Design Within Reach (DWRI) 10-Q 2006 Q3 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 April 1, 2006

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 a shell company (as defined in Rule 12b-2 of the Exchange Act).  ¨  Yes    x  No.

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

Large accelerated filer  ¨                Accelerated filer  x                Non-accelerated filer  ¨

The number of outstanding shares of the registrant’s common stock, par value $0.001 per share, as of May 8, 2006 was 14,329,795.

DESIGN WITHIN REACH, INC.

FORM 10-Q — QUARTERLY REPORT

FOR THE QUARTERLY PERIOD ENDED APRIL 1, 2006

TABLE OF CONTENTS

		Page No
PART I – FINANCIAL INFORMATION
Item 1	Financial Statements	3
	Condensed Balance Sheets (unaudited) as of April 1, 2006, December 31, 2005 and April 2, 2005	3
	Condensed Statements of Earnings (unaudited) for the thirteen week periods ended April 1, 2006 and April 2, 2005	4
	Condensed Statements of Cash Flows (unaudited) for the thirteen week periods ended April 1, 2006 and April 2, 2005	5
	Notes to Unaudited Condensed Financial Statements	6
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12
Item 3	Quantitative and Qualitative Disclosure about Market Risk	19
Item 4	Controls and Procedures	19
PART II – OTHER INFORMATION
Item 1A	Risk Factors	25
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	37
Item 3	Defaults Upon Senior Securities	37
Item 4	Submission of Matters to a Vote of Security Holders	37
Item 5	Other Information	37
Item 6	Exhibits	37
SIGNATURES		39

2

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

Design Within Reach, Inc.

Condensed Balance Sheets

(Unaudited)

(amounts in thousands, except per share data)

	April 1, 2006			December 31, 2005			April 2, 2005
							(restated)
ASSETS
Current assets
Cash and cash equivalents	$	990		$	3,428		$	2,684
Investments		8,250			9,652			13,500
Inventory		38,492			31,239			25,771
Accounts receivable (less allowance for doubtful accounts of $265, $253 and $23)		2,138			1,568			1,863
Prepaid catalog costs		1,252			1,237			2,053
Deferred income taxes		2,290			2,569			5,814
Other current assets		4,517			4,125			2,797
Total current assets		57,929			53,818			54,482
Property and equipment, net		26,592			25,474			22,243
Non-current investments		—			—			2,953
Deferred income taxes, net		9,694			7,365			1,201
Other non-current assets		885			676			579
Total assets	$	95,100		$	87,333		$	81,458
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable	$	23,121		$	18,056		$	13,875
Accrued expenses		8,360			5,415			5,919
Deferred revenue		3,354			1,690			2,024
Customer deposits and other liabilities		1,854			2,898			2,208
Bank credit facility		1,649			—			—
Capital lease obligation, current portion		105			114			112
Total current liabilities		38,443			28,174			24,138
Deferred rent and lease incentives		5,131			4,470			2,543
Capital lease obligation		—			22			112
Deferred income tax liabilities		1,127			1,127			1,042
Total liabilities		44,701			33,793			27,835
Commitments and Contingencies
Stockholders’ equity
Preferred stock – $0.001 par value; 10,000 shares authorized; no shares issued and outstanding		—			—			—
Common stock – $0.001 par value; authorized 30,000 shares; issued and outstanding, 14,328, 14,042 and 13,739 shares		14			14			14
Additional paid-in capital		55,774			55,756			53,243
Deferred compensation		—			(628	)		(1,345	)
Accumulated other comprehensive loss		(359	)		(789	)		(431	)
Accumulated earnings (deficit)		(5,030	)		(811	)		2,142
Total stockholders’ equity		50,399			53,542			53,623
Total liabilities and stockholders’ equity	$	95,100		$	87,333		$	81,458

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

3

Design Within Reach, Inc.

