Design Within Reach (DWRI) 10-Q 2005 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended October 1, 2005

OR

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

For the transition period from                    to                    

Commission File Number: 000-50807

DESIGN WITHIN REACH, INC.

(Exact name of registrant as specified in its charter)

Delaware	94-3314374
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
225 Bush Street, 20th Floor, San Francisco, CA	94104
(Address of principal executive offices)	(Zip Code)

(415) 676-6500

(Registrant’s telephone number, including area code)

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.x  Yes    ¨  No.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).¨  Yes    x  No.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).¨  Yes    x  No.

The number of outstanding shares of the registrant’s common stock, par value $0.001 per share, as of November 8, 2005 was 13,957,120.

DESIGN WITHIN REACH, INC.

FORM 10-Q — QUARTERLY REPORT

FOR THE QUARTERLY PERIOD ENDED OCTOBER 1, 2005

TABLE OF CONTENTS

		Page No
PART I – FINANCIAL INFORMATION
Item 1	Financial Statements	3
	Condensed Balance Sheets (unaudited) as of October 1, 2005, January 1, 2005 and September 25, 2004	3
	Condensed Statements of Earnings (unaudited) for the thirteen and thirty-nine week periods ended October 1, 2005 and September 25, 2004	4
	Condensed Statements of Cash Flows (unaudited) for the thirty-nine week periods ended October 1, 2005 and September 25, 2004	5
	Notes to Unaudited Condensed Financial Statements	6
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	11
Item 3	Quantitative and Qualitative Disclosure about Market Risk	19
Item 4	Controls and Procedures	19
PART II – OTHER INFORMATION
Item 1A	Risk Factors	22
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	33
Item 5	Other Information	34
Item 6	Exhibits	34
SIGNATURES		36

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PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

Design Within Reach, Inc.

Condensed Balance Sheets

(amounts in thousands, except per share data)

	October 1, 2005 (unaudited)			January 1, 2005			September 25, 2004 (unaudited)
				(restated)			(restated)
ASSETS
Current assets
Cash and cash equivalents	$	6,317		$	1,075		$	1,036
Investments		7,750			23,610			21,350
Accounts receivable (less allowance for doubtful accounts of $15, $36 and $76)		2,356			1,344			1,487
Inventory on hand		24,876			13,815			13,276
Inventory in transit		2,571			7,049			2,726
Prepaid catalog costs		1,550			1,862			1,732
Deferred income taxes, net of valuation allowance		5,771			1,512			970
Other current assets		6,017			2,352			1,061
Total current assets		57,208			52,619			43,638
Property and equipment, net		25,427			18,572			16,484
Non-current investments		—			2,016			2,009
Deferred income taxes, net of valuation allowance		1,201			887			811
Other non-current assets		552			526			553
Total assets	$	84,388		$	74,620		$	63,495
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable	$	13,229		$	14,317		$	8,604
Accrued expenses		3,797			4,668			3,296
Deferred revenue		2,129			2,014			2,162
Customer deposits and other liabilities		2,975			1,573			1,387
Bank credit facility		1,974			1,053			—
Capital lease obligation, current portion		112			112			112
Total current liabilities		24,216			23,737			15,561
Deferred rent and lease incentives		3,180			1,874			1,559
Capital lease obligation		54			140			168
Deferred income tax liabilities		1,249			867			438
Total liabilities		28,699			26,618			17,726
Stockholders’ equity
Common stock – $0.001 par value; authorized 30,000 shares; issued and outstanding, 13,856, 12,869 and 12,857		17			13			13
Additional paid-in capital		54,616			47,823			47,825
Deferred compensation		(905	)		(1,574	)		(1,751	)
Accumulated other comprehensive income (loss)		(1,091	)		482			(47	)
Accumulated earnings (deficit)		3,052			1,258			(271	)
Total stockholders’ equity		55,689			48,002			45,769
Total liabilities and stockholders’ equity	$	84,388		$	74,620		$	63,495

The accompanying notes are an integral part of these financial statements.

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Design Within Reach, Inc.

Condensed Statements of Earnings

(Unaudited)

(amounts in thousands, except per share data)

	Thirteen weeks ended						Thirty-nine weeks ended
	October 1, 2005			September 25, 2004			October 1, 2005			September 25, 2004
Net sales	$	39,442		$	30,146		$	116,833		$	80,882
Cost of sales		22,150			16,096			65,315			43,294
Gross margin		17,292			14,050			51,518			37,588
Selling, general and administrative expenses (including compensation expense related to noncash stock transactions)		16,826			11,703			45,002			31,320
Amortization of stock-based deferred compensation		141			149			445			374
Depreciation and amortization		1,820			775			4,156			2,060
Facility relocation costs		—			—			—			198
Earnings (loss) from operations		(1,495	)		1,423			1,915			3,636
Other income (expense)
Other income		284			—			284			—
Interest income		80			58			289			58
Interest expense		(13	)		(9	)		(51	)		(92	)
Earnings (loss) before income taxes		(1,144	)		1,472			2,437			3,602
Income tax expense (benefit)		(703	)		566			642			1,387
Net earnings (loss)	$	(441	)	$	906		$	1,795		$	2,215
Net earnings (loss) per share:
Basic	$	(0.03	)	$	0.07		$	0.13		$	0.34
Diluted	$	(0.03	)	$	0.06		$	0.12		$	0.18
Weighted average shares used in calculation of net earnings per share:
Basic		13,931			12,643			13,630			6,493
Diluted		13,931			14,636			14,755			12,556

The accompanying notes are an integral part of these financial statements.

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Design Within Reach, Inc.

Condensed Statements of Cash Flows

(Unaudited)

(amounts in thousands)

	Thirty-nine weeks ended
	October 1, 2005			September 25, 2004
Cash flows from operating activities
Net earnings	$	1,795		$	2,215
Adjustments to reconcile net earnings to net cash provided by operating activities:
Depreciation and amortization		4,156			2,060
Amortization of stock-based deferred compensation		445			374
Compensation associated with employee stock purchase plan and accelerated vesting of stock options		357			—
Proceeds from early termination of lease		284			—
Change in assets and liabilities:
Accounts receivable		(1,012	)		(867	)
Inventory		(11,199	)		(2,244	)
Inventory in transit		4,478			(654	)
Prepaid catalog		312			(1,118	)
Deferred income taxes, net of valuation allowance		(197	)		(450	)
Other current assets		(3,667	)		(382	)
Other non-current assets		(26	)		(442	)
Accounts payable		(1,085	)		2,073
Accrued expenses		(883	)		579
Deferred revenue		114			1,475
Customer deposits and other liabilities		56			296
Deferred rent and lease incentives		1,306			972
Deferred income tax liabilities		382			40
Net cash (used in) provided by operating activities		(4,384	)		3,927
Cash flows from investing activities
Net purchases of property and equipment		(11,298	)		(9,570	)
Purchases of investments		—			(23,359	)
Sales of investments		17,908			—
Net cash provided by (used in) investing activities		6,610			(32,929	)
Cash flows from financing activities
Proceeds from issuance of common stock pursuant to employee stock option plan		1,274			107
Proceeds from warrant exercises		—			1,442
Proceeds from issuance of common stock, net of expenses		907			31,840
Net borrowing (repayment) on bank credit facility		921			(3,325	)
Repayments of long term obligations		(86	)		(70	)
Net cash provided by financing activities		3,016			29,994
Net increase in cash and cash equivalents		5,242			992
Cash and cash equivalents at beginning of period		1,075			44
Cash and cash equivalents at end of period	$	6,317		$	1,036
Supplemental disclosure of cash flow information
Cash paid during the period for:
Income taxes	$	1,761		$	1,296
Interest	$	51		$	108
Non cash investing and financing activities:
Forfeiture of stock options related to deferred compensation	$	105		$	—

The accompanying notes are an integral part of these financial statements.

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Design Within Reach, Inc.

Notes to the Condensed Financial Statements

(Unaudited)

(amounts in thousands, except per share data)

Note 1 – Summary of Significant Accounting Policies

Design Within Reach, Inc. (the “Company”) was incorporated in California in November 1998 and reincorporated in Delaware in March 2004. The Company is an integrated multi-channel provider of distinctive modern design furnishings and accessories. The Company markets and sells its products to both residential and commercial customers through three sales channels consisting of its catalog, studios, and website. The Company sells its products directly to customers throughout the United States.

The Company operates on a 52- or 53-week fiscal year, which ends on the Saturday closest to December 31. Each fiscal year consists of four 13-week quarters, with an extra week added onto the fourth quarter every five to six years. The Company’s 2004 fiscal year ended on January 1, 2005 and its 2005 fiscal year will end on December 31, 2005. Fiscal year 2004 consisted of 53 weeks and fiscal year 2005 consists of 52 weeks.

In connection with the preparation of its financial statements for the quarter ended July 2, 2005, the Company concluded that it was appropriate to classify its auction rate securities as marketable securities. Previously, such investments had primarily been classified as cash and cash equivalents. Accordingly, the Company has revised the classification to report these securities as investments in the Condensed Balance Sheets:

	As Reported		Adjustment			As Restated
As of January 1, 2005:
Cash and Cash Equivalents	$	21,141	$	(20,066	)	$	1,075
Investments		3,544		20,066			23,610
As of September 25, 2004:
Cash and Cash Equivalents	$	20,884	$	(19,848	)	$	1,036
Investments		1,502		19,848			21,350

Quarterly information (unaudited)

The accompanying unaudited condensed interim financial statements as of and for the fiscal quarters ended October 1, 2005 and September 25, 2004 have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission regarding interim financial reporting. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements and should be read in conjunction with the audited financial statements and related notes thereto included in the Company’s annual report on Form 10-K for the year ended January 1, 2005. The accompanying unaudited interim financial statements reflect all adjustments that are, in the opinion of management, necessary for a fair statement of results for the interim periods presented. The results of operations for the fiscal periods ended October 1, 2005 and September 25, 2004 are not necessarily indicative of the results to be expected for any future period or the full fiscal year.

Segment Reporting

The Company’s business is conducted in a single operating segment. The Company’s chief operating decision maker is the Chief Executive Officer who reviews a single set of financial data that encompasses the Company’s entire operations for purposes of making operating decisions and assessing performance.

Inventories

Inventory on hand consists primarily of finished goods purchased from third-party manufacturers. Inventory on hand cost is computed using an average cost method and is carried at the lower of cost or market. As of October 1, 2005 and September 25, 2004, inventory was $24,876 and $13,276, net of write-downs of $1,590 and $940, respectively. Inventory in transit consists of purchased goods from third-party manufacturers which are shipments in transit as of the respective reporting dates. Inventory in transit is carried at actual cost. As of October 1, 2005 and September 25, 2004, the Company recorded inventory in transit of $2,571 and $2,726, respectively.

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Amortization of Stock-Based Deferred Compensation

In the Third Quarter 2005, the Company recorded approximately $141 in expenses associated with amortization resulting from the issuance of (1) 120 options to purchase common stock with an exercise price of $4.50 per share and an estimated fair market value of $10.00 per share granted in first quarter 2004 and (2) 366 options to purchase common stock with an exercise price of $7.00 per share and an estimated fair market value of $11.00 per share granted in first quarter 2004. Stock-based compensation was $149 in the third quarter of 2004. Stock based compensation for the aforementioned grants was $445 and $374 for the thirty-nine weeks ended October 1, 2005 and September 25, 2004 respectively.

The Company accounts for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board (“APB”) Statement No. 25, “Accounting for Stock Issued to Employees,” and complies with the disclosure provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure,” and related interpretations. The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123 and related interpretations. The following table illustrates the effect on net earnings (loss) if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation:

	Thirteen weeks Ended						Thirty-nine weeks Ended
	October 1, 2005			September 25, 2004			October 1, 2005			September 25, 2004
	(unaudited)						(unaudited)
Net earnings (loss) – as reported	$	(441	)	$	906		$	1,795		$	2,215
Add: Total stock-based employee compensation expense included in reported net earnings (loss), net of taxes		87			92			275			230
Deduct: Total stock-based employee compensation expense determined under fair value method for all awards, net of taxes		(350	)		(207	)		(907	)		(455	)
Pro forma net earnings (loss)	$	(704	)	$	791		$	1,163		$	1,990
Basic earnings (loss) per share – as reported	$	(0.03	)	$	0.07		$	0.13		$	0.34
Diluted earnings (loss) per share – as reported	$	(0.03	)	$	0.06		$	0.12		$	0.18
Basic earnings (loss) per share – pro forma	$	(0.05	)	$	0.06		$	0.09		$	0.31
Diluted earnings (loss) per share – pro forma	$	(0.05	)	$	0.05		$	0.08		$	0.16

The fair value of option grants has been determined using the Black-Scholes option pricing model with the following weighted average assumptions:

	Thirteen weeks Ended				Thirty-nine weeks Ended
	October 1, 2005		September 25, 2004		October 1, 2005		September 25, 2004
	(unaudited)				(unaudited)
Risk-free interest rate	5	%	4	%	4	%	4	%
Expected volatility	64	%	65	%	46	%	34	%
Expected life (in years)	5		5		5		5
Dividend yield	—		—		—		—

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Other Income

In the Third Quarter 2005, the Company recorded $284 as other income associated with the early termination of a warehouse lease arrangement at the option of the landlord.

