in the accompanying Consolidated Statements of Operations for the fiscal years ended June 29, 2005 and June 30, 2004 because all options granted under the Company’s plans had exercise prices equal to the market values of the underlying common stock on the date of grant.

F-12

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Pro forma net income (loss) and pro forma net income (loss) per share, as if the fair value-based method of SFAS No. 123 had been applied in measuring compensation cost for stock-based awards, is as follows:

	Year Ended June 29, 2005			Year Ended June 30, 2004
Net income (loss) as reported	$	14,623,000		$	251,000
Add:  Stock based employee compensation expense included in reported net income (loss), net of related tax effects		47,000			22,000
Deduct:  Stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax effects		(528,000	)		(926,000	)
Pro forma net income (loss)	$	14,142,000		$	(653,000	)
Basic and dilutive net income (loss) per share – as reported	$	2.80		$	0.05
Basic and dilutive net income (loss) per share – pro forma	$	2.71		$	(0.13	)

The fair value of each option award is estimated on the date of grant using a Black-Scholes option valuation model that uses the assumptions noted in the following table. Expected volatility is based on the historical volatility of the price of the Company’s stock. The Company uses historical data to estimate option exercise and employee termination rates within the valuation model. The expected term of options is derived from the output of the option valuation model and represents the period of time that options are expected to be outstanding. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The fair values of the options were estimated using the Black-Scholes option-pricing model based on the following weighted average assumptions:

	Year Ended June 28, 2006	Year Ended June 29, 2005	Year Ended June 30, 2004
Risk free interest rate	4.74%	4.00%	3.81%
Expected life	2 years	6 years	6 years
Expected volatility	56%	44%	57%
Expected dividend yield	0%	0%	0%

The Company uses a forfeiture rate of 4.9% for the fiscal year ended June 28, 2006.

Long-Lived Assets

The Company accounts for long-lived assets in accordance with the provisions of SFAS No. 144. This requires that long-lived assets be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.

Revenue Recognition

Retail and wholesale sales are recorded when payment is tendered at point of sale for retail, and upon shipment of product for wholesale, respectively. Initial franchise fees are recognized when a franchised coffeehouse begins operations, at which time the Company has performed its obligations related to such fees.

F-13

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Initial franchise fees are referred to as “Front end fees” in the table below. Such fees are collected (if applicable) before the franchised location begins operation, and are nonrefundable. Initial franchise fees apply primarily in the case of domestic franchise development. Franchise royalties are recognized as earned, based upon a percentage of a franchise coffeehouse sales over time.

The following table details the various components included in franchise revenue:

	June 28, 2006		June 29, 2005		June 30, 2004
Royalties	$	3,362,000	$	3,432,000	$	3,658,000
Front end fees		413,000		393,000		428,000
Other		—		341,000		321,000
Total	$	3,775,000	$	4,166,000	$	4,407,000

Barter Transaction

In fiscal year 2004, the Company recorded a charge reducing holiday gift pack inventory to its net realizable value and exchanged $67,000 of this impaired inventory for advertising barter credits valued by the barter provider in excess of the impaired inventory value. The Company recorded the advertising credits as a prepaid expense at the $67,000 net realizable value of the inventory exchanged. Additionally, in accordance with EITF No. 99-17, “Accounting for Advertising Barter Transactions,” the Company accounted for this transaction as a sale, recording revenue and cost of sales of $67,000, leaving no net impact to income (loss). There were no barter transactions during the 2005 and 2006 fiscal years.

Shipping and Handling Costs

Shipping and handling costs are included as a component of cost of sales and related occupancy costs. A corresponding amount is billed to the Company’s wholesale customers, and is included as a component of wholesale and other revenue.

Advertising and Promotion Costs

The following table details the components of advertising and promotion costs:

	Fiscal Years Ended
Advertising and Promotion Costs:	June 28, 2006		June 29, 2005		June 30, 2004
Advertising and promotion payments	$	1,796,000	$	2,165,000	$	1,926,000
Less franchisee ad fund contributions		1,173,000		1,116,000		1,060,000
Net advertising and promotion payments	$	623,000	$	1,049,000	$	866,000
Included in general and administrative expense	$	159,000	$	336,000	$	140,000
Included in operating expenses		464,000		713,000		726,000
Total advertising and promotion expense	$	623,000	$	1,049,000	$	866,000

Total advertising and promotion costs are for all Company brands sold in company-operated and franchise units. Franchisees are required to contribute 2% of sales to an ad fund that is segregated and designated for advertising. The Company acts as an agent for the franchisees with regard to these contributions. The Company consolidates the fund into its financial statements on a net basis, whereby contributions from franchisees, when received, are recorded as offsets to the Company’s reported advertising expenses, in accordance with SFAS No. 45,

F-14

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

“Accounting for Franchisee Fee Revenue”. As discussed in this Note 1 below, in Variable Interest Entities, the Company began to consolidate the advertising fund as of June 30, 2004, also on a net basis, as required for accounting periods ending after March 15, 2004.

The Company charges advertising costs to expense as incurred.

Store Closures

Effective January 1, 2003, the Company adopted SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” and now records these estimated costs when they are incurred rather than at the date of a commitment to an exit or disposal plan. Such costs primarily consist of the estimated cost to terminate real estate leases.

	Beginning Balance		Amounts Charged to Expense		Adjustments			Cash Payments			Ending Balance
Accrued provision for store closure
Year ended June 29, 2005	$	109,000	$	—	$	—		$	(18,000	)	$	91,000
Year ended June 28, 2006	$	91,000	$	401,000	$	(75,000	)	$	(16,000	)	$	401,000

Amounts charged to expense for the years ended June 29, 2005 and June 28, 2006 were $0 and $401,000, respectively.

Variable Interest Entities

On June 30, 2004 the Company adopted FASB Interpretation No. 46 (revised), “Consolidation of Variable Interest Entities—an interpretation of Accounting Research Bulletin (“ARB”) No. 51” (“FIN 46R”) which addresses the consolidation of entities in which a reporting enterprise has an economic interest but for which the traditional voting interest approach to consolidation, based on voting rights, is ineffective in identifying where control of the entity lies, or in which the equity investors do not bear the economic risks and rewards of the entity. FIN 46R refers to those entities as variable interest entities (“VIEs”). FIN 46R requires the consolidation of VIEs by the primary beneficiary that absorbs a majority of the economic risks and rewards from the VIEs activities.

The Company acquired its franchise operations in 1999. At June 28, 2006, there were 148 domestic franchise units, all of which are owned by franchisees. The Company, as the franchisor, receives royalty fees on franchise sales, but has no equity interest and does not share in profits or losses of the franchise operation. The franchisees make the key decisions that impact the success of their operations. The Company’s rights are protective in nature and are designed to preserve the value of the brand that it licenses to the franchisee through the franchise agreement. Of the 148 domestic franchise locations, the Company provides subordinated financial support to the extent that it is the primary lessee on 86 of the coffeehouse leases and subleases the premises to the franchisees on a pass-through basis on the same terms as the primary lease. The franchisees generally pay rent directly to the primary lease landlord.

The Company calculated the present value of the subordinated financial support provided to each of the franchisees by the lease arrangements and compared it to the overall subordinated financing support as defined by FIN 46R and determined that for all but six stores the Company was providing less than 50% of the franchisees’ total subordinated financial support. For the remaining four stores a further quantitative test of the franchisee’s equity indicated that it was well above the 10% minimum and that the franchisee would not be considered a VIE. The remaining two stores may be considered a VIE, however, the consolidation of this franchisee would be immaterial.

F-15

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

The Company believes its risk of loss is not significant. As a condition to acquire a franchise, the prospective franchisee is required to have a personal net worth of at least $350,000, an amount believed to be sufficient to absorb possible franchise losses. Each franchisee is personally liable, either through direct ownership of the franchise or by a personal guarantee if the franchise is operated as a company. The Company looks to the franchisee’s personal assets to satisfy the franchise’s obligations, including the lease on which the Company is the primary lessee. This arrangement has historically insulated the Company from loss. In the rare situation where the franchisee’s personal assets have been insufficient to meet the obligations of the franchise, the Company has been able to accomplish an early termination of the lease at a substantial discount to the present value of the rentals for the remaining primary lease term.

The Company’s franchise agreements require that the franchisees pay an advertising fund contribution of 2% of franchise sales. These funds are maintained in a segregated fund and used to pay for franchise brand marketing. All contributions are used solely for brand advertising and none are revenue or income to the Company. The fund is administered by an employee of the Company and is subject to audit by a franchisee committee. In the event that the advertising fund in not sufficient to pay all outstanding invoices, the Company could be contingently liable for their payment. Accordingly, the Company determined that consolidation of the fund is appropriate under FIN 46R and adopted it in the quarter ended June 30, 2004. The Company included $217,000 and $218,000 of advertising fund assets, restricted, and advertising fund liabilities in the consolidated balance sheet as of June 28, 2006 and June 29, 2005, respectively. Advertising fund assets are primarily cash, which is segregated and restricted to use for franchise brand advertising. Advertising fund liabilities consist mainly of accounts payable, accrued expenses and deferred obligations. As noted in “Advertising and Promotion Costs” above, the advertising contributions and disbursements are reported in the consolidated statement of operations on a net basis whereby contributions are recorded as offsets to the Company’s reported operating and general and administrative expenses.

Cash Surrender Value of Life Insurance

The change in the cash surrender value (“CSV”) of company owned life insurance (“COLI”) contracts, net of insurance premiums paid and gains realized, is reported in compensation and benefits expense. See Note 15.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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 materially differ from those estimates.

Recent Accounting Pronouncements

In July 2006, the FASB issued Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”) which seeks to reduce the diversity in practice associated with the accounting and reporting for uncertainty in income tax positions. This Interpretation prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company will adopt the new requirements in its fiscal first quarter of 2008. The cumulative effects, if any, of adopting FIN 48 will be recorded as an adjustment to retained earnings as of the beginning of the period of adoption. The Company has not yet determined the impact, if any, of adopting FIN 48 on its consolidated financial statements.

F-16

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

On October 6, 2005, FASB released FASB Staff Position (“FSP”) FAS 13-1, Accounting for Rental Costs Incurred during a Construction Period. This FSP affects companies that are engaged in construction activities on buildings or grounds, which are accounted for as operating leases. The FSP requires companies to expense rental costs associated with these leases starting on the date that the tenant is given control of the premises. As a result, companies must cease capitalizing rental costs during construction periods. The FSP is effective for the first reporting period beginning after December 15, 2005, which is the fourth quarter of fiscal 2006 for the Company. Retrospective application is permitted but not required. Our adoption of this FSP in the fourth quarter of fiscal 2006 did not have a material impact on our financial position, results of operations or cash flows.

Reclassifications

Certain reclassifications have been made to prior periods to conform to the 2006 presentation.

2.    Liquidity and Management Plans

In recent years, the Company has experienced recurring operating losses and negative cash flows from operations. The Company has taken steps to reduce future losses and with positive revenue trends, the cost control measures initiated by the Company should result in improved financial performance in the near term. The Company has announced its plans to strengthen its two core business segments by focusing the resources dedicated to its expanding wholesale business and by narrowing its retail focus to its franchise stores without significant capital investment. The Company also announced that it would exit its company operated Diedrich and Coffee People retail locations through the previously disclosed transaction with Starbucks Corporation (see Note 16).

While Company management fully expects that the transaction with Starbucks Corporation will be completed, there are no absolute assurances that this will occur. In the unlikely event that the transaction is not fully completed, the anticipated improvement in the Company’s cash flow and financial condition would reflect only the cost control measures initiated by the Company and any portion of the transaction that is completed.

Based on the terms of the Company’s credit agreements, as amended (see Note 7), management’s expectations that the transaction to exit the Company operated Diedrich and Coffee People retail locations will be completed, the focus on growing the wholesale and franchise business segments, the status of the Company’s balance sheet and the overall business outlook for the Company and the specialty coffee market, management believes that cash from ongoing operations, the anticipated proceeds from the sale transaction and funds available to the Company from its current credit agreements will be sufficient to satisfy the working capital needs of the Company at the anticipated operating levels for at least the next twelve months.

3.    Inventories

Inventories consist of the following:

	June 28, 2006		June 29, 2005
Unroasted coffee	$	1,522,000	$	1,481,000
Roasted coffee		791,000		643,000
Accessory and specialty items		136,000		225,000
Other food, beverage and supplies		1,397,000		1,077,000
	$	3,846,000	$	3,426,000

F-17

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

4.    Notes Receivable

Notes receivable consist of the following:

	June 28, 2006			June 29, 2005
Notes receivable bearing interest at rates from 0% to 9.5%, payable in monthly installments varying between $115 and $4,268 and due between January, 2006 and October 1, 2016. Notes are secured by the assets sold under the asset purchase and sale agreements or general security agreement.	$	206,000		$	181,000
Notes receivable from a corporation discounted at an annual rate of 8.0%, payable annually in installments varying between $1,000,000 and $2,000,000, due between January 31, 2007 and January 31, 2011.		4,903,000			5,538,000
Less: current portion of notes receivable		(1,137,000	)		(1,165,000	)
Long-term portion of notes receivable	$	3,972,000		$	4,554,000

5.    Property and Equipment

Property and equipment is summarized as follows:

	June 28, 2006			June 29, 2005
Buildings	$	365,000		$	365,000
Leasehold improvements		9,195,000			7,870,000
Equipment		15,567,000			14,621,000
Furniture and fixtures		2,330,000			1,871,000
Construction in progress		224,000			604,000
		27,681,000			25,331,000
Accumulated depreciation and amortization		(18,593,000	)		(17,357,000	)
	$	9,088,000		$	7,974,000

Property held under capitalized leases in the amount of $958,000 at June 28, 2006 and June 29, 2005, is included in equipment. Accumulated amortization of such equipment amounted to $680,000 and $653,000 at June 28, 2006 and June 29, 2005, respectively.

6.    Intangible Assets

On February 1, 2005 the Company purchased a retail location from one of its franchisees which resulted in goodwill of $80,000.

The Company did not incur any goodwill impairment adjustments during fiscal years 2006, 2005 and 2004. It is possible that the assumptions used by management related to the evaluation of the Company’s goodwill may change or that actual results may vary significantly from management’s estimates. As a result, additional impairment charges may occur.

F-18

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Goodwill by segment was as follows:

	June 28, 2006		June 29, 2005
Retail Operations	$	1,347,000	$	1,347,000
Wholesale Operations		6,311,000		6,311,000
Franchise Operations		521,000		521,000
Goodwill	$	8,179,000	$	8,179,000

7.     Debt

On May 10, 2004 the Company entered into a $5,000,000 Contingent Convertible Note Purchase Agreement. The agreement provides for the Company to, at its election, issue notes with up to an aggregate principal amount of $5,000,000. The notes are to be amortized on a monthly basis at a rate that will repay 60% of the principal amount of the note by June 30, 2008. The remaining 40% will mature on that date. Interest is payable at three-month LIBOR plus 5.30%, and a facility fee of 1.00% annually is payable on the unused portion of the facility. The agreement contains covenants that limit the amount of indebtedness that the Company may have outstanding in relation to its tangible net worth. As of June 28, 2006, the Company was in compliance with all the covenants in the agreement. Notes are convertible into common stock only upon certain changes of control. For notes issued and repaid, warrants to purchase shares are to be issued with the same rights and restrictions for exercise as existed for convertibility of the notes at the time of their issuance. Warrants are exercisable only in the event of a change of control and expire on June 30, 2010. The fair value of warrants issued with respect to notes repaid will be recorded as a discount to debt, at the date of issuance, which will then be amortized using the effective interest method. Warrants to purchase common stock of the Company will be issued only upon a change in control of the Company. The lender under this agreement is a limited partnership of which the chairman of the Company’s board of directors serves as the sole general partner. On May 10, 2004, upon entering into the agreement, the Company immediately issued a $1,000,000 note under the facility, and used the proceeds of the note and other available cash to repay all outstanding debt with Bank of the West. On September 15, 2004, the Company issued a second note for $1,000,000 under this facility. Both the notes were fully repaid in fiscal year 2005, and thus a total of 455,184 warrants are issuable upon a change in control. The Company has issued 4,219 warrants as of June 28, 2006. As of June 28, 2006, the Company had no borrowings outstanding under the facility and the full amounts are available for borrowing at that date.

On June 30, 2004, the Company entered into Amendment No. 1 to Contingent Convertible Note Purchase Agreement (“Amendment No. 1”) which revised the definition of “Availability” to mean, on any date, the loan amount less the sum of the principal amounts then outstanding under the Note Purchase Agreement. Under the original Note Purchase Agreement, availability was calculated using a formula that reduced availability over time.

On November 4, 2005, the Company entered into a new Credit Agreement with Bank of the West. The agreement provides for a $750,000 letter of credit facility that expires on October 15, 2006. The letter of credit facility is secured by a deposit account at Bank of the West. As of June 28, 2006, this deposit account had a balance of $583,000, which is shown as restricted cash on the consolidated balance sheets. As of June 28, 2006, $651,000 of letters of credit was outstanding under the letter of credit facility. The agreement contains covenants that, among other matters, require the Company to submit financial statements to the bank within specified time periods. As of June 28, 2006, the Company was in compliance with all Bank of the West agreement covenants.

On March 31, 2006, the Company entered into Amendment No. 2 to Contingent Convertible Note Purchase Agreement (“Amendment No. 2”). Amendment No. 2: (i) contains a waiver with respect to the default of the Minimum EBITDA Covenant as of March 8, 2006 and removes the Minimum EBITDA from the Note Purchase

F-19

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Agreement; (ii) clarifies that warrants to purchase common stock of the Company will be issued with respect to repaid principal amounts only upon a change in control of the Company; (iii) increases the interest rate applicable to outstanding amounts under the credit facility by 2%, to LIBOR plus 5.30%; and (iv) extended the exercise date of all warrants issued or to be issued under the Note Purchase Agreement by one year, to May 10, 2009, which was subsequently extended as discussed below. The maturity date for any notes issued in the future was unaffected by Amendment No. 2. The Company is in compliance with all agreement covenants as amended by Amendment No 2.

On September 22, 2006, the Company entered into Amendment No. 3 to Contingent Convertible Note Purchase Agreement (“Amendment No. 3”). Amendment No. 3 (i) changes the date specified in the definition of “Maturity Date” from May 10, 2007 to June 30, 2008; (ii) adjusts the calculation of monthly payments to reflect the extended maturity date; (iii) removes a condition precedent to each loan that previously required there to be no material adverse effect or event reasonably likely to result in a material adverse effect before the obligation of the lender to purchase any note arose; (iv) amends the events of default so that an event that has, or is reasonably likely to have, a material adverse effect will not be considered such an event of default; (v) amends the notice requirements so that the Company is not required to give notice to the lender of any event that is reasonably likely to have a material adverse effect; and (vi) extends the exercise date of all warrants issued or to be issued under the Note Purchase Agreement to June 30, 2010.

8.    Commitments and Contingencies

Lease Commitments

As of June 28, 2006, the Company leases warehouse and office space in Irvine, California, and Castroville, California, as well as 52 retail locations. The leases expire at various dates through November 2017. The leases for four of the coffeehouse locations are guaranteed by an officer or 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.

F-20

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Future minimum lease payments under non-cancelable operating leases, franchise-system operating leases and capital leases, and minimum future sublease rentals expected to be received as of June 28, 2006, are as follows:

Year Ending June	Capital Leases			Non-Cancelable Operating Leases (D)
				Total		Company operated retail locations and other (A)		Gloria Jean’s Franchise operated retail locations (B)		Other subleased locations (C)
2007	$	44,000		$	8,315,000	$	3,659,000	$	4,203,000	$	453,000
2008		44,000			7,189,000		3,486,000		3,373,000		330,000
2009		44,000			6,269,000		3,351,000		2,664,000		254,000
2010		44,000			5,546,000		3,085,000		2,312,000		149,000
2011		44,000			4,629,000		2,566,000		1,938,000		125,000
Thereafter		285,000			15,685,000		9,708,000		5,678,000		299,000
		505,000		$	47,633,000	$	25,855,000	$	20,168,000	$	1,610,000
Less: amount representing interest (8% to 15%)		(177,000	)
Present value of minimum lease payments		328,000
Less current installments		(19,000	)
Obligations under capital leases, excluding current installments	$	309,000

(A) Includes Irvine and Castroville office and warehouse space and company operated retail locations.

(B) The Company is liable on the master leases for 79 Gloria Jean’s franchise locations. Under the Company’s historical franchising business model, the Company executed the master leases for these locations, and entered into subleases on the same terms with its franchisees, which typically pay their rent directly to the landlords. Should any of these franchisees default on their subleases, the Company would be responsible for making payments under the master lease. The Company’s maximum theoretical future exposure at June 28, 2006, computed as the sum of all remaining lease payments through the expiration dates of the respective leases, was $20,168,000. This amount does not take into consideration any mitigating measures that the Company could take to reduce this exposure in the event of default, including re-leasing the locations or terminating the master lease by negotiating a lump sum payment to the landlord less than the sum of all remaining future rents and other amounts payable.

(C) The Company has leased and subleased land and buildings to others including Diedrich franchisees. Many of these leases provide for fixed payments with contingent rents when sales exceed certain levels, while others provide for monthly rentals based on a percentage of sales. The Company directly pays the rents on these master leases, and collects associated rent amounts directly from its sublessees.

(D) Some leases provide for CPI increases in renewals.

Rent expense under operating leases approximated $5,245,000, $4,537,000, and $4,238,000 for the years ended June 28, 2006, June 29, 2005, and June 30, 2004, respectively.

F-21

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Purchase Commitments

At June 28, 2006, the Company had commitments to purchase coffee through fiscal year 2007, totaling $1,874,000 for 1,215,000 pounds of green coffee, the majority of which were fixed as to price. Such contracts are generally short-term in nature, and the Company believes that their cost approximates fair market value.

Capital Commitments

At June 28, 2006, the Company had capital commitments of $2,018,000 comprised of $1,177,000 for opening new stores and $841,000 for remodels, equipment and software upgrades.

Guarantees and Indemnifications

The Company guarantees the performance of its subsidiary franchisor obligations and also indemnifies franchisees for costs incurred in defending the Company’s trademarks and tradenames.