Condensed Statements of Earnings

(Unaudited)

(amounts in thousands, except per share data)

	Thirteen weeks ended
	April 1, 2006			April 2, 2005
Net sales	$	34,970		$	35,465
Cost of sales		20,588			19,927
Gross margin		14,382			15,538
Selling, general and administrative expenses		21,010			14,207
Earnings (loss) from operations		(6,628	)		1,331
Other income (expense):
Interest income		86			115
Interest expense		(49	)		(10	)
Other income (expense), net		43			2
Total Other income		80			107
Earnings (loss) before income taxes		(6,548	)		1,438
Income tax expense (benefit)		(2,329	)		554
Net earnings (loss)	$	(4,219	)	$	884
Net earnings (loss) per share:
Basic	$	(0.30	)	$	0.07
Diluted	$	(0.30	)	$	0.06
Weighted average shares used in calculation of net earnings per share:
Basic		14,230			13,131
Diluted		14,230			14,706

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

4

Design Within Reach, Inc.

Condensed Statements of Cash Flows

(Unaudited)

(amounts in thousands)

	Thirteen weeks ended
	April 1, 2006			April 2, 2005
				(restated)
Cash flows from operating activities
Net earnings (loss)	$	(4,219	)	$	884
Adjustments to reconcile net earnings (loss) to net cash used in operating activities:
Depreciation and amortization		2,200			1,067
Stock-based compensation		487			155
Ineffectiveness loss of derivatives		29			—
Loss on the sale/disposal of long-lived assets		4			—
Change in assets and liabilities:
Accounts receivable, net		(570	)		(519	)
Inventory		(6,707	)		(4,971	)
Prepaid catalog costs		(15	)		(191	)
Other assets		(599	)		(1,101	)
Accounts payable		5,065			(1,495	)
Accrued expenses		1,992			1,251
Deferred revenue		1,664			10
Customer deposits and other liabilities		(909	)		213
Deferred rent and lease incentives		661			669
Deferred income taxes		(2,328	)		2
Net cash used in operating activities		(3,245	)		(4,026	)
Cash flows from investing activities
Purchases of property and equipment, net		(2,381	)		(4,738	)
Sales of property and equipment, net		12			—
Purchases of investments		(8,225	)		(5,700	)
Sales of investments		9,625			14,779
Net cash provided by (used in) investing activities		(969	)		4,341
Cash flows from financing activities
Proceeds from issuance of common stock, net of expenses		158			1,322
Borrowing on bank credit facility		1,649			—
Repayments of long term obligations		(31	)		(28	)
Net cash provided by financing activities		1,776			1,294
Net increase (decrease) in cash and cash equivalents		(2,438	)		1,609
Cash and cash equivalents at beginning of period		3,428			1,075
Cash and cash equivalents at end of period	$	990		$	2,684
Supplemental disclosure of cash flow information
Cash paid during the period for:
Income taxes	$	55		$	1,497
Interest	$	49		$	10
Non cash investing and financing activities:
Unrealized (loss) on investments	$	(2	)	$	(2	)

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

5

Design Within Reach, Inc.

Notes to the Condensed Financial Statements

(Unaudited)

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 2005 fiscal year ended on December 31, 2005 and its 2006 fiscal year will end on December 30, 2006. Fiscal year 2005 consists of 52 weeks and fiscal year 2006 consists of 52 weeks.

In connection with the preparation of its financial statements for the quarter ended April 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:

(in thousands)	As Reported		Adjustment			As Restated
As of April 2, 2005:
Cash and cash equivalents	$	12,147	$	(9,463	)	$	2,684
Current investments		6,990		6,510			13,500
Noncurrent investments		—		2,953			2,953

Quarterly information (unaudited)

The accompanying unaudited condensed interim financial statements as of and for the fiscal quarters ended April 1, 2006 and April 2, 2005 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 December 31, 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 April 1, 2006 and April 2, 2005 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 is carried at a computed average cost which approximates a first-in first-out method and the lower of cost or market. As of April 1, 2006 and April 2, 2005, inventory was $38.5 million and $25.8 million, net of write-downs of $2.3 million and $1.2 million, 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 April 1, 2006 and April 2, 2005, the Company recorded inventory in transit of $7.0 million and $5.5 million, respectively.