Comprehensive Income

Comprehensive income for the thirteen and thirty-nine weeks ended October 1, 2005 and September 25, 2004 was as follows:

	Thirteen weeks Ended						Thirty-nine weeks Ended
	October 1, 2005			September 25, 2004			October 1, 2005			September 25, 2004
	(unaudited)						(unaudited)
Net earnings (loss)	$	(441	)	$	906		$	1,795		$	2,215
Other comprehensive income (loss):
Unrealized loss on available for sale securities		(4	)		(7	)		(12	)		(7	)
Unrealized gain (loss) on derivatives		(91	)		(40	)		(1,585	)		(40	)
Comprehensive income (loss)	$	(536	)	$	859		$	198		$	2,168

Earnings per Share

Basic earnings per share is calculated by dividing the Company’s net earnings available to the Company’s common stockholders for the period by the number of weighted average common shares outstanding for the period. Diluted earnings per share includes the effects of dilutive instruments, such as stock options, warrants and convertible preferred stock, and uses the average share price for the period in determining the number of incremental shares that are to be added to the weighted average number of shares outstanding. The following table summarizes the incremental shares from potentially dilutive securities, calculated using the treasury stock method at the end of each fiscal period:

	Thirteen weeks Ended		Thirty-nine weeks Ended
	October 1, 2005	September 25, 2004	October 1, 2005	September 25, 2004
	(unaudited)		(unaudited)
Shares used to compute basic earnings per share	13,931	12,643	13,630	6,493
Add: Effect of dilutive securities
Preferred stock Series A	—	45	—	1,375
Preferred stock Series B	—	74	—	2,264
Effect of dilutive options outstanding	—	1,853	1,125	1,776
Warrants outstanding	—	21	—	648
Shares used to compute diluted earnings per share	13,931	14,636	14,755	12,556

For the thirteen weeks ended October 1, 2005, effects of dilutive options outstanding, approximately 833 shares, have been excluded from the calculation because inclusion of such shares would be antidilutive.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management of the Company to make estimates and assumptions affecting the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as revenues and expenses during the reporting period. The Company’s significant accounting estimates include estimates of market value used in calculating the value of inventory on a lower of cost or market basis, estimates of assumptions used in calculating the value of stock options, estimates of expected future cash flows used in the review for impairment of long-lived assets, estimates of the Company’s ability to realize its deferred tax assets which are also used to establish whether valuation allowances are needed on those assets, and estimates of returns used to calculate sales return reserves. Actual results could differ from those estimates and such differences could affect the results of operations reported in future periods.

New Accounting Pronouncements

In December 2004, FASB issued SFAS No. 123R (revised 2004),“Share-Based Payment” (SFAS 123R). This Statement is a revision of SFAS 123. This Statement supersedes APB Opinion No. 25,“Accounting for Stock Issued to Employees”, and its related

8

implementation guidance. SFAS 123R covers a wide range of share-based compensation arrangements including stock options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. The new standard is effective as of the beginning of the first interim or annual reporting period that begins after December 15, 2005. Based on the aforementioned effective date, the Company will begin expensing stock options granted to its employees in its Statement of Earnings using a fair-value based method effective the period beginning January 1, 2006. Adoption of the expensing requirements will increase the Company’s operating expenses. In April 2005, Staff Accounting Bulletin (SAB) 107 was released by the Securities and Exchange Commission which summarizes the views of the SEC staff regarding the interaction between SFAS 123(R) and certain SEC rules and regulations and provides the staff’s views regarding the valuation of share-based payment arrangements for public companies. The provisions of this statement will be effective as of January 1, 2006. The Company is evaluating the alternatives under the guidance and has yet to determine the impact of adoption.

In May of 2005, the FASB issued SFAS No. 154, “Accounting for Changes and Error Corrections” which changes the requirements for the accounting for, and reporting of, a change in accounting principle. Previously, most voluntary changes in accounting principle were recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. This Statement requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. This Statement also requires that a change in depreciation, amortization, or depletion method for long-lived, nonfinancial assets be accounted for as a change in accounting estimate effected by a change in accounting principle. These changes are accounted for in the period of change and future periods, as applicable, and may be made only if the new accounting principle is preferable. This Statement is effective for accounting principles changed on or after January 1, 2006.

Note 2 – Income Taxes

In the third quarter, the Company changed its effective tax rate to 28.4% for the remainder of the year due to a higher proportion of tax-free interest income received from municipal bonds relative to taxable income and the true up of state tax rates applied. The Company anticipates the 28.4% effective tax rate to remain through fiscal 2005. The effective tax rate at the end of the third quarter 2004 was 38.5%. The Company is currently being audited by the Internal Revenue Service for their 2003 income tax returns filed. The outcome is not yet determined.

Note 3 – Bank Credit Facility

The Company amended its secured revolving line of credit agreement with Wells Fargo HSBC Trade Bank (“the Bank”) to extend the expiration date to November 30, 2005. As of October 1, 2005, the Company was in violation of a covenant to achieve positive net earnings. On November 11, 2005, the Company obtained a waiver of default from the bank related to the breached covenant. The waiver is valid through October 1, 2005. Management intends to restructure the line of credit agreement with the Bank upon expiration.

Note 4 – Related Party Transactions

The Company rents studio space from an affiliate of a significant stockholder of the Company and member of the Board of Directors pursuant to a lease dated February 9, 2004. Rent expense related to this space was $25 for both the thirteen weeks ended October 1, 2005 and September 25, 2004. Rent expense related to this space was $75 for both the thirty-nine weeks ended October 1, 2005 and September 25, 2004. The Company received consulting services from the same affiliate on a monthly basis. Consulting expense related to these services for the thirteen weeks ended October 1, 2005 and September 25, 2004 was $0 and $8, respectively.

From 2002 through 2004, a former member of management served on the board of directors of an information systems vendor which supplied the Company with design, programming and development services for a computer system. During this time, the Company spent approximately $2.1 million with this vendor. The former member of management resigned from the board of directors of the vendor effective in April 2004. The Company continues to purchase goods from, and use the services of, the systems vendor until functional upgrades are no longer needed. Cumulative amounts paid to the vendor from the inception of services through October 1, 2005 were approximately $4.8 million.

In fiscal 2004, the Company combined its print buying with NapaStyle, Inc., in order to obtain beneficial pricing with the printer of the Company’s catalog. In order to obtain the best pricing, the Company guaranteed NapaStyle, Inc.’s payments to the printer. NapaStyle Inc. owed the Company approximately $121 which was repaid to the Company in full on July 9, 2004. The Company no longer guarantees NapaStyle Inc.’s payments to the printer. The Company’s Chairman and another one of the members of its Board of Directors are members of the board of directors of NapaStyle, Inc., and some of the Company’s significant stockholders also are stockholders of NapaStyle, Inc.

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In May 2003, the Company made a $100 loan to NapaStyle, Inc., which was repaid to the Company in full by the end of fiscal year 2003. In connection with this loan, NapaStyle, Inc. issued the Company a warrant to purchase 67 shares of NapaStyle, Inc. Series B preferred stock at an exercise price of $0.01 per share. The warrant expires on May 21, 2008. The Company has not ascribed a fair market value to these warrants for financial statement purposes.

Note 5 – Commitments

Operating lease obligations consist of office, studio and fulfillment center lease obligations. Capital lease obligation consists of an obligation for the lease of certain equipment. Between January 1, 2005 and October 1, 2005, the Company has entered into additional operating leases with additional minimum lease obligations of $33.6 million.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion contains forward-looking statements, which involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth below under the caption “Risk Factors.” The interim financial statements and this Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the financial statements and notes thereto for the fiscal year ended January 1, 2005 and the related Management’s Discussion and Analysis of Financial Condition and Results of Operations, both of which are contained in our Annual Report on Form 10-K for the fiscal year ended January 1, 2005 filed with the Securities and Exchange Commission on February 17, 2005.

Overview

Design Within Reach, Inc. is an integrated multi-channel provider of distinctive modern design furnishings and accessories. We market and sell our products to both residential and commercial customers through three integrated sales channels, consisting of our catalog, studios, and website. We offer over 800 collections in numerous categories, including chairs, tables, workspace and outdoor furniture, lighting, floor coverings, beds and related accessories, bathroom fixtures, fans and other home and office accessories. In September 2005, we introduced an exclusive bedding collection to our product assortment. In October 2005, the Company launched a comprehensive product assortment of furnishings and accessories for babies and children called “DWRjax”. Our policy of having products “in stock and ready to ship” is a departure from the approach taken by many other modern design furnishings retailers, which we believe typically requires customers to wait weeks or months to receive their products.

We established our business strategy on the premise that multiple, integrated sales channels improve customer convenience, reinforce brand awareness, enhance customer knowledge of our products, and produce operational benefits that ultimately improve market penetration and returns on capital. All of our sales channels utilize a single common inventory held at our Hebron, Kentucky fulfillment center and share centralized information technology systems, which together provide a level of scalability to facilitate our future growth. This integration further improves customer service, speeds delivery times and provides real-time data availability.

We have experienced significant growth in customers and net sales since our founding in 1998. We began selling products through our catalog and online in the second half of 1999, and we opened our first studio in November 2000. In recent years, we have continued to increase sales across all distribution channels with particular growth in sales through our studios, which have increased in number from one at the end of 2001 to 52 studios operating in twenty-one states as of October 1, 2005. We expect to open 3 new studios in the remainder of 2005 and 10 to 15 new studios in 2006. As of October 1, 2005, we had signed leases for 4 additional studios. We closed our Oakland, California studio during third quarter 2004, as the lease was ending and we acquired a superior location within the same market.

As one measure of the performance of our business, we analyze our total market penetration rates across all of our sales channels in the top 50 metropolitan areas in the United States by household population as identified by the U.S. Census Bureau. We calculate our market penetration rates in a particular metropolitan market area based on net sales per capita in that area. We base our decisions on where to open new studios by categorizing markets into five “tiers” based on household population statistics and supporting sales data collected from our other sales channels. We plan to open the majority of our new studios in markets in our top two tiers during 2005 and 2006. Although nearly all of our studios have been open less than three full years, our experience indicates that studio openings significantly improve our overall market penetration rates in the markets in which they are located even though the opening of a studio may initially have an adverse effect on sales growth in our other sales channels in the same market.

In January 2004, we moved our fulfillment operations from Union City, California to Hebron, Kentucky. The new facility, at approximately 317,000 square feet, is nearly 100,000 square feet larger than our previous Union City facility. We expect this facility to support our distribution capacity needs for at least the next three years. We support all of our sales channels through the new fulfillment center, and the vast majority of our inventory is received and distributed through it. Approximately 7% of our merchandise is shipped directly by the manufacturers to our customers. In February 2004, we moved our corporate headquarters from an approximately 23,000 square foot facility in Oakland, California to an approximately 59,000 square foot facility in downtown San Francisco, California. We expect that this headquarters facility will provide us with adequate space for growth for at least the next five years. In fiscal year 2004, we incurred approximately $172,000 in costs associated with the relocation of our fulfillment center operations and approximately $26,000 in costs associated with the relocation of our headquarters. No further relocation costs are expected with respect to these matters.

Until the end of the second quarter 2004, we had funded our capital expenditures and working capital needs primarily through cash flows from operations, private sales of equity securities and borrowings under our bank credit facility, which includes a $9.0 million operating line of credit and a $2.5 million equipment line of credit. In addition, on July 6, 2004, we completed an initial public offering of 4,715,000 shares of common stock at $12.00 per share. Of the shares offered, 3,000,000 were offered by us and 1,715,000

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were offered by selling stockholders. We raised net proceeds of $31.8 million in our initial public offering, net of underwriting discounts and offering expenses. On March 15, 2005, we completed a public offering of 2,070,000 shares of common stock at $15.80 per share. Of the shares offered, 100,000 were offered by us and 1,970,000 were offered by selling stockholders. We raised net proceeds of $907,000 in this public offering, net of underwriting discounts and offering expenses.

As a public company, we have incurred and will continue to incur significant legal, accounting and other expenses that we did not incur as a private company. In addition, the Sarbanes-Oxley Act of 2002, as well as new rules subsequently implemented by the SEC and the Nasdaq National Market, have required changes in corporate governance practices of public companies. We expect these new rules and regulations to significantly increase our legal and financial compliance costs and to make some activities more time-consuming and costly. We are also in the process of evaluating our internal control structure in relation to Section 404 of the Sarbanes-Oxley Act and, pursuant to this section, we will be required to include management and auditor reports on internal controls as part of our annual report for the year ending December 31, 2005. We will incur additional costs in, and dedicate significant resources toward, remediating known material weaknesses in internal controls over financial reporting and complying with the requirements, which may divert management’s attention from, and which may in turn adversely affect, our business. We also expect these new laws, rules and regulations to make it more difficult and more expensive for us to obtain director and officer liability insurance and we may be required to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. We are currently evaluating and monitoring developments with respect to these new laws, rules and regulations, and we cannot predict or estimate the amount of additional costs we may incur or the timing of such costs.

Basis of Presentation

Net sales consist of studio sales, phone sales, online sales, other sales and shipping and handling fees, net of returns by customers. Studio sales consist of sales of merchandise to customers at our studios, phone sales consist of sales of merchandise through the toll-free numbers associated with our printed catalogs, online sales consist of sales of merchandise from orders placed through our website, and other sales consist of sales made by our business development executives and warehouse sales. Warehouse sales consist of periodic clearance sales at our fulfillment center of product samples and products that customers have returned. Shipping and handling fees consist of amounts we charge customers for the delivery of merchandise. Cost of sales consists of the cost of the products we sell and inbound and outbound freight costs. Handling costs, including our fulfillment center expenses, are included in selling, general and administrative expenses.

Selling, general and administrative expenses consist of studio costs, including salaries and studio occupancy costs, costs associated with publishing our catalogs and maintaining our website, and corporate and fulfillment center costs, including salaries and occupancy costs, among others.

We operate on a 52- or 53-week fiscal year, which ends on the Saturday closest to December 31. Each fiscal year consists of four 13-week quarters, with an extra week added onto the fourth quarter every five to six years. Our 2004 fiscal year ended on January 1, 2005 and our 2005 fiscal year will end on December 31, 2005. Fiscal year 2004 consisted of 53 weeks and fiscal year 2005 consists of 52 weeks.