Contingencies

In the ordinary course of its business, the Company may become involved in legal proceedings from time to time. The Company is not aware of any pending legal proceedings which in the opinion of management, based in part on advice from legal counsel, would significantly adversely affect the Company’s consolidated financial position or results of operations.

9.    Stockholders’ Equity

Stock Options

On October 20, 2000, the Company’s board of directors authorized the adoption of the Diedrich Coffee, Inc. 2000 Equity Incentive Plan (the “2000 Equity Incentive Plan”) and the concurrent discontinuation of the option grants under the Diedrich Coffee, Inc. Amended and Restated 1996 Stock Incentive Plan and the Diedrich Coffee, Inc. 1996 Non-Employee Directors Stock Option Plan. The Company’s stockholders approved the 2000 Equity Incentive Plan on October 16, 2000. A total of 1,087,500 shares of the Company’s common stock may be issued under the 2000 Equity Incentive Plan, as amended. The board of directors determines the number of shares, terms and exercise periods for awards under the 2000 Equity Incentive Plan on a case by case basis, except for automatic annual grants of options to non-employee directors. Options generally vest ratably over three years and expire ten years from the date of grant. The exercise price of options is generally equivalent to the fair market value of the Company’s common stock on the date of grant.

During fiscal 2004, the Company issued Marty Lynch, the Company’s former CFO, and Sean McCarthy, the CFO (held the position as Vice President Controller in 2004), 150,000 and 20,000, respectively, options to purchase shares of the Company’s common stock at a per share price of $3.38 and $3.69, respectively, which were below market value. The options were granted under the 2000 Equity Incentive Plan previously approved by stockholders. The Company recognized $22,000 in compensation expense related to these options in accordance with the provisions of APB 25.

During fiscal 2005, the Company issued Paul Heeschen, Lawrence Goelman, Peter Churm, Richard Spencer and Randy Powell, as members of the Company’s Board of Directors, 15,000 options each to purchase shares of the Company’s common stock at a per share price of $4.65, which was below market value. The options were granted under the 2000 Equity Incentive Plan previously approved by stockholders. In 2005, the Company recognized $47,000 in compensation expense related to these options in accordance with the provisions of APB 25.

F-22

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Information regarding the Company’s stock options is summarized below:

	Options			Weighted Average Exercise Price
Number of options authorized for future grant at June 28, 2006		361,084
Outstanding at July 2, 2003		748,867		$	5.85
Granted		245,000		$	3.52
Exercised		—			—
Forfeited		(24,625	)	$	5.13
Outstanding at June 30, 2004		969,242		$	5.27
Granted		102,500		$	4.63
Exercised		(111,666	)	$	3.29
Forfeited		(22,459	)	$	12.32
Outstanding at June 29, 2005		937,617		$	5.27
Granted		150,000		$	4.82
Exercised		(35,000	)	$	3.93
Forfeited		(111,284	)	$	7.87
Outstanding at June 28, 2006		941,333		$	4.94
Weighted-average fair value of options granted:
Year ended June 30, 2004	$	3.05
Year ended June 29, 2005	$	4.76
Year ended June 28, 2006	$	2.39
Options exercisable:
At June 30, 2004		521,239
At June 29, 2005		654,448
At June 28, 2006		786,332

The following table summarizes information about stock options outstanding at June 28, 2006:

	Options Outstanding				Options Exercisable
Range of Exercise Price	Number Outstanding At June 28, 2006	Weighted Average Remaining Life (Years)	Weighted Average Exercise Price		Number Exercisable At June 28, 2006 (1)	Weighted Average Exercise Price
$ 2.16 - $ 3.38	177,500	6.92	$	3.27	177,500	$	3.27
$ 3.44 - $ 3.44	200,000	6.82		3.44	200,000		3.44
$ 3.69 - $ 3.97	227,833	6.13		3.81	221,166		3.82
$ 4.14 - $ 4.65	227,500	8.92		4.50	94,166		4.52
$ 5.00 - $ 41.00	108,500	3.73		13.71	93,500		14.88
	941,333	6.83		4.94	786,332		5.00

(1) The weighted average remaining life for the options exercisable at June 28, 2006 was 6.3 years at June 28, 2006.

F-23

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Stock option-based compensation expense included in the statement of operations for the fiscal year ended June 28, 2006 was approximately $403,000. As of June 28, 2006, there was approximately $234,000 of total unrecognized stock option-based compensation cost related to options granted under our plans that will be recognized over a weighted average period of 1.9 years. The total intrinsic value of options exercised during the year ended June 28, 2006 was approximately $100,000.

A summary of option activity under our stock option plans for the year ended June 28, 2006 is as follows:

Unvested Options	Options		Weighted-Average Grant-Date Fair Value ($)
Unvested options at June 29, 2005	283,000		3.92
Granted	135,000		4.82
Vested	(240,000	)	3.90
Forfeited	(23,000	)	4.48
Unvested options at June 28, 2006	155,000		4.64

The total fair value of vested options during the year ended June 28, 2006 was $937,000.

Stock Purchase Warrants

On May 8, 2001, in connection with the sale of 2,000,000 shares of Company common stock, the Company issued warrants to Sequoia Enterprises, L.P., of which the Company’s chairman, Paul C. Heeschen, is the general partner, to purchase 250,000 shares of the Company’s common stock at a price of $4.80 per share. Other investors also received warrants to purchase an additional 250,000 shares at a price of $4.80 per share. The warrants were exercisable immediately upon issuance and expire on May 8, 2011. At June 28, 2006, all 500,000 warrants were outstanding.

The terms of the Contingent Convertible Note Purchase Agreement (see Note 7) provide that upon a change of control, outstanding Notes are convertible into shares of the Company’s common stock at a price that is equal to the greater of the price of the stock on the date that Note is issued or 85% of the average price paid per share of common stock by a person who engages in a transaction that results in a change of control, as defined in the Agreement. The Notes are convertible only if and when a change of control event occurs. As Notes are paid, the Agreement provides that warrants are to be issued. The warrants are exercisable on substantially the same terms as the Notes are convertible. The warrants are also only exercisable if and when a change of control event occurs. The price of the Company’s common stock on May 10, 2004, the date that the first $1,000,000 Note was issued, was $3.95 per share. The price of the Company’s common stock on September 15, 2004, the date that the second $1,000,000 Note was issued, was $4.95 per share. Since both the Notes were fully paid off in fiscal year 2005, a total of 455,184 warrants are issuable. The Company has issued 4,219 warrants at June 28, 2006.

On March 31, 2006, the Company entered into Amendment No. 2 to Contingent Convertible Note Purchase Agreement. Amendment No. 2 contains among other things, clarification that warrants to purchase common stock of the Company will be issued with respect to repaid principal amounts only upon a change in control of the Company. This amendment also extended the exercise date of all warrants issued or to be issued under the Note Purchase Agreement by one year, to May 10, 2009.

On September 22, 2006, the Company entered into Amendment No. 3 to Contingent Convertible Note Purchase Agreement. Amendment No. 3 extends the exercise date of all warrants issued or to be issued under the Note Purchase Agreement to June 30, 2010.

F-24

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

10.    Income Taxes

The components of income tax benefit from continuing operations are as follows:

	Year Ended June 28, 2006			Year Ended June 29, 2005			Year Ended June 30, 2004
Current:
Federal	$	(552,000	)	$	(1,578,000	)	$	(1,040,000	)
State		(249,000	)		(273,000	)		(93,000	)
		(801,000	)		(1,851,000	)		(1,133,000	)
Deferred:
Federal		—			—			—
State		—			—			—
	$	(801,000	)	$	(1,851,000	)	$	(1,133,000	)

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:

	June 28, 2006			June 29, 2005
Deferred tax assets:
Net operating loss carryforwards	$	3,399,000		$	1,229,000
Intangible assets		119,000			136,000
Property and equipment		2,634,000			2,584,000
Accrued expenses		1,019,000			883,000
Accrued provision for store closure		—			35,000
Other		736,000			340,000
Total gross deferred tax assets		7,907,000			5,207,000
Less: valuation allowance		(5,094,000	)		(2,631,000	)
Deferred tax liabilities:
Installment gain and other		(2,813,000	)		(2,576,000	)
Net deferred tax assets	$	—		$	—

A reconciliation of the statutory federal income tax rate with the Company’s effective income tax provision (benefit) rate for continuing operations is as follows:

	Year Ended June 28, 2006		Year Ended June 29, 2005		Year Ended June 30, 2004
Federal statutory rate	(34.0	)%	(34.0	)%	(34.0	)%
State income taxes, net of Federal benefit	(1.9	)	(3.6	)	(3.0	)
Goodwill and other non-deductible costs	0.1		—		0.7
Net operating loss utilization	—		29.3		(3.3	)
Valuation allowance	22.6		(30.1	)	—
Other	3.9		2.6		(1.2	)
	(9.3	)%	(35.8	)%	(40.8	)%

F-25

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Due to the uncertainty of future taxable income, deferred tax assets resulting from these net operating losses have been fully reserved. Due to the utilization of net operating loss carryforwards in the sale of the Gloria Jean’s international franchise operations and following a Section 382 analysis, as of June 28, 2006, net operating loss carryforwards of $8,721,000 and $7,883,000 for federal and state income tax purposes, respectively are available to be utilized against future taxable income for years through fiscal 2026, subject to possible annual limitation pertaining to change in ownership rules under the Internal Revenue Code. Due to the uncertainty of future taxable income, deferred tax assets resulting from these net operating loss carryforwards have been fully reserved are available to be utilized against future taxable income for years through fiscal 2026, subject to possible annual limitation under the Internal Revenue Code.

In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods which the deferred tax assets are deductible, management believes it is not more likely than not that the Company will not realize the benefits of these deductible differences, and thus has recorded a valuation allowance against the entire deferred tax asset balance. As of June 28, 2006 and June 29, 2005, the valuation allowance was $5,094,000 and $2,631,000, respectively. The change in the valuation allowance during 2006 was an increase of $2,463,000.

11.    Impairment and Restructuring Charges

The Company recorded an asset impairment charge of $94,000 in fiscal 2004 to reduce the carrying value associated with one of its coffeehouses. This was comprised of a charge of $90,000 to write down the carrying amount of one Company operated coffeehouse, and a charge of $4,000 to terminate a lease obligation on a subleased location. No provision was required in fiscal 2005 and 2006.

12.    Earnings Per Share

The following table sets forth the computation of basic and diluted net income per share from continuing operations:

	Year Ended June 28, 2006			Year Ended June 29, 2005			Year Ended June 30, 2004
Numerator:
Net loss from continuing operations	$	(7,796,000	)	$	(3,315,000	)	$	(1,647,000	)
Denominator:
Basic weighted average shares outstanding		5,303,000			5,218,000			5,161,000
Effect of dilutive securities		—			—			—
Diluted adjusted weighted average shares		5,303,000			5,218,000			5,161,000
Basic and diluted net loss per share from continuing operations	$	(1.47	)	$	(0.64	)	$	(0.32	)

F-26

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For the years ended June 28, 2006, June 29, 2005 and June 30, 2004, employee stock options of 941,000, 938,000, and 912,000, respectively, and warrants of 500,000 for each year (as described in note 9), were excluded from the computation of diluted earnings per share as their impact would have been anti-dilutive. The 451,000 stock purchase warrants outstanding in 2006 and 2005 and the 4,200 stock purchase warrants outstanding in 2004, pursuant to terms of the Convertible Note Purchase Agreement were excluded from the computation of diluted earnings per share for the fiscal years ended June 28, 2006, June 29, 2005 and June 30, 2004 as their impact would have been anti-dilutive. The weighted average strike price of anti-dilutive securities for the years ended June 28, 2006, June 29, 2005 and June 30, 2004 was $5.00, $5.85 and $6.70, respectively.

The following table sets forth the computation of basic and diluted net income per share:

	Year Ended June 28, 2006			Year Ended June 29, 2005		Year Ended June 30, 2004
Numerator:
Net income (loss)	$	(7,796,000	)	$	14,623,000	$	251,000
Denominator:
Basic and diluted weighted average shares outstanding		5,303,000			5,218,000		5,161,000
Basic and diluted net income (loss) per share	$	(1.47	)	$	2.80	$	0.05

13.    Segment Information

The Company has three reportable segments, retail operations, wholesale operations and franchise operations. The Company evaluates performance of its operating segments based on income before provision for asset impairment and restructuring costs, income taxes, interest expense, depreciation and amortization, and general and administrative expenses.

The retail operations segment includes only company-operated retail units. Revenues are derived from sales of products and services by the units. Retail segment profit before tax is net of cost of goods sold and related occupancy costs, retail-operating expenses and specifically identified general and administrative costs.

The wholesale operations segment sells coffee products to company stores, franchisees, and third parties. Reported revenues for the wholesale segment include sales to franchisees and third parties, but sales to company-operated retail units are eliminated in consolidation. Wholesale segment profit before tax includes a manufacturing profit on all sales, including those to company-operated retail units, but inter-company profit in retail unit inventories is eliminated at each period end. Wholesale segment profit before tax also is net of specifically identified selling, general and administrative expenses as well as costs of the Company’s coffee roasting facility.

The franchise operations segment revenues include franchise store opening fees, franchise renewal and various service fees, roasting fees and royalty fees. Franchise segment profit before tax is net of specifically identified operating, general and administrative expenses.

F-27

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Summarized financial information of continuing operations of the Company’s reportable segments is shown in the following table. The other total assets consist of corporate cash, corporate notes receivable, corporate prepaid expenses, and corporate property, plant and equipment. The other component of segment profit before tax includes corporate general and administrative expenses, provision for asset impairment and restructuring costs, depreciation and amortization expense, and interest expense.

	Retail Operations			Wholesale Operations		Franchise Operations		Other			Total
	(in thousands, except per share data)
Year ended June 28, 2006
Total revenue	$	34,428		$	21,244	$	3,775	$	—		$	59,447
Interest expense		26			—		3		87			116
Depreciation and amortization		1,756			519		—		326			2,601
Segment profit (loss) before tax		(728	)		2,772		2,405		(13,046	)		(8,597	)
Total assets as of June 28, 2006	$	9,115		$	13,742	$	1,798	$	9,475		$	34,130
Year ended June 29, 2005
Total revenue	$	31,890		$	16,482	$	4,166	$	—		$	52,538
Interest expense		34			—		21		168			223
Depreciation and amortization		1,505			588		—		279			2,372
Segment profit (loss) before tax		375			2,019		3,657		(11,217	)		(5,166	)
Total assets as of June 29, 2005	$	8,499		$	12,277	$	2,635	$	16,902		$	40,313
Year ended June 30, 2004
Total revenue	$	31,617		$	14,861	$	4,407	$	—		$	50,885
Interest expense		31			—		38		279			348
Depreciation and amortization		1,366			578		—		371			2,315
Segment profit (loss) before tax		935			2,284		4,051		(10,050	)		(2,780	)
Total assets as of June 30, 2004	$	6,366		$	11,797	$	4,269	$	2,786		$	25,218

Intercompany sales from wholesale operations to retail operations of $ 2,607,000 for fiscal 2004, $2,819,000 for fiscal 2005 and $3,220,000 for fiscal 2006 have been eliminated.

F-28

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

14.    Selected Quarterly Financial Data (Unaudited)

The quarterly results of operations for the years ended June 28, 2006 and June 29, 2005 were as follows:

	First Quarter			Second Quarter			Third Quarter			Fourth Quarter
	(in thousands, except per share data)
Fiscal 2006
Total revenue	$	12,180		$	14,943		$	14,049		$	18,275
Operating loss from continuing operations		(2,020	)		(1,464	)		(1,898	)		(3,647	)
Net loss		(1,552	)		(1,442	)		(1,684	)		(3,118	)
Basic and diluted income (loss) per share		(0.29	)		(0.27	)		(0.32	)		(0.59	)
Fiscal 2005
Total revenue	$	11,214		$	13,442		$	11,624		$	16,258
Operating loss from continuing operations		(1,301	)		(265	)		(877	)		(2,779	)
Loss from continuing operations		(1,344	)		(315	)		(873	)		(2,634	)
Income (loss) from discontinued operations before tax		883			841			19,851			(180	)
Net income (loss)		(468	)		522			15,601			(1,032	)
Basic and diluted income (loss) per share		(0.09	)		0.10			2.99			(0.20	)

Quarterly operating results are not necessarily representative of operations for a full year for various reasons, including the seasonal nature of the Company’s business, which may affect sales volume and food costs. All quarters have 12-week accounting periods, except the fourth quarter, which has a 16-week accounting period.

On February 11, 2005, the Company completed the sale of its Gloria Jean’s international franchise operations. The sale resulted in a gain on the disposal of discontinued operations of $15,795,000, net of $3,139,000 in taxes (see Note 1). The tax expense associated with the discontinued operations differed from the statutory federal effective tax rate primarily due to changes in the valuation allowance and permanently nondeductible goodwill associated with the discontinued operations.

15.    Employee Benefit Plans

401(k) Plan

The Company has a 401(k) Plan that covers eligible employees. The contributions to this plan were $53,000, $55,000 and $44,000 for the fiscal years 2006, 2005 and 2004, respectively.

Deferred Compensation Plan

Effective December 15, 2005, the Company amended its non-qualified deferred compensation plan. Under the amended plan, participants may elect to defer, on a pre-tax basis, a portion (from 0% to 100%) of their base salary, service bonus, and performance-based compensation. Any amounts deferred by a participant will be credited to the participant’s deferred compensation account. The plan further provides that the Company may

F-29

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

make discretionary contributions to a plan participant’s deferred compensation account. Each plan participant will be vested in the amounts held in the plan participant’s deferred compensation account as follows: (i) one hundred percent (100%) vested at all times with respect to all amounts of deferred compensation; and (ii) one hundred percent (100%) vested at all times with respect to all employer discretionary contributions. The Company made no discretionary contributions to plan participants’ accounts for the year ended June 28, 2006.

The plan also provides that any amounts deferred under the plan may not be distributed to a plan participant until the earlier of: (i) the plan participant’s separation from service with the Company; (ii) the Plan participant’s retirement from the Company; (iii) the plan participant’s disability; (iv) the plan participant’s death; (v) the occurrence of a change in control of the Company; (vi) the occurrence of an unforeseeable emergency, as defined in the plan; or (vii) such other date as set forth in the plan participant’s deferral election, including a date that occurs prior to the plan participant’s separation from service with the Company. Any amounts distributed to a plan participant will be paid in a form specified by the plan participant, or in the form of either a lump sum payment in an amount equal to the plan participant’s deferred compensation account balance or equal annual installments of the plan participant’s deferred compensation account balance over a period not to exceed (i) 20 years in the case of a distribution due to separation from service, death or disability or (ii) five years in the case of a distribution for educational expenses.

The Company has purchased a company-owned life insurance (“COLI”) contract insuring two of the participants in the deferred compensation plan. The policy is held in a trust to provide additional benefit security for the deferred compensation plan. The assets in the trust are owned by the Company and are subject to claims of its creditors. The gross cash surrender value of these contracts as of June 28, 2006 was $391,000 as shown in the accompanying consolidated balance sheets. Total life insurance policy death benefits payable were $14,864,000 at June 28, 2006. Management intends to use the future death benefits from these insurance contracts to fund the deferred compensation arrangements; however, there may not be a direct correlation between the timing of the future cash receipts and disbursements under these arrangements.

16.    Recent Developments

On September 14, 2006, the Company and Starbucks Corporation entered into an asset purchase agreement pursuant to which Starbucks has agreed to purchase the Company’s leasehold interests in most of the 47 locations where the Company operates retail stores under the Diedrich Coffee and Coffee People brands, along with certain related fixtures and equipment, improvements, prepaid items, and ground lease improvements, and to assume certain liabilities as set forth in the asset purchase agreement.

Pursuant to the asset purchase agreement, Starbucks will pay the Company up to $13,520,000 in cash, which includes payment of $120,000 as consideration for the Company’s agreement to a non-compete provision. The actual amount paid by Starbucks under the asset purchase agreement is dependent on which and how many of the Company Stores are ultimately transferred to Starbucks. Ten percent of the amount paid to the Company upon transfer of the Company Stores will be deposited into an escrow fund to be held in connection with the Company’s indemnification obligations. The Closing is expected to occur approximately 90 days after the date of the asset purchase agreement, provided that certain conditions, including that a specified minimum number of Company Stores are transferred to Starbucks at Closing, are met. After the Closing, the Company and Starbucks have agreed to use commercially reasonable efforts to transfer certain remaining Company Stores until approximately 150 days after the date of the asset purchase agreement or such other longer period as agreed to by the Company and Starbucks.

The Company and Starbucks have made certain customary representations, warranties and covenants in the asset purchase agreement. Specifically, they have agreed that, subject to a “fiduciary-out” provision and payment

of a break-up fee, the Company will not (i) take any action to solicit any proposal from, (ii) furnish any

F-30

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

information to, or (iii) participate in any discussions with, any entity other than Starbucks regarding any transaction involving the Company Stores. Upon termination of the asset purchase agreement under certain circumstances, including the Company’s entry into an alternative transaction involving the Company Stores, the Company shall pay Starbucks’ actual fees and expenses incurred in connection with the Transaction up to a maximum amount of $500,000; provided, however, that Starbucks is entitled to a minimum of $250,000, regardless of its actual fees and expenses. The asset purchase agreement also contains customary indemnification provisions for certain claims and provides for a basket of $100,000 and a cap of $2,000,000 for breaches of the Company’s representations and warranties contained in the asset purchase agreement.

The consummation of the transaction is subject to certain customary conditions, including: approval of the transaction by the Company’s stockholders; a specified minimum number of Company Stores transferred to Starbucks at Closing; the receipt by Starbucks of permits and approvals for at least 70% of certain Company Stores that are transferred if the Closing occurs within 90 days of the date of the asset purchase agreement; receipt of lease extensions of at least 10 years for at least 40% of certain Company Stores that are transferred; and, receipt of consents to the assignment of the leases for each of the Company Stores that are transferred, with estoppel provisions being agreed to for at least 50% of the Company Stores that are transferred. The asset purchase agreement contains customary termination provisions and may be terminated by either the Company or Starbucks if the Closing does not occur within 150 days from the date of the asset purchase agreement. The Company may also terminate the asset purchase agreement if the Closing has not occurred within 90 days, provided that Starbucks has not used commercially reasonable efforts to achieve the Closing.