6

Accounts Payable

The accounts payable amounts on the condensed balance sheets include approximately $5.8 million and $1.3 million, as of April 1, 2006 and April 2, 2005, respectively, representing outstanding checks in excess of the cash balances in the Company’s bank accounts with Wells Fargo Trade Bank, N.A.

Stock-based Compensation

Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123R, Share-Based Payment (“SFAS 123R”). SFAS 123R supersedes the Company’s previous accounting under Accounting Principles Board Opinion No. 25, Accounting for Stock issued to Employees (“APB 25”), for periods beginning in fiscal 2006. Under APB 25, the Company accounted for stock options under the intrinsic value method. Accordingly, the Company only recognized expense related to employee stock options granted at an exercise price below the fair value of the underlying stock on the grant date. The Company did not recognize any expense related to employee stock options granted at an exercise price equal to the fair value of the underlying stock on the grant date.

The Company adopted SFAS 123R using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of the Company’s fiscal year 2006. Under the modified prospective method, compensation expense recognized includes the estimated expense for stock options granted on and subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123R, and the estimated expense for the portion vesting in the period for options granted prior to, but not vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123. The Company’s condensed financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123R. See “Note 2—Stock-based Compensation” for additional related disclosures.

Prior to adopting SFAS 123R, the Company recorded deferred stock-based compensation charges in the amount by which the exercise prices of certain options were less than the fair value of the Company’s common stock at the date of grant under the intrinsic value method of accounting as defined by the provisions of APB 25. The Company previously disclosed the fair value of its stock options under the provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock Based Compensation (“SFAS No. 123”). The Company accounted for stock-based employee compensation arrangements in accordance with the provisions of APB 25 and complied 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 accounted for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123 and related interpretations.

Comprehensive Loss

Comprehensive loss for the thirteen weeks ended April 1, 2006 and April 2, 2005 was as follows:

	Thirteen weeks Ended
(in thousands)	April 1, 2006			April 2, 2005
	(unaudited)
Net earnings (loss)	$	(4,219	)	$	884
Other comprehensive loss:
Unrealized loss on available for sale securities		(2	)		(2	)
Change in activity related to derivatives		432			(911	)
Comprehensive loss	$	(3,789	)	$	(29	)

7

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
(in thousands)	April 1, 2006	April 2, 2005
	(unaudited)
Shares used to compute basic earnings (loss) per share	14,231	13,131
Add: Effect of dilutive options outstanding	—	1,575
Shares used to compute diluted earnings (loss) per share	14,231	14,706

For the thirteen weeks ended April 1, 2006, approximately 328,000 shares have been excluded from the calculation of diluted loss per share 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 inventory reserves to reflect inventory carried at the lower of cost or market, estimates of fair value used in calculating the value of stock-based compensation (including estimated volatility and terms), estimates of future forfeiture rates to determine net stock-based compensation, estimates of expected future cash flows and useful lives 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, estimates of freight costs used to calculate accrued liabilities 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 May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections - a replacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. This statement is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of SFAS 154 did not have an impact on the Company’s financial statements.

In November 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 151, “Inventory Costs - an amendment of ARB No. 43, Chapter 4.” SFAS 151 is an amendment of Accounting Research Board Opinion No. 43 and sets standards for the treatment of abnormal amounts of idle facility expense, freight, handling costs and spoilage. SFAS 151 is effective for fiscal years beginning after June 15, 2005. The adoption of SFAS 151 did not have a material impact on the Company’s financial statements.

In June 2005, the Emerging Issues Task Force (“EITF”) reached consensus on EITF 05-6, “Determining the Amortization Period for Leasehold Improvements.” Under EITF 05-6, leasehold improvements placed in service significantly after and not contemplated at or near the beginning of the lease term, should be amortized over the lesser of the useful life of the assets or a term that includes renewals that are reasonably assured at the date the leasehold improvements are purchased. EITF 05-6 is effective for periods beginning after June 29, 2005. The adoption of EITF 05-6 did not have a material impact on the Company’s financial statements.