Results of Operations

Comparison of the thirteen weeks ended October 1, 2005 (Third Quarter 2005) to September 25, 2004 (Third Quarter 2004)

Net sales.Net sales increased $9.3 million, or 31%, in the Third Quarter 2005, compared to the Third Quarter 2004. An approximate increased amount of $8.2 million and increase of 55% was due to increased studio sales, resulted primarily from a 55% growth in the number of studios. We expanded our number of studios from 29 at the end of the Third Quarter 2004 to 52 by the end of the Third Quarter 2005. Online sales increased 19.0% in the Third Quarter 2005 primarily due to increased online marketing initiatives including search optimization and more strategic use of email databases which increased the number of hits on our website by 40%. Phone sales were down 18% in the Third Quarter 2005 due to the increase of sales in other channels. Shipping and handling fees received from customers for delivery of merchandise increased 36% primarily related to sales volumes.

	Thirteen weeks Ended
(in millions)	October 1, 2005		% of Net Sales		September 25, 2004		% of Net Sales		Change			% Change
Studio Sales	$	23.1	58.6	%	$	14.9	49.5	%	$	8.2		55	%
Online Sales		6.9	17.5	%		5.8	19.3	%		1.1		19	%
Phone Sales		5.2	13.2	%		6.3	20.9	%		(1.1	)	(18	)%
Shipping and Handling Fees		4.2	10.7	%		3.1	10.3	%		1.1		36	%
Net Sales	$	39.4	100	%	$	30.1	100	%	$	9.3		31	%

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Cost of Sales. Cost of sales increased $6.0 million, or 37.3%, to $22.1 million in the Third Quarter 2005 from $16.1 million in the Third Quarter 2004. As a percentage of net sales, cost of sales increased to 56.2% in the Third Quarter 2005 from 53.4% in Third Quarter 2004, a 2.8 percentage point increase. Of this increase, 2.3 percentage points relates to additional sales volume. Other factors effecting the percentage of net sales increase relate to the effect of the appreciation of the euro against the U.S. dollar and product returns.

Selling, General and Administrative Expenses (“SG&A”). SG&A expenses increased $5.1 million, or 44%, to $16.8 million in the Third Quarter 2005 from $11.7 million in the Third Quarter 2004. As a percentage of net sales, SG&A expenses increased to 42.6% in the Third Quarter 2005 from 38.8% in the Third Quarter 2004. Increased amounts in salaries and benefits and occupancy and related expenses are primarily due to studio growth which increased from 29 at the end of the Third Quarter 2004 to 52 at the end of the Third Quarter 2005. These expenses are expected to increase in future periods with studio expansion and growth. Other variable expenses consist of fulfillment, information systems and telecommunications, merchant and bank fees, and miscellaneous expenses. The increase in variable costs primarily corresponds to an approximate 31% increase in sales volume from the Third Quarter 2004 to the Third Quarter 2005. The Company anticipates information system expenses to increase in the future as non-capitalizable costs related to the implementation of a new computer system increase. The increase in professional fees, consisting of accounting, legal, consulting, and Sarbanes-Oxley compliance related fees, is primarily due to an approximate $730,000 in consulting costs for Sarbanes-Oxley compliance and systems conversion—items which did not exist in 2004. The following table details SG&A expenses:

	Thirteen weeks Ended
(in millions)	October 1, 2005		% of Net Sales		September 25, 2004		% of Net Sales		Change		% Change
Salaries and benefits	$	6.7	17.0	%	$	4.8	15.9	%	$	1.9	40	%
Occupancy and related expense		3.8	9.6	%		2.1	7.0	%		1.7	81	%
Catalog, advertising and promotion		2.8	7.1	%		2.6	8.6	%		0.2	8	%
Other variable expenses related to volume		2.5	6.3	%		2.0	6.6	%		0.5	25	%
Professional – legal, consulting, SOX		1.0	2.5	%		0.2	0.7	%		0.8	400	%
Total SG&A	$	16.8	42.6	%	$	11.7	38.8	%	$	5.1	44	%

Amortization of stock-based deferred compensation. In the Third Quarter 2005 and 2004, we recorded approximately $141,000 and $149,000, respectively, in non-cash expenses associated with the issuance of (1) 120,000 options to purchase common stock with an exercise price of $4.50 per share and an estimated fair market value of $10.00 per share granted in the First Quarter 2004 and (2) 366,250 options to purchase common stock with an exercise price of $7.00 per share and an estimated fair market value of $11.00 per share granted in first quarter 2004.

Depreciation and Amortization Expenses. Depreciation and amortization expenses increased to approximately $1,820,000 in the Third Quarter 2005 from approximately $775,000 in the Third Quarter 2004. As a percentage of net sales, depreciation and amortization expenses increased to 4.6% of net sales in the Third Quarter 2005 from 2.6% of net sales in the Third Quarter 2004. These expenses increased as a result of significant increases in spending on capital assets associated with our new studio openings and improvements in our network infrastructure, such as investments in servers, desktop computers and related software licenses.

Other Income/Expense. In the Third Quarter 2005, we recorded other income of approximately $284,000 as proceeds from an early termination of a warehouse lease arrangement at the option of the landlord. Interest income was approximately $80,000 in the Third Quarter 2005 and $58,000 in the Third Quarter 2004. We incurred approximately $13,000 of interest expense in the Third Quarter 2005 and $9,000 in the Third Quarter 2004 related to short-term borrowings under our bank credit facility for working capital purposes and for capital expenditures associated with new studios.

Income Taxes. In the Third Quarter 2005, management reviewed projected taxable income and our effective tax rate for the remainder of fiscal 2005 in which certain adjustments to income taxes were made to reflect the changes. We recorded an income tax benefit of approximately $703,000 in the Third Quarter 2005 and income tax expense of approximately $566,000 in the Third Quarter 2004. Our projected effective tax rate was changed to 28.4% due to a higher proportion of tax-free interest income received from municipal bonds relative to other income and trued up state tax rates. Our effective tax rate at the end of the Third Quarter 2004 was 38.5%.

Net Earnings/Losses. As a result of the foregoing factors, net earnings of $906,000 in the Third Quarter 2004 decreased approximately $1,347,000 to an approximate $441,000 earnings loss in the Third Quarter 2005.

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Comparison of Thirty-nine weeks Ended October 1, 2005 to Thirty-nine weeks Ended September 25, 2004

Net sales.Net sales increased $36.0 million, or 44.4%, during the thirty-nine weeks ended October 1, 2005 compared to the thirty-nine weeks ended September 25, 2004. Approximately $28.6 million of this increase was due an increase in studio sales. The increase in part is primarily due to the expansion of studios from 29 at the end of the Third Quarter 2004 to 52 by the end of the Third Quarter 2005. Online sales increased 26% during the thirty-nine weeks ended October 1, 2005 primarily due to increased online marketing initiatives including search optimization and more strategic use of email databases which increased the number of hits on our website by 40%. Phone sales decreased 6.6% during the thirty-nine weeks ended October 1, 2005 due to the increase in sales in other channels. Shipping and handling fees received from customers for delivery of merchandise increased 50% primarily related to undiscounted sales volumes.

	Thirty-nine weeks Ended
(in millions)	October 1, 2005		% of Net Sales		September 25, 2004		% of Net Sales		Change			% Change
Studio Sales	$	65.7	56.3	%	$	37.1	45.9	%	$	28.6		77	%
Online Sales		21.4	18.3	%		17.0	21.0	%		4.4		26	%
Phone Sales		17.3	14.8	%		18.5	22.8	%		(1.2	)	(6	)%
Shipping and Handling Fees		12.4	10.6	%		8.3	10.3	%		4.1		49	%
Net Sales	$	116.8	100	%	$	80.9	100	%	$	35.9		44	%

Cost of Sales. Cost of sales increased $22.0 million, or 50.9%, to $65.3 million in the thirty-nine weeks ended October 1, 2005 from $43.3 million in the thirty-nine weeks ended September 25, 2004. As a percentage of net sales, cost of sales increased to 55.9% in the thirty-nine weeks ended October 1, 2005 from 53.5% in the thirty-nine weeks ended September 25, 2004, a 2.4 percentage point increase. Of this increase, 2.1 percentage points relates to additional sales volume. Other factors effecting the percentage of net sales increase relate to the effect of the appreciation of the euro against the U.S. dollar and product returns.

Selling, General and Administrative Expenses (“SG&A”). SG&A increased $13.7 million, or 43.8%, to $45.0 million in the thirty-nine weeks ended October 1, 2005 from $31.3 million in the thirty-nine weeks ended September 25, 2004. As a percentage of net sales, SG&A expenses decreased to 38.5% in the thirty-nine weeks ended October 1, 2005 from 38.7% in the thirty-nine weeks ended September 25, 2004 primarily due to leveraging our catalog, advertising and promotions expense. Increased amounts in salaries and benefits and occupancy and related expenses are primarily due to studio growth which increased from 29 at the end of the Third Quarter 2004 to 52 at the end of the Third Quarter 2005. These expenses are expected to increase in future periods with studio expansion and growth. Other variable expenses consist of fulfillment, information systems and telecommunications, merchant and bank fees, and miscellaneous expenses. The increase in variable costs primarily corresponds to a 30.8% increase in sales volume to the thirty-nine weeks ended October 1, 2005 from the thirty-nine weeks ended September 25, 2004. The Company anticipates information system expenses to increase in the future as non-capitalizable costs related to the implementation of a new computer system increase. The increase in professional fees, consisting of accounting, legal, consulting, and Sarbanes-Oxley compliance related fees, is primarily due to an approximate $1.2 million in consulting costs for Sarbanes-Oxley compliance and systems conversion—items which did not exist in 2004. The following table details SG&A expenses:

	Thirty-nine weeks Ended
(in millions)	October 1, 2005		% of Net Sales		September 25, 2004		% of Net Sales		Change		% Change
Salaries and benefits	$	18.3	15.7	%	$	12.3	15.2	%	$	6.0	49	%
Occupancy and related expense		9.8	8.4	%		5.5	6.8	%		4.3	78	%
Catalog, advertising and promotion		8.5	7.3	%		7.7	9.5	%		0.8	10	%
Other variable expenses related to volume		6.8	5.8	%		5.4	6.7	%		1.4	26	%
Professional – legal, consulting, SOX		1.6	1.4	%		0.4	0.5	%		1.2	300	%
Total SG&A	$	45.0	38.6	%	$	31.3	38.7	%	$	13.7	44	%

Amortization of stock-based deferred compensation. In the thirty-nine weeks ended October 1, 2005, we recorded approximately $445,000 in non-cash expenses associated with the issuance of (1) 120,000 options to purchase common stock with an exercise price of $4.50 per share and an estimated fair market value of $10.00 per share granted in the First Quarter 2004 and (2) 366,250 options to purchase common stock with an exercise price of $7.00 per share and an estimated fair market value of $11.00 per share granted in first quarter 2004. Stock based compensation was $374,000 in the thirty-nine weeks ended September 25, 2004.

Depreciation and Amortization Expenses. Depreciation and amortization expenses increased to $4.2 million in the thirty-nine weeks ended October 1, 2005 from approximately $2.1 million in the thirty-nine weeks ended September 25, 2004. As a percentage of net

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sales, depreciation and amortization expenses increased to 3.6% of net sales in the thirty-nine weeks ended October 1, 2005 from 2.5% of net sales in the thirty-nine weeks ended September 25, 2004. These expenses increased as a result of increases in spending on capital assets associated with new studio openings and improvements in our network infrastructure, such as investments in servers, desktop computers and related software licenses.

Facility Relocation Costs. In the thirty-nine weeks ended October 1, 2005, we incurred no costs associated with the relocation of our fulfillment operations from Union City, California to Hebron, Kentucky, compared to approximately $198,000 in such costs incurred in the thirty-nine weeks ended September 25, 2004. We also incurred $26,000 in costs associated with the relocation of our headquarters from Oakland, California to San Francisco, California in the thirty-nine weeks ended September 25, 2004.

Other Income/Expense. We recorded other income of approximately $284,000 as proceeds from an early termination of a warehouse lease arrangement at the option of the landlord in the thirty-nine weeks ended October 1, 2005. No other income was recorded for the thirty-nine weeks ended September 25, 2004. Interest income was $289,000 and $58,000 in the thirty-nine weeks ended October 1, 2005 and the thirty-nine weeks ended September 25, 2004, respectively. Our interest income for both thirty-nine week periods was generated by interest paid on our cash and cash equivalents. We incurred approximately $51,000 and $92,000 of interest expense in the thirty-nine weeks ended October 1, 2005 and the thirty-nine weeks ended September 25, 2004, respectively, related to short-term borrowings under our bank credit facility for working capital purposes and for capital expenditures associated with new studios.

Income Taxes. In the Third Quarter 2005, management reviewed projected taxable income and our effective tax rate for the remainder of fiscal 2005 in which certain adjustments to income taxes were made to reflect the changes. We recorded income tax expense of approximately $642,000 and $1,387,000 in the thirty-nine weeks ended October 1, 2005 and September 25, 2004, respectively. Our projected effective tax rate was changed to 28.4% due to a higher proportion of tax-free interest income received from municipal bonds relative to other income and trued up state tax rates. Our effective tax rate at the end of the Third Quarter 2004 was 38.5%.

Net Earnings/Losses. As a result of the foregoing factors, net earnings decreased to $1.8 million, or 1.5% of net sales, in the thirty-nine weeks ended October 1, 2005 from approximately $2.2 million in the thirty-nine weeks ended September 25, 2004.

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Liquidity and Capital Resources

Through the end of Second Quarter 2004, we had funded our operations primarily through cash flows from operations, private placements of equity securities and short-term borrowings under our bank credit facility. In addition, on July 6, 2004, we completed an initial public offering of 4,715,000 shares of common stock at $12.00 per share. Of the shares offered, 3,000,000 were offered by us and 1,715,000 were offered by selling stockholders. We raised net proceeds of $31.8 million in our initial public offering, net of underwriting discounts and offering expenses. On March 15, 2005, we completed a public offering of 2,070,000 shares of common stock at $15.80 per share. Of the shares offered, 100,000 were offered by us and 1,970,000 were offered by selling stockholders. We raised net proceeds of $907,000 in our second public offering, net of underwriting discounts and offering expenses.