As part of the asset purchase agreement, the Company has agreed to a non-compete provision that for three years after the Closing restricts the Company’s ability to operate or have any interest in the ownership or operation of any entity operating any retail specialty coffee stores in any city where a Company Store is presently located. The non-compete provision applies only to stores opened after the date of the asset purchase agreement and does not apply to (1) any retail stores operated under the “Gloria Jean’s” brand name, (2) wholesale sales to retail businesses that are not operated by the Company, or other non-retail businesses, or (3) the conversion of Company-operated stores existing on the date of the asset purchase agreement to franchise stores. The Company has also agreed that it will not solicit any Starbucks employee to enter the Company’s employment for three years after the Closing.

No assurances can be given that the asset purchase will be completed according to the foregoing terms, if at all.

F-31

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

SCHEDULE II – VALUATION AND QUALIFYING ACCOUNTS

	Balance at Beginning of Period		Provisions (Recoveries)		Additional Provisions Obtained in Acquisitions		Accounts Written Off			Balance at End of Period
Allowance for Bad Debt:
Year ended June 30, 2004	$	1,375,000	$	253,000	$	0	$	(473,000	)	$	1,155,000
Year ended June 29, 2005	$	1,155,000	$	829,000	$	0	$	(592,000	)	$	1,392,000
Year ended June 28, 2006	$	1,392,000	$	589,000	$	0	$	(118,000	)	$	1,863,000

F-32

DIEDRICH COFFEE, INC.

INDEX TO EXHIBITS

Exhibit No.	Description
2.1	Agreement and Plan of Merger, dated March 16, 1999, among Diedrich Coffee, Inc., CP Acquisition Corp., a wholly owned subsidiary of Diedrich Coffee, Inc., and Coffee People, Inc.(1)
3.1	Restated Certificate of Incorporation of the Company, dated May 11, 2001(2)
3.2	Bylaws of the Company(3)
4.1	Specimen Stock Certificate(4)
4.2	Purchase Agreement for Series A Preferred Stock dated as of December 11, 1992 by and among Diedrich Coffee, Inc., Martin R. Diedrich, Donald M. Holly, SNV Enterprises, and D.C.H., LP(5)
4.3	Purchase Agreement for Series B Preferred Stock dated as of June 29, 1995 by and among Diedrich Coffee, Inc., Martin R. Diedrich, Steven A. Lupinacci, Redwood Enterprises VII, LP, and Diedrich Partners I, LP(5)
4.4	Form of Conversion Agreement in connection with the conversion of Series A and Series B Preferred Stock into Common Stock(3)
4.5	Form of Warrant, dated May 8, 2001(2)
4.6	Registration Rights Agreement, dated May 8, 2001(2)
4.7	Form of Common Stock and Option Purchase Agreement with Franchise Mortgage Acceptance Company, dated as of April 3, 1998(6)
10.1	Form of Indemnification Agreement(5)
10.2	Diedrich Coffee, Inc. 2000 Equity Incentive Plan(19)*
10.3	Diedrich Coffee, Inc. 2000 Non-Employee Directors Stock Option Plan(8)*
10.4	Amended and Restated Diedrich Coffee, Inc. 1996 Stock Incentive Plan(9)*
10.5	Diedrich Coffee, Inc. 1996 Non-Employee Directors Stock Option Plan(10)*
10.6	Reserved.
10.7	Form of Diedrich Coffee Franchise Agreement(18)
10.8	Form of Gloria Jean’s Franchise Agreement(18)
10.9	Form of Area Development Agreement(18)
10.10	Employment Agreement with Roger M. Laverty, dated April 24, 2003(13)*
10.11	Stock Option Plan and Agreement with Roger M. Laverty, dated April 24, 2003(13)*

S-1

10.12	Employment Agreement with Martin A. Lynch, dated March 26, 2004(7)*
10.13	Employment Agreement with Matthew McGuinness, effective March 13, 2000(16)*
10.14	Employment Letter regarding the employment of Pamela Britton, dated February 6, 2001(18)*
10.15	Employment Letter regarding the employment of Carl Mount dated October 29, 1999(17)*
10.16	Separation Agreement by and between Diedrich Coffee, Inc. and Philip G. Hirsch dated January 3, 2003(13)*
10.17	Contingent Convertible Note Purchase Agreement, dated May 10, 2004 (includes form of convertible promissory note and form of warrant)(24)
10.18	Standard Industrial/Commercial Multi-Tenant Lease Agreement by and between The Westphal Family Trust and Diedrich Coffee, Inc., dated September 10, 2003(14)
10.19	Office Space Lease Agreement by and between The Irvine Company and Diedrich Coffee, Inc., dated August 1, 2003(14)
10.20	Amendment No. 1 to Contingent Convertible Note Purchase Agreement dated June 30, 2004
10.21	Amendment No. 2 to Contingent Convertible Note Purchase Agreement dated March 31, 2006(22)
10.22	Mutual Release Agreement by and between Diedrich Coffee, Inc. and Roger M. Laverty, dated December 13, 2005(20)*
10.23	Engagement Agreement by and between Diedrich Coffee, Inc. and Stephen V. Coffey, dated December 14, 2005(20)*
10.24	Letter Agreement with Sean M. McCarthy, effective January 1, 2006(21)*
10.25	Agreement of Purchase and Sale of Assets by and between Starbucks Corporation, Diedrich Coffee, Inc. and Coffee People, Inc.
10.26	Form of Separation Agreement and Release with Martin Diedrich, effective October 28, 2004(23)*
10.27	Credit Agreement with Bank of the West dated November 4, 2005(25)
10.28	Amendment No. 3 to Contingent Convertible Note Purchase Agreement dated September 22, 2006
21.1	List of Subsidiaries(16)
23.1	Consent of Independent Registered Public Accounting Firm – BDO Seidman, LLP
23.2	Consent of Independent Registered Public Accounting Firm – KPMG LLP
31.1	Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

S-2

* Management contract or compensatory plan or arrangement

(1) 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.

(2) Previously filed as an exhibit to Diedrich Coffee’s Current Report on Form 8-K, filed with the Securities and Exchange Commission on May 16, 2001.

(3) Previously filed as an exhibit to Diedrich Coffee’s Registration Statement on Form S-1/A (Registration No. 333-08633), filed with the Securities and Exchange Commission on August 28, 1996 and declared effective on September 11, 1996.

(4) Previously filed as an exhibit to Diedrich Coffee’s Registration Statement on Form S-3 (Registration No. 333-66744), filed with the Securities and Exchange Commission on August 3, 2001.

(5) Previously filed as an exhibit to Diedrich Coffee’s Registration Statement on Form S-1 (Registration No. 333-08633), filed with the Securities and Exchange Commission on July 24, 1996 and declared effective on September 11, 1996.

(6) Previously filed as an exhibit to Diedrich Coffee’s Annual Report on Form 10-K for the fiscal year ended January 28, 1998, filed with the Securities and Exchange Commission on April 28, 1998.

(7) Previously filed as an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for the period ended March 10, 2004, filed with the Securities and Exchange Commission on April 26, 2004.

(8) Previously filed as an exhibit to Diedrich Coffee’s Registration Statement on Form S-8, filed with the Securities and Exchange Commission on November 21, 2000.

(9) Previously filed as an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for the period ended September 22, 1999, filed with the Securities and Exchange Commission on November 5, 1999.

(10) Previously filed as an exhibit to Diedrich Coffee’s Registration Statement on Form S-1/A (Registration No. 333-08633), filed with the Securities and Exchange Commission on August 12, 1996 and declared effective on September 11, 1996.

(11) Previously filed as an exhibit to Diedrich Coffee’s Annual Report on Form 10-K for the fiscal year ended July 3, 2002, filed with the Securities and Exchange Commission on October 1, 2002.

(12) Previously filed as an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for the period ended December 18, 2002, filed with the Securities and Exchange Commission on January 31, 2003.

(13) Previously filed as an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for the period ended March 12, 2003, filed with the Securities and Exchange Commission on April 28, 2003.

(14) Previously filed as an exhibit to Diedrich Coffee’s Annual Report on Form 10-K for the fiscal year ended July 2, 2003, filed with the Securities and Exchange Commission on September 30, 2003.

(15) Previously filed as an exhibit to Diedrich Coffee’s Annual Report on Form 10-K for the fiscal year ended June 27, 2001, filed with the Securities and Exchange Commission on September 25, 2001.

S-3

(16) Previously filed as an exhibit to Diedrich Coffee’s Annual Report on Form 10-K for the fiscal year ended June 28, 2000, filed with the Securities and Exchange Commission on September 27, 2000.

(17) Previously filed as an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for the period ended September 20, 2000, filed with the Securities and Exchange Commission on November 6, 2000.

(18) Previously filed as an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for the period ended September 24, 2003, filed with the Securities and Exchange Commission on November 7, 2003.

(19) Previously filed as an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for the period ended December 17, 2003, filed with the Securities and Exchange Commission on January 30, 2004.

(20) Previously filed as an exhibit to Diedrich Coffee’s Current Report on Form 8-K, filed with the Securities and Exchange Commission on December 16, 2005.

(21) Previously filed as an exhibit to Diedrich Coffee’s Current Report on Form 8-K, filed with the Securities and Exchange Commission on January 5, 2006.

(22) Previously filed as an exhibit to Diedrich Coffee’s Current Report on Form 8-K, filed with the Securities and Exchange Commission on March 31, 2006.

(23) Previously filed as an exhibit to Diedrich Coffee’s Current Report on Form 8-K, filed with the Securities and Exchange Commission on November 3, 2004.

(24) Previously filed with this Annual Report on Form 10-K for the fiscal year ended June 30, 2004, filed with the Securities and Exchange Commission on September 28, 2004.

(25) Previously filed as an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for the period ended March 8, 2006, filed with the Securities and Exchange Commission on April 21, 2006.

S-4

EXHIBIT INDEX

Exhibit No.	Description
10.20	Amendment No. 1 to Contingent Convertible Note Purchase Agreement dated June 30, 2004
10.25	Agreement of Purchase and Sale of Assets by and between Starbucks Corporation, Diedrich Coffee, Inc. and Coffee People, Inc.
10.28	Amendment No. 3 to Contingent Convertible Note Purchase Agreement dated September 22, 2006
23.1	Consent of Independent Registered Public Accounting Firm – BDO Seidman, LLP
23.2	Consent of Independent Registered Public Accounting Firm – KPMG LLP
31.1	Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

EX-10.20

EXHIBIT 10.20

AMENDMENT NO. 1

TO

CONTINGENT CONVERTIBLE NOTE PURCHASE AGREEMENT

This Amendment No.1 to Contingent Convertible Note Purchase Agreement (this “Amendment”) is made and entered into as of this 30th day of June, 2004 by and between Diedrich Coffee, Inc., a Delaware corporation (the “Company”), and Sequoia Enterprises, L.P., a California limited partnership (“Lender”).

RECITALS

A. On May 10, 2004, Company and Lender entered into that certain Contingent Convertible Note Purchase Agreement (the “Note Purchase Agreement”) pursuant to which Lender agreed to loan to the Company an aggregate principal amount of up to $5,000,000 on the terms and conditions set forth in the Note Purchase Agreement.

B. The parties desire to revise the definition of “Availability” set forth in the Note Purchase Agreement and therefore amend the Note Purchase Agreement on the terms and as provided in this Amendment.

AGREEMENT

In consideration of the foregoing recitals, the parties agree as follows:

1. Definitions. Capitalized terms not otherwise defined in this Amendment shall have the meanings given to them in the Note Purchase Agreement.

2. Revised Definition of Availability. The definition of “Availability” set forth in Section 1.1 of the Note Purchase Agreement shall be deleted in it’s entirety and replaced with the following:

“Availability” means, on any date, the Loan Amount, less the sum of the principal amount of all Notes outstanding under this Agreement.

3. Express Changes Only. The parties hereto intend to amend the Note Purchase Agreement only as set forth herein, and the parties hereto agree that, except as expressly amended hereby, all other terms and conditions of the Note Purchase Agreement are hereby ratified and confirmed and shall remain in full force and effect.

4. Authority. Each of the parties hereto represents and warrants that it has the authority to enter into this Amendment. This Amendment has been carefully read by, the contents hereof are known and understood by, and it is signed freely by, each person executing this Amendment.

5. Independent Legal Advice. Each of the parties hereto has received independent legal advice from attorneys of its or his own choice, with respect to the advisability of entering into this Amendment. Each party, together with its attorneys, has made such investigation of the facts pertaining to the matters set forth herein and this Amendment, and of all the matters pertaining thereto, as it deems necessary.

6. Governing Law. This Amendment shall be governed by, and construed, interpreted and enforced in accordance with, the laws of the State of California without regard to conflict of laws principles.

7. Counterparts. This Amendment may be executed in any number of counterparts, each of which will be deemed an original, but all of which together will constitute one instrument. Signatures transmitted electronically or by facsimile will be deemed original signatures; provided that the party delivering such electronic or facsimile signature shall deliver to the other an original signature page as soon thereafter as practicable.

IN WITNESS WHEREOF, the parties have executed and delivered this Amendment as of the date first written above.

COMPANY:
DIEDRICH COFFEE, INC.
By:	/s/ Roger M. Laverty
	Roger M. Laverty
	Chief Executive Officer
By:	/s/ Martin A. Lynch
	Martin A. Lynch
	Chief Financial Officer
LENDER
SEQUOIA ENTERPRISES, L.P.
By:	/s/ Paul Heeschen
	Paul Heeschen, General Partner

2

EX-10.25

Exhibit 10.25

AGREEMENT OF PURCHASE AND SALE OF ASSETS

by and between

STARBUCKS CORPORATION,

as Buyer

DIEDRICH COFFEE, INC.,

as Seller

and COFFEE PEOPLE, INC.

September 14, 2006

TABLE OF CONTENTS

		Page
ARTICLE 1	DEFINITIONS	2
ARTICLE 2	THE TRANSACTION	9
2.1	Acquisition Assets	9
2.2	Assets Not Being Acquired	10
2.3	Assumed Liabilities	10
2.4	Excluded Liabilities	11
2.5	Determination of Subject Locations	11
2.6	Purchase Price	12
2.7	Escrow	12
2.8	Employees	13
2.9	Closing	13
ARTICLE 3	REPRESENTATIONS AND WARRANTIES OF SELLER	14
3.1	Organization and Qualification	14
3.2	Authority Relative to Agreements	15
3.3	No Conflicts	15
3.4	No Consents	15
3.5	Compliance with Laws; Permits	15
3.6	Real Estate Leases/Occupancy Agreements/Ground Leases	16
3.7	Good Title to the Acquisition Assets; Condition of F&E	16
3.8	Tax Matters	16
3.9	No Restrictions on Business Activities	17
3.10	Litigation	17
3.11	Environmental Matters	17
3.12	Brokers’ Fees	18
3.13	Fraudulent Transfer	18
3.14	Insurance	18
3.15	Employment Matters	19
3.16	Board Approval	19
ARTICLE 4	REPRESENTATIONS AND WARRANTIES OF BUYER	20
4.1	Organization and Qualification	20
4.2	Authority Relative to Agreements	20
4.3	No Conflicts	20

-i-

TABLE OF CONTENTS

(Continued)

		Page
4.4	Access to Information	20
4.5	No Consents	20
4.6	Availability of Funds	21
4.7	Brokers’ Fees	21
ARTICLE 5	COVENANTS	21
5.1	Covenants of Seller Prior to the Closing and each Post-Closing Transfer	21
5.2	No Negotiations	22
5.3	Public Announcements	23
5.4	Confidentiality	24
5.5	Access to Information and Subject Locations	24
5.6	Required Filings	25
5.7	Non-Disparagement	25
5.8	Noncompetition; Nonsolicitation	26
5.9	Forms of Consent to Assignment of Lease; Lease and Agreement Amendment	26
5.10	Allocation	26
5.11	Books and Records	26
5.12	Transfer Fees and Taxes; Prorations	27
5.13	Additional Covenants	27
5.14	Environmental Assessment	28
5.15	Meeting of Stockholders	29
ARTICLE 6	CONDITIONS TO THE CLOSING AND EACH POST-CLOSING TRANSFER	29
6.1	Conditions to Obligations of Seller and Buyer	29
6.2	Conditions to Obligations of Seller	29
6.3	Conditions to Obligations of Buyer	30
6.4	Termination Date	32
6.5	Post-Closing Transfers	32
6.6	Waiver	32
ARTICLE 7	SURVIVAL OF REPRESENTATIONS AND WARRANTIES; INDEMNIFICATION	32
7.1	Nature and Survival of Representations and Warranties	32

-ii-

TABLE OF CONTENTS

(Continued)

		Page
7.2	Indemnification by Seller	33
7.3	Indemnification by Buyer	33
7.4	Procedure for Indemnification and Dispute Resolution	34
7.5	Remedies	37
ARTICLE 8	TERMINATION	37
8.1	Termination	37
8.2	Effect of Termination	38
ARTICLE 9	MISCELLANEOUS	38
9.1	Transaction Expenses; Termination Fees	38
9.2	Notices	39
9.3	Governing Law; Venue	39
9.4	No Third Party Beneficiaries	40
9.5	Assignment	40
9.6	Intent to be Binding; Entire Agreement; Severability	40
9.7	Waiver of Provisions	40
9.8	Construction	41
9.9	Acknowledgement; Independent Due Diligence	41
9.10	Disclaimer Regarding Assets	41

-iii-

SCHEDULES
Schedule 1.0	Subject Locations
Schedule 1.3	Ground Lease Subject Locations
Schedule 1.5	Knowledge Personnel
Schedule 2.1(a)	Assumed Leases and Occupancy Agreements
Schedule 2.1(c)	Prepaid Items
Schedule 2.1(d)	F&E
Schedule 2.1(e)	Assumed Permits
Schedule 2.3	Assumed Liabilities
Schedule 3.0	Schedule of Exceptions
Schedule 5.10	Allocation Schedule
Schedule 6.2	Required Approvals and Consents
Schedule 6.3(h)	Encumbrances
EXHIBITS
Exhibit A	Form of Escrow Agreement
Exhibit B	Form of Bill of Sale
Exhibit C	Form of Assignment and Assumption Agreement
Exhibit D	Form of Consent to Assignment of Lease
Exhibit E	Chart of Terms for Lease and Agreement Amendments
Exhibit F-1	Form of Certificate of Seller
Exhibit F-2	Form of Certificate of Buyer

AGREEMENT OF PURCHASE AND SALE OF ASSETS

This Agreement is made as of September 14, 2006, by and between Starbucks Corporation, a Washington corporation (“Buyer”), Diedrich Coffee, Inc., a Delaware corporation (“Seller”) and Coffee People, Inc., an Oregon corporation (“Coffee People”).

RECITAL

Subject to the terms and conditions set forth in this Agreement, Seller and Coffee People desire to sell and assign to Buyer, and Buyer desires to purchase and assume from Seller and Coffee People, Seller’s and Coffee People’s entire right, title and interest in and to the leasehold interests and occupancy rights under the leases and occupancy agreements set forth on Schedule 2.1(a) and other specifically identified tangible assets and properties used in connection with the operation of the retail stores owned or operated by Seller and Coffee People, respectively, under the Diedrich Coffee and Coffee People brands, all as listed on Schedule 1.0, as it may be amended from time to time (the “Subject Locations”).

ARTICLE 1

DEFINITIONS

For purposes of this Agreement and the attached schedules and exhibits, certain initially capitalized terms have the meanings ascribed to them in Article 1. Other terms are defined in the body of this Agreement.

“Acquisition Assets” has the meaning set forth in Section 2.1.

“Additional Assessment” has the meaning set forth in Section 5.14(a).

“Affiliate” with respect to any party, means any person or entity controlling, controlled by, or under common control with, such party, including but not limited to any subsidiary of such party.

“Allocation Schedule” has the meaning set forth in Section 5.10.

“Applicable Laws” mean all laws, regulations, ordinances and other restrictions of foreign, federal, state and local governments and agencies regulating or otherwise affecting Buyer, Seller, Coffee People, the Subject Locations or the Acquisition Assets, including, without limitation, those regulating or affecting employee health and safety, discharge of pollutants or wastes, consumer protection and employee benefit plans.

“Assignment and Assumption Agreement” means the Assignment and Assumption Agreement substantially in the form attached hereto as Exhibit C.

“Assumed Leases and Occupancy Agreements” has the meaning set forth in Section 2.1(a).

2

“Assumed Liabilities” has the meaning set forth in Section 2.3.

“Assumed Permits” has the meaning set forth in Section 2.1(e).

“Assumption Time” has the meaning set forth in Section 2.3.

“Business Day” means a day other than Saturday, Sunday or any day on which banks located in Seattle, Washington are closed.

“Buyer” means Starbucks Corporation, a Washington corporation.

“Buyer Group” has the meaning set forth in Section 5.2.

“Buyer’s Cap” has the meaning set forth in Section 7.4(b).

“Claim Notice” has the meaning set forth in Section 7.4(d).

“Closing” has the meaning set forth in Section 2.9(a).

“Closing Date” has the meaning set forth in Section 2.9(a).

“COBRA” has the meaning set forth in Section 3.15.

“Code” means the Internal Revenue Code of 1986, as amended.

“Coffee People” means Coffee People, Inc., an Oregon corporation.

“Consent to Assignment of Lease” means the Consent to Assignment of Lease agreed to between Buyer and Seller or Coffee People, as applicable, substantially in the form attached hereto as Exhibit D (to obtain all applicable landlord’s, sublandlord’s, ground lessor’s or other applicable contract party’s signature thereon) and providing for the assignment to Buyer of the lease or occupancy agreement for each Subject Location, together with estoppel, release and consent provisions in connection therewith.

“Encumbrance” means any claim, lien, charge, security interest, pledge, mortgage or any other restriction or encumbrance of any kind or nature.

“Environment” means soil, land surface or subsurface strata, surface waters (including navigable waters and ocean waters), groundwaters, drinking water supply, stream sediments, ambient air (including indoor air), plant and animal life and any other environmental medium or natural resource.