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140.” SFAS 155 permits fair value measurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. This statement is effective for all financial instruments acquired or issued after the beginning of an entity’s fiscal year that begins after September 15, 2006. The Company does not expect the adoption of SFAS 155 to have a material impact on the Company’s financial statements.

Note 2 – Stock-based Compensation

Stock Options Plans

In 1999, the Company adopted the 1999 Stock Plan (the “1999 Plan”) which allows for the issuance of incentive stock options and nonstatutory stock options to purchase shares of the Company’s common stock. The Company has reserved a total of 3,100,000 shares for issuance under the 1999 Plan.

In 2004, the Company adopted the 2004 Equity Incentive Award Plan (the “2004 Plan” and together with the 1999 Plan, the “Plans”) which allows for the issuance of incentive stock options and nonstatutory stock options to purchase shares of the Company’s common stock. The Company has reserved a total of 500,000 shares for issuance under the 2004 Plan.

8

Options granted under the Plans are for periods not to exceed ten years, and must be issued at prices not less than 100% of the fair market value for incentive stock options and not less than 85% of fair market value for nonstatutory options. Stock options granted to stockholders who own greater than 10% of the outstanding stock must be issued at prices not less than 110% of the fair market value of the stock on the date of grant. Options granted under the Plans generally vest within three to four years. The Plans allow certain options to be exercised prior to the time such options are vested. All unvested shares are subject to repurchase at the exercise price paid for such shares, at the option of the Company.

Employee Stock Purchase Plan

In 2004, the Company adopted an Employee Stock Purchase Plan (the “ESPP”). The ESPP allows employees to purchase Company common stock at a 15% discount to the market price through payroll deductions at the beginning or end of the offering period, whichever is less. The ESPP operates through a series of concurrent twelve-month offering periods. Except for the first offering period, these offering periods generally start on the first trading day on or after May 1st and November 1st of each year and end, respectively, on the last trading day of the next October and April. The Company initially registered 300,000 shares of Common Stock for purchase under the ESPP. The reserve automatically increases on each December 31 during the term of the plan by an amount equal to the lesser of (1) 100,000 shares or (2) a lesser amount determined by the board of directors.

Accounting for Stock-based Compensation

Under SFAS 123R, the Company recognized $487,000, or $0.03 per share net of $116,000 tax benefit, of stock-based compensation expense related to stock options and employee stock purchases in the thirteen weeks ended April 1, 2006. Stock-based compensation expense is included in Selling, General and Administrative Expenses. Prior to adoption of SFAS 123R, the Company recorded approximately $155,000, or $0.01 per share, in amortized expenses for deferred stock-based compensation in accordance with APB 25 for the thirteen weeks ended April 2, 2005. Upon adoption of SFAS 123R, the balance of $628,000 of deferred compensation was charged to additional paid-in capital.

The table below reflects net earnings and diluted net earnings per share had compensation expense been recognized in accordance with SFAS 123 for the thirteen weeks ended April 2, 2005 (in thousands except per share amounts):

	Thirteen weeks Ended April 2, 2005
Net earnings:
As reported	$	884
Add stock-based employee compensation expense included in net earnings, net of tax		95
Less total stock-based employee compensation expense determined under fair value method for all awards, net of taxes		(264	)
Pro forma net earnings	$	715
Basic earnings per common share:
As reported (1)	$	0.07
Including the effect of stock-based compensation expense	$	0.05
Diluted earnings per common share:
As reported (1)	$	0.06
Including the effect of stock-based compensation expense	$	0.05

(1) Net earnings and net earnings per share prior to fiscal 2006 did not include stock-based compensation expense for employee stock options and employee stock purchases under SFAS 123 because the Company did not adopt the recognition provisions of SFAS 123.