Discussion of Cash Flows

For the thirty-nine weeks ended October 1, 2005, cash and cash equivalents increased by approximately $5.2 million to approximately $6.3 million from approximately $1.0 million at January 1, 2005.

Net cash used in operating activities was approximately $4.4 million for the thirty-nine weeks ended October 1, 2005, compared to $3.9 million provided by operating activities for the thirty-nine weeks ended September 25, 2004. The shift in net cash used in operating activities during the thirty-nine weeks ended October 1, 2005 compared to the thirty-nine weeks ended September 25, 2004 was primarily because of an investment in inventory to meet customer demand and the related accounts payable and accrued expenses associated with this increased inventory level.

Net cash provided by investing activities was $6.6 million for the thirty-nine weeks ended October 1, 2005, compared to $13.1 million used in investing activities for the thirty-nine weeks ended September 25, 2004. The shift in net cash provided by investing activities during the thirty-nine weeks ended October 1, 2005 compared to the thirty-nine weeks ended September 25, 2004 was primarily due to the withdrawal of funds from our investment accounts to support the opening of 19 new studios during 2005.

Net cash provided by financing activities was $3.0 million for the thirty-nine weeks ended October 1, 2005, compared to net cash provided by financing activities of $30.0 million for the thirty-nine weeks ended September 25, 2004. In the thirty-nine weeks ending October 1, 2005, our financing activities were impacted by funds raised in our secondary public offering that closed on March 15, 2005, net repayments on borrowings and capital leases, and cash receipts for the exercise of employee stock options. The net cash provided by financing activities during the thirty-nine weeks ended September 25, 2004 represents $31.8 million raised in our initial public offering, repayments on our line of credit and cash received upon exercise of employee stock options and warrants.

Until required for other purposes, our cash and cash equivalents are maintained in deposit accounts or highly liquid investments with remaining maturities of 90 days or less at the time of purchase.

Liquidity Sources, Requirements and Contractual Cash Requirements and Commitments

Our principal sources of liquidity as of October 1, 2005 consisted of: (1) $6.3 million in cash and cash equivalents; (2) $7.7 million in short-term investments; (3) our bank credit facility, consisting of a $9.0 million operating line of credit, of which nothing had been drawn down and $813,000 had been used for outstanding letters of credit as of October 1, 2005; and (4) cash we expect to generate from operations during this fiscal year. The amount available from the bank facility as of October 1, 2005 is $8.2 million. The line of credit agreement was extended to expire on November 30, 2005. Management intends to restructure the line of credit agreement with the Bank upon expiration.

Historically, our principal liquidity requirements have been to meet our working capital and capital expenditure needs.

We believe that our sources of cash will be sufficient to fund our operations and anticipated capital expenditures for at least the next twelve months. Our ability to fund these requirements and comply with the financial covenants under our bank credit agreement will depend on our future operations, performance and cash flow and is subject to prevailing economic conditions and financial, business and other factors, some of which are beyond our control. In addition, as part of our strategy, we intend to continue to expand our studio sales channel. Such expansion will require additional capital. We cannot assure you that additional funds from available sources will be available on terms acceptable to us, or at all.

In fiscal years 2005 and 2006, we anticipate that our investment in property and equipment will increase to between approximately $13 million and $15 million in each year, from $12.9 million in fiscal year 2004. Part of this increase is a result of our planned opening of 15 to 20 new studios in each of fiscal years 2005 and 2006, the cost of which we expect to be between approximately $8 million and $12 million in each such fiscal year. Our planned investment of information systems and technology is currently under evaluation and can not yet be determined. We expect our investment in property and equipment in subsequent years to increase due to

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the continued expansion of our studio channel. We plan to finance these investments in fiscal years 2005 and 2006 from cash flows from operations and our available cash resources.

The following table summarizes our future contractual obligations as of January 1, 2005:

	Payment due by period
Contractual Obligations (1)	Total		Less than 1 year		1-3 years		3-5 years		More than 5 years
	(in thousands)
Operating lease obligations	$	63,093	$	7,881	$	17,001	$	15,591	$	22,620
Capital lease obligation		273		131		142		—		—
Total	$	63,366	$	8,012	$	17,143	$	15,591	$	22,620

(1) Operating lease obligations consist of office, studio and fulfillment center lease obligations. Capital lease obligation consists of an obligation for the lease of certain equipment. Between January 2, 2005 and October 1, 2005, the Company has entered into additional operating leases with additional minimum lease obligations of $33.6 million.

In addition, our credit agreement with Wells Fargo HSBC Trade Bank, N.A., which we amended in June 2004, provides for a $9.0 million operating line of credit and a $2.5 million equipment line of credit. The $9.0 million operating line of credit is subject to availability guidelines that specify the amount that can be borrowed under the facility at any given time to provide working capital and previously scheduled to expire on July 31, 2005. The Company has signed a four month extension with Wells Fargo HSBC Trade Bank, N.A. extending the term through November 30, 2005. Amounts borrowed under this line of credit bear interest at an annual rate equal to the lender’s prime lending rate plus 0.25%. The $2.5 million equipment line of credit was repaid in full in July 2004. Amounts borrowed under our credit agreement are secured by our accounts receivable, inventory and equipment. We have borrowed funds under these lines of credit from time to time and periodically have repaid such borrowings with available cash. The credit agreement also sets forth a number of affirmative and negative covenants to which we must adhere, including financial covenants that require us to achieve positive net earnings in each quarter and limitations on capital expenditures. As of October 1, 2005, the Company was in violation of a covenant to achieve positive net earnings. On November 11, 2005, the Company obtained a waiver of default from the bank related to the breached covenant. The waiver is valid only through October 1, 2005. Management intends to restructure the line of credit agreement with the Bank upon expiration.

Critical Accounting Policies

Our financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, sales and expenses. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies are set forth below.

Revenue recognition. We recognize revenue on the date on which we estimate that the product has been received by the customer, and we record any payments received prior to the estimated date of receipt of the goods by the customer as deferred revenue until the estimated date of receipt. We use our third-party freight carrier information to estimate when delivery has occurred. Sales are recorded net of returns by customers. Significant management judgments and estimates must be made and used in connection with determining net sales recognized in any accounting period. Our management must make estimates of potential future product returns related to current period revenue. We analyze historical returns, current economic trends and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns and other allowances in any accounting period. Although our actual returns historically have not differed materially from estimated returns, in the future, actual returns may differ materially from our reserves. As a result, our operating results and financial condition could be affected adversely. The reserve for returns was approximately $615,000 as of October 1, 2005. We recognize net sales revenue for shipping and handling fees charged to customers at the time products are estimated to have been received by customers.

Shipping and handling costs. Shipping costs, which include inbound and outbound freight costs, are included in cost of sales. We record costs of shipping products to customers in our cost of sales at the time products are estimated to have been received by customers. Handling costs, which include fulfillment center expenses, call center expenses, and credit card fees, are included in selling, general and administrative expenses. Handling costs were approximately $2,400,000 for Third Quarter 2005. Our gross margin calculation may not be comparable to that of other entities, which may allocate all shipping and handling costs to cost of sales, resulting in lower gross margin, or to operating expenses, resulting in higher gross margin.

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Inventory. Our inventory is valued at the lower of cost or market. Cost has been determined using an average cost method. We write down inventory for estimated damage equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions or demand for our products are less favorable than projected by management, additional inventory write-downs may be required. Although our actual inventory write-downs historically have not differed materially from estimated inventory write-downs, in the future, actual inventory write downs may differ materially from our reserves. As a result, our operating results and financial condition could be affected adversely. As of October 1, 2005, estimated inventory write-downs amounted to approximately $1,590,000.

Amortization of stock-based deferred compensation. We account for stock options granted to employees using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” As of December 27, 2003, we had not recognized any compensation expense for stock options in our financial statements, as all options granted up to that date have an exercise price equal to the estimated fair value of the underlying common stock on the date of grant. During the First Quarter of 2004, we recognized approximately $76,000 in stock-based compensation expense, and we also recorded $2.1 million in deferred compensation. During Third Quarter 2005, we recognized approximately $141,000 in stock-based compensation expense. However, Statement of Financial Accounting Standard (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” requires the disclosure of pro forma net earnings and earnings per share as if we had adopted the fair value method. Under SFAS No. 123, the fair value of stock-based awards to employees is calculated through the use of option pricing models. These models require subjective assumptions, including future stock price volatility and expected time to exercise, which affect the calculated values. Our calculations are based on a single option valuation approach and forfeitures are recognized as they occur. With the release of SFAS No. 123R (revised 2004),“Share-Based Payment” (SFAS 123R) which will require to begin expensing stock options granted to its employees in its Statement of Earnings using a fair-value based method effective the period beginning January 1, 2006. Adoption of the expensing requirements will increase the Company’s operating expenses for fiscal 2006.

Accounting for income taxes. We record an estimated valuation allowance on our deferred tax assets if it is more likely than not that they will not be realized. Significant management judgment is required in determining our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets, including judgments regarding whether or not we will generate sufficient taxable income to realize our deferred tax assets.

Amortization of prepaid catalog costs. Prepaid catalog costs consist of third-party costs, including paper, printing, postage, name acquisition and mailing costs, for all of our direct response catalogs. Such costs are capitalized as prepaid catalog costs and are amortized over their expected period of future benefit. Such amortization is based upon the ratio of actual sales to the total of actual and estimated future sales on an individual catalog basis. The period of expected future benefit is calculated based on our projections of when approximately 90% of sales generated by the catalog will be made. Based on data we have collected, we historically have estimated that catalogs have a period of expected future benefit of two to four months. The period of expected future benefit of our catalogs would decrease if we were to publish new catalogs more frequently in each year, or increase if we published them less frequently. Prepaid catalog costs are evaluated for realizability at the end of each reporting period by comparing the carrying amount associated with each catalog to the estimated probable remaining future net benefit associated with that catalog. If the carrying amount is in excess of the estimated probable remaining future net benefit of the catalog, the excess is expensed in the reporting period. We account for consideration received from our vendors for co-operative advertising as a reduction of selling, general and administrative expense. Co-operative advertising amounts received from such vendors were approximately $77,000 for Third Quarter 2005. The balance of prepaid catalog costs at October 1, 2005 was $1.6 million.

Valuation of long-lived assets. Long-lived assets held and used by us are reviewed for impairment whenever events or changes in circumstances indicate the net book value may not be recoverable. An impairment loss is recognized if the sum of the expected future cash flows from use of the asset is less than the net book value of the asset. The amount of the impairment loss will generally be measured as the difference between net book values of the assets and their estimated fair values.

Caution on Forward-Looking Statements

Any statements in this report about our expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and are forward-looking statements. You can identify these forward-looking statements by the use of words or phrases such as “believe,” “may,” “could,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “seek,” “plan,” “expect,” “should,” or “would.” Among the factors that could cause actual results to differ materially from those indicated in the forward-looking statements are risks and uncertainties inherent in our business including, without limitation, the discussions set forth below under the caption “Risk Factors” and other factors detailed in our Annual Report on Form 10-K for the fiscal year ended January 1, 2005 filed with the Securities and Exchange Commission on February 17, 2005.

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Although we believe that the expectations reflected in our forward-looking statements are reasonable, we cannot guarantee future results, events, levels of activity, performance or achievement. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, unless required by law.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

All of our sales and a portion of our expenses are denominated in U.S. dollars, and our assets and liabilities together with our cash holdings are predominantly denominated in U.S. dollars. However, in fiscal year 2004 we obtained approximately 50.9% of our product inventories from manufacturers in Europe, and these transactions typically were denominated in currencies other than the U.S. dollar, principally the euro. During fiscal year 2004, the value of the U.S. dollar declined approximately 8% relative to the euro, which effectively increased the cost to us of merchandise sourced from Europe. As a result of such currency fluctuations, we have experienced and may continue to experience fluctuations in our operating results on an annual and a quarterly basis going forward. To mitigate our exchange rate risk relating to the euro, we typically purchase foreign currency forward contracts with maturities of less than 12 months relating to invoices for supplies of merchandise after the payable amount and due date of the invoice are known. We account for these contracts by adjusting the carrying amount of the contract to market and recognizing any corresponding realized gain or loss in cost of sales in each reporting period. Based on our euro-denominated purchases during fiscal year 2004, a hypothetical additional 10% weakening in the value of the dollar relative to the euro would have increased our cost of sales in fiscal year 2004 by approximately $2.4 million, and would have decreased both our net earnings and cash flows for that year by a corresponding amount. Future hedging transactions may not successfully mitigate losses caused by currency fluctuations. In addition to the direct effect of changes in exchange rates on cost of goods, changes in exchange rates also affect the volume of purchases or the foreign currency purchase price as vendors’ prices become more or less attractive. We expect to continue to experience the effect of exchange rate fluctuations on an annual and quarterly basis, and currency fluctuations could have a material adverse impact on our results of operations.

Starting in the third quarter of fiscal year 2004, we adopted a program to hedge the potential foreign currency risk relating to the amount of our forecasted monthly euro purchases, on a rolling twelve-month basis. The objective of our foreign exchange risk management program is to manage the financial and operational exposure arising from these risks by offsetting gains and losses on the underlying exposures with gains and losses on derivatives used to hedge them. We have comprehensive hedge documentation that defines the hedging objectives, practices, procedures, and accounting treatment. Our hedging program and our derivative positions and strategy are reviewed on a regular basis by our management. In addition, we have entered into agreements that allow us to settle positive and negative positions with the same counterparty on a net basis. Derivative positions are used only to manage identified exposures.

We typically do not attempt to reduce or eliminate our market exposures on our investment securities because the majority of our investments are short-term. The fair value of our investment portfolio or related income would not be significantly impacted by either a 100 basis point increase or decrease in interest rates due mainly to the short-term nature of our investment portfolio.