“Environmental Assessment” has the meaning set forth in Section 5.14(a).

“Environmental, Health and Safety Liabilities” mean any cost, damages expense, liability, obligation or other responsibility arising from or under any Environmental Law or Occupational Safety and Health Law, including those consisting of or relating to:

3

(a) any environmental, health or safety matter or condition (including on-site or off-site contamination, occupational safety and health and regulation of any chemical substance or product);

(b) any fine, penalty, judgment, award, settlement, legal or administrative proceeding, damages, loss, claim, demand or response, remedial or inspection cost or expense arising under any Environmental Law or Occupational Safety and Health Law;

(c) financial responsibility under any Environmental Law or Occupational Safety and Health Law for cleanup costs or corrective action, including any cleanup, removal, containment or other remediation or response actions (“Cleanup”) required by any Environmental Law or Occupational Safety and Health Law (whether or not such Cleanup has been required or requested by any governmental body or any other person or entity) and for any natural resource damages; or

(d) any other compliance, corrective or remedial measure required under any Environmental Law or Occupational Safety and Health Law.

The terms “removal,” “remedial” and “response action” include the types of activities covered by the United States Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended (CERCLA).

“Environmental Law” means as of the date of the Closing any and all civil, criminal and administrative laws (including common law), statutes, codes, rules, regulations, ordinances, orders, decrees, judgments, permits, licenses, approvals, authorizations and other requirements, directives, consents and obligations lawfully imposed by any Governmental Entity pertaining to the protection of the Environment, protection of ecology, protection of public health, protection of worker health and safety, and/or the treatment, emission and/or discharge of gaseous, particulate and/or effluent pollutants, and/or the handling of Hazardous Materials, and regulations, guidelines, and policies promulgated under any of the foregoing, including, but not limited to, requirements that relate to:

(a) notifying appropriate authorities, employees or the public of intended or actual Releases of pollutants or hazardous substances or materials, violations of discharge limits or other prohibitions and the commencement of activities, such as resource extraction or construction, that could have significant impact on the Environment;

(b) preventing or reducing to acceptable levels the Release of pollutants or hazardous substances or materials into the Environment;

(c) reducing the quantities, preventing the Release or minimizing the hazardous characteristics of wastes that are generated;

(d) assuring that products are designed, formulated, packaged and used so that they do not present unreasonable risks to human health or the Environment when used or disposed of;

(e) protecting resources, species or ecological amenities;

4

(f) reducing to acceptable levels the risks inherent in the transportation of hazardous substances, pollutants, oil or other potentially harmful substances;

(g) cleaning up pollutants that have been Released, preventing the Threat of Release or paying the costs of such clean up or prevention; or

(h) making responsible parties pay private parties, or groups of them, for damages done to their health or the Environment or permitting self-appointed representatives of the public interest to recover for injuries done to public assets.

“Environmental Violation” has the meaning set forth in Section 5.14(b).

“ERISA” means the Employee Retirement Income Security Act of 1974, as amended, or any successor law, and regulations and rules issued pursuant thereto.

“ERISA Affiliate” means the Seller, any subsidiary of Seller and, with respect to any employee benefit plan (as defined in Section 3(3) of ERISA), any trade or business (whether or not incorporated) that is or, at any relevant time, was treated as a single employer with Seller within the meaning of Section 414(b), (c), (m) or (o) of the Code.

“Escrow Agent” has the meaning set forth in Section 2.7.

“Escrow Agreement” has the meaning set forth in Section 2.7.

“Escrow Fund” has the meaning set forth in Section 2.7.

“Escrow Period” has the meaning set forth in Section 2.7.

“Excluded Agreements” has the meaning set forth in Section 2.2(c).

“Excluded Assets” has the meaning set forth in Section 2.2.

“Excluded Business” has the meaning set forth in Section 2.2(a).

“Excluded Liabilities” has the meaning set forth in Section 2.4.

“F&E” has the meaning set forth in Section 2.1(d).

“Governmental Entity” means any court, or any federal, state, municipal, provincial or other governmental authority, department, commission, board, service, agency, political subdivision or other instrumentality.

“Ground Leases” means the Assumed Leases and Occupancy Agreements relating to the Ground Lease Subject Locations.

“Ground Lease Improvements” shall have the meaning set forth in Section 2.1(f).

“Ground Lease Subject Locations” means the Subject Locations on Schedule 1.3.

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“Hazardous Activity” means the distribution, generation, handling, importing, management, manufacturing, processing, production, refinement, Release, storage, transfer, transportation, treatment or use (including any withdrawal or other use of groundwater) of Hazardous Material in, on, under, about or from any of the Acquisition Assets or any part thereof into the Environment and any other act, business, operation or thing that increases the danger, or risk of danger, or poses an unreasonable risk of harm, to persons or property on or off the Subject Locations.

“Hazardous Material” means any substance, material or waste which is regulated by any governmental body, including any material, substance or waste which is defined as a “hazardous waste,” “hazardous material,” “hazardous substance,” “extremely hazardous waste,” “restricted hazardous waste,” “contaminant,” “toxic waste” or “toxic substance” under any provision of Environmental Law, and including petroleum, petroleum products, asbestos, or asbestos-containing material, urea formaldehyde and polychlorinated biphenyls.

“Improvements” has the meaning set forth in Section 2.1(b).

“Indemnified Party” means the party that is entitled, or is seeking, to be indemnified under this Agreement.

“Indemnifying Party” means the party required to indemnify, or against which indemnification is sought, under this Agreement.

“JAMS” has the meaning set forth in Section 7.4(f).

“Knowledge of Seller” means the actual knowledge of such matter of any officer of Seller set forth on Schedule 1.5. Any such individual will be deemed to have knowledge of a particular fact, circumstance, event or other matter if (i) such individual has actual knowledge of such fact, circumstance, event or other matter; (ii) such fact, circumstance, event or other matter is reflected in one or more documents (whether written or electronic, including e-mails sent to or by such individual) in, or that have been in, such individual’s possession, including personal files of such person; or (iii) such fact, circumstance, event or other matter is explicitly set forth in one or more documents (whether written or electronic) contained in books and records of Seller that, based upon the historical practices of Seller, would be reviewed by a person who has the duties and responsibilities of such individual in the customary performance of such duties and responsibilities.

“Lease and Agreement Amendment” means the Lease and Agreement Amendments for each lease or occupancy agreement with respect to each Subject Location containing substantially the terms set forth on the Exhibit E.

“Liability” means all liabilities, indebtedness, obligations (contractual, statutory or otherwise) or guarantees of any kind, character or description, whether known or unknown, absolute or contingent, accrued or unaccrued, disputed or undisputed, liquidated or unliquidated, secured or unsecured, joint or several, due or yet to become due, vested or unvested, executory, determined, determinable or otherwise.

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“Loss” means any loss, demand, action, cause of action, claim, diminution in value, assessment, damage, fine, penalty, lost profits, Liability, cost (including but not limited to costs of cleanup, containment or other remediation), expense or other losses, including without limitation, interest, penalties and reasonable attorneys’ and other professional fees and expenses incurred in the investigation, prosecution, defense or settlement thereof (including, without limitation, interest which may be imposed in connection therewith, court costs, litigation expenses, costs of investigation and reasonable attorneys’, accounting and expert fees).

“Material Adverse Effect” means any event, circumstance, change or effect that individually or in the aggregate has or is reasonably likely to have a material adverse effect on (i) the physical condition, use or operation of the Acquisition Assets taken as a whole, (ii) the ability of Buyer to operate the Subject Locations as Buyer’s coffee stores in a manner consistent with Seller’s and Coffee People’s past practice in operating Seller’s and Coffee People’s coffee stores, (iii) the Assumed Liabilities, or (iv) the ability of Seller to perform its obligations under this Agreement or to consummate transactions contemplated by this Agreement; provided, however, that “Material Adverse Effect” shall not include the effect of any circumstance, change, development, event or state of facts arising out of or attributable to any of the following, either alone or in combination: (1) the markets in which Seller and Coffee People operate generally; (2) general economic or political conditions (including those affecting the securities markets); (3) the public announcement of this Agreement or of the consummation of the transactions contemplated by this Agreement; (4) acts of war (whether or not declared), sabotage or terrorism or military actions or the escalation thereof; or (5) any changes in Applicable Laws, regulations or accounting rules.

“Maximum Aggregate Purchase Price” has the meaning set forth in Section 2.5.

“Negative Value Subject Location” has the meaning set forth in Section 2.5.

“Non-Competition Amount” has the meaning set forth in Section 2.5.

“Occupational Safety and Health Law” means any legal requirement designed to provide safe and healthful working conditions and to reduce occupational safety and health hazards, including the Occupational Safety and Health Act, and any program, whether governmental or private (such as those promulgated or sponsored by industry associations and insurance companies), designed to provide safe and healthful working conditions.

“Payment Obligations” has the meaning set forth in Section 5.12.

“Permits” means any license, certificate, permit, approval, franchise or registration issued by a Governmental Entity.

“Permits and Approvals” has the meaning set forth in Section 5.5.

“Permitted Liens” mean (i) statutory liens for current Taxes or assessments not yet due and payable, (ii) terms and conditions of the Assumed Leases and Occupancy Agreements, as amended by the Lease and Agreement Amendments, (iii) items specified on Schedule 2.3, (iv) the rights of the parties pursuant to this Agreement, the Transaction Documents and any other instruments to be delivered hereunder, (v) standard exceptions listed on any Title Policy

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procured and delivered to Buyer, and (vi) any other Encumbrances related to the Acquisition Assets that are specifically and fully set forth in a schedule or exhibit attached to this Agreement identifying each Acquisition Asset to which the Encumbrance relates, if and to the extent such Encumbrances are accepted by Buyer at or prior to Transfer to Buyer; provided, that, without limiting the specificity of the foregoing, the term Permitted Liens will not include any materialmen’s, mechanic’s or other similar statutory liens applicable to the Subject Locations.

“Person” means an individual, partnership (general or limited), corporation, business trust, limited liability company, limited liability partnership, joint stock company, trust, unincorporated association, joint venture or other entity or a governmental authority.

“Phase I” has the meaning set forth in Section 5.14(a).

“Post-Closing Transfer” has the meaning set forth in Section 6.5.

“Prepaid Items” has the meaning set forth in Section 2.1(c).

“Purchase Price” has the meaning set forth in Section 2.6.

“Release” means any release, spill, emission, leaking, pumping, pouring, dumping, emptying, injection, deposit, disposal, discharge, dispersal, leaching or migration on or into the Environment or into or out of any property.

“Release Date” has the meaning set forth in Section 7.1.

“Remaining Subject Locations” has the meaning set forth in Section 6.5.

“Representative” means any officer, director, principal, attorney, agent, employee or other representative.

“Returns” has the meaning set forth in Section 3.8.

“Seller” means Diedrich Coffee, Inc., a Delaware corporation.

“Seller Group” has the meaning set forth in Section 7.3.

“Seller’s Cap” has the meaning set forth in Section 7.4(a).

“Stockholder Meeting” has the meaning set forth in Section 5.15.

“Subject Locations” has the meaning set forth in the RECITAL.

“Superior Offer” has the meaning set forth in Section 5.2(d).

“Tax” means any and all federal, state, local, foreign or other tax, levy, impost, fee, assessment or other government charge, including without limitation (i) income, estimated income, business, occupation, franchise, property, payroll, personal property, real property, sales, value added, transfer, use, excise, employment, commercial rent, occupancy, franchise or withholding taxes and (ii) any premium, interest, penalties and additions in connection therewith.

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“Termination Date” has the meaning set forth in Section 6.4.

“Third Party Claim” has the meaning set forth in Section 7.4(d).

“Threat of Release” means a reasonable likelihood of a Release that may require action in order to prevent or mitigate damage to the Environment that may result from such Release.

“Threshold” has the meaning set forth in Section 7.4(a).

“Title Company” means the title company that will issue the Title Policies.

“Title Policies” means a leasehold policy of title insurance on the standard form issued in the State of Oregon with respect to each of the Ground Leases, each in (i) amounts reasonably acceptable to Buyer, and (ii) showing only Permitted Liens.

“Transaction Documents” means the Escrow Agreement, Bill of Sale and the Assignment and Assumption Agreement.

“Transfer” has the meaning set forth in Section 2.1.

“Transfer Premium Subject Location” means a Subject Location for which the applicable lease requires the payment to the landlord of any consideration, or portion thereof, that Seller is entitled to receive from Buyer pursuant to this Agreement.

“Transfer Proposal” means any offer, proposal, inquiry or indication of interest (other than an offer, proposal, inquiry or indication of interest by Buyer) contemplating or otherwise relating to any acquisition of any of the Acquisition Assets, any acquisition of Seller that would include any of the Acquisition Assets or any merger or consolidation with or involving Seller that would include any of the Acquisition Assets.

ARTICLE 2

THE TRANSACTION

2.1 Acquisition Assets. At the Closing (or a Post-Closing Transfer in accordance with the terms of this Agreement), and subject to Seller’s ability to retain certain Subject Locations in accordance with Section 2.5, Seller will (and will cause Coffee People to) sell, assign, convey, transfer and deliver (“Transfer”) to Buyer all of Seller’s and Coffee People’s right, title and interest in the following assets (the “Acquisition Assets”):

(a) the leases and occupancy agreements listed on Schedule 2.1(a) (the “Assumed Leases and Occupancy Agreements”);

(b) all fixtures, alterations or modifications that are attached to the Subject Locations and owned by Seller, except for photographs, pastry cases, menu boards, signage and any items that contain the Coffee People and Diedrich Coffee trademarks or tradenames (“Improvements”);

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(c) all credits, security deposits, prepaid expenses and prepaid items related to the Assumed Leases and Occupancy Agreements or otherwise relating to the operation of the Subject Locations, including but not limited to those listed on Schedule 2.1(c) (“Prepaid Items”);

(d) (x) all sinks, freezers (including walk-in freezers) and refrigerators, (y) with respect to store number 1116, identified on row 27 of Schedule 1.0 (the San Juan Capistrano store), the custom kitchen hood attached to the wall of such Subject Location, and (z) all other equipment specifically set forth on Schedule 2.1(d) (“F&E”);

(e) to the extent assignable to Buyer, all Permits (excluding liquor licenses) specifically listed on Schedule 2.1(e) (“Assumed Permits”); and

(f) any buildings, structures or other improvements located at or on the Ground Lease Subject Locations (the “Ground Lease Improvements”).

2.2 Assets Not Being Acquired. Other than the assets specifically set forth in Section 2.1, no other assets are to be sold and delivered to Buyer (the “Excluded Assets”). By way of example and not in limitation of the foregoing, the parties hereto expressly agree that the Excluded Assets include:

(a) any rights or assets related to Seller’s or Seller’s Affiliates’ franchise business, or operations or any other lines of business that do not involve the operation of the Subject Locations (collectively, the “Excluded Business”);

(b) Seller’s or Coffee People’s intellectual property, intellectual property rights and other intangible assets, including, without limitation, Seller’s or Coffee People’s trade names, trademarks, logos, patents, copyrights, trade secrets and business methods;

(c) any customer, supplier and service agreements (the “Excluded Agreements”); and

(d) all claims for refund of Taxes and other governmental charges of whatever nature paid by Seller or Coffee People related to the Acquisition Assets for periods prior to the date at which such Acquisition Assets were Transferred to Buyer, except amounts paid for Assumed Permits.

2.3 Assumed Liabilities. At the Closing or a Post-Closing Transfer (as applicable, the “Assumption Time”), Buyer will assume only the following Liabilities of Seller and Coffee People (the “Assumed Liabilities”):

(a) all Liabilities under the Assumed Leases and Occupancy Agreements, as amended by the Lease and Agreement Amendments, and under the Assumed Permits, in each case only to the extent (i) related to Subject Locations actually Transferred to Buyer at the Closing or the applicable Post-Closing Transfer and (ii) related to or arising out of events or circumstances occurring after the applicable Assumption Time (but excluding any Liabilities under any Assumed Lease or Occupancy Agreement which are not set forth therein and that become due after the applicable Assumption Time but arise out of or are based on or calculated on the basis of events or circumstances occurring prior to the applicable Assumption Time);

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(b) all Liabilities accruing, arising out of, related to or resulting from the ownership, use, operations or maintenance of the Improvements, F&E and Ground Lease Improvements after the applicable Assumption Time;

(c) all Liabilities for Taxes relating to the ownership or operation of the Acquisition Assets after the applicable Assumption Time; and

(d) the items specified on Schedule 2.3, to the extent they relate to the Acquisition Assets actually acquired by Buyer at the Closing or the applicable Post-Closing Transfer.

2.4 Excluded Liabilities. Other than the Assumed Liabilities, Buyer will not assume any Liability relating to or arising out of or in connection with the Excluded Business, or any other Liabilities of Seller or Coffee People, including without limitation (the “Excluded Liabilities”):

(a) any Liability relating to or arising out of or in connection with the Excluded Assets; or

(b) any Liability relating to or arising out of or in connection with the Excluded Agreements, including but not limited to any termination, cancellation or similar fees, or other costs or damages, associated with Seller’s cancellation or termination of the Excluded Agreements or other services at the Subject Locations in accordance with Section 5.1(d).

2.5 Determination of Subject Locations. Upon execution of this Agreement, Schedule 1.0 will contain an initial list of all Subject Locations, and the Purchase Price applicable to the Transfer of each Subject Location pursuant to this Agreement. Subject to the other provisions of this Section 2.5, prior to the Closing or a Post-Closing Transfer, Buyer and Seller may mutually agree to delete Subject Locations from Schedule 1.0 (and appropriately adjust the Maximum Aggregate Purchase Price), provided, that Buyer may elect to delete a Subject Location from Schedule 1.0 in the event that, prior to the applicable Assumption Time such Subject Location is adversely affected by fire, flood, earthquake or other force majeure that causes the physical condition of such Subject Location to be substantially different from the condition of such Subject Location prior to such event. The aggregate Purchase Price for (i) all Subject Locations not designated on Schedule 1.0 as having a negative value (each, a “Negative Value Subject Location”), prior to any deletions or adjustments pursuant to this Agreement, is $13,400,000 and (ii) the non-competition covenant set forth in Section 5.8(a) is $120,000 (the “Non-Competition Amount”), for total maximum aggregate purchase consideration of $13,520,000 (the “Maximum Aggregate Purchase Price”), provided, that the Purchase Price applicable to a Subject Location actually Transferred to Buyer will be increased by the amount of any Prepaid Items set forth on Schedule 2.1(c) attributable to such Subject Location, and provided, further, that Seller may elect to retain and not Transfer, at any time prior to the Termination Date, any Subject Locations listed on Schedule 1.0 (i) designated under the column entitled “Transfer Premium Subject Location,” where the landlord does not waive or amend the

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payment to the landlord of any consideration, or portion thereof, that Seller is entitled to receive from Buyer pursuant to this Agreement and neither Seller nor Buyer agrees to make such payment to the landlord, (ii) that is a Negative Value Subject Location, or (iii) if the applicable landlord, in exchange for providing a Consent to Assignment of Lease or a Lease and Agreement Amendment, requests any payment from Seller or Buyer (other than payments in respect of a Transfer Premium Subject Location, which are covered by (i) above) and neither Seller nor Buyer agrees to settle such payment with the applicable landlord. If Seller elects to retain any Subject Location that is not a Negative Value Subject Location pursuant to this Section 2.5, then the Maximum Aggregate Purchase Price will be decreased by the amount of value allocated to it in Schedule 1.0. If Seller elects to retain any Negative Value Subject Location, such election will have no effect on the Maximum Aggregate Purchase Price. If Seller elects to Transfer any Negative Value Subject Location, such Transfer will have the effect of decreasing the Maximum Aggregate Purchase Price in accordance with the negative value attributed to such Negative Value Subject Location in Schedule 1.0. For the avoidance of doubt and by way of example only, if Seller elects to Transfer to Buyer store number 1103 (the Costa Mesa store, having a value of ($85,000) (a negative value)) listed on Schedule 1.0 at the Closing, the aggregate Purchase Price payable for all Subject Locations transferred to Buyer at the Closing will be reduced by $85,000. Buyer and Seller acknowledge and agree that, notwithstanding any other provision of this Agreement, no Negative Value Subject Location will be Transferred to Buyer unless and until a number of Subject Locations equal to the difference between (x) 25 and (y) the number of Subject Locations designated on Schedule 1.0 as Transfer Premium Subject Locations, have been Transferred to Buyer.

2.6 Purchase Price. At the Closing and at each Post-Closing Transfer, for each Subject Location Transferred at the applicable Assumption Time, Buyer will (i) pay to Seller the amount set forth on Schedule 1.0 opposite each Subject Location (the amount set forth on Schedule 1.0 with respect to each Subject Location, the “Purchase Price”), plus an amount equal to the Prepaid Items attributable to such Subject Location that is Transferred to Buyer and less the applicable portion of the Escrow Fund to be deposited with the Escrow Agent at the Closing or the Post-Closing Transfer and (ii) assume the Assumed Liabilities relating to each Subject Location being Transferred at the Closing or a Post-Closing Transfer. At the Closing, Buyer will also pay the Non-Competition Amount (less the portion of the Non-Competition Amount contributed to the Escrow Fund) to Seller. All payments to Seller at the Closing and any Post-Closing Transfer will be paid in accordance with wire transfer instructions provided in writing by Seller at least six (6) Business Days prior to the Closing or the Post-Closing Transfer, as applicable.

2.7 Escrow. At the Closing and thereafter until the Release Date (the “Escrow Period”), subject to the other provisions of this Agreement and the terms of the Escrow Agreement attached hereto as Exhibit A (the “Escrow Agreement”), 10% of the total Purchase Price paid to Seller with respect to Subject Locations (including any Prepaid Items and the Non-Competition Amount) transferred to Buyer at the Closing and any Post-Closing Transfer (the “Escrow Fund”) will be deposited with and held in escrow by Greater Bay Trust Company (or other institution mutually selected by Buyer and Seller) as escrow agent (the “Escrow Agent”) to secure the accuracy and full and timely performance of Seller’s representations, warranties, covenants and agreements, and Seller’s other indemnity obligations under this Agreement. Seller’s indemnity obligations pursuant to this Agreement will be satisfied first from the Escrow

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Fund to the extent the Escrow Fund is sufficient to do so, and thereafter Buyer may seek recovery from Seller directly. Buyer and Seller will share equally in the payment of any fees to the Escrow Agent for the maintenance and administration of the Escrow Fund.