Upon adoption of SFAS 123R, the Company continues to calculate the fair value of each employee stock option, estimated on the date of grant, using the Black-Scholes model in accordance with SFAS 123R. The weighted-average estimated value of employee stock options granted during the thirteen weeks ended April 1, 2006 and April 2, 2005 was $4.14 per share and $6.28 per share, respectively using the following weighted-average assumptions:

	Thirteen weeks Ended
	April 1, 2006		April 2, 2005
Expected volatility	61.0	%	60	%
Risk-free interest rate	4.4	%	4.0	%
Dividend yield	0.0	%	0.0	%
Expected life (years)	6		5

9

The Company used a blended volatility rate using a combination of historical stock price and market-implied volatility for traded and quoted options on the equities for the group of retail companies for which exchange traded options are observed. Prior to the first quarter of fiscal 2006, the Company used a historical volatility rate in accordance with SFAS 123 for purposes of its pro forma information.

The risk-free interest rate assumption is based upon the average daily closing rates during the quarter for U.S. treasury notes that have a life which approximates the expected life of the option. The dividend yield assumption is based on the Company’s history and expectation of dividend payouts.

The expected life of employee stock options is based on the simplified method of estimating expected life in accordance with SAB 107. Under the guidance of SAB 107, companies with “plain vanilla” options may use the simplified method to calculate the expected term. This method is available until December 31, 2007. The Company plans to make a refined estimate of expected term before that date.

Beginning the first quarter of 2006, the Company began using an estimated forfeiture rate of 11% based on historical data. Prior to 2006, the Company assumed a 0% forfeiture rate in its calculation of the SFAS 123 pro forma disclosure. SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

Stock option activity for the thirteen weeks ended April 1, 2006 was as follows:

	Shares Subject to Options (in thousands)		Wtd. avg. exercise price		Wtd. avg. Contractual Remaining Life (in yrs.)	Aggregate Intrinsic Value
Options outstanding at January 1, 2006	1,717		$	7.98	7.9
Options granted	244			6.83
Options exercised	(282	)		0.56
Options terminated, cancelled or expired	(78	)		9.11
Options outstanding at April 1, 2006	1,601		$	9.06	8.3	$	—
Options exercisable at April 1, 2006	925		$	8.37	7.6		—

At April 1, 2006, 251,013 shares were available for future grants under the terms of the Plans.

For the thirteen weeks ended April 1, 2006, the fair value of stock options vested was $4.7 million.

At April 1, 2006, the Company had approximately $5.7 million of total unrecognized compensation expense, related to stock option plans that will be recognized over the remaining weighted average period of 2.6 years. Cash received from stock option exercises was approximately $158,000 and the total intrinsic value of options exercised was approximately $1.8 million for the thirteen weeks ended April 1, 2006.

Note 3 – Income Taxes

In the first quarter 2006, the Company recorded a tax benefit of $2.3 million. The Company’s effective tax rate of 35.6% differs from the federal statutory tax rate of 34% due primarily to the impact of state taxes and permanent book-to-tax differences, which include tax-free interest income received from municipal bonds. The Company’s 2003 income tax returns are currently being audited by the Internal Revenue Service. Management believes that the outcome of the audit will not materially impact the financial statements.

Note 4 – Bank Credit Facility

During the first quarter of 2006, the Company borrowed $1.6 million against the operating credit line. As of April 1, 2006, $1.0 million of stand-by letters of credit were outstanding under this facility and approximately $3.4 million was available to be drawn from the operating line of credit. As of April 1, 2006, the Company was not in compliance with financial covenants relating to net earnings and adjusted leverage ratios under our credit agreement. The Company received a waiver of default on May 16, 2006 covering breaches incurred through the thirteen weeks ended April 1, 2006. As a result, the Company’s ability to borrow under the line was not interrupted.

10

Note 5 – Related Party Transactions

The Company rents studio space from an affiliate of a member of the Board of Directors pursuant to a lease dated February 9, 2004. Rent expense related to this space was $40,500 and $25,000 for the thirteen weeks ended April 1, 2006 and April 2, 2005, 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. Cumulative amounts paid to the vendor from the inception of services through April 1, 2006 were approximately $5.1 million.