Item 4. Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports pursuant to the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

In connection with the completion of its audit of, and the issuance of an unqualified report on, our financial statements for the year ended January 1, 2005, Grant Thornton LLP identified deficiencies in the design or operation of our internal controls that it considers to be material weaknesses in the effectiveness of our internal controls pursuant to standards established by the Public Company Accounting Oversight Board. A “material weakness” is a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.

In its letter to the Audit Committee, Grant Thornton LLP identified the following two material weaknesses:

(1) During the course of its audit, Grant Thornton LLP identified that we had not correctly recorded inventory in transit from our European vendors, when the terms were FOB shipping point. As a consequence, we restated our balance sheet for the fiscal year ended December 31, 2003 to reflect an increase in inventories and a corresponding liability in the amount of $1.7

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million. Grant Thornton LLP noted that in accordance with professional standards this restatement indicates the existence of a material weakness in our internal controls over financial reporting.

(2) During the course of its audit, Grant Thornton identified numerous informal or undocumented internal control procedures, as well as instances of inadequate segregation of duties. We also recorded a number of closing and adjusting journal entries during the course of the audit. Grant Thornton LLP stated that the volume of these findings and adjustments constitutes significant deficiencies that aggregate to form a material weakness over financial reporting.

Grant Thornton LLP recommended that we take the following actions to address these items:

(A) Consider allocating additional resources to our accounting and finance department to strengthen our SEC reporting and accounting.

(B) Use cross-training to delegate certain responsibilities to other individuals already employed by our company, and to help further delegate responsibilities to lower-level accounting staff-members.

(C) Have the individuals involved in financial reporting obtain additional training in connection with their duties so that they can keep current with U.S. generally accepted accounting principles and the new regulatory reporting standards and requirements.

Grant Thornton LLP stated in their letter that they understood the formalization and documentation of our internal controls over financial reporting will be undertaken in the fiscal year ending December 31, 2005 as part of our Sarbanes-Oxley Section 404 certification process.

Grant Thornton LLP has discussed the areas of weakness described above with the Audit Committee. The Audit Committee is taking an active role in responding to the deficiencies identified by Grant Thornton LLP, including overseeing management’s implementation of remediation efforts described below.

The Company is addressing the matters identified by Grant Thornton LLP as a general matter by undertaking to formalize and document internal control procedures as appropriate, hire additional accounting staff, and have our financial and accounting personnel obtain additional training in public company reporting matters. Our response to the specific matters identified by Grant Thornton LLP is as follows. With respect to the balance sheet restatement, once the matter was identified by Grant Thornton LLP the restatement was effected, and in-transit inventory is now accurately reflected in our financial statements.

With respect to documentation of our internal control procedures, we have developed a risk assessment and plan defining the scope of control risk and have identified internal control procedures which are necessary to mitigate those risks as part of our Sarbanes-Oxley §404 certification process. The Company has identified several business process and general IT internal controls needed to maintain a sound internal control environment over financial reporting. Additionally, foundational controls such as documented policies and procedures, segregation of duties, system access, and monitoring costs through budgeting and strategic plans have been identified as entity-level controls. Management anticipates that it will conclude that a substantial number of these control activities identified will not be designed and operational effective upon evaluation and our assessment of our internal controls over financial reporting as of December 31, 2005. There is currently internal control deficiencies related to inventory valuation, payables processing, tracking and remitting information related to taxes, capitalization of long-lived assets, cash receipts and revenue recognition, spreadsheet usage, reconciliations and system application processing. Entity-level controls which we consider to be weak include segregation of duties, system access, strategic plans, and the establishment of certain policies and procedures. We intend to continue with remediation efforts of those internal control weaknesses throughout the Fourth Quarter 2005; however, it is more than likely that significant deficiencies and material weaknesses with respect to our internal controls over financial reporting will be reported on as of December 31, 2005. Management intends to complete the evaluation of the effectiveness of our internal controls over financial reporting as required by Sarbanes-Oxley Section 404.

With respect to inadequate segregation of duties reported by Grant Thornton LLP, we have taken measures to remediate these weaknesses. During 2005, we have increased the Finance staff with an SEC Compliance Manager, Financial Reporting Analyst and Senior Financial Systems Analyst. Also during 2005 due to large turnover, six staff personnel, including an Accounting Manager, have been replaced by those who possess related work experience. The number of Certified Public Accountants increased from one in 2004 to five in 2005. Additionally, we have subscribed to an online accounting research database to ensure that U.S. generally accepted accounting practices and SEC reporting guidelines are implemented and followed. Company personnel participate in SEC training seminars as needed. Our tax activities were outsourced to Deloitte Tax LLP and other tax experts by the end of the Third Quarter 2005.

With respect to the closing and adjusting journal entries, we presented our financial statements for the year ended January 1, 2005 to Grant Thornton LLP prior to our having completed all appropriate closing journal entries. As such, these entries were made in conjunction with the audit process.

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In May 2005, we converted our existing information technology systems to a new, custom-built system. We encountered problems with the conversion, due in large part to the absence of rigorous testing of the new systems prior to implementation. In particular, the new systems do not contain mechanisms to automatically identify and correct or reject erroneous or incomplete data. We considered this to be a material weakness in internal controls over financial reporting. Due to the problems encountered with the system, we perform a substantial amount of manual reconciliations and have had to build additional exception reporting mechanisms in order to detect errors and make adjustments. We intend to continue to address and rectify systems conversion matters in the remainder of the fiscal year ending December 31, 2005. During Third Quarter 2005, we hired a consulting firm to assess the deficiencies of the system. As a result, consideration is currently being given to replacement or enhancement of the existing system. Management anticipates that the foregoing may constitute a material weakness in the effectiveness of our internal controls over financial reporting in our December 31, 2005 assessment of the effectiveness of internal controls in conjunction with Sarbanes-Oxley §404.

Currently, the Company does not have a Disclosure Committee. We, however, have enhanced the review process of our financial statements and SEC filings to include certain disclosure controls over financial reporting. Our Chief Executive Officer and Chief Financial Officer continue to improve and refine our disclosure controls. This process is ongoing, and will continue during the fiscal year ending December 31, 2005 as part of our Section 404 certification process. As required by SEC Rule 13a-15(b), we carried out an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operations of our disclosure controls and procedures as of October 1, 2005. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer determined that the deficiencies described above could cause our disclosure controls and procedures to be not fully effective at a reasonable assurance level.

Other than described above, there were no changes in our internal controls over financial reporting during the quarter ended October 1, 2005 that are foreseen to materially effect, or are reasonably likely to materially affect, our internal controls over financial reporting. However, we believe the measures we currently are implementing and planning to improve our internal controls are reasonably likely to have a material impact on our internal controls over financial reporting in future periods.

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PART II - OTHER INFORMATION

Item 1A. Risk Factors

The following information sets forth factors that could cause our actual results to differ materially from those contained in forward-looking statements we have made in this report, the information incorporated herein by reference and those we may make from time to time.

Risks Relating to our Business

Our limited operating history makes evaluation of our business difficult.

We were originally incorporated in November 1998 and began selling products in July 1999. As an early stage company with limited operating history, we face risks and difficulties, such as challenges in accurate financial planning and forecasting as a result of limited historical data and the uncertainties resulting from having had a relatively limited time period in which to implement and evaluate our business strategies as compared to older companies with longer operating histories. These difficulties are particularly evident with respect to the evaluation and prediction of the operating results and expenses of our studios, as we opened our first studio in November 2000 and have expanded from one studio at the end of 2001 to 52 studios as of October 1, 2005. Further, our limited operating history will make it difficult for investors and securities analysts who may choose to follow our common stock, if any, to evaluate our business, strategy and prospects. Our failure to address these risks and difficulties successfully would seriously harm our business.

If we fail to offer merchandise that our customers find attractive, the demand for our products may be limited.

In order for our business to be successful, our product offerings must be distinctive in design, useful to the customer, well made, affordable and generally not widely available from other retailers. We may not be successful in offering products that meet these requirements in the future. If our products become less popular with our customers, if other retailers, especially department stores or discount retailers, offer the same products or products similar to those we sell, or if demand generally for design products such as ours decreases or fails to grow, our sales may decline or we may be required to offer our products at lower prices. If customers buy fewer of our products or if we have to reduce our prices, our net sales will decline and our operating results would be affected adversely.

We believe that our future growth will be substantially dependent on the continued increase in sales growth of existing core products, DWR exclusive, ownable products and other design classics and new products, while at the same time maintaining or increasing our current gross margin rates. We may not be able to increase the growth of existing core and new products or successfully introduce new products or maintain or increase our gross margin rate in future periods. Failure to do so may adversely affect our business.

Moreover, in order to meet our strategic goals, we must successfully identify, obtain supplies of, and offer to our customers new, innovative and high quality design products on a continuous basis. These products must appeal to a wide range of residential and commercial customers whose preferences may change in the future. If we misjudge either the market for our products or our customers’ purchasing habits, we may be faced with significant excess inventories for some products and missed opportunities for products we chose not to stock. In addition, our sales may decline or we may be required to sell our products at lower prices. This would have a negative effect on our business.

We do not have long-term vendor contracts and as a result we may not have continued or exclusive access to products that we sell.

All of the products that we offer are manufactured by third-party suppliers. We do not typically enter into formal exclusive supply agreements for our products and, therefore, have no contractual rights to exclusively market and sell them. Since we do not have arrangements with any vendor or distributor that would guarantee the availability or exclusivity of our products from year to year, we do not have a predictable or guaranteed supply of these products in the future. If we are unable to provide our customers with continued access to popular products, our net sales will decline and our operating results would be harmed.

Our business depends, in part, on factors affecting consumer spending that are not within our control.

Our business depends on consumer demand for our products and, consequently, is sensitive to a number of factors that influence consumer spending, including general economic conditions, disposable consumer income, recession and fears of recession, stock market volatility, war and fears of war, acts of terrorism, inclement weather, consumer debt, interest rates, sales tax rates and rate increases, inflation, consumer confidence in future economic conditions and political conditions, and consumer perceptions of personal well-being and security generally. Adverse changes in factors affecting discretionary consumer spending could reduce consumer demand for our products, thus reducing our net sales and adversely affecting our operating results.

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Our business will be harmed if we are unable to implement our growth strategy successfully.

Our growth strategy primarily includes the following components:

• open additional studios;

• expand and edit product offerings;

• increase marketing within and across our sales channels; and

• expand market awareness and appreciation for design products.

• product development across all existing product categories and new categories

Any failure on our part to implement any or all of our growth strategies successfully would likely have a material adverse effect on our financial condition.

The expansion of our studio operations could result in increased expenses with no guarantee of increased earnings.

We plan to open between 10 to 15 new studios in 2006. We anticipate the costs associated with opening these new studios will be between approximately $8 million and $12 million in 2006. However, we may not be able to attain our target number of new studio openings, and any of the new studios that we open may not be profitable, either of which could have an adverse impact on our financial results. Our ability to expand by opening new studios will depend in part on the following factors:

• the availability of attractive studio locations;

• our ability to negotiate favorable lease terms;

• our ability to identify customer demand in different geographic areas;

• general economic conditions; and

• availability of sufficient funds for expansion.

Even though we plan to continue to expand the number of geographic areas in which our studios are located, we expect that our studio operations will remain concentrated in limited geographic areas. This concentration could increase our exposure to fluctuating customer demand, adverse weather conditions, competition, distribution problems and poor economic conditions in these regions. In addition, our catalog sales, online sales or existing studio sales in a specific region may decrease as a result of new studio openings in that region.

In order to continue our expansion of studios, we will need to hire additional management and staff for our corporate offices and employees for each new studio. We must also expand our management information systems and distribution systems to serve these new studios. If we are unable to hire necessary personnel or grow our existing systems, our expansion efforts may not succeed and our operating results may suffer.

Some of our expenses will increase with the opening of new studios, such as headcount and lease occupancy expenses. Moreover, as we increase inventory levels to provide studios with product samples and support the incremental sales generated from additional studios, our inventory expenses will increase. We may not be able to manage this increased inventory without decreasing our earnings. If studio sales are inadequate to support these new costs, our earnings will decrease. In addition, if we were to close any studio, whether because a studio is unprofitable or otherwise, we likely would be unable to recover our investment in leasehold improvements and equipment at that studio and would be liable for remaining lease obligations.

We rely on our catalog operations, which could have significant cost increases and could have unpredictable results.

Our success depends in part on our ability to market, advertise and sell our products effectively through the Design Within Reach catalog. We believe that the success of our catalog operations and its ability to drive sales in all other sales channels depends on the following factors:

• our ability to continue to offer a merchandise mix that is attractive to our customers;

• our ability to achieve adequate response rates to our mailings;

• our ability to add new customers in a cost-effective manner;

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• our ability to design, produce and deliver appealing catalogs in a cost-effective manner; and

• timely delivery of catalog mailings to our customers.

Catalog production and mailings entail substantial paper, postage, merchandise acquisition and human resource costs, including costs associated with catalog development and increased inventories. We incur nearly all of these costs prior to the mailing of each catalog. As a result, we are not able to adjust the costs incurred in connection with a particular mailing to reflect the actual performance of the catalog. Increases in costs of mailing, paper or printing would increase our costs and would adversely impact our earnings as we would be unable to pass such increases directly on to our customers or offset such increases by raising prices. If we were to experience a significant shortfall in anticipated sales from a particular mailing, and thereby not recover the costs associated with that mailing, our future results would be adversely affected. In addition, response rates to our mailings and, as a result, sales generated by each mailing, are affected by factors such as consumer preferences, economic conditions, the timing of catalog mailings, the product mix in a particular catalog, the timely delivery by the postal system of our catalog mailings and changes in our merchandise mix, several of which may be outside our control. Furthermore, we have historically experienced fluctuations in the response rates to our catalog mailings. Customer response to our catalogs is dependent on merchandise assortment, merchandise availability and creative presentation, as well as the size and timing of delivery of the catalogs. If we are unable to achieve adequate response rates, we could experience lower sales, significant markdowns or write-offs of inventory and lower margins, which would adversely affect our future operating results.

We must manage our online business successfully or our business will be adversely affected.