2.8 Employees.

(a) Subject to the Closing, Buyer will offer employment to all hourly non-management (below assistant store manager level) store employees of Seller or Coffee People (as applicable) at each Subject Location actually Transferred to Buyer who are in good standing, without conducting employment interviews. Employees in “good standing” are those whose most recent performance evaluations by Seller or Coffee People, as applicable, indicate performance at a satisfactory level or higher, and who are not former employees of Buyer identified on Buyer’s internal records as ineligible to be rehired by Buyer. Buyer and Seller will mutually agree on a plan for Buyer to interview employees at the assistant store manager level and higher. Buyer is not obligated to hire any such management employees of Seller or Coffee People. Within ten (10) Business Days after execution of this Agreement, Buyer and Seller will mutually agree on a plan to facilitate informational sessions for Seller’s or Coffee People’s employees who currently work at the Subject Locations. The content of any such informational sessions will be at Buyer’s discretion, and at locations and times to be determined by Buyer. Seller is and will remain solely responsible for any pension, severance, bonus, overtime pay and other compensation, benefits (including but not limited to workers’ compensation benefits), perquisites or payments incurred in connection with Seller’s or Coffee People’s termination of any of its employees, whether or not they are re-hired by Buyer, including but not limited to accrued vacation, sick time, sick pay, personal leave and compensatory time, none of which will be assumed by Buyer.

(b) Seller will be responsible for any notice required under or obligations and/or liabilities associated with the Worker Adjustment and Retraining Notification Act (29 U.S.C. §§ 2101-2109), and any Applicable Law related to any closings, mass layoff, relocation or severance associated with Seller’s or Coffee People’s employees, which takes place or arises on or before the Closing or the applicable Post-Closing Transfer, as applicable.

(c) Seller will be responsible for any group health plan continuation or conversion coverage required under Section 4980B of the Code, Part 6 of Title I of ERISA and the regulations thereunder, or Applicable Laws with respect to Seller’s or Coffee People’s employees due to a qualifying event occurring on or before the Closing or a Post-Closing Transfer, as applicable.

2.9 Closing.

(a) The closing (the “Closing”) of the transactions contemplated by this Agreement will be held not later than the Termination Date, except as provided in this Section 2.9 and shall take place ninety (90) days after the date of this Agreement (or if such date falls on a non-Business Day, the next Business Day) provided that the conditions to Closing set forth in Sections 6.1, 6.2 and 6.3 have been satisfied or waived, or on such other date that the parties mutually agree, provided, further, that, if the Closing is to occur more than ninety (90) days after the date of this Agreement (or if such date falls on a non-Business Day, then the next

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Business Day), Buyer must be in compliance with Section 5.13(b), as determined by Seller in its reasonable discretion (the “Closing Date”). The Closing and each Post-Closing Transfer will be held at the offices of DLA Piper US LLP, 701 5th Avenue, Suite 7000, Seattle, WA 98104. Post-Closing Transfers may occur in accordance with Section 6.5 hereof.

(b) Buyer may give written notice to Seller if Buyer deems the conditions to the Closing set forth in Sections 6.3(b), 6.3(d) and 6.3(f) to have been satisfied or waived, or to be within Seller’s or Buyer’s control to satisfy at any time, (such notice, the “Pre-Closing Notification”). Delivery of the Pre-Closing Notification by Buyer, and Seller’s receipt of such Pre-Closing Notification, serves a notice purpose only and will not constitute an acknowledgement by Buyer or Seller or give rise to any inference or estoppel on the part of Buyer or Seller that any or all of the other Closing conditions have been satisfied in accordance with this Agreement. Buyer and Seller will exercise commercially reasonable efforts to close the Transfers contemplated therein within ten (10) Business Days after Buyer gives such Pre-Closing Notification, if ever, subject to the provisions of Article 6 of this Agreement, provided, that the obligation to exercise commercially reasonable efforts will not apply with respect to the Negative Value Subject Locations.

(c) At the Closing and at each Post-Closing Transfer, in addition to the documents to be delivered to Buyer pursuant to Article 6, Seller shall deliver or cause to be delivered to Buyer: (i) physical possession of the F&E in connection with the Subject Locations being Transferred; (ii) executed assignments or transfers of the Assumed Permits; (iii) an executed Bill of Sale, in the form attached as Exhibit B; and (iv) an executed Assignment and Assumption Agreement, in the form attached as Exhibit C.

(d) At the Closing and at each Post-Closing Transfer, in addition to the documents to be delivered to Seller pursuant to Article 6, Buyer shall deliver or cause to be delivered to Seller (i) the Purchase Price applicable to the Subject Locations being Transferred minus the amount of the Escrow Fund, by wire transfer of immediately available funds, and (ii) the executed Assignment and Assumption Agreement. In addition, Buyer shall deliver the Escrow Fund to the Escrow Agent at Closing.

ARTICLE 3

REPRESENTATIONS AND WARRANTIES OF SELLER

Representations of Seller. Except as otherwise set forth in the Schedule of Exceptions attached hereto as Schedule 3.0, the following representations and warranties are made by Seller as set forth below as of the date of this Agreement, and as of the Closing and each Post-Closing Transfer. The paragraph numbers in the Schedule of Exceptions will correspond to the paragraph numbers in this Agreement; provided, however, that any information disclosed therein under any Schedule number shall be deemed to be disclosed and incorporated into any other paragraph or section number in the Schedule of Exceptions where such disclosure would be appropriate and where the purpose of disclosure in another section is readily apparent on the face of the disclosure.

3.1 Organization and Qualification. Seller is a corporation duly organized, validly existing, and in good standing under the laws of the State of Delaware, and has the requisite

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corporate power and authority to own and operate its properties and to carry on its business as now conducted. Seller is duly qualified to do business and is in good standing in California and Oregon. Coffee People is a wholly-owned subsidiary of Seller, all of the officers and directors of Coffee People are officers of Seller. Coffee People is a corporation duly organized, validly existing, and in good standing under the laws of the State of Oregon, and has the requisite corporate power and authority to own and operate its properties and to carry on its business as now conducted. Coffee People is duly qualified to do business and is in good standing in Oregon.

3.2 Authority Relative to Agreements. Subject to receiving stockholder approval, Seller has the requisite corporate power and authority to enter into this Agreement, the Escrow Agreement and all other agreements in connection with the transactions contemplated hereby to which Seller is or will be a party, and has the requisite corporate power and authority to carry out its obligations hereunder and thereunder. The execution and delivery of this Agreement and such other agreements by Seller and the consummation by Seller of such transactions have been duly authorized by the Board of Directors of Seller and by all required board and shareholder action of Coffee People. This Agreement has been duly executed and delivered by Seller, and, after receiving stockholder approval, will constitute a valid and binding obligation of Seller, enforceable against it in accordance with its terms, except as the enforceability thereof may be limited by bankruptcy, insolvency, reorganization, moratorium or other similar laws relating to the enforcement of creditors’ rights generally and by general principles of equity.

3.3 No Conflicts. Seller is not subject to, or obligated under, any provision of (i) Seller’s certificate of incorporation or bylaws, (ii) any agreement, arrangement, or understanding to which Seller is a party or by which Seller or any of its properties or assets is bound or affected, (iii) any Permit, or (iv) any Applicable Law, that would be breached or violated, or in respect of which a right of termination or acceleration would arise, or pursuant to which any Encumbrance on any of the Acquisition Assets would be created, by Seller’s execution, delivery, and performance of this Agreement and the consummation by Seller of the transactions contemplated hereby.

3.4 No Consents. Except as will be delivered at or prior to the Closing or the relevant Post-Closing Transfer, as applicable, and except as described on Schedule 6.2, no authorization, consent, or approval of, or filing with, any governmental body, court, other authority or third party is necessary on the part of Seller for the consummation by Seller of the transactions contemplated by this Agreement.

3.5 Compliance with Laws; Permits. Except with respect to tax matters (which are addressed in Section 3.8), environmental matters (which are addressed in Section 3.11) and labor and employment matters (which are addressed in Section 3.15) Seller and Coffee People and their respective Representatives have complied in all material respects with all Applicable Laws related to the Acquisition Assets and the Assumed Liabilities, and there are no claims, investigations or proceedings pending, or to the Knowledge of Seller reasonably expected or threatened, against Seller or Coffee People alleging a violation of any Applicable Law and Seller has no basis to expect any such claim, investigation or proceeding. Each of Seller and Coffee People holds and is in compliance in all material respects with all Permits required for the conduct of its business at the Subject Locations.

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3.6 Real Estate Leases/Occupancy Agreements/Ground Leases.

(a) Schedule 2.1(a) of the Agreement sets forth a list of the Assumed Leases and Occupancy Agreements, in each case, setting forth (i) the parties thereof and the date and term of each of the leases and occupancy agreements, (ii) the street address of each property covered thereby, and (iii) the aggregate amount of rent, deferred rent, CAM, taxes and insurance paid to the applicable landlord during the thirteen (13) fiscal periods ending July 26, 2006 under such lease or occupancy agreement (each fiscal period is four (4) weeks). The Assumed Leases and Occupancy Agreements are in full force and effect, Seller or Coffee People has a valid and existing leasehold or occupancy interest under each such lease or occupancy agreement for the term set forth therein, and a valid right to occupy the Subject Location for each such lease or occupancy agreement in the manner described in such lease or occupancy agreement for the term set forth therein, and neither Seller nor Coffee People nor to the Knowledge of Seller any other party thereto is in default or breach under any such leases or occupancy agreements. To the Knowledge of Seller no event has occurred that, with the passage of time or the giving of notice or both, would cause a breach of or default under any of such leases or occupancy agreements. During the prior 12 months, neither Seller nor Coffee People has asserted any written claim against the other party under any Assumed Lease and Occupancy Agreement.

(b) Neither Seller nor Coffee People has received any written notice of any condemnation proceeding with respect to any of the Subject Locations.

(c) Other than the leasehold interests, neither Seller nor Coffee People has any right, title or interest in or to any buildings or structures at the Subject Locations, except for the Ground Lease Improvements, and no such buildings or structures are under construction.

(d) To the Knowledge of Seller, the Assumed Leases and Occupancy Agreements are assignable to Buyer without payment of any fee that is not set forth in the Assumed Leases and Occupancy Agreements.

(e) Seller or Coffee People has fee title to the Ground Lease Improvements.

3.7 Good Title to the Acquisition Assets; Condition of F&E. Seller or Coffee People owns the Acquisition Assets free and clear of all Encumbrances other than Permitted Liens. Seller or Coffee People leases the Subject Locations under leases and occupancy agreements as previously delivered to Buyer. All F&E Transferred to Buyer at Closing and any Post-Closing Transfer is in good working order and has no material deferred maintenance obligations.

3.8 Tax Matters.

(a) Either Seller or Coffee People has prepared and timely filed all federal, foreign, state, county and local income, excise, property, sales, employment-related wages and benefits, and other Tax returns, estimates, information statements and reports (“Returns”) required to be filed by Seller or Coffee People or in respect of the Acquisition Assets for any period ending on or before the Closing, and all such returns are true, complete and correct and have been completed in accordance with applicable law.

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(b) All Taxes due and payable by Seller have been paid and all Taxes due and payable by Coffee People with respect to the Acquisition Assets have been paid.

(c) There is no tax deficiency outstanding and neither Seller nor Coffee People has waived any statute of limitations in respect of Taxes or agreed to any extension of time with respect to a Tax assessment or deficiency related to the Acquisition Assets.

(d) Neither Seller nor Coffee People has received notice of any unresolved questions or claims concerning its Tax liability related to the Acquisition Assets.

3.9 No Restrictions on Business Activities. There is no agreement (non-compete or otherwise), commitment, judgment, injunction, order or decree to which Seller or Coffee People is a party or otherwise binding on Seller, Coffee People or the Acquisition Assets that has or reasonably could be expected to have the effect of prohibiting or impairing the Buyer’s ability to own and operate the Acquisition Assets in a similar manner as presently conducted by Seller and Coffee People.

3.10 Litigation. There are no claims, suits, actions, arbitrations, investigations or proceedings pending or, to the Knowledge of Seller, threatened against Seller or Coffee People that could reasonably be expected to have any adverse effect upon the Acquisition Assets. Neither Seller nor Coffee People is subject to any court, governmental or administrative order, writ, injunction, or decree applicable to the Acquisition Assets. To the Knowledge of Seller, there are no facts or conditions that have had or, if continued, will result in, a default or claim of default under any Assumed Lease and Occupancy Agreement.

3.11 Environmental Matters.

(a) Each of Seller and Coffee People is, and at all times has been, in full compliance with, and has not been and is not in violation of or liable under, any Environmental Law with respect to the Acquisition Assets or Assumed Liabilities. Neither Seller nor Coffee People has, and, to the Knowledge of Seller, no other person or entity for whose conduct either Seller or Coffee People is or may be held to be responsible has, received, any actual or, to the Knowledge of Seller, threatened, order, notice or other communication of any actual or potential violation or failure to comply with any Environmental Law, or of any actual or threatened obligation to undertake or bear the cost of any Environmental, Health and Safety Liabilities with respect to any Acquisition Asset or Assumed Liability.

(b) There are no pending or, to the Knowledge of Seller, threatened claims, Encumbrances, civil, criminal or administrative actions, proceedings, directives, inquiries, investigations or other restrictions of any nature resulting from any Environmental, Health and Safety Liabilities or arising under or pursuant to any Environmental Law with respect to or affecting any Acquisition Asset or Assumed Liability.

(c) Neither Seller nor Coffee People, nor to the Knowledge of Seller, any person or entity for whose conduct either Seller or Coffee People is or may be held responsible, has received and, to the Knowledge of Seller, there is no basis to expect, any citation, directive, inquiry, notice, order, summons, warning or other communication that relates to Hazardous Activities, Hazardous Materials, or any alleged, actual, or potential violation or failure to comply with any Environmental Law with respect to any Acquisition Asset or Assumed Liability.

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(d) Neither Seller nor Coffee People, nor any of their respective Representatives, nor, to the Knowledge of Seller, any person or entity for whose conduct Seller or Coffee People is or may be held responsible, has permitted or conducted any Hazardous Activity with respect to any Subject Location or adjoining property or Acquisition Assets (whether real, personal or mixed) except in full compliance with all applicable Environmental Laws, and neither Seller, Coffee People nor any of their respective Representatives, nor, to the Knowledge of Seller, any person or entity for whose conduct Seller or Coffee People is or may be held responsible, has caused (by act or omission) there to be any Hazardous Materials (whether or not contained in barrels, aboveground or underground storage tanks or otherwise) present on or in the Environment at any Subject Location or adjoining property, or deposited or located in land, water, sumps or any other part of the Subject Locations or such adjoining property, or incorporated into any structure therein or thereon, except in full compliance with all applicable Environmental Laws and as could not reasonably be expected to have a Material Adverse Effect. There has been no Release by Seller or Coffee People or any Threat of Release by Seller or Coffee People, of any Hazardous Materials at or from any Subject Location or adjoining property or Acquisition Asset (whether real, personal or mixed) during the tenancy of Seller or Coffee People, as applicable. Neither Seller nor Coffee People has received any written notice of any such Release or Threat of Release by any other person or entity at or from any Subject Location or adjoining property or Acquisition Asset.

(e) Seller has delivered to Buyer true, complete and correct copies and results of any reports, studies, analyses, tests or monitoring possessed or initiated by Seller or Coffee People pertaining to Hazardous Materials or Hazardous Activities in, on or under the Subject Locations, or concerning compliance, by Seller or Coffee People with Environmental Laws with respect to the Subject Locations.

3.12 Brokers’ Fees. No broker, finder or other person or entity is entitled to any brokerage commissions, finders’ fees or similar compensation in connection with the transactions contemplated by this Agreement based on any actions of Seller.

3.13 Fraudulent Transfer. The transfer of the Acquisition Assets to Buyer in accordance with the terms of this Agreement does not constitute a fraudulent transfer or conveyance with respect to any third party under Applicable Laws. The payment of the Purchase Price in accordance with the terms of this Agreement for the Acquisition Assets constitutes the payment of no less than a reasonably equivalent value for the Acquisition Assets. Seller acknowledges and agrees that the Purchase Price was the result of arms-length negotiations between Buyer and Seller.

3.14 Insurance. Seller and Coffee People (to the extent not provided by Seller) have maintained insurance coverage with respect to the Acquisition Assets in accordance with normal industry practice for similar businesses (taking into account the cost and availability of such insurance).

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3.15 Employment Matters.

(a) None of Seller, any subsidiary or any ERISA Affiliate has ever maintained, established, sponsored, participated in, contributed to, or is obligated to contribute to, or otherwise incurred any obligation or liability (including, without limitation, any contingent liability) under any (i) “multiemployer plan” (as defined in Section 3(37) of ERISA) or to any “pension plan” (as defined in Section 3(2) of ERISA) subject to Title IV of ERISA or Section 412 of the Code or (ii) any “welfare plan” (as defined in Section 3(1) of ERISA) that promises or provides retiree medical or other retiree welfare benefits to any person. None of Seller, any subsidiary or any ERISA Affiliate has any actual or potential withdrawal liability (including, without limitation, any contingent liability) for any complete or partial withdrawal (as defined in Sections 4203 and 4205 of ERISA) from any multiemployer plan.

(b) With respect to each “welfare plan” (as defined in Section 3(1) of ERISA) sponsored, maintained, contributed to, or required to be contributed to by Seller, any subsidiary of Seller, Seller and each of its United States subsidiaries have complied with the applicable health care continuation and notice provisions of the Consolidated Omnibus Budget Reconciliation Act of 1985 (“COBRA”) and the regulations thereunder or any state law governing health care coverage extension or continuation, except to the extent that such failure to comply could not reasonably be expected to have a Material Adverse Effect. Neither Seller nor Coffee People has any material unsatisfied obligations to any employees, former employees, or qualified beneficiaries pursuant to COBRA or any state law governing health care coverage extension or continuation.

(c) None of Seller’s employee benefit plans will be assumed by Buyer as a matter of law or otherwise in connection with this Agreement or the transactions contemplated hereby.

(d) With respect to all employees of Seller or Coffee People who work at any Subject Location: (i) Seller is not a party to any collective bargaining or union agreement, and, to the Knowledge of Seller, there have been no efforts at any Subject Location to organize or the employees at such location into a union; and (ii) to the Knowledge of Seller, there are no discussions, negotiations, demands, or proposals that are pending or that have been conducted or made with or by any labor union or association.

(e) Except as set forth in the Schedule of Exceptions, each of Seller’s and Coffee People’s employees is in “good standing,” as defined in Section 2.8(a) (assuming none of such employees is a former employee of Buyer identified on Buyer’s internal records as ineligible to be rehired by Buyer).

3.16 Board Approval. The board of directors of Seller has (i) approved this Agreement and the transactions contemplated hereby and (ii) recommended that the stockholders of Seller adopt and approve this Agreement and the transactions contemplated hereby.

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ARTICLE 4

REPRESENTATIONS AND WARRANTIES OF BUYER

Representations of Buyer. The following representations and warranties are made by Buyer as set forth below as of the date of this Agreement and the Closing:

4.1 Organization and Qualification. Buyer is a corporation duly organized, validly existing, and in good standing under the laws of the State of Washington, and has the requisite corporate power and authority to own and operate its properties and to carry on its business as now conducted. Buyer is duly qualified to do business and is in good standing in all jurisdictions where the failure to be so qualified would have a material adverse effect on Buyer.

4.2 Authority Relative to Agreements. Buyer has the requisite corporate power and authority to enter into this Agreement, the Escrow Agreement and all other agreements in connection with the transactions contemplated hereby to which Buyer is or will be a party, and has the requisite corporate power and authority to carry out its obligations hereunder and thereunder. The execution and delivery of this Agreement and such other agreements by Buyer and the consummation by Buyer of such transactions have been duly approved by all necessary corporate action on the part of Buyer, and no other corporate proceedings on the part of Buyer are necessary to authorize this Agreement and such transactions. This Agreement has been duly executed and delivered by Buyer and constitutes a valid and binding obligation of Buyer, enforceable against it in accordance with its terms, except as the enforceability thereof may be limited by bankruptcy, insolvency, reorganization, moratorium or other similar laws relating to the enforcement of creditors’ rights generally and by general principles of equity.

4.3 No Conflicts. Buyer is not subject to, or obligated under, any provision of (i) its articles of incorporation or bylaws, (ii) any material agreement, arrangement, or understanding to which Buyer is a party or by which Buyer or any of its properties or assets is bound or affected, (iii) any material Permit, or (iv) any law, regulation, order, judgment, or decree that would be breached or violated in a material manner, or in respect of which a right of termination or acceleration would arise, by Buyer’s execution, delivery, and performance of this Agreement and the consummation by Buyer of the transactions contemplated hereby.

4.4 Access to Information. Buyer acknowledges that Buyer has had the opportunity to conduct due diligence with respect to the Acquisition Assets and to inspect the Acquisition Assets. Buyer has been afforded the opportunity to review all information provided to it by Seller and has had the opportunity to ask questions of and receive answers to its satisfaction from representatives of the Seller concerning the Acquisition Assets, and to obtain any additional information reasonably requested by it.

4.5 No Consents. No authorization, consent, or approval of, or filing with, any governmental body, court, other authority or third party is necessary on the part of Buyer for the consummation by Buyer of the transactions contemplated by this Agreement, except for such authorizations, consents or approvals which if not obtained, or filings which if not made, would not individually or in the aggregate, have a material adverse effect on Buyer’s ability to perform its obligations under this Agreement.

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4.6 Availability of Funds. Buyer has access to sufficient funds (with no obligation to set aside, escrow or otherwise segregate funds) to enable Buyer to pay the Maximum Aggregate Purchase Price and to consummate the transactions contemplated by this Agreement.

4.7 Brokers’ Fees. No broker, finder or other person or entity is entitled to any brokerage commissions, finders’ fees or similar compensation in connection with the transactions contemplated by this Agreement based on any actions of Buyer.