The Company made sales to certain members of its Board of Directors. These sales totaled approximately $9,400 and $3,800 for the thirteen weeks ended April 1, 2006 and April 2, 2005, respectively. The Company also made sales to employees. These sales totaled approximately $277,000 and $49,000 for the thirteen weeks ended April 1, 2006 and April 2, 2005, respectively.

Note 6 - 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 December 31, 2005 and April 1, 2006, the Company has entered into operating lease commitments for new studios increasing minimum lease obligations by $3.3 million.

11

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 December 31, 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 December 31, 2005 filed with the Securities and Exchange Commission on April 14, 2006.

Overview

Design Within Reach 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 phone sales, studios sales and online sales. We offer over 850 products 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.

Our business operates on the premise that multiple, integrated sales channels improve customer convenience, reinforce brand awareness, and enhance knowledge of our product, and our customers often use all of these channels in the course of making a purchase decision. We consider our catalog to be our primary marketing vehicle and tool for building brand awareness and educating the customer about our products and designers. Due to its higher ticket price, the furniture buying process can be a lengthy one, often leading the customer to contact us multiple times before making a purchase. We believe the seamless connection between our studios, website and catalog help to facilitate this process, and because many of our studio proprietors and sales associates are educated in design or have design related experience, we believe this helps to drive sales and provides a better customer experience.

We have experienced significant growth in customers and net sales since our founding in 1998. We began selling products through the phone and web in the second half of 1999, and we opened our first studio in November 2000. We base our decisions on where to open new studios by categorizing markets into “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 fiscal year 2006. Although most 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 recent years, we have continued to increase sales with particular growth in sales through our studios, which have increased in number from one at the end of 2001 to 58 studios operating in 21 states and the District of Columbia as of April 1, 2006. During fiscal year 2005, we opened new studios, many of them in smaller urban markets. This was our first significant studio deployment outside major metropolitan areas. We are currently monitoring and analyzing studio results in these areas, and have developed tailored advertising programs to drive awareness in these markets. During the thirteen weeks ended April 1, 2006, we opened two new studios. As of May 15, 2006, we have opened a total of 5 new studios since December 31, 2005, and we plan to open an additional 4 studios during the remainder of fiscal year 2006 that are currently under construction. As of May 15, 2006, we had signed leases for two additional studios, one new outlet, two expanded studios, two remodeled studios and one studio relocation. We expect to open 5 to 10 new studios in 2007, both in major and smaller urban markets.

All of our sales channels utilize a single common inventory held at our Hebron, Kentucky fulfillment center. Because we don’t offer a “cash and carry” option in our studios, we are able to more fully utilize selling space and avoid the operational issues that often arise with stock balancing and store replenishment. We currently source our products primarily in the U.S. and Europe. In fiscal year 2005, we purchased approximately 39% of our product inventories from manufacturers in foreign countries, 35.4% of which was paid for in Euros. Although we put a hedging strategy in place to mitigate the impact of currency fluctuations during the fourth quarter of 2004, we have not been satisfied with the results of this strategy. Consequently, we are evaluating our currency hedging strategy going forward and intend to make changes to it during fiscal year 2006. We also plan to increase our efforts to develop products internally and include more exclusive items in our mix, and in doing so, we will strive to source products in other parts of the world including Latin America and Asia. We believe this could favorably impact our product margins during fiscal year 2006, and help us better manage currency risk.

In May 2005, we converted our then existing information technology systems to new, custom-built systems supporting our product sourcing, merchandise planning, forecasting, inventory management, product distribution and transportation and price management. These information technology systems also are used to generate information for our financial reporting. 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

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new systems do not contain mechanisms to automatically identify and correct or reject erroneous or incomplete data. During the third quarter of fiscal year 2005, we hired a consulting firm to assess the inadequacies of the system. As a result of that review process, we plan to replace the existing system. Our existing system cost us approximately $5.1 million and the net book value was approximately $2.4 million as of April 1, 2006.