Our success depends in part on our ability to market, advertise and sell our products through our website. During the thirty-nine weeks ended October 1, 2005, online sales totaled $21.4 million, representing 18.3% of our total net sales. The success of our online business depends, in part, on factors over which we have limited control. In addition to changing consumer preferences and buying trends relating to Internet usage, we are vulnerable to additional risks and uncertainties associated with the Internet. These risks include changes in required technology interfaces, website downtime or slowdowns and other technical failures or human errors, changes in applicable federal and state regulation, security breaches, and consumer privacy concerns. Our failure to respond successfully to these risks and uncertainties might adversely affect the sales through our online business, as well as damage our reputation and increase our selling, general and administrative expenses.

If we do not manage our inventory levels successfully, our operating results will be adversely affected.

We must maintain sufficient inventory levels to operate our business successfully. However, we also must guard against the risk of accumulating excess inventory as we seek to fulfill our “in stock and ready to ship” philosophy. Our success depends upon our ability to anticipate and respond to changing merchandise trends and customer demands in a timely manner. If we misjudge market trends, we may overstock unpopular products and be forced to take significant inventory markdowns, which would have a negative impact on our operating results. Conversely, shortages of popular items could result in loss of sales and have a material adverse effect on our operating results.

Consumer preferences may change between the time we order a product and the time it is available for sale. We base our product selection on our projections of consumer preferences in a future period, and our projections may not be accurate. As a result, we are vulnerable to consumer demands and trends, to misjudgments in the selection and timing of our merchandise purchases and fluctuations in the U.S. economy. Additionally, much of our inventory is sourced from vendors located outside the United States that often require lengthy advance notice of our requirements in order to be able to produce products in the quantities we request. This usually requires us to order merchandise, and enter into purchase order contracts for the purchase and manufacture of such merchandise, well in advance of the time such products will be offered for sale, which makes us vulnerable to changes in consumer demands and trends. If we do not accurately predict our customers’ preferences and acceptance levels of our products, our inventory levels will not be appropriate and our operating results may be negatively impacted.

We source many of our products from manufacturers and suppliers located in Europe, many of which close for vacation during the month of August each year. Accordingly, during September and in many cases for several weeks thereafter as manufacturing resumes and products are shipped to the United States, we are often unable to receive product shipments from these suppliers. As a result, we are required to make projections regarding customer demand for these products for the third and fourth quarters of each year and order sufficient product quantities for delivery in advance of the August shutdown. If we misjudge demand for any of these items, our inventory levels may be too high or low. If we have a shortage of a particular item affected by the August shutdown, we may not be able to procure additional quantities for some weeks or months, which could result in loss of sales and have a material adverse effect on our operating results.

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We depend on domestic and foreign vendors, some of which are our competitors, for timely and effective sourcing of our merchandise.

Our performance depends on our ability to purchase our merchandise in sufficient quantities at competitive prices. We purchase our merchandise from over 200 foreign and domestic designers, manufacturers and distributors. We have no long-term purchase contracts with any of our suppliers and, therefore, have no contractual assurances of continued supply, pricing or access to products, and any vendor could discontinue selling to us at any time. In the thirty-nine weeks ended October 1, 2005, products supplied by our five largest vendors represented approximately 29.8% of net sales.

Additionally, some of our suppliers, including Herman Miller, Inc., Vitra Inc. and Kartell US Inc., compete directly with us in both residential and commercial markets and may in the future choose not to supply products to us. In the thirty-nine weeks ended October 1, 2005, products supplied by Herman Miller, Inc., Vitra Inc. and Kartell US Inc. represented approximately 14.3% of our net sales.Additionally, some of our smaller vendors have limited resources, production capacities and operating histories, which means that they may not be able to timely produce sufficient quantities of certain products demanded by our customers. We may not be able to acquire desired merchandise in sufficient quantities on terms acceptable to us in the future. Any inability to acquire suitable merchandise or the loss of one or more key vendors could have a negative effect on our business and operating results because we would be missing products from our merchandise mix unless and until alternative supply arrangements are made. Moreover, we may not be able to develop relationships with new vendors and products from alternative sources, if any, may be of a lesser quality or more expensive than those we currently purchase.

We have made and will continue to make certain systems changes that might disrupt our supply chain operations.

Our success depends on our ability to source merchandise efficiently through appropriate systems and procedures. We are in the process of substantially modifying our information technology systems supporting our product sourcing, merchandise planning, forecasting, inventory management, product distribution and transportation and price management. Modifications will involve updating or replacing legacy systems with successor systems during the remainder of fiscal year 2005 and in fiscal year 2006. In May 2005, we converted our existing information technology systems to a new, custom-built system. We encountered problems with the conversion, due in large part to the absence of rigorous testing of the new systems prior to implementation. In particular, the new systems do not contain mechanisms to automatically identify and correct or reject erroneous or incomplete data.

There are inherent risks associated with replacing our core systems, including supply chain disruptions that affect our ability to deliver products to our customers. We may not be able to successfully launch these new systems or launch them without supply chain disruptions in the future. Any resulting supply chain disruptions could have a material adverse effect on our operating results.

Intellectual property claims against us could be costly and could impair our business.

Third parties may assert claims against us alleging infringement, misappropriation or other violations of patent, trademark, trade dress, or other proprietary rights held by them, whether or not such claims have merit. Some of the products we offer, including some of our best selling items, are reproductions of designs that some of our competitors believe they have exclusive rights to manufacture and sell, and who may take action to seek to prevent us from selling those reproductions. Alternatively, such persons may seek to require us to enter into distribution relationships with them, thereby requiring us to sell their version of such products, at a significantly higher price than the reproduction that we offer, which may have a significant adverse impact on our sales volume, net sales and gross margin. In addition, when marketing or selling our products we may refer to or use product designations that are or may be trademarks of other people, who may allege that we have no right to use such marks or product designations and bring actions against us to prevent us from using them. If we are forced to defend against third-party infringement claims, whether they are with or without merit or are determined in our favor, we could face expensive and time-consuming litigation, which could divert management personnel, or result in product shipment delays. If an infringement claim is determined against us, we may be required to pay monetary damages or ongoing royalties, or to cease selling the infringing product, which may have a significant adverse impact on our sales volume and gross margins, especially if we are required to stop selling any of our best-selling items as a result of, or in connection with, such claim. Further, as a result of infringement claims either against us or against those who license rights to us, we may be required to enter into costly royalty, licensing or product distribution agreements. Such royalty, licensing or product distribution agreements may be unavailable on terms that are acceptable to us, or at all. If a third party successfully asserts an infringement claim against us and we are required to pay monetary damages or royalties or we are unable to obtain suitable non-infringing alternatives or license the infringed or similar intellectual property on reasonable terms on a timely basis, it could significantly harm our business. Moreover, any such litigation regarding infringement claims may result in adverse publicity which may harm our reputation.

We are subject to various risks and uncertainties that might affect our ability to procure quality merchandise.

Our performance depends on our ability to procure quality merchandise from our vendors. Our vendors are subject to certain risks, including availability of raw materials, labor disputes, union organizing activity, inclement weather, natural disasters, and

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general economic and political conditions, that might limit their ability to provide us with quality merchandise on a timely basis. For these or other reasons, one or more of our vendors might not adhere to our quality control standards, and we might not identify the deficiency before merchandise ships to us or our customers. Our vendors’ failure to manufacture or import quality merchandise could reduce our net sales, damage our reputation and have an adverse effect on our financial condition.

A substantial portion of our sales during any given period of time may be generated by a particular product or line of products obtained from a small number of vendors, and if sales of those products or line of products decrease, our common stock price may be adversely affected.

Sales of products supplied by our top five vendors constituted approximately 29.8% of our total net sales for the thirty-nine weeks ended October 1, 2005. Although we have no formal supply agreements with any of these vendors, we believe that sales of products we obtain from these vendors will continue to constitute a substantial portion of our sales in the future. However, sales of products from these vendors may not continue to increase or may not continue at this level in the future. If sales of products from these vendors decrease, our net sales will decrease and the price of our common stock may be adversely affected.

Declines in the value of the U.S. dollar relative to foreign currencies could adversely affect our operating results.

We procure supplies of our products from manufacturers in thirteen countries outside the United States. For the thirty-nine weeks ended October 1, 2005, approximately 58.9% of our merchandise purchases were sourced from outside the United States. Our dependence on foreign vendors means, in part, that we may be affected by declines in the relative value of the U.S. dollar to other foreign currencies, particularly the euro. Specifically, as the value of the U.S. dollar declines relative to other currencies, such as the euro, our effective cost of supplies of product increases. As a result, continued declines in the value of the U.S. dollar relative to the euro and other foreign currencies would increase our cost of goods sold and decrease our gross margin.

We rely on foreign sources of production, which subjects us to various risks.

We currently source a substantial portion of our products from foreign manufacturers located in Canada, the Czech Republic, Denmark, France, Germany, Israel, Italy and in other countries. As such, we are subject to other risks and uncertainties associated with changing economic and political conditions in foreign countries. These risks and uncertainties include import duties and quotas, work stoppages, economic uncertainties including inflation, foreign government regulations, wars and fears of war, acts of terrorism, political unrest and trade restrictions. Additionally, countries in which our products are currently manufactured or may be manufactured in the future may become subject to trade restrictions imposed by the United States or foreign governments. Any event causing a disruption or delay of imports from foreign vendors, including the imposition of additional import restrictions, restrictions on the transfer of funds or increased tariffs or quotas, or both could increase the cost or reduce the supply of merchandise available to us and adversely affect our operating results.

There is also a risk that one or more of our foreign vendors will not adhere to fair labor standards and may engage in child labor practices. If this happens, we could lose customer goodwill and favorable brand recognition, which could negatively affect our business.

If we fail to timely and effectively obtain shipments of product from our vendors and deliver merchandise to our customers, our operating results will be adversely affected.

We cannot control all of the various factors that might affect our timely and effective procurement of supplies of product from our vendors and delivery of merchandise to our customers. All products that we purchase, domestically or overseas, must be shipped to our fulfillment center in Hebron, Kentucky by third-party freight carriers, except for those products that are shipped directly to our customers from the manufacturer. Our dependence on foreign imports also makes us vulnerable to risks associated with products manufactured abroad, including, among other things, risks of damage, destruction or confiscation of products while in transit to our fulfillment center, work stoppages including as a result of events such as longshoremen strikes, transportation and other delays in shipments including as a result of heightened security screening and inspection processes or other port-of-entry limitations or restrictions in the United States, lack of freight availability and freight cost increases. In addition, if we experience a shortage of a popular item, we may be required to arrange for additional quantities of the item, if available, to be delivered to us through airfreight, which is significantly more expensive than standard shipping by sea. As a result, we may not be able to obtain sufficient freight capacity on a timely basis or at favorable shipping rates and, therefore, we may not be able to timely receive merchandise from our vendors or deliver our products to our customers.

We rely upon land-based carriers for merchandise shipments from U.S. ports to our facility in Hebron, Kentucky and from this facility to our customers. Accordingly, we are subject to the risks, including labor disputes, union organizing activity, inclement weather and increased fuel costs, associated with such carriers’ ability to provide delivery services to meet our inbound and outbound shipping needs. For example, recent increases in oil prices resulted in increases in our shipping expenses and we have not passed all of this increase on to our customers, which has adversely affected our shipping margins. Failure to procure and deliver merchandise

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either to us or to our customers in a timely, effective and economically viable manner could damage our reputation and adversely affect our business. In addition, any increase in fulfillment costs and expenses could adversely affect our future financial performance.

All of our fulfillment operations are located in our facility in Hebron, Kentucky, and any significant disruption of this center’s operations would hurt our ability to make timely delivery of our products.

We conduct all of our fulfillment operations from our facility in Hebron, Kentucky. Our fulfillment center houses all of our product inventory and is the location from which all of our products are shipped to customers, except for those products that are shipped directly to our customers from the manufacturer. A natural disaster or other catastrophic event, such as an earthquake, fire, flood, severe storm, break-in, terrorist attack or other comparable event would cause interruptions or delays in our business and loss of inventory and could render us unable to accept or fulfill customer orders in a timely manner, or at all. Further, we have no formal disaster recovery plan and our business interruption insurance may not adequately compensate us for losses that may occur. In the event that a fire, natural disaster or other catastrophic event were to destroy a significant part of our Hebron, Kentucky facility or interrupt our operations for any extended period of time, or if harsh weather conditions prevent us from delivering products in a timely manner, our net sales would be reduced and our operating results would be harmed.

Our computer and communications hardware and software systems are vulnerable to damage and interruption, which could harm our business.

Our ability to receive and fulfill orders successfully is critical to our success and largely depends upon the efficient and uninterrupted operation of our computer and communications hardware and software systems. Our primary computer systems and operations are located at our corporate headquarters in San Francisco, California and distribution center in Hebron, Kentucky and are vulnerable to damage or interruption from power outages, computer and telecommunications failures, computer viruses, security breaches, catastrophic events, and errors in usage by our employees and customers. Further, our website servers are located at the facilities of, and hosted by, a third-party service provider in Santa Clara, California. In the event that this service provider experiences any interruption in its operations or ceases operations for any reason or if we are unable to agree on satisfactory terms for a continued hosting relationship, we would be forced to enter into a relationship with another service provider or take over hosting responsibilities ourselves. In the event it became necessary to switch hosting facilities in the future, we may not be successful in finding an alternative service provider on acceptable terms or in hosting our website servers ourselves. Any significant interruption in the availability or functionality of our website or our sales processing, distribution or communications systems, for any reason, could seriously harm our business.

If we are unable to provide satisfactory customer service, we could lose customers and our reputation could be harmed.