ARTICLE 5

COVENANTS

5.1 Covenants of Seller Prior to the Closing and each Post-Closing Transfer. Prior to the Closing or each Post-Closing Transfer, as applicable, Seller will, and will cause Coffee People to (as applicable):

(a) except as required to perform Seller’s obligations under this Agreement, (i) timely and fully perform all of its obligations under each of the Assumed Leases and Occupancy Agreements and Assumed Agreements, unless in the good faith judgment of the management of Seller, and after notice to Buyer, Seller determines that it is necessary from a financial perspective to cease operations at a Subject Location, (ii) operate the Acquisition Assets in the ordinary course of business (subject to the parenthetical in the foregoing subsection (i)) and materially discharge the Assumed Liabilities in the ordinary course of business and in accordance with their respective terms, and (iii) not enter into any transaction outside the ordinary course of business that would create any Encumbrance (other than a Permitted Lien) on the Acquisition Assets and/or the Assumed Liabilities without the prior written consent of Buyer;

(b) reasonably protect the Acquisition Assets from removal, damage and destruction and maintain existing insurance coverage on the Acquisition Assets;

(c) remove or cause the removal of all security systems or other third party assets and other Excluded Assets from the Subject Locations being acquired by Buyer at the Closing or the applicable Post-Closing Transfer, notify all affected third parties of the removal of such assets from such Subject Locations, whether or not required by contract, provided, however, that if Seller or Coffee People, as applicable, fails to remove any of such security systems or other assets, then Buyer will have the right, in its sole and absolute discretion, to retain or dispose of such systems and other assets without any notice or Liability to Seller, Coffee People or any third parties whatsoever and Seller will indemnify Buyer for any claims brought by, or amounts owed to, third parties in connection therewith, from the Escrow Fund (which, for the avoidance of doubt, will not be subject to the Threshold but will be subject to the administrative procedures described in Article 7);

(d) if Seller or Coffee People, as applicable, has not already done so, cease all business and operations at the Subject Locations that Buyer will acquire at the Closing or, with respect to a Post-Closing Transfer, that are to be acquired at such Post-Closing Transfer, and terminate all services and arrange for payment in full of all termination and other fees under the Excluded Agreements as provided herein with respect to such Subject Locations;

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(e) promptly notify Buyer in writing of (i) any adverse change relating to (a) the Acquisition Assets that materially impairs Seller’s or Coffee People’s, as applicable, ability to operate a Subject Location or (b) the Assumed Liabilities, excluding any actions taken by Seller or Coffee People to perform its obligations under this Agreement, (ii) any governmental or third party written demands, complaints, investigations, proceedings or hearings (or written communications indicating that any may be contemplated) related to any of the Acquisition Assets or Assumed Liabilities or (iii) any event occurring subsequent to the date of this Agreement that would render any representation or warranty of Seller contained in this Agreement, if made on or as of the date of that event or the date of the Closing, materially untrue or inaccurate;

(f) not mortgage, pledge, subject to a lien, or grant a security interest in, or suffer to exist or otherwise encumber, any of the Acquisition Assets;

(g) use commercially reasonable efforts to (i) satisfy the obligations set forth in Section 6.3 and (ii) obtain the Consents to Assignment of Lease, Lease and Agreement Amendments, and all required third party consents necessary to effect the Closing or a Post-Closing Transfer, as applicable, provided, that the obligation to exercise commercially reasonable efforts will not apply with respect to the Negative Value Subject Locations; and

(h) cause Coffee People to take all actions reasonably necessary to enable Seller to perform all of its obligations pursuant to this Agreement, including but not limited to under this Article 5.

5.2 No Negotiations.

(a) Subject to the provisions of Sections 5.2(b) and 5.2(c), between the date of this Agreement and the first to occur of (i) the Closing, and (ii) the termination of this Agreement, Seller will not (and will cause its Representatives and Affiliates not to), directly or indirectly, (a) take any action to solicit, initiate, seek, encourage or support any inquiry, proposal, submission or offer from, (b) furnish any information to, or (c) participate in any discussions or negotiations with, any Person or other entity or group (other than Buyer) regarding any acquisition of Seller that would include any of the Acquisition Assets, any merger or consolidation with or involving Seller that would include any of the Acquisition Assets, or any acquisition of any of the Acquisition Assets. Seller agrees that any such discussions or negotiations in progress as of the date hereof will be terminated or suspended during such period. Seller represents and warrants that it has the legal right to terminate or suspend any such pending discussions or negotiations and agrees to indemnify and hold harmless the Buyer and its Representatives and Affiliates (the “Buyer Group”) from and against any claims by any party, including, without limitation, any party to such pending discussions or negotiations, which claims are based on or arise out of such pending discussions or negotiations or the execution of this Agreement or any consummation of the transactions contemplated by this Agreement, as further set forth in Section 7.2(e).

(b) Seller will immediately (and in no event later than 24 hours after the board of directors of Seller or any committee thereof has considered any bona fide Transfer Proposal) notify Buyer in writing of any bona fide Transfer Proposal that has been considered by the board

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of directors of Seller or any committee thereof, (including the material terms thereof) that is made or submitted by any Person during the period set forth in the first sentence of Section 5.2(a). Seller will keep Buyer fully informed with respect to the status of any such Transfer Proposal and any modification or proposed modification thereto.

(c) Notwithstanding the provisions of Section 5.2(a), Seller, during the period set forth in the first sentence of Section 5.2(a), may provide non-public information to and enter into discussions with any third party with respect to an unsolicited written bona fide Transfer Proposal if (1) neither Seller nor any Representative of Seller shall have violated any of the restrictions set forth in this Section 5.2, (2) the board of directors of Seller concludes in good faith, after having taken into account the advice of its outside legal counsel, that such action is required for the board of directors of Seller to comply with its fiduciary obligations to Seller’s stockholders under applicable law, (3) the board of directors of Seller concludes in good faith that such Transfer Proposal is reasonably likely to result in the making of a Superior Offer, (4) at least two (2) Business Days prior to furnishing any such non-public information to, or entering into discussions with, such third party, Seller gives Buyer the material terms of the Transfer Proposal and of Seller’s intention to furnish non-public information to, or enter into discussions with, such third party, and Buyer does not within such two (2) Business Day period, adjust the Maximum Aggregate Purchase Price commensurate with the Transfer Proposal, (5) Seller receives from such third party an executed confidentiality agreement containing customary limitations on the use and disclosure of all non-public written and oral information furnished to such third party by or on behalf of Seller, and (6) at least two (2) Business Days prior to furnishing any such non-public information to, or entering into discussions with, such third party, Seller furnishes such non-public information to Buyer (to the extent such non-public information has not been previously furnished by Seller to Buyer). Without limiting the generality of the foregoing, Seller acknowledges and agrees that any violation of any of the restrictions set forth in the preceding sentence by any Representative of Seller, whether or not such Representative is purporting to act on behalf of Seller, shall be deemed to constitute a breach of this Section 5.2 by Seller.

(d) For purposes of Section 5.2(c), “Superior Offer” shall mean any unsolicited, bona fide written Transfer Proposal that the Seller’s board of directors determines, in its good faith judgment taking into account applicable legal, financial, regulatory and other relevant aspects of the Transfer Proposal, the identity of the third party making the proposal and other relevant considerations, (i) is more favorable from a financial point of view to Seller’s stockholders than the sale of the Acquisition Assets to Buyer, (ii) is subject only to conditions to the consummation of such Transfer Proposal that are reasonably capable of being satisfied promptly, and (iii) is supported by financing that is then committed or for which Seller’s board of directors concludes in good faith is available.

5.3 Public Announcements. Neither Buyer nor Seller will make any public announcement concerning this Agreement, the related discussions or negotiations, or any other memoranda, letters or agreements between Buyer and Seller relating to this Agreement without the prior written consent of, and review of content by, Seller or Buyer, as applicable, except, after complying with the provisions of Section 5.6, to the extent that disclosure is required under Applicable Laws or the rules of any national securities exchange or quotation system. Neither Buyer nor Seller will make any comments to the media about the other party in connection with

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this Agreement and will refer all inquiries about such other party to such party’s media relations hotline or to such other media relations contact as designated in writing by Buyer or Seller, as the case may be, from time to time in accordance with the notice provisions set forth in Section 9.2 of this Agreement. Buyer’s media relations hotline is 206-318-7100. Seller’s media relations contact number is (310) 788-2850.

5.4 Confidentiality. Buyer agrees, and agrees to cause its Representatives, to keep confidential and not disclose to any other Person or use for its own benefit or the benefit of any other Person any confidential or proprietary information of Seller disclosed by Seller during the negotiations of this Agreement or preparations for the Closing or any Post-Closing Transfer (including the existence of this Agreement, except as permitted by Section 5.3). Seller agrees to, and agrees to cause its Representatives to, keep confidential and not disclose to any other Person or use for its own benefit or the benefit of any other Person any confidential or proprietary information of Buyer disclosed by Buyer during the negotiations of this Agreement or preparations for the Closing or any Post-Closing Transfer (including the existence of this Agreement, except as permitted by Section 5.3). Notwithstanding the foregoing, any party to this Agreement may disclose information related to this Agreement to the extent such party deems disclosure is necessary or appropriate to (i) such party’s legal, accounting and financial advisors who have a need to know such information solely for purposes of assisting in regard to this Agreement and who are subject to confidentiality obligations to such party, (ii) landlords/contract parties, as applicable, of the Subject Locations, and (iii) other parties whose consent is required to satisfy any closing conditions under this Agreement. The parties will inform their respective legal, accounting and financial advisors, landlords/contract parties, as applicable, and other parties giving consent in regard to this Agreement of the confidential nature of information shared with such persons and will direct such persons to treat such information in accordance with the terms of this Section. The obligations contained in this Section 5.4 will continue after the Closing and each Post-Closing Transfer.

5.5 Access to Information and Subject Locations. To facilitate Buyer’s continued due diligence investigation for purposes of this Agreement and to facilitate an efficient Closing and one or more Post-Closing Transfers, if applicable, Seller will, upon reasonable notice to Buyer, provide Buyer and its Representatives with reasonable access during normal business hours to (i) all documents, assets, contracts, books, records, litigation and claims history, files, drawings, data or information that have been or now are used in or with respect to, in connection with, or otherwise relate to, the Acquisition Assets and Subject Locations, and (ii) title reports, surveys, environmental reports and correspondence in Seller’s possession related to the Subject Locations and the Assumed Leases and Occupancy Agreements and the real property or other rights subject to such leases and agreements. Seller will make key personnel available to Buyer and its Representatives as Buyer may reasonably request to assist in these efforts. In connection with the transactions contemplated under this Agreement, and from time to time after the date hereof until the later to occur of the Closing or the last Post-Closing Transfer, as applicable, Buyer and its Representatives will have the right to access, inspect and examine all of the Subject Locations, including the Improvements and F&E and other assets located thereon, at mutually convenient times, provided that Buyer and its Representatives shall not unreasonably disrupt operations during normal business hours at the Subject Locations. Such access will include, but not be limited to, access for purposes of performing site surveys and other inspections reasonably necessary or appropriate to remodel, construct, identify, build-out and convert, as applicable, the

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Subject Locations to Buyer’s coffee stores and subsequently operate them as such after the Closing or the applicable Post-Closing Transfer, including, without limitation, in connection with obtaining all Permits reasonably necessary or appropriate to remodel, construct, identify, build-out and convert, as applicable, the Subject Locations to Buyer’s coffee stores and subsequently operate them as such (the “Permits and Approvals”). Seller will reasonably cooperate with Buyer in providing access to the interior of the premises, Improvements, F&E and other assets located at each Subject Location in accordance with this Section 5.5.

5.6 Required Filings. Each of Seller and Buyer will make any and all filings required to be made by it under Applicable Laws in connection with this Agreement and the transactions contemplated hereby, including but not limited to any required premerger notification or other required filings with federal, state, provincial or local governmental bodies or applicable foreign governmental agencies. Each of Seller and Buyer will provide the other party with a reasonable amount of time, but not less than (a) two (2) Business Days, in the case of any filings made on Form 8-K, and (b) three (3) Business Days in each other case, to review and comment on any such filings before they are filed and/or distributed to stockholders. Neither party will be required to receive the consent of the other in connection with any such filing. Each party will be responsible for all expenses and filing fees incurred by it in the preparation of its required filings. The parties will use commercially reasonable efforts to make such filings promptly, to respond to any requests for additional information and to obtain all consents, waivers, approvals, authorizations and orders required in connection with the authorization, execution and delivery of this Agreement and the transactions contemplated hereby.

5.7 Non-Disparagement.

(a) On and after the date of this Agreement, Seller will not make any false or misleading statements about Buyer (including but not limited to any of Buyer’s coffee stores or products) or any of Buyer’s Representatives or take any action that could reasonably be expected to harm the public perception of Buyer, or its coffee stores or products. Without limiting the foregoing, Seller will not take any action to divert customers away from any of the Subject Locations, or in any manner attempt to discourage current customers of Seller from patronizing Buyer’s coffee stores. Nothing in this Section is intended to prohibit Seller from advertising its businesses and products in the normal course of business.

(b) On and after the date of this Agreement, Buyer will not make any false or misleading statements about Seller (including but not limited to any of Seller’s coffee stores or products) or any of Seller’s Representatives or take any action that could reasonably be expected to harm the public perception of Seller, or its coffee stores or products. Without limiting the foregoing, Buyer will not take any action to divert customers away from any of the Subject Locations, or in any manner attempt to discourage current customers of Buyer from patronizing Seller’s coffee stores. Nothing in this Section is intended to prohibit Buyer from advertising its businesses and products in the normal course of business.

5.8 Noncompetition; Nonsolicitation.

(a) For a period of three (3) years after the Closing Date, Seller agrees that it will not in any manner, directly or indirectly, by itself or in conjunction with any other Person,

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conduct, or have any interest, direct or indirect, in the ownership or operation of any Person that is operating any retail specialty coffee stores in any city in which a Subject Location is situated, including without limitation by opening new Seller-operated stores or selling franchises, provided, however, that the foregoing limitations (i) will apply only to stores opened after the date of this Agreement, (ii) will not apply to any retail stores operated under the “Gloria Jean’s” brand name and the existing “Gloria Jean” business model and product line, and (iii) will not apply to wholesale sales to retail businesses that are not operated by Seller or other non-retail businesses or the conversion of Seller-operated stores existing on the date of this Agreement to franchise stores.

(b) Seller further agrees that, for a period of three (3) years after the Closing Date, it will not, without first obtaining the written consent of Buyer, solicit or attempt to solicit any employee of Buyer or any of its Affiliates to leave his or her employer, provided, however, that Seller shall not be precluded from hiring any such employee of Buyer (or an Affiliate) who was not solicited directly or indirectly by Seller or who responds to notices of employment published generally by or on behalf of Seller.

(c) If any court having jurisdiction at any time hereafter shall hold any provision or clause of this Section 5.8 to be unreasonable as to its scope, territory or term, and if such court in its judgment or decree shall declare or determine that scope, territory or term that such court deems to be reasonable, then such scope, territory or term, as the case may be, shall be deemed automatically to have been reduced or modified to conform to that declared or determined by such court to be reasonable.

5.9 Forms of Consent to Assignment of Lease; Lease and Agreement Amendment. Within five (5) Business Days of the date of this Agreement, Buyer will provide to Seller the forms of Consent to Assignment of Lease and Lease and Agreement Amendment to be submitted to obtain the applicable landlord, sublandlord, ground lessor or other applicable contract party’s signature thereon. Such forms will initially be in substantial compliance with Exhibits D and E, respectively, and will not be altered, changed or amended without Buyer’s prior consent, which shall not be unreasonably withheld. Such forms will be submitted to the applicable landlord, sublandlord, ground lessor or other applicable contract party within two (2) Business Days after Seller’s receipt from Buyer.

5.10 Allocation. Prior to Closing Buyer and Seller will prepare Schedule 5.10 (the “Allocation Schedule”) allocating the Purchase Price amongst the different asset classes contained within the Acquisition Assets and the non-competition covenant in Section 5.8. Seller and Buyer will each file IRS Form 8594, and all federal, state, local and foreign tax returns, in accordance with the Allocation Schedule.

5.11 Books and Records. The parties will make reasonably available to one another any records or documents that they maintain with respect to the Acquisition Assets for purposes of compliance with applicable Tax laws or in defending any third-party litigation arising in respect of this Agreement. Seller will make available to Buyer, at Buyer’s request with at least four (4) Business Days prior notice, all books and records of Seller relating to the Acquisition Assets and Assumed Liabilities for inspection or copying by Buyer at any reasonable time for a period of three (3) years after the later of the Closing Date or the last Post-Closing Transfer.

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5.12 Transfer Fees and Taxes; Prorations. All transfer and assumption fees and expenses and all Taxes arising out of the transfer to Buyer of the Acquisition Assets, which fees and expenses include but are not limited to all amounts owing under the Assumed Leases and Occupancy Agreements and characterized as “additional rent,” “key money,” “bonus money,” “excess consideration,” “goodwill,” “other consideration” and similar words or phrases, if any, shall be handled in a manner to be determined upon mutual agreement by the parties. Seller will be responsible for any expenses or other payment obligations of rent, real and personal property taxes, water, gas, electricity and other utilities and periodic charges (including, without limitation, common area maintenance fees, tax and insurance contributions due to landlords) and Taxes payable with respect to the Acquisition Assets and Assumed Liabilities (“Payment Obligations”) related to any period on or before the Closing Date or a Post-Closing Transfer, as applicable. Buyer will be responsible for any Payment Obligations related to any period after the Closing Date or a Post-Closing Transfer, as applicable. With respect to any Payment Obligations that relate to periods both before and after the Closing Date, Buyer and Seller shall prorate such expenses or other payment obligations such that Seller shall be liable with respect to any period on or before the Closing Date or a Post-Closing Transfer, as applicable, and Buyer shall be liable with respect to any periods after the Closing Date.

5.13 Additional Covenants.

(a) At any time before or after the Closing or the last Post-Closing Transfer, as applicable, Buyer, Seller and Coffee People will execute and deliver any further documents and instruments of transfer reasonably requested by the other party, and will take any other action reasonably requested by the other party consistent with the terms of this Agreement, for the purpose of transferring and conveying to Buyer all property and rights to be transferred and conveyed by this Agreement;

(b) Seller will timely and fully discharge all of Seller’s and Coffee People’s debts, obligations and liabilities related to the Subject Locations, the Acquisition Assets and the Assumed Liabilities as they come due before and after the applicable Assumption Time; provided, however, that agreement by Seller or Coffee People and the landlord of a Subject Location as to the cessation of business operations at such Subject Location shall not be deemed a breach of this Section 5.13(b). Buyer shall use commercially reasonable efforts to satisfy the obligations set forth in Section 6.2 and obtain the executed Consents to Assignment of Lease, the executed Lease and Agreement Amendments and all required third party consents necessary to effect the Closing or Post-Closing Transfer, as applicable, provided, that the obligation to exercise commercially reasonable efforts will not apply with respect to the Negative Value Subject Locations;

(c) Seller will deliver a completed Form W-9 (Request for Taxpayer Identification Number and Certification) to Buyer at least two (2) Business Days prior to the Closing;

(d) Buyer and Seller hereby waive compliance with the provisions of the “bulk transfer laws” of any jurisdiction in connection with the sale of the Acquisition Assets to Buyer; and

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(e) Coffee People will take all actions reasonably necessary to enable Seller to perform all of its obligations pursuant to this Agreement, including but not limited to under this Article 5, and to effect the Transfer of the Assumed Lease and Occupancy Agreements to which it is a party.

5.14 Environmental Assessment.

(a) Not later than sixty (60) days after execution of this Agreement, Buyer may obtain a Phase I (the “Phase I”) environmental assessment of each of the Ground Lease Subject Locations by an environmental engineer selected by Buyer. If, in Buyer’s reasonable judgment based on the findings and recommendations of any Phase I, Buyer determines that any further environmental assessment, including, but not limited to, a Phase II (the “Additional Assessment”) of one or more of the Ground Lease Subject Locations is appropriate, Buyer shall be entitled, subject to the consent and approval of the owner of each Ground Lease Subject Location, to obtain an Additional Assessment on such Ground Lease Subject Location or any portion thereof (the Phase I and the Additional Assessment, if obtained with respect to any Ground Lease Subject Location, shall each be referred to herein as an “Environmental Assessment”). If Buyer seeks to obtain any Additional Assessment, the 60-day environmental review period referenced above shall be extended to be ninety (90) days from the date of execution of this Agreement (or if such date falls on a non-Business Day, then the period shall be extended to the next Business Day). The Buyer shall commission and pay the cost of each such Environmental Assessment.

(b) If based upon the Environmental Assessment, Buyer reasonably concludes that Hazardous Material exists at any portion of the Ground Lease Subject Locations in violation of applicable Environmental Law (an “Environmental Violation”), Buyer shall deliver to Seller a copy of the Environmental Assessment indicating such Environmental Violation within the 60-day (or 90-day, if applicable) review period referenced above. Within ten (10) Business Days of receiving any such copy of an Environmental Assessment indicating an Environmental Violation, Seller shall notify Buyer in writing if Seller will agree to remove, correct, or remedy any such Environmental Violation at Seller’s sole cost and expense prior to Closing and will agree to provide Buyer, as a condition to Closing, a certificate from an environmental abatement firm reasonably acceptable to Buyer that any such Environmental Violation has been fully removed, corrected or remediated (or, at Buyer’s election and cost, Buyer may require the environmental assessment firm that performed the original Environmental Assessment to provide a new environmental report showing that any previously identified conditions have been corrected).

(c) If Seller notifies Buyer that it will not correct or remedy any Environmental Violation prior to Closing, or fails to notify Buyer whether it will correct or remedy any Environmental Violation within the ten (10) Business Day period referenced in Section 5.14(b), Buyer may elect to exclude the Ground Lease Subject Location that is affected by the Environmental Violation from the Subject Locations to be acquired pursuant to this Agreement (with a corresponding reduction to the Maximum Aggregate Purchase Price), by providing Seller with written notice of such election within five (5) Business Days after receiving Seller’s written notice of its election not to cure the Environmental Violation.