During the first quarter of 2006, we undertook a process to clearly define and document the requirements for the new system. During the second quarter of 2006, we expect to finalize the specifications for the new system, hire a consulting firm and begin the process of customizing, testing and implementing the new system. We are currently targeting an early fiscal year 2007 installation of the new system.

On July 6, 2004, we completed our initial public offering of 4,715,000 shares of common stock at $12.00 per share. Of the shares offered, 3,000,000 were sold by us and 1,715,000 were sold 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 $898,000 in this public offering, net of underwriting discounts and offering expenses.

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 2005 fiscal year ended on December 31, 2005 and our 2006 fiscal year will end of December 30, 2006. Fiscal year 2005 consists of 52 weeks and fiscal year 2006 consists of 52 weeks.

Results of Operations

Comparison of the thirteen weeks ended April 1, 2006 (First Quarter 2006) to April 2, 2005 (First Quarter 2005)

Net sales.Net sales decreased $0.5 million, or 1%, to $35.0 million in the First Quarter 2006, compared to $35.5 million in the First Quarter 2005 primarily due to more limited marketing activities in the First Quarter 2006, offset by an increase in the number of studios. In First Quarter 2005 we held promotional activities, such as our Founders Letter and sale offering a 10% discount on customer purchases—events which did not occur in First Quarter 2006. As a result, online and phone sales decreased $1.2 million, or 16%, and $1.2 million, or 22%, respectively, in the First Quarter 2006 compared to the First Quarter 2005 due to the increase of sales in our studio channel as well as decreased promotional activities discussed above. Studio sales increased $2.3 million or 12% to $20.9 million in First Quarter 2006 from $18.6 million in First Quarter 2005 primarily due to an increase in the number of studios. We had 58 studios open at the end of the First Quarter 2006 compared to 37 open at the end of the First Quarter 2005. Shipping and handling fees received from customers for delivery of merchandise decreased $0.4 million, or 11%, to $3.4 million in the First Quarter 2006 compared to $3.8 million in the First Quarter 2005 primarily due to free shipping offered to sales using our private label credit card and bedding product purchases.

	Thirteen weeks Ended
(in millions)	April 1, 2006		% of Net Sales		April 2, 2005		% of Net Sales		Change			% Change
Studio Sales	$	20.9	59.7	%	$	18.6	52.4	%	$	2.3		12	%
Online Sales		6.4	18.3	%		7.6	21.4	%		(1.2	)	(16	)%
Phone Sales		4.3	12.3	%		5.5	15.5	%		(1.2	)	(22	)%
Shipping and Handling Fees		3.4	9.7	%		3.8	10.7	%		(0.4	)	(11	)%
Net Sales	$	35.0	100	%	$	35.5	100	%	$	(0.5	)	(1	)%

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Cost of Sales. Cost of sales increased $0.7 million, or 3.3%, to $20.6 million in the First Quarter 2006 from $19.9 million in the First Quarter 2005. As a percentage of net sales, cost of sales increased to 58.9% in the First Quarter 2006 from 56.2% in First Quarter 2005. This increase is due primarily 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 $6.8 million, or 48%, to $21.0 million in the First Quarter 2006 from $14.2 million in the First Quarter 2005 primarily due to increases in salaries and benefits, occupancy and related costs and professional fees. As a percentage of net sales, SG&A expenses increased to 60.1% in the First Quarter 2006 from 40.1% in the First Quarter 2005. Increased amounts in salaries and benefits and occupancy and related expenses are primarily due to a 57% increase in the number of studios from 37 at the end of the First Quarter 2005 to 58 at the end of the First Quarter 2006. These expenses are expected to increase in future periods with studio expansion and growth. Also included in salaries and benefits is stock-based compensation. In conjunction with the adoption of SFAS 123R, we recorded compensation expense of approximately $487,000 or $0.03 per share, net of $116,000 tax benefit, related to stock options and employee stock purchases. In the First Quarter 2005, we recorded approximately $155,000 in amortized deferred stock based compensation in accordance with APB 25. Also included in occupancy and related expense is depreciation of long-lived assets. Depreciation expense increased to approximately $2.2 million in the First Quarter 2006 from approximately $1.1 million in the First Quarter 2005. Included in the increase is approximately $300,000 in additional depreciation expense related to our information technology systems due to our decision in the Fourth Quarter 2005 to shorten the expected life of the systems, which we plan to replace by early fiscal 2007. As a percentage of net sales, depreciation and amortization expenses increased to 6.3% of net sales in the First Quarter 2006 from 3.0% of net sales in the First Quarter 2005. These expenses increased primarily 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 expenses consist primarily of fulfillment and merchant fees which are directly related to sales volume as well as information systems and telecommunications, bank fees, and miscellaneous corporate expenses. Other expenses increased $0.3 million from $2.0 million in the First Quarter 2005 to $2.3 million in the First Quarter 2006 due to higher corporate expenses. The increase in professional fees, consisting of accounting, legal, consulting, and Sarbanes-Oxley compliance related fees, is primarily due to approximately $633,000 in consulting costs for Sarbanes-Oxley compliance—items which did not exist in the First Quarter 2005 and an increase in audit fees of approximately $753,000 incurred in the First Quarter 2006 compared to the First Quarter 2005. The following table details SG&A expenses:

	Thirteen weeks Ended
(in millions)	April 1, 2006		% of Net Sales		April 2, 2005		% of Net Sales		Change			% Change
Salaries and benefits	$	8.3	23.7	%	$	5.6	15.8	%	$	2.7		48	%
Occupancy and related expense		6.3	18.0	%		3.7	10.4	%		2.6		70	%
Catalog, advertising and promotion		2.1	6.1	%		2.5	7.0	%		(0.4	)	(16	)%
Other expenses		2.3	6.6	%		2.0	5.7	%		0.3		15	%
Professional – legal, consulting, SOX		2.0	5.7	%		0.4	1.2	%		1.6		400	%
Total SG&A	$	21.0	60.1	%	$	14.2	40.1	%	$	6.8		48	%

Other Income (Expense). In the First Quarter 2006, we recorded other income of approximately $43,000, consisting primarily of the rental of customer lists, which was offset by losses incurred from the disposal or sale of long-lived assets, compared to $2,000 in the First Quarter 2005. Interest income was approximately $86,000 in the First Quarter 2006 and $115,000 in the First Quarter 2005. The decrease is primarily due to higher investment and cash balances in the First Quarter 2005. We incurred approximately $49,000 of interest expense in the First Quarter 2006 and $10,000 in the First Quarter 2005 related to short-term borrowings under our bank credit facility for working capital purposes and for capital expenditures associated with new studios. The increase is due primarily to higher borrowings in the First Quarter 2006.

Income Taxes. We recorded an income tax benefit of approximately $2.3 million in the First Quarter 2006 and income tax expense of approximately $554,000 in the First Quarter 2005. Our effective tax rate was 35.6% due to permanent book-to-tax differences, which include incentive stock options and tax-free interest income from municipal bonds. Our combined federal and state statutory tax rate was 39.2%.

Net Earnings (Losses). As a result of the foregoing factors, net earnings of $0.9 million in the First Quarter 2005 decreased $5.1 million to a $4.2 million loss in the First Quarter 2006.

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Liquidity and Capital Resources

Cash, cash equivalents and investments: Cash, cash equivalents and investments consist of cash, auction rate securities and municipal bonds. As of April 1, 2006, cash, cash equivalents and investments were approximately $9.2 million. Working capital was $19.5 million and $30.3 million for the First Quarters ended April 1, 2006 and April 2, 2005, respectively.

Cash Flows

Net cash provided by (used in):

	Thirteen Weeks Ended
	April 1, 2006			April 2, 2005
	(In thousands)
Operating activities	$	(3,245	)	$	(4,026	)
Investing activities		(969	)		4,341
Financing activities		1,776			1,294

Net cash used in operating activities decreased in First Quarter 2006 compared to First Quarter 2005 due to an increase of $7.1 million in accounts payable and accrued expenses