Our ability to provide satisfactory levels of customer service depends, to a large degree, on the efficient and uninterrupted operation of our customer call center. Any material disruption or slowdown in our order processing systems resulting from labor disputes, telephone or Internet failures, power or service outages, natural disasters or other events could make it difficult or impossible to provide adequate customer service and support. Further, we may be unable to attract and retain adequate numbers of competent customer service representatives, who are essential in creating a favorable, interactive customer experience. In addition, e-mail and telephone call volumes in the future may exceed our present system’s capacities. If this occurs, we could experience delays in taking orders, responding to customer inquiries and addressing customer concerns, which would have an adverse effect on customer satisfaction and our reputation.

We also are dependent on third-party shipping companies for delivery of products to customers. If these companies do not deliver goods in a timely manner or damage products in transit, our customers may be unsatisfied. Because our success depends in large part on keeping our customers satisfied, any failure to provide high levels of customer service would likely impair our reputation and have an adverse effect on our future financial performance.

We face intense competition and if we are unable to compete effectively, we may not be able to maintain profitability.

The specialty retail furnishings market is highly fragmented but highly competitive. We compete with other companies that market lines of merchandise similar to ours, such as large retailers with a national or multinational presence, regional operators with niche assortments and catalog and Internet companies. Many of our competitors are larger companies with greater financial resources than us. We expect that as demand for high quality design products grows, many new competitors will enter the market and competition from established companies will increase.

Moreover, increased competition may result in potential or actual litigation between us and our competitors relating to such activities as competitive sales practices, relationships with key suppliers and manufacturers and other matters. As a result, increased competition may adversely affect our future financial performance.

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The competitive challenges facing us include:

• anticipating and quickly responding to changing consumer demands better than our competitors;

• maintaining favorable brand recognition and achieving customer perception of value;

• effectively marketing and competitively pricing our products to consumers in several diverse market segments; and

• offering products that are distinctive in design, useful to the customer, well made and affordable, in a manner that favorably distinguishes us from our competitors.

The U.S. retail industry, the specialty retail industry in particular, and the e-commerce sector are constantly evolving and have undergone significant changes over the past several years. Our ability to anticipate and successfully respond to continuing challenges is critical to our long-term growth, and we may not be successful in anticipating and responding to changes in the retail industry and e-commerce sector.

In light of the many competitive challenges facing us, we may not be able to compete successfully. Increased competition could adversely affect our future net sales.

We maintain a liberal merchandise return policy, which allows customers to return most merchandise and, as a result, excessive merchandise returns could harm our business.

We maintain a liberal merchandise return policy that allows customers to return most merchandise received from us if they are dissatisfied with those items. We make allowances for returns in our financial statements based on historical return rates. Actual merchandise returns may exceed our allowances for returns. In addition, because our allowances are based on historical return rates, the introduction of new products, the opening of new studios, the introduction of new catalogs, increased sales online, changes in our merchandise mix or other factors may cause actual returns to exceed return allowances. Any significant increase in merchandise returns that exceed our allowances could have a material adverse effect on our future operating results.

The loss of key personnel could have an adverse effect on our ability to execute our business strategy and on our business results.

Our success depends to a significant extent upon the efforts and abilities of our current senior management to execute our business plan. In particular, we are dependent on the services of Tara Poseley, our President and Chief Executive Officer, Ken La Honta, our Chief Operating Officer and Chief Financial Officer, and Robert Forbes, Jr., our founder. We do not have long-term employment agreements with any of our key personnel. The loss of the services of Ms. Poseley, Mr. La Honta, Mr. Forbes or any of the other members of our senior management team or of other key employees could have a material adverse effect on our ability to implement our business strategy and on our business results. Changes in our senior management and any future departures of key employees or other members of senior management may be disruptive to our business and may adversely affect our operations. Additionally, our future performance will depend upon our ability to attract and retain qualified management, merchandising and sales personnel. If members of our existing management team are not able to manage our company or our growth, or if we are unable to attract and hire additional qualified personnel as needed in the future, our business results will be negatively impacted.

Our independent auditors have indicated to us that they believe there were material weaknesses in our internal controls for the fiscal year ended January 1, 2005. Our failure to implement and maintain effective internal controls in our business could have a material adverse effect on our business, financial condition, results of operations and stock price.

In connection with the completion of its audit of, and the issuance of an unqualified report on, our financial statements for the fiscal year ended January 1, 2005, our independent auditors, Grant Thornton LLP, delivered a management letter identifying deficiencies involving our internal controls that it considers to be material weaknesses pursuant to standards established by the Public Company Accounting Oversight Board. The deficiencies noted by Grant Thornton LLP are that (1) we had not correctly recorded inventory in transit from our European vendors in our inventory, when the terms were FOB shipping point, and (2) they identified numerous informal or undocumented internal control procedures, instances of inadequate segregation of duties, and a number of closing and adjusting entries during the course of their audit. Additionally, we have noted additional material weaknesses or significant deficiencies in our internal controls which we may be unable to correct in time to meet the deadline imposed by Section 404 of the Sarbanes-Oxley Act. See “Item 4—Controls and Procedures.”

We intend to take steps to strengthen our internal control processes to address the matters identified by Grant Thornton LLP and management. These measures may not, however, completely eliminate the material weaknesses identified by our independent auditors and management, and we anticipate having additional material weaknesses or significant deficiencies in our internal controls that neither they nor our management has yet identified and are unable to correct in time to meet the deadline imposed by Section 404 of the Sarbanes-Oxley Act. The existence of one or more material weaknesses or significant deficiencies could result in errors in our

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financial statements, and substantial costs and resources may be required to rectify any internal control deficiencies. If we fail to achieve and maintain the adequacy of our internal controls in accordance with applicable standards, we may be unable to conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404. If we cannot produce reliable financial reports, our business and financial condition could be harmed, investors could lose confidence in our reported financial information, the market price of our stock could decline significantly and we may be unable to obtain additional financing to operate and expand our business.

We have grown quickly and if we fail to manage our growth, our business will suffer.

We have rapidly and significantly expanded our operations, and anticipate that further significant expansion will be required to address potential growth in our customer base and market opportunities. This expansion has placed, and is expected to continue to place, a significant strain on our management and operational resources. Additionally, we need to properly implement and maintain our financial and managerial controls, reporting systems and procedures, including disclosure controls and procedures and internal controls over financial reporting. Moreover, if we are presented with appropriate opportunities, we may in the future make investments in, or possibly acquire, assets or businesses that we believe are complementary to ours. Any such investment or acquisition may further strain our financial and managerial controls and reporting systems and procedures. These difficulties could disrupt our business, distract our management and employees and increase our costs. If we are unable to manage growth effectively or successfully integrate any assets or businesses that we may acquire, our future financial performance would be adversely affected.

If the protection of our trademarks and proprietary rights is inadequate, our brand and reputation could be impaired and we could lose customers.

We regard our copyrights, service marks, trademarks, trade dress, trade secrets and similar intellectual property as critical to our success. Our principal intellectual property rights include a registered trademark on our name, “Design Within Reach,” copyrights in our catalogs, rights to our domain name,www.dwr.com, and our databases and information management systems. As such, we rely on trademark and copyright law, trade secret protection and confidentiality agreements with our employees, consultants, suppliers, and others to protect our proprietary rights. Nevertheless, the steps we take to protect our proprietary rights may be inadequate. In addition, the relationship between regulations governing domain names and laws protecting trademarks and similar proprietary rights is unclear. Therefore, we may be unable to prevent third parties from acquiring domain names that are similar to, infringe upon or otherwise decrease the value of our trademarks and other proprietary rights. If we are unable to protect or preserve the value of our trademarks, copyrights, trade secrets or other proprietary rights for any reason, our brand and reputation could be impaired and we could lose customers.

We may face product liability claims or product recalls that are costly and create adverse publicity.

The products we sell may from time to time contain defects which could subject us to product liability claims and product recalls. Any such product liability claim or product recall may result in adverse publicity regarding us and the products we sell, which may harm our reputation. If we are found liable under product liability claims, we could be required to pay substantial monetary damages. Further, even if we successfully defend ourselves against this type of claim, we could be forced to spend a substantial amount of money in litigation expenses, our management could be required to spend valuable time in the defense against these claims and our reputation could suffer, any of which could harm our business. In addition, although we maintain limited product liability insurance, if any successful product liability claim or product recall is not covered by or exceeds our insurance coverage, our financial condition would be harmed.

The security risks of online commerce, including credit card fraud, may discourage customers from purchasing products from us online.

For our online sales channel to continue to succeed, we and our customers must be able to transmit confidential information, including credit card information, securely over public networks. Third parties may have the technology or know-how to breach the security of customer transaction data. Any breach could cause customers to lose confidence in the security of our website and choose not to purchase from us. Although we take the security of our systems very seriously, our security measures may not effectively prohibit others from obtaining improper access to our information. If a person is able to circumvent our security measures, he or she could destroy or steal valuable information or disrupt our operations. Any security breach could expose us to risks of data loss, litigation and liability and could seriously disrupt our operations and harm our reputation.

We do not carry insurance against the risk of credit card fraud, so the failure to prevent fraudulent credit card transactions could adversely affect our operating results. In addition, we may in the future suffer losses as a result of orders placed with fraudulent credit card data even though the associated financial institution approved payment of the orders. Under current credit card practices, we may be liable for fraudulent credit card transactions because we do not obtain a cardholder’s signature when we sell our products by

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telephone or online. If we are unable to detect or control credit card fraud, our liability for these transactions could harm our financial condition.

Existing or future government regulation could harm our business.

We are subject to the same federal, state and local laws as other companies conducting business online, including consumer protection laws, user privacy laws and regulations prohibiting unfair and deceptive trade practices. In particular, under federal and state financial privacy laws and regulations, we must provide notice to our customers of our policies on sharing non-public information with third parties, must provide advance notice of any changes to our privacy policies and, with limited exceptions, must give consumers the right to prevent sharing of their non-public personal information with unaffiliated third parties. Further, the growth of online commerce could result in more stringent consumer protection laws that impose additional compliance burdens on us. Today there are an increasing number of laws specifically directed at the conduct of business on the Internet. Moreover, due to the increasing use of the Internet, many additional laws and regulations relating to the Internet are being debated at the state and federal levels. These laws and regulations could cover issues such as freedom of expression, pricing, user privacy, fraud, quality of products and services, taxation, advertising, intellectual property rights and information security. Applicability of existing laws to the Internet relating to issues such as property ownership, copyrights and other intellectual property issues, taxation, libel, obscenity and personal privacy could also harm our business. For example, U.S. and international laws regulate our ability to use customer information and to develop, buy and sell mailing lists. Many of these laws were adopted prior to the advent of the Internet, and do not contemplate or address the unique issues raised by the Internet. The applicability and reach of those laws that do reference the Internet, such as the Digital Millennium Copyright Act, are uncertain. The restrictions imposed by, and costs of complying with, current and possible future laws and regulations related to our business could harm our future operating results.

Tax authorities in a number of states, as well as a Congressional advisory commission, are currently reviewing the appropriate tax treatment of companies engaged in online commerce, and new state tax regulations may subject us to additional state sales and income taxes, which could have an adverse effect on our cash flows and results of operations. Further, there is a possibility that we may be subject to significant fines or other payments for any past failures to comply with these requirements.

The State of California recently enacted a law that requires any company that does business in California and possesses computerized data, in unencrypted form, containing certain personal information about California residents to provide prompt notice to such residents if that personal information was, or is reasonably believed to have been, obtained by an unauthorized person such as a computer hacker. The law defines personal information as an individual’s name together with one or more of that individual’s social security number, driver’s license number, California identification card number, credit card number, debit card number, or bank account information, including any necessary passwords or access codes. As our customers, including California residents, generally provide information to us that is covered by this definition of personal information in connection with their purchases via our website, our business will be affected by this new law. As a result, we will need to ensure that all computerized data containing the previously-described personal information is sufficiently encrypted or that we have implemented appropriate measures to detect unauthorized access to our data. These measures may not be sufficient to prevent unauthorized access to the previously described personal information. In the event of an unauthorized access, we are required to notify our California customers of any such access to the extent it involves their personal information. Such measures will likely increase the costs of doing business and, if we fail to detect and provide prompt notice of unauthorized access as required by the new law, we could be subject to potential claims for damages and other remedies available to California residents whose information was improperly accessed or, under certain circumstances, the State of California could seek to enjoin our online operations until appropriate corrective actions have been taken. While we intend to comply fully with this new law, we may not be successful in avoiding all potential liability or disruption of business resulting from this law. If we were required to pay any significant amount of money in satisfaction of claims under this new law, or any similar law enacted by another jurisdiction, or if we were forced to cease our business operations for any length of time as a result of our inability to comply fully with any such law, our operating results could be adversely affected. Further, complying with the applicable notice requirements in the event of a security breach could result in significant costs.

In addition, because our website is accessible over the Internet in multiple states and other countries, we may be subject to their laws and regulations or may be required to qualify to do business in those locations. Our failure to qualify in a state or country where we are required to do so could subject us to taxes and penalties and we could be subject to legal actions and liability in those jurisdictions. The restrictions or penalties imposed by, and costs of complying with, these laws and regulations could harm our business, operating results and financial condition. Our ability to enforce contracts and other obligations in states and countries in which we are not qualified to do business could be hampered, which could have a material adverse effect on our business.

Laws or regulations relating to privacy and data protection may adversely affect the growth of our online business or our marketing efforts.

We are subject to increasing regulation relating to privacy and the use of personal user information. For example, we are subject to various telemarketing laws that regulate the manner in which we may solicit future customers. Such regulations, along with increased governmental or private enforcement, may increase the cost of growing our business. In addition, several states have

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proposed legislation that would limit the uses of personal, user information gathered online or require online services to establish privacy policies. The Federal Trade Commission has adopted regulations regarding the collection and use of personal identifying information obtained from children under 13 years of age. Bills proposed in Congress would extend online privacy protections to adults. Moreover, proposed legislation in the United States and existing laws in other countries require companies to establish procedures to notify users of privacy and security policies, obtain consent from users for collection and use of personal information, and/or provide users with the ability to access, correct and delete personal information stored by companies. These data protection regulations and enforcement efforts may restrict our ability to collect demographic and personal information from users, which could be costly or harm our marketing efforts. Further, any violation of privacy or data protection laws and regulations may subject us to fines, penalties and damages and may otherwise have material adverse effect on our financial condition.