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5.15 Meeting of Stockholders. Seller will promptly after the date hereof take all action necessary in accordance with the Delaware General Corporation Law and its certificate of incorporation and bylaws to convene a meeting of the stockholders of Seller within ninety (90) days of the date of this Agreement (or if such date falls on a non-Business Day, then the period shall be extended to the next Business Day) to vote on the adoption of this Agreement and the transactions contemplated hereby (the “Stockholder Meeting”). Seller shall use its commercially reasonable efforts to solicit from its stockholders proxies in favor of the adoption of this Agreement and the transactions contemplated hereby and shall take all other action necessary or advisable to secure the vote or consent of stockholders required to effect the same.

ARTICLE 6

CONDITIONS TO THE CLOSING AND

EACH POST-CLOSING TRANSFER

6.1 Conditions to Obligations of Seller and Buyer. The respective obligations of each party hereto to complete the transactions contemplated by this Agreement will be subject to the fulfillment on or prior to the Closing Date or Post-Closing Transfer, as applicable, of the following conditions, except that the condition in Section 6.1(c) shall not apply to Post-Closing Transfers:

(a) no order will have been entered, and not vacated, by a court or administrative agency of competent jurisdiction, in any action or proceeding that enjoins, restrains or prohibits the Transfers or the consummation of all or any part of any transaction contemplated herein;

(b) there will be no litigation, proceeding or investigation pending by any third party or Governmental Entity in which (x) an injunction is or may be sought against the transactions contemplated herein or (y) relief is or may be sought against any party hereto as a result of this Agreement or any of the transactions contemplated herein; and

(c) receipt of approval from Seller’s stockholders of this Agreement and the transactions contemplated hereby.

6.2 Conditions to Obligations of Seller and Coffee People. The obligations of Seller and Coffee People to complete the transactions contemplated by this Agreement at the Closing or Post-Closing Transfer, as applicable, are subject to the satisfaction of the following conditions, unless waived by Seller in writing, except that the condition in Section 6.2(c) shall not apply to Post-Closing Transfers:

(a) delivery by Buyer of all Transaction Documents, except for the Escrow Agreement in the case of Post-Closing Transfers, executed by Buyer;

(b) delivery of all governmental approvals or notices and all third-party consents including the Consents to Assignment of Lease each executed by Buyer and the respective landlord or other contract party necessary to Transfer the Acquisition Assets being Transferred, as set forth on Schedule 6.2;

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(c) Buyer’s purchase at the Closing of the number of Subject Locations equal to 30 less the sum of (i) the Negative Value Subject Locations and (ii) the other Subject Locations that Seller determines to retain and not Transfer in accordance with Section 2.5 herein;

(d) delivery of a certificate from Buyer, in the form attached as Exhibit F-2, which certifies that: (i) the representations and warranties referred to in Article 4 remain true, complete and correct in all material respects as of the Closing Date or the relevant Post-Closing Transfer, as applicable, except that if such representation or warranty is qualified by materiality, then a certification that such representation or warranty remains true, complete and correct in all respects; and (ii) except as expressly waived in writing by Seller, Buyer has satisfied all of its obligations under this Agreement that are required to be satisfied on or before the Closing Date or the relevant Post-Closing Transfer, as applicable.

6.3 Conditions to Obligations of Buyer. The obligations of Buyer to complete the transactions contemplated by this Agreement at the Closing or Post-Closing Transfer, as applicable, are subject to the satisfaction of the following conditions, unless waived by Buyer in writing, except that the condition in Section 6.3(b) shall not apply to Post-Closing Transfers:

(a) delivery by Seller of all Transaction Documents, except for the Escrow Agreement in the case of Post-Closing Transfers, executed by Seller;

(b) Buyer having obtained all Permits and Approvals for at least 70% of the Subject Locations being Transferred if the Closing occurs within ninety (90) days of the date of this Agreement (or if such date falls on a non-Business Day, then on the next Business Day);

(c) delivery by Seller or Coffee People, as applicable, of executed assignments or transfers of all Assumed Permits that are listed on Schedule 2.1(e) for the Subject Locations being Transferred;

(d) receipt by Buyer of executed Lease and Agreement Amendments for each of the Subject Locations Transferred at Closing or the relevant Post-Closing Transfer; provided, however, that, with respect to the Closing, Buyer must receive executed Lease and Agreement Amendments providing for a minimum ten (10) year term for at least 40% (rounded down to the nearest integer) of the Subject Locations being transferred that are designated on Schedule 1.0 as requiring a “minimum 10 year term.” With respect to Post-Closing Transfers, the 40% threshold in the prior sentence shall be calculated on a cumulative basis including all Subject Locations that have been previously Transferred;

(e) delivery of an executed and notarized deed that conveys to Buyer legal fee title to each of the Ground Lease Improvements being Transferred at Closing or the relevant Post-Closing Transfer;

(f) receipt by Buyer of Consents to Assignment of Lease each executed by Seller or Coffee People, as applicable, and the respective landlord or other contract party for each of the Subject Locations being Transferred at Closing or the relevant Post-Closing Transfer; provided, that the estoppel provisions set forth in the Form of Consent to Assignment of Lease attached hereto as Exhibit D must be agreed to for 50% (rounded down to the nearest integer) of the Subject Locations Transferred at Closing or any Post-Closing Transfer (calculated on a cumulative basis including all Subject Locations that have been previously Transferred);

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(g) since the date of this Agreement, there will not have occurred any Material Adverse Effect, nor will there have occurred any event or circumstance that, in combination with any other events or circumstances, could reasonably be expected to have a Material Adverse Effect;

(h) releases of all Encumbrances identified on Schedule 6.3(h) in respect of the Acquisition Assets being Transferred other than Permitted Liens;

(i) Title Company standing ready to issue the Title Policies with respect to each Ground Lease Subject Location to be acquired, with such endorsements as are reasonably requested by Buyer and customarily available in Oregon for similar title conditions and in similar transactions, insuring Buyer’s interest in each of the Ground Leases and the Ground Lease Improvements, dated the day of the Closing or the Post-Closing Transfer, as applicable, with liability in the amounts of the Purchase Price for each Ground Lease Subject Location (as set forth on Schedule 1.0) and subject only to Permitted Liens;

(j) all governmental approvals or notices and all third-party consents (other than the Lease and Agreement Amendments and the Consents to Assignment of Lease necessary to Transfer the Acquisition Assets being Transferred), as set forth on Schedule 6.2, which Schedule includes a complete list of all consents required to effect the transactions set forth herein, including all mortgagee, governmental, regulatory and other required third-party consents;

(k) a good standing certificate from the state of Delaware and tax clearance or similar certificate from the states of California and Oregon certifying to the absence of unpaid Taxes that might constitute an Encumbrance on the Acquisition Assets or that might become enforceable against Buyer in the event of non-payment by Seller or Coffee People;

(l) a certificate from Seller, in the form attached as Exhibit F-1, which certifies that: (i) the representations and warranties referred to in Article 3 remain true, complete and correct in all material respects as of the Closing Date or the relevant Post-Closing Transfer, as applicable, except that if such representation or warranty is qualified by materiality, then a certification that such representation or warranty remains true, complete and correct in all respects; (ii) except as expressly waived in writing by Buyer, Seller has satisfied all of its obligations and covenants under this Agreement that are required to be satisfied on or before the Closing Date or the relevant Post-Closing Transfer, as applicable; and (iii) Seller has complied with the Worker Adjustment and Retraining Notification Act; and

(m) if any Environmental Violation with respect to a Ground Lease Subject Location (which is included as part of the Acquisition Assets) has been disclosed by the Environmental Assessments and Seller has agreed to remove, correct, or remedy any such Environmental Violation at Seller’s sole cost and expense prior to Closing pursuant to Section 5.14(b), Seller will deliver to Buyer a certificate from an environmental abatement firm reasonably acceptable to Buyer that any such Environmental Violation has been fully removed, corrected or remediated.

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6.4 Termination Date. If the conditions to the Closing set forth in Sections 6.1, 6.2 and 6.3 have not been satisfied or waived (a) in the event that Buyer has not complied with its obligations described in Section 5.13(b), as determined by Seller in its reasonable discretion, within ninety (90) days from the date of this Agreement or (b) within 150 days from the date of this Agreement (or if such 90th or 150th day falls on a non-Business Day, then the period will end on the next Business Day) (as applicable, the “Termination Date”), this Agreement may be terminated in accordance with Section 8.1.

6.5 Post-Closing Transfers. If, by the Termination Date, the conditions to the Closing set forth in Sections 6.1, 6.2 and 6.3 have been satisfied or waived, then Buyer and Seller will close such Transfers as provided in Section 2.9. After the Closing, for a period ending 150 days after the date of this Agreement (or if such date falls on a non-Business Day, then the period will end on the next Business Day), or such longer period as agreed to by the parties, Seller and Buyer will use commercially reasonable efforts to satisfy all of the conditions set forth in Article 6 to Transfer (the “Post-Closing Transfers”) the remaining Subject Locations (the “Remaining Subject Locations”), provided, that the obligation to use commercially reasonable efforts will not apply with respect to the Negative Value Subject Locations. Buyer’s obligation to acquire and assume the Remaining Subject Locations, and the related Acquisition Assets and Assumed Liabilities, and fulfill its other obligations at the Post-Closing Transfer under this Agreement is subject to and conditioned upon the satisfaction or waiver, at or before the applicable Post-Closing Transfer, of the conditions set forth in Sections 6.1 and 6.3 that are applicable to Post-Closing Transfers with respect to the Remaining Subject Locations. Upon satisfaction or waiver of such conditions, Seller will Transfer (or cause to be Transferred) the Remaining Subject Locations for which the conditions set forth in Section 6.2 that are applicable to Post-Closing Transfers have been satisfied, provided, that Seller may elect not to Transfer any Negative Value Subject Location. Buyer and Seller will complete such Post-Closing Transfers on the 120^th day and 150^th day after the date of this Agreement (or if such date falls on a non-Business Day, then such Post-Closing Transfers shall take place on the next Business Day) or on such other dates as the parties may mutually agree.

6.6 Waiver. The party entitled to satisfaction of any condition to the Closing or a Post-Closing Transfer set forth in this Agreement may, in its sole and absolute discretion, waive satisfaction of any condition, in whole or in part, which must be in writing, provided, that no such waiver will waive any claim such party may have for non-compliance with the representations and warranties with respect to any Subject Location that is Transferred.

ARTICLE 7

SURVIVAL OF REPRESENTATIONS AND WARRANTIES; INDEMNIFICATION

7.1 Nature and Survival of Representations and Warranties. No representation or warranty made by either party to this Agreement or in any document, certificate, schedule, exhibit or other instrument delivered by or on behalf of either party pursuant to this Agreement will in any manner be limited by any investigation of the subject matter thereof made by or on behalf of either party or by the waiver or satisfaction of any condition to the Closing or a Post-

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Closing Transfer and except as provided below all such representations and warranties will survive the Closing for a period ending six months after the Closing Date (the “Release Date”); provided, however, that the representations and warranties set forth in Sections 3.4 (No Consents), 3.8 (Tax Matters), 3.11 (Environmental Matters) and 3.15 (Employment Matters) will survive the Closing for a period ending three years after the Closing Date and that the representations and warranties set forth in Sections 3.2 (Authority Relative to This Agreement), and 3.7 (Good Title to the Acquisition Assets) and 4.2 (Authority Relative to This Agreement), and any fraud or knowing or intentional breach of any representation or warranty, will survive the Closing and each Post-Closing Transfer until the expiration of the applicable statute of limitations.

7.2 Indemnification by Seller. Subject to the limitations set forth in Section 7.4(a), Seller agrees to indemnify, defend and hold harmless the Buyer Group from, against, for and in respect of any and all Losses asserted against, imposed upon or incurred by any member of the Buyer Group by reason of, resulting from, based upon, arising out of, or in connection with any of the following:

(a) the breach, or inaccuracy (taking into account any applicable qualifications set forth in the text of such representation or warranty), of any representation or warranty of Seller contained in Article 3 of this Agreement or any certificate, schedule or Transaction Document delivered by Seller in connection with this Agreement;

(b) the material breach or nonperformance of any covenant or agreement by Seller or Coffee People contained in this Agreement or any certificate or Transaction Document delivered in connection with this Agreement;

(c) all causes of action, lawsuits, judgments, claims and demands of any nature arising out of or relating to the Excluded Business or the Excluded Assets;

(d) Seller’s failure to discharge the Excluded Liabilities;

(e) the termination or suspension of any previous or existing discussions or negotiations with any third party with respect to the Acquisition Assets that were terminated or suspended or will be terminated or suspended as a result of this Agreement, whether or not the transactions contemplated by this Agreement are consummated; and

(f) any breach by Seller of this Article 7.

7.3 Indemnification by Buyer. Subject to the limitations set forth in Section 7.4(b), Buyer agrees to indemnify, defend and hold harmless Seller and its Representatives (the “Seller Group”) from, against, for and in respect of any and all Losses asserted against, imposed upon or incurred by any member of the Seller Group by reason of, resulting from, based upon, arising out of, or in connection with any of the following:

(a) the breach of any representation or warranty of Buyer contained in Article 4 or made pursuant to this Agreement or any certificate or Transaction Document delivered by Buyer in connection with this Agreement;

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(b) the material breach or nonperformance of any covenant or agreement by Buyer contained in this Agreement or any certificate or Transaction Document delivered in connection with this Agreement;

(c) Buyer’s failure to discharge any Assumed Liabilities arising after their Assumption Date; and

(d) any breach by Buyer of this Article 7.

7.4 Procedure for Indemnification and Dispute Resolution. Each of the parties will follow the indemnification procedures set forth in this Article 7. Any Buyer Loss, indemnity claim or other disputed amount will first be deducted from the Escrow Fund but exhaustion or payment of the Escrow Fund will not limit Buyer’s ability to pursue Seller directly.

(a) Seller’s Threshold and Cap Amount. Subject to the following sentence, in order to facilitate an efficient closing of the transactions contemplated by this Agreement, Buyer acknowledges and agrees that it will not seek indemnification for claims arising under Section 7.2(a) until the aggregate amount of all claims against Seller exceeds $100,000 (the “Threshold”), in which event Seller will only be liable for such claims to the extent the Losses exceed the Threshold. Notwithstanding anything to the contrary contained in this Agreement, in no event will Seller’s aggregate Liability arising out of its indemnification obligations under Section 7.2(a) exceed $2,000,000 (the “Seller’s Cap”); provided, however, that, with respect to the representations and warranties set forth in Sections 3.2 (Authority Relative to This Agreement), 3.4 (No Consents), 3.7 (Good Title to the Acquisition Assets), 3.8 (Tax Matters), 3.11 (Environmental Matters), 3.15 (Employment Matters), the covenants set forth in Sections 5.1(c) and 5.12 and any fraud or knowing or intentional breach of any representation and warranty, Seller will be liable from dollar one up to, but not in excess of, the sum of (x) the aggregate Purchase Price actually received by Seller with respect to all Subject Locations Transferred to Buyer, (y) the Non-Competition Amount and (z) the amount of Prepaid Items transferred to Buyer.

(b) Buyer’s Threshold and Cap Amount. Subject to the following sentence, in order to facilitate an efficient closing of the transactions contemplated by this Agreement, Seller acknowledges and agrees that it will not seek indemnification for claims arising under this Section 7.3(a) until the aggregate amount of all claims against Buyer exceeds the Threshold, in which event Buyer will be liable for such claims only to the extent the Losses exceed the Threshold. Notwithstanding anything to the contrary contained in this Agreement, in no event will Buyer’s aggregate Liability arising out of its indemnification obligations under Section 7.3(a) exceed $2,000,000 (the “Buyer’s Cap”); provided, however, that, with respect to the representations and warranties in Section 4.2 (Authority Relative to This Agreement), and any fraud or knowing or intentional breach of any representation and warranty, Buyer will be liable from dollar one, without regard to the Threshold or Buyer’s Cap.

(c) Escrow Period; Release From Escrow.

(i) The Escrow Period will terminate on the Release Date; provided, however, that all or a portion of the Escrow Fund, which, in the reasonable judgment of Buyer, is

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necessary to satisfy any unsatisfied claims specified in any Claim Notice delivered to the Escrow Agent prior to the Release Date with respect to facts and circumstances existing prior to expiration of the Escrow Period, will remain in the Escrow Fund and subject to the Escrow Agreement until such claims have been resolved.

(ii) Within three (3) Business Days after the Release Date, the Escrow Agent will release from escrow to Seller the Escrow Fund less the dollar amount equal to (A) any portion of the Escrow Fund delivered to Buyer in accordance with Section 7.4(d) in satisfaction of resolved indemnification claims by Buyer and (B) any portion of the Escrow Fund withheld in accordance with Section 7.4(c)(i) with respect to any pending but unresolved indemnification claims of Buyer. Any portion of the Escrow Fund held as a result of clause (B) will be released to Seller or delivered to Buyer (as appropriate) promptly upon resolution of each specific indemnification claim involved.

(iii) The Escrow Agent is hereby granted the power to effect any transfer of the Escrow Fund contemplated by this Agreement.

(d) Notice of Claim. The Indemnified Party will give written notice to the Indemnifying Party of the existence and nature of any claims with respect to which indemnification is sought (and if Buyer is making a claim against the Escrow Fund, such notice will also be delivered to the Escrow Agent). Each such notice (a “Claim Notice”) will be delivered reasonably promptly, but in any event (A) prior to expiration of any applicable survival period for such claim as specified in Section 7.1, (B) if the claim involves a claim against the Escrow Fund, prior to the Release Date, and (C) if such claim relates to the assertion against the Indemnified Party of any claim by a third party (a “Third Party Claim”), within sixty (60) days after assertion of such Third Party Claim, provided, that no failure or delay by the Indemnified Party to so notify the Indemnifying Party will reduce or otherwise affect the obligation of the Indemnifying Party to indemnify and hold the Indemnified Party harmless, except to the extent the Indemnified Party’s failure to give or delay in giving the Claim Notice materially impairs the Indemnifying Party’s ability to perform its obligation to indemnify or defend or to mitigate its damages, in which case the Indemnifying Party will have no obligation to indemnify the Indemnified Party to the extent of Loss, if any, caused by such failure to give or delay in giving the Claim Notice. The Claim Notice must be accompanied by copies of all relevant documentation, including but not limited to any summons, complaint or other pleading that may have been served or written demand or other instrument, and will specify in reasonable detail the facts and circumstances on which the asserted claim is based, specify the amount of such claim if then ascertainable and, if not then ascertainable, the estimated amount thereof. Upon Buyer’s delivery to the Escrow Agent on or before the Release Date of a Claim Notice, the Escrow Agent will, subject to the provisions of this Article 7, maintain cash in the Escrow Fund having a value equal to the amount set forth in the Claim Notice (or such lesser amount as then remains in the Escrow Fund) until resolution of the indemnification claim.

(e) Objections to Claims.

(i) At the time of delivery of any Claim Notice from Buyer to the Escrow Agent, a duplicate copy of such Claim Notice will be delivered to Seller and for a period of thirty (30) days after such delivery, the Escrow Agent will make no delivery of the Escrow

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Fund unless the Escrow Agent shall have received written authorization from Seller to make such delivery. After the expiration of such thirty (30) day period, the Escrow Agent shall make delivery of the portion of the Escrow Fund in accordance with Section 7.4(d) hereof, provided, that no such payment may be made if Seller shall object in a written statement to the claim made in the Claim Notice, and such statement has been delivered to the Escrow Agent and Buyer prior to the expiration of such thirty (30) day period.

(ii) In case Seller has timely objected in writing to any claim by Buyer made in any Claim Notice, Buyer will have thirty (30) days to respond in a written statement to the objection of Seller. If after such thirty (30) day period there remains a dispute as to any claims made in any Claim Notice, Seller and Buyer will attempt in good faith for thirty (30) days to agree upon the rights of the respective parties with respect to each of such claims. If Seller and Buyer should so agree, a memorandum setting forth such agreement will be prepared and signed by both parties and will be furnished to the Escrow Agent. The Escrow Agent will be entitled to rely on any such memorandum and will distribute the cash from the Escrow Fund in accordance with the terms thereof.

(f) Resolution of Conflicts and Arbitration. If no agreement can be reached after good faith negotiation between the parties pursuant to Section 7.4(e)(ii), either party may, by written notice to the other, demand arbitration of the matter. The Parties agree that such matters shall be submitted for binding arbitration and final resolution to the office of the Judicial Arbitration and Mediation Services (“JAMS”) located in Orange County, California. In the event a matter is submitted to JAMS for resolution, the parties will either agree on a single arbitrator or JAMS will provide one through its procedures. The arbitration shall be conducted in accordance with JAMS Streamlined Arbitration Rules and Procedures, unless the Parties agree otherwise. The Parties agree that the arbitrator may award attorney’s fees and costs to the prevailing party. Unless and until re-allocated by the arbitrator, the Parties will share evenly in the costs of arbitration. The decision of the arbitrator as to the validity and amount of any claim in such Claim Notice will be binding and conclusive upon the parties to this Agreement, and notwithstanding anything in Article 7 hereof, the Escrow Agent and the parties will be entitled to act in accordance with such decision and the Escrow Agent will be entitled to make or withhold payments out of the Escrow Fund in accordance therewith.

(g) Third Party Claims. Subject to Section 7.4(h), In the event that any Third Party Claim is brought against an Indemnified Party with respect to which the Indemnifying Party may have liability under this Agreement, the Third Party Claim shall, upon the written agreement of the Indemnifying Party, be defended by the Indemnifying Party at its sole cost and expense by counsel reasonably acceptable to the Indemnified Party and such defense shall include all appeals or reviews which counsel for the Indemnifying Party shall deem appropriate. For any such Third Party Claim, the Indemnified Party shall have the right to be represented by advisory counsel and accountants, at its own expense, and the Indemnifying Party shall keep the Indemnified Party fully informed as to such proceeding at all stages thereof, whether or not the Indemnified Party is represented by its own counsel. The Indemnifying Party shall have the right to elect to settle any claim for monetary damages without the Indemnified Party’s consent only if the settlement includes a complete release of the Indemnified Party and no non-monetary relief or other limitations that would apply to the Indemnified Party. If the settlement does not include such a release or does contain or provide for any such non-monetary relief or other limitations, it

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will be subject to the consent of the Indemnified Party, which consent will not be unreasonably withheld. The Indemnifying Party may not admit any liability of the Indemnified Party or waive any of the Indemnified Party’s rights without the Indemnified Party’s prior written consent. It shall not be deemed unreasonable to withhold consent to a settlement involving injunctive or other non-monetary relief against the Indemnified Party or its assets, employees, business or methods of doing business.

(h) Non-Monetary Relief. If the claim set forth in the Claim Notice seeks injunctive or other non-monetary relief and could have an adverse effect on the Indemnified Party, the Indemnified Party will have the right, notwithstanding anything in this Article 7 to the contrary, to control the defense and settlement of such claim, at the risk and expense of the Indemnified Party. In such case, the Indemnifying Party will have the right fully to participate in the defense at its sole cost and expense.

7.5 Remedies. The indemnification provisions of this Article 7 shall be the sole and exclusive remedy of the parties following the Closing or any Post-Closing Transfer, including for any claims for the recovery of Losses, whether directly or by way of contribution, for any and all breaches or alleged breaches of any representations, warranties, covenants or agreements of the parties or other provision of this Agreement or relating to the transactions contemplated hereby other than for claims of, or causes of action arising from fraud or knowing or intentional breach of any representation or warranty. Under no circumstances shall any Indemnified Party be entitled to be indemnified for punitive or other similar damages.

ARTICLE 8

TERMINATION

8.1 Termination. This Agreement may be terminated at any time prior to the Closing:

(a) by mutual written consent of Buyer and Seller;

(b) by Buyer or by Seller if the other party materially breaches any of its representations, warranties or covenants contained in this Agreement and, if the breach is curable, the breach is not cured within ten (10) Business Days after notice and a description in reasonable detail of the breach;

(c) by Buyer or by Seller if a court of competent jurisdiction or other Governmental Entity issues a final and nonappealable order, decree or ruling, or takes any other action, having the effect of permanently restraining, enjoining or otherwise prohibiting the transactions contemplated hereby;

(d) by Seller if (i) the Closing does not occur within ninety (90) days from the date of this Agreement (or if such date falls on a non-Business Day, then the period shall end on the next Business Day) and Buyer has not complied with its obligations described in Section 5.13(b), as determined by Seller in its reasonable discretion or (ii) the board of directors of Seller recommends and accepts a Transfer Proposal;

(e) by Buyer if (i) Seller provides non-public information to, or enters into discussion with, any third party in accordance with Section 5.2(c), (ii) the board of directors of

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Seller withdraws or modifies its recommendation of this Agreement and the transactions contemplated hereby in a manner adverse to Buyer or resolves to do any of the foregoing, (iii) the board of directors of Seller recommends, endorses, accepts or agrees to a Transfer Proposal, (iv) for any reason Seller fails to call and hold the Stockholder Meeting within ninety (90) days after the date of this Agreement (or if such date falls on a non-Business Day, then the period shall end on the next Business Day), or (v) Seller fails to obtain the required vote of stockholders at the Stockholder Meeting or at any adjournment thereof after public disclosure of a Transfer Proposal.

(f) by Buyer or by Seller if the Closing does not occur within 150 days from the date of this Agreement (or if such date falls on a non-Business Day, then the period shall end on the next Business Day), except that neither Seller nor Buyer will have the right to terminate this Agreement unilaterally if it has failed to use commercially reasonable efforts to fulfill the obligations set forth in Article 6 (except that neither Buyer nor Seller nor Coffee People shall have any obligation whatsoever pursuant to this Agreement or otherwise to use commercially reasonable efforts with respect to any Negative Value Subject Locations) and such party’s failure to fulfill any of its obligations under this Agreement is the reason for the failure of the Closing to occur by the Termination Date.

8.2 Effect of Termination. If this Agreement is terminated as provided in Section 8.1, the obligations of the parties to complete the transactions contemplated by this Agreement will expire and neither party shall have any further obligations under this Agreement except as set forth in Section 5.3, Section 5.4, Section 5.7, Section 8.2, Section 9.1, Section 9.2 and Section 9.3 of this Agreement, and except for Liability arising from a material breach of this Agreement.

ARTICLE 9

MISCELLANEOUS

9.1 Transaction Expenses; Termination Fees.

(a) Except as otherwise expressly provided for herein, each party is responsible for all of its own fees and expenses relating to the proposed transactions, including but not limited to all legal, accounting and financial advisory fees and expenses, provided¸ that Buyer shall pay (i) the premium for the Title Policies with respect to the Ground Leases, and (ii) the fee for recording the Deeds and the Assignment of Leases (with respect to the Ground Leases).

(b) If this Agreement is terminated by Buyer pursuant to Sections 8.1(b) (by reason of a breach of Section 5.2) or 8.1(e), or by Seller pursuant to Section 8.1(d)(ii), then Seller shall make a nonrefundable cash payment to Buyer in an amount equal to Buyer’s actual fees and expenses (including all attorneys’ fees, accountants’ fees, financial advisory fees, fees and expenses related to site surveys, architectural design and architectural processing (e.g. for expeditors) and filing fees) that have been paid or that are due and owing by or on behalf of Buyer in connection with the preparation and negotiation of this Agreement and otherwise in connection with the transactions contemplated hereby up to an amount no greater than $500,000; provided, however, that Buyer shall, in any event, be entitled to a minimum amount of $250,000

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notwithstanding Buyer’s actual fees and expenses. Such payment shall be made by Seller within ten (10) Business Days after Buyer’s delivery to Seller of a written statement of the amounts described above, which shall be supported by reasonable documentation if the aggregate amount payable under this Section 9.1(b) exceeds $250,000. Buyer and Seller acknowledge and agree that such payment will be the exclusive remedy available to Buyer in connection with a termination of the Agreement by Seller pursuant to Section 8.1(d)(ii) or by Buyer pursuant to Sections 8.1(b) (provided, that such limitation shall not apply to the breach or nonperformance of the covenants set forth in Sections 5.3, 5.4 or 5.7) and 8.1(e).

9.2 Notices. All notices and other communications hereunder will be in writing and will be deemed given (a) upon receipt if delivered personally (or if mailed by registered or certified mail), (b) the day after dispatch if sent by overnight courier or (c) upon dispatch if transmitted by telecopier or other means of facsimile transmission, in each case to the following:

If to Buyer:	Starbucks Corporation
	2401 Utah Avenue South
	Mail Stop S-RE1
	Seattle, Washington 98134
	Phone: (206) 318-8720
	Fax No.: (206) 318-0658
	Attn: Michael Malanga, vice president, Strategic Planning
	and New Store Development
With a copy to:	Starbucks Corporation
	2401 Utah Avenue South
	Mail Stop S-LA1
	Seattle, Washington 98134
	Phone: (206) 318-8028
	Fax No.: (206) 318-0720
	Attn: Michael Fink, vice president and assistant general
	counsel
If to Seller:	Diedrich Coffee, Inc.
	28 Executive Park, Suite 200
	Irvine, California 92614
	Phone: (949) 260-1600
	Fax No.: (949) 260-1610
	Attn: Chief Executive Officer
With a copy to:	Gibson, Dunn & Crutcher LLP
	4 Park Plaza
	Irvine, California 92614
	Phone: (949) 451-3800
	Fax No.: (949) 451-4220
	Attn: John M. Williams

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9.3 Governing Law; Venue. The validity, construction and enforceability of this Agreement will be governed in all respects by the laws of the State of California, without regard to its conflict of laws principles. If any legal action or any arbitration or other proceeding is brought in connection with this Agreement, the prevailing party will be entitled to recover reasonable attorneys’ fees, accounting fees, and other costs incurred in that action or proceeding, in addition to any other relief to which it may be entitled. Any action to enforce, or which arises out of or in any way relates to, any of the provisions of this Agreement (except for any actions that are expressly subject to arbitration), including any action to compel compliance with the arbitration provisions of this Agreement and any action to enforce an arbitration judgment, will be brought and prosecuted exclusively in the United States District Court, Central District of California (or, in the event such court does not have jurisdiction, the courts of the State of California located in such district), and the parties hereto hereby consent to the jurisdiction of such court or courts and to service of process by registered mail, return receipt requested, or by any other manner provided by the law of the State of California and the rules of such courts.

9.4 No Third Party Beneficiaries. Nothing in this Agreement is intended to or shall confer upon any Person other than the parties and their respective successors and permitted assigns any legal or equitable right, benefit or remedy of any nature under or by reason of this Agreement.

9.5 Assignment. Neither Seller nor Buyer nor Coffee People may assign this Agreement, by operation of law or otherwise, without obtaining the prior written consent of the other parties, provided such consent will not be unreasonably withheld, and provided further that Buyer may assign this Agreement or any of its rights hereunder to a wholly-owned Affiliate of Buyer; provided that Buyer remains liable for all obligations of Buyer set forth herein.

9.6 Intent to be Binding; Entire Agreement; Severability. The schedules and exhibits referred to herein are incorporated herein by reference as if fully set forth in the text of this Agreement. This Agreement may be executed in any number of counterparts, and each counterpart constitutes an original instrument, but all such separate counterparts constitute one and the same agreement. Except as otherwise provided herein, this Agreement may not be amended except by an instrument in writing signed by Buyer and Seller. This Agreement embodies the entire agreement and understanding of the parties hereto in respect of the subject matter contained herein. This Agreement supersedes all prior agreements and the understandings between the parties with respect to such subject matter. No discussions regarding or exchange of drafts or comments in connection with the transactions contemplated herein will constitute an agreement among the parties thereto. If any term, provision, covenant or restriction of this Agreement is held by a court to be invalid or unenforceable, the remainder of the terms, provisions, covenants and restrictions of this Agreement will remain in full force and effect and will in no way be affected or invalidated and the court will modify this Agreement or, in the absence thereof, the parties agree to negotiate in good faith to modify this Agreement to preserve each party’s anticipated benefits under this Agreement.

9.7 Waiver of Provisions. The terms, covenants, representations, warranties and conditions of this Agreement may be waived only by a written instrument executed by the party waiving compliance. The failure of any party at any time to require performance of any provisions hereof will, in no manner, affect the right of such party at a later date to enforce the

39

same. No waiver by any party of any condition, or breach of any provision, term, covenant, representation, or warranty contained in this Agreement, whether by conduct or otherwise, in any one or more instances, will be deemed to be or construed as a further or continuing waiver of any such condition or of the breach of any other provision, term, covenant, representation or warranty of this Agreement.

9.8 Construction. The captions and titles of the articles, sections and subsections of this Agreement are for convenience of reference only and are not to be considered in construing this Agreement. This Agreement has been jointly prepared by Seller and Buyer and shall be construed without regard to any presumption or other rule requiring the resolution of any ambiguity regarding the interpretation or construction hereof against the party causing this Agreement to be drafted.

9.9 Acknowledgement; Independent Due Diligence. Buyer acknowledges that:

(a) Buyer, either alone or together with any individuals or entities Buyer has retained to advise it with respect to the transactions contemplated hereby, has knowledge and experience in transactions of this type and in the business related to the Acquisition Assets, and is therefore capable of evaluating the risks and merits of acquiring the Acquisition Assets;

(b) neither Seller nor any representative or agent of Seller has given any investment, legal or other advice or rendered any opinion as to whether the purchase of the Acquisition Assets is prudent;

(c) Buyer has conducted due diligence, including a review of the documents, records and books pertaining to the Acquisition Assets that Seller has made available to Buyer; and

(d) Buyer and its attorneys, accountants and advisors have had the opportunity to ask questions and receive answers concerning the Acquisition Assets.

9.10 Disclaimer Regarding Assets. Other than the representations and warranties set forth in this Agreement or any certificate, schedule or Transaction Document delivered in connection with this Agreement, Seller expressly disclaims, and Buyer acknowledges that it is not relying upon, any representations or warranties of any kind or nature, express or implied, as to the condition, value or quality of the Acquisition Assets and the Assumed Liabilities or the prospects (financial or otherwise), risks and other incidents of the Acquisition Assets and Assumed Liabilities.

[The remainder of this page is intentionally blank.]

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Buyer, Seller and Coffee People have executed this Agreement on the date first written above. By signing below, each individual signing on behalf of an entity represents that he or she is a duly elected officer of such company and is authorized to sign in that capacity.

“Buyer”
STARBUCKS CORPORATION, a Washington corporation
By:	/s/ MICHAEL MALANGA
Name:	Michael Malanga
Title:	vice president, Strategic Planning and New Store Development
“Seller”
DIEDRICH COFFEE, INC., a Delaware corporation
By:	/s/ STEPHEN V. COFFEY
Name:	Stephen V. Coffey
Title:	Chief Executive Officer
“Coffee People”
COFFEE PEOPLE, INC., an Oregon corporation
By:	/s/ STEPHEN V. COFFEY
Name:	Stephen V. Coffey
Title:	President

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EX-10.28

EXHIBIT 10.28

AMENDMENT NO. 3 TO

CONTINGENT CONVERTIBLE NOTE PURCHASE AGREEMENT

This Amendment No. 3 to Contingent Convertible Note Purchase Agreement (this “Amendment”) is entered into as of September 22, 2006 by and between Diedrich Coffee, Inc., a Delaware corporation (the “Company”), and Sequoia Enterprises, L.P., a California limited partnership (the “Lender”).

WHEREAS, pursuant to that certain Contingent Convertible Note Purchase Agreement dated as of May 10, 2004 by and between the Company and the Lender (as amended to date, the “Note Purchase Agreement”), the Lender agreed to loan money to the Company on the terms and subject to the conditions set forth therein.

WHEREAS, the Company has requested that the Lender amend the Note Purchase Agreement in certain respects and the Lender has agreed to do so on the terms and subject to the conditions set forth herein.

NOW, THEREFORE, for good and valuable consideration, the receipt and adequacy of which are hereby acknowledged, the parties hereto hereby agree as follows:

1. Amendment of Conditions Precedent. The parties hereto agree that the Material Adverse Effect condition precedent to each loan shall be deleted and that Section 5.1(c) of the Note Purchase Agreement shall be amended and restated as follows: “Reserved.”

2. Amendment of Events of Default. The parties hereto agree that the Material Adverse Effect event of default shall be deleted and that Section 10.1(a)(xi) of the Note Purchase Agreement shall be amended and restated as follows: “Reserved.”

3. Amendment of Notice Requirements. The parties hereto agree that the Material Adverse Effect notice requirement shall be deleted and that Section 8.5(c) of the Note Purchase Agreement shall be amended and restated as follows: “Reserved.”

4. Extension of Maturity Date.

(a) The parties hereto agree to extend the Maturity Date; accordingly, the definition of “Maturity Date” set forth in Section 1.1 of the Note Purchase Agreement shall be amended and restated as follows:

“Maturity Date” shall mean the earliest of (i) the date of consummation of a Change of Control transaction, (ii) the date Notes are declared due and payable by Lender upon an Event of Default, or (iii) June 30, 2008.

(b) For the avoidance of doubt, the term “Maturity Date” used in Notes issued under the Note Purchase Agreement that are currently outstanding is hereby amended to reflect the amended and restated definition of such term in Section 4(a) hereof.

5. Calculation of Monthly Payments.

(a) To reflect the agreement of the parties hereto to extend the Maturity Date, the parties hereto agree to amend the calculation of Monthly Payments and that Section 3.3(a)(ii) of the Note Purchase Agreement shall be amended and restated as follows:

a principal payment on each Note equal to a percentage of the Outstanding Balance on the date of such Monthly Payment such that, when amortized in equal payments of interest over the term of the Note (from the date of issuance to June 30, 2008), 60% of the Outstanding Balance on the date of issuance of such Note shall be repaid by Maturity, plus

(b) To reflect the agreement of the parties hereto to extend the Maturity Date, the parties hereto agree to amend the calculation of Monthly Payments and that Section 2(c)(ii) of the Notes issued under the Note Purchase Agreement that are currently outstanding shall be amended and restated as follows:

a principal repayment equal to a percentage of the Outstanding Balance on the date of such Monthly Payment such that, when amortized in equal principal payments over the term of this Note (from the date of issuance to June 30, 2008), 60% of the Outstanding Balance on the date of issuance of this Note shall be repaid by Maturity.

(c) To reflect the agreement of the parties hereto to extend the Maturity Date, the parties hereto agree to amend the calculation of Monthly Payments and that Section 2(c)(ii) of the Form of Note attached to the Note Purchase Agreement as Exhibit A shall be amended and restated as follows:

a principal repayment equal to a percentage of the Outstanding Balance on the date of such Monthly Payment such that, when amortized in equal principal payments over the term of this Note (from the date of issuance to June 30, 2008), 60% of the Outstanding Balance on the date of issuance of this Note shall be repaid by Maturity.

6. Expiration Date of Warrants.

(a) To reflect the agreement of the parties hereto to extend the Maturity Date, the term “Expiration Date” used in warrants issued pursuant to the Note Purchase Agreement that are currently outstanding is hereby amended to mean June 30, 2010.

(b) To reflect the agreement of the parties hereto to extend the Maturity Date, the definition of “Expiration Date” in the Form of Warrant attached as Exhibit B to the Note Purchase Agreement is hereby amended to mean June 30, 2010.

7. Definitions. Capitalized terms not otherwise defined in this Amendment shall have the meanings given to them in the Note Purchase Agreement.

8. No Other Amendments. Except as expressly amended hereby, the Note Purchase Agreement shall remain in full force and effect as written.

9. Governing Law. This Amendment shall be governed in all respects by and construed in accordance with the laws of the state of California without regard to provisions regarding conflict of laws.

10. Counterparts. This Amendment may be executed in any number of counterparts, each of which when so executed shall be deemed to be an original and all of which when taken together shall constitute one and the same agreement. Signatures transmitted by facsimile or email shall constitute original signatures.

IN WITNESS WHEREOF, the parties hereto have caused this Amendment to be executed as of the day and year first above written.

DIEDRICH COFFEE, INC.
By:	/s/ Stephen V. Coffey
	Stephen V. Coffey
	Chief Executive Officer
	/s/ Sean M. McCarthy
	Sean M. McCarthy
	Chief Financial Officer
SEQUOIA ENTERPRISES, L.P.
By:	/s/ Paul C. Heeschen
	Paul C. Heeschen
	General Partner

EX-23.1

Exhibit 23.1

Consent of Independent Registered Public Accounting Firm

The Board of Directors

Diedrich Coffee, Inc.:

We hereby consent to the incorporation by reference in the registration statements (Nos. 333-111669, 333-66744, 333-74626, 333-52190, 333-61269, 333-50412, 333-61271, 333-50127, 333-50129) on Form S-8 and Form S-3 of Diedrich Coffee, Inc. of our report dated August 18, 2006, except as to Note 16, which is as of September 14, 2006 and Note 2 and last paragraphs of Notes 7 and 9, which are as of September 22, 2006, relating to the consolidated financial statements and schedules which appear in this Form 10-K.

/s/    BDO Seidman, LLP

Costa Mesa, California

September 26, 2006

EX-23.2

Exhibit 23.2

Consent of Independent Registered Public Accounting Firm

The Board of Directors

Diedrich Coffee, Inc.:

We consent to the incorporation by reference in the registration statements (Nos. 333-111669, 333-66744, 333-74626, 333-52190, 333-61269, 333-50412, 333-61271, 333-50127, 333-50129) on Form S-8 and Form S-3 of Diedrich Coffee, Inc. of our report dated August 20, 2004, except as to paragraphs 3, 4, 5, 6 and 7 of note 1, which are as of September 22, 2005, with respect to the consolidated statements of operations, stockholders’ equity, and cash flows of Diedrich Coffee, Inc. and subsidiaries for the year ended June 30, 2004, and the related financial statement schedule, which report appears in the June 28, 2006, annual report on Form 10-K of Diedrich Coffee, Inc.

/s/ KPMG LLP

Costa Mesa, California

September 26, 2006

EX-31.1

EXHIBIT 31.1

Section 302 Certification

I, Stephen V. Coffey, certify that:

1. I have reviewed this annual report on Form 10-K of Diedrich Coffee, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b. Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

c. Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

a. All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b. Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Dated:    September 26, 2006	/s/ Stephen V. Coffey
	Stephen V. Coffey Chief Executive Officer (Principal Executive Officer)

EX-31.2

EXHIBIT 31.2

Section 302 Certification

I, Sean M. McCarthy, certify that:

1. I have reviewed this annual report on Form 10-K of Diedrich Coffee, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b. Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

c. Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

a. All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b. Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Dated:    September 26, 2006	/s/ Sean M. McCarthy
	Sean M. McCarthy Vice President and Chief Financial Officer (Principal Financial Officer)

EX-32.1

EXHIBIT 32.1

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

The undersigned hereby certifies, in his capacity as an officer of Diedrich Coffee, Inc. (the “Company”), for purposes of 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to the best of his knowledge:

• the Annual Report of the Company on Form 10-K for the period ended June 28, 2006 (the “Report”) fully complies with the requirements of Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934, as amended; and

• the information contained in the Report fairly presents, in all material respects, the financial condition and results of operation of the Company.

Dated:    September 26, 2006	/s/ Stephen V. Coffey
	Stephen V. Coffey Chief Executive Officer (Principal Executive Officer)

Note: A signed original of this written statement required by Section 906 has been provided to Diedrich Coffee, Inc. and will be retained by Diedrich Coffee, Inc. and furnished to the Securities and Exchange Commission or its staff upon request.

EX-32.2

EXHIBIT 32.2

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

The undersigned hereby certifies, in his capacity as an officer of Diedrich Coffee, Inc. (the “Company”), for purposes of 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to the best of his knowledge:

• the Annual Report of the Company on Form 10-K for the period ended June 28, 2006 (the “Report”) fully complies with the requirements of Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934, as amended; and

• the information contained in the Report fairly presents, in all material respects, the financial condition and results of operation of the Company.

Dated:    September 26, 2006	/s/ Sean M. McCarthy
	Sean M. McCarthy Vice President and Chief Financial Officer (Principal Financial Officer)

Note: A signed original of this written statement required by Section 906 has been provided to Diedrich Coffee, Inc. and will be retained by Diedrich Coffee, Inc. and furnished to the Securities and Exchange Commission or its staff upon request.