We may be subject to liability for the content that we publish.

As a publisher of catalogs and online content, we face potential liability for intellectual property infringement and other claims based on the information and other content contained in our catalogs and website. In the past, parties have brought these types of claims and sometimes successfully litigated them against online services. If we incur liability for our catalog or online content, our financial condition could be affected adversely.

We may need additional financing and may not be able to obtain additional financing on favorable terms or at all, which could increase our costs, limit our ability to grow and dilute the ownership interests of existing stockholders.

We may need to raise additional capital in the future to open additional studios, to facilitate long-term expansion, to respond to competitive pressures or to respond to unanticipated financial requirements. We may not be able to obtain additional financing on commercially reasonable terms or at all. A failure to obtain additional financing or an inability to obtain financing on acceptable terms could require us to incur indebtedness that has high rates of interest or substantial restrictive covenants, issue equity securities that will dilute the ownership interests of existing stockholders, or scale back, or fail to address opportunities for expansion or enhancement of, our operations.

Our inability to obtain commercial insurance at acceptable prices might have a negative impact on our business.

During fiscal year 2005, we did not experienced a substantial increase in the costs of insurance compared to that spent in prior years. We believe that extensive commercial insurance coverage is prudent for risk management and anticipate that our insurance costs may continue to increase substantially. However, for certain types or levels of risk (e.g., risks associated with earthquakes or terrorist attacks), we might determine that we cannot obtain commercial insurance at acceptable prices. Therefore, we might choose to forego or limit our purchase of relevant commercial insurance, choosing instead to self-insure one or more types or levels of risks. If we suffer a substantial loss that is not covered by commercial insurance, the loss and attendant expenses could have a material adverse effect on our operating results.

Anti-takeover provisions in our organizational documents and Delaware law make any change in control more difficult. This could affect our stock price adversely.

Our amended and restated certificate of incorporation and bylaws contain provisions that may delay or prevent a change in control, discourage bids at a premium over the market price of our common stock and affect adversely the market price of our common stock and the voting and other rights of the holders of our common stock. These provisions include:

• the division of our board of directors into three classes serving staggered three-year terms;

• prohibiting our stockholders from calling a special meeting of stockholders;

• our ability to issue additional shares of our common stock or preferred stock without stockholder approval;

• prohibiting our stockholders from making certain changes to our amended and restated certificate of incorporation or bylaws except with two-thirds stockholder approval; and

• Advance notice requirements for raising matters of business or making nominations at stockholders’ meetings.

We are also subject to provisions of the Delaware corporation law that, in general, prohibit any business combination with a beneficial owner of 15% or more of our common stock for five years unless the holder’s acquisition of our common stock was approved in advance by our board of directors.

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Our costs have increased and may continue to increase as a result of being a public company, and complying with regulations applicable to public companies may adversely affect our business.

As a public company, we have incurred and will continue to incur significant legal, accounting and other expenses that we did not incur as a private company. In addition, the Sarbanes-Oxley Act of 2002, as well as new rules subsequently implemented by the SEC and the Nasdaq National Market, have required changes in corporate governance practices of public companies. We expect these new rules and regulations to significantly increase our legal and financial compliance costs and to make some activities more time-consuming and costly. For example, in connection with becoming a public company, we created additional board committees and adopted policies regarding internal controls and disclosure controls and procedures. In addition, we are in the process of evaluating our internal control structure in relation to Section 404 of the Sarbanes-Oxley Act and, pursuant to this section, we will be required to include management and auditor reports on internal controls as part of our annual report for the year ending December 31, 2005. We will incur additional costs in, and dedicate significant resources toward, complying with these requirements, which may divert management’s attention from, and which may in turn adversely affect, our business. We also expect these new laws, rules and regulations to make it more difficult and more expensive for us to obtain director and officer liability insurance and we may be required to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. As a result, it may be more difficult for us to attract and retain qualified persons to serve on our board of directors or as executive officers. We are currently evaluating and monitoring developments with respect to these new laws, rules and regulations, and we cannot predict or estimate the amount of additional costs we may incur or the timing of such costs. The costs of compliance or our failure to comply with these laws, rules and regulations could adversely affect our reputation, financial condition, results of operation and the price of our common stock.

Risks Relating to the Securities Markets and Ownership of Our Common Stock

Our stock price may be volatile and you may lose all or a part of your investment.

Our common stock had not been publicly traded prior to our initial public offering, which was completed in July 2004, and an active trading market may not develop or be sustained. The market price of our common stock may be subject to significant fluctuations. It is possible that in some future periods our results of operations may be below the expectations of securities analysts who may choose to follow our common stock, if any, and investors. If this occurs, our stock price may decline. Factors that could affect our stock price include the following:

• actual or anticipated fluctuations in our operating results;

• Changes in securities analysts’ recommendations or estimates, if any, of our financial performance;

• publication of research reports by analysts, if any;

• Changes in market valuations of similar companies;

• announcements by us, our competitors or other retailers;

• additions or departures of key personnel;

• the trading volume of our common stock in the public market;

• general economic conditions;

• financial market conditions;

• changes in accounting principles or policies, including the requirement to treat, with effect from the third quarter of 2005, stock option grants as an operating expense;

• acts of terrorism; and

• war or threats of war.

In addition, the stock markets have experienced significant price and trading volume fluctuations, and the market prices of retail companies in particular have been extremely volatile and have recently experienced sharp share price and trading volume changes. These broad market fluctuations may adversely affect the trading price of our common stock.

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Securities analysts may not cover our common stock or may issue negative reports, and this may have a negative impact on our common stock’s market price.

Securities analysts may not cover our common stock. If securities analysts do not cover our common stock, the lack of research coverage may adversely affect our common stock’s market price. The trading market for our common stock will rely in part on the research and reports that industry or financial analysts publish about us or our business. If one or more of the analysts who cover us downgrades our common stock, our common stock price would likely decline rapidly. If one or more of these analysts ceases coverage of our company, we could lose visibility in the market, which in turn could cause our common stock price to decline. In addition, recently-adopted rules mandated by the Sarbanes-Oxley Act, and a global settlement reached between the SEC, other regulatory analysts and a number of investment banks in April 2003 has led to a number of fundamental changes in how analysts are reviewed and compensated. In particular, many investment banking firms will now be required to contract with independent financial analysts for their stock research. It may be difficult for companies with smaller market capitalizations, such as our company, to attract independent financial analysts that will cover our common stock, which could have a negative effect on the market price of our common stock.

Our directors and executive officers hold a substantial portion of our common stock, which may lead to conflicts with other stockholders over corporate transactions and other corporate matters.

Our directors and executive officers beneficially own approximately 19.6% of our outstanding common stock, including options to purchase shares of our common stock that are exercisable within 60 days after October 1, 2005. These stockholders, acting together, may be able to influence all matters requiring stockholder approval, including the election of directors and significant corporate transactions such as mergers or other business combinations. This control may delay, deter or prevent a third party from acquiring or merging with us, which could adversely affect the market price of our common stock.

Future sales of our common stock may depress our stock price.

Persons who were our stockholders prior to the sale of shares in our initial public offering continue to hold a substantial number of shares of our common stock that they will be able to sell in the public market in the near future. Significant portions of these shares are held by a small number of stockholders. Sales by our current stockholders of a substantial number of shares, or the expectation that such sales may occur, could significantly reduce the market price of our common stock. These sales also could impede our ability to raise future capital.

We do not intend to pay dividends on our common stock.

We have never declared or paid any cash dividends on our common stock and do not intend to pay dividends on our common stock for the foreseeable future. We intend to invest our future earnings, if any, to fund our growth. Therefore, you are not likely to receive any dividends from us on our common stock for the foreseeable future.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Our initial public offering of common stock was effected through a Registration Statement on Form S-1 (File No. 333-113903) that was declared effective by the Securities and Exchange Commission on June 29, 2004. On July 6, 2004, 3,000,000 shares of our common stock were sold on our behalf at an initial public offering price of $12.00 per share, for an aggregate offering price of $36.0 million, and 1,715,000 shares of our common stock were sold on behalf of certain selling stockholders at an initial public offering price of $12.00 per share, for an aggregate offering price of $20.6 million. The initial public offering was managed by CIBC World Markets Corp., William Blair & Co., L.L.C. and SG Cowen & Co., LLC.

We paid to the underwriters underwriting discounts and commissions totaling approximately $2.5 million in connection with the offering. In addition, we incurred additional expenses of $1.6 million in connection with the offering, which when added to the underwriting discounts and commissions paid by us, amounts to total expenses of $4.1 million. Thus, the net offering proceeds to us, after deducting underwriting discounts and commissions and offering expenses, were $31.8 million. No offering expenses were paid directly or indirectly to any of our directors or officers (or their associates) or persons owning ten percent or more of any class of our equity securities or to any other affiliates.

We intend to use the net proceeds from this offering as follows:

• between approximately $15 million and $18 million to finance the opening of additional studios;

• to pay all of the indebtedness outstanding under our bank credit facility, approximately $3.6 million; and

• the remaining net proceeds for other general corporate purposes, including working capital.

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We also may use a portion of the net proceeds for the acquisition of complementary businesses or products in the event that an attractive opportunity presents itself in the future. We have no current agreements or commitments with respect to any acquisition. Pending application of the net proceeds, we will invest the net proceeds in short-term, investment-grade, interest-bearing securities.

Item 5. Other Information

On November 10, 2005, Wayne Badovinus resigned from his position on our Board of Directors.

Item 6. Exhibits

Exhibit Number		Exhibit Title
3.01	(1)	Amended and Restated Certificate of Incorporation
3.02	(3)	Amended and Restated Bylaws
4.01	(2)	Form of Specimen Common Stock Certificate
4.03	(1)	Investors’ Rights Agreement, dated May 12, 2000, by and among Design Within Reach, Inc. and the investors named therein
4.04	(1)	Amendment to Investors’ Rights Agreement, dated May 8, 2003, by and among Design Within Reach, Inc. and the investors named therein
10.01	(1)	Form of Indemnification Agreement entered into by Design Within Reach, Inc. and its directors and executive officers
10.02	(1)	Sublease Agreement, dated October 23, 2003, by and between National Broadcasting Company, Inc. and Design Within Reach, Inc.
10.03	(1)	Lease Agreement, dated October 2, 2003, by and between Dugan Financing LLC and Design Within Reach, Inc.
10.04	(1)	Design Within Reach, Inc. 1999 Stock Plan, amended as of October 29, 2003
10.05	(2)	Design Within Reach, Inc. 2004 Equity Incentive Award Plan
10.06	(1)	Design Within Reach, Inc. Employee Stock Purchase Plan
10.07	(1)	Credit Agreement, dated as of July 10, 2002, by and between Design Within Reach, Inc. and Wells Fargo HSBC Trade Bank, N.A.
10.08	(1)	First Amendment to Credit Agreement, dated as of July 30, 2003, by and between Design Within Reach, Inc. and Wells Fargo HSBC Trade Bank, N.A.
10.09	(1)	Second Amendment to Credit Agreement, dated as of November 18, 2003, by and between Design Within Reach, Inc. and Wells Fargo HSBC Trade Bank, N.A.
10.10	(1)	Private Label Credit Card Program Agreement, dated as of November 13, 2003, between World Financial Network National Bank and Design Within Reach, Inc.
10.11	(1)	Offer of Employment Letter dated February 22, 2000 between Design Within Reach, Inc. and Wayne Badovinus
10.13	(2)	Letter Agreement, dated February 9, 2004, by and between Design Within Reach, Inc. and JH Partners, LLC, formerly known as Jesse.Hansen&Co.
10.14	(4)	Third Amendment to Credit Agreement, dated as of June 3, 2004, by and between Design Within Reach, Inc. and Wells Fargo HSBC Trade Bank, N.A.
10.15	(5)	Offer of Employment Letter dated June 1, 2004 between Design Within Reach, Inc. and Tara Poseley
10.16	(5)	Form of Option Agreement under Design Within Reach, Inc. 2004 Equity Incentive Award Plan
31.01		Certification of Chief Executive Officer pursuant to Rules 13a-14 and 15d-14 promulgated under the Securities Exchange Act of 1934
31.02		Certification of Chief Financial Officer pursuant to Rules 13a-14 and 15d-14 promulgated under the Securities Exchange Act of 1934
32*		Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(1) Incorporated by reference to the same-numbered exhibit (except where otherwise noted) to the Registration Statement on Form S-1 (No. 333-113903) filed on March 24, 2004, as amended.

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Exhibit
Number
Exhibit Title

(2) Incorporated by reference to the same-numbered exhibit (except where otherwise noted) to Amendment No. 1 to Registration Statement on Form S-1 (No. 333-113903) filed on May 17, 2004, as amended.

(3) Incorporated by reference to the same-numbered exhibit (except where otherwise noted) to Amendment No. 2 to Registration Statement on Form S-1 (No. 333-113903) filed on June 1, 2004, as amended.

(4) Incorporated by reference to the same-numbered exhibit (except where otherwise noted) to Amendment No. 3 to Registration Statement on Form S-1 (No. 333-113903) filed on June 10, 2004, as amended.

(5) Incorporated by reference to the same-numbered exhibit to the Company’s Annual Report on Form 10-K for the fiscal year ended January 1, 2005 filed on February 17, 2005.

* These certifications are being furnished solely to accompany this annual report pursuant to 18 U.S.C. Section 1350, and are not being filed for purposes of Section 18 of the Securities Exchange Act of 1934 and are not to be incorporated by reference into any filing of Design Within Reach, Inc., whether made before or after the date hereof, regardless of any general incorporation language in such filing.

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SIGNATURES

Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Dated: November 15, 2005

/s/ KEN LA HONTA

Ken La Honta

Chief Financial Officer and Secretary

(Duly authorized Officer and

Principal Financial Officer)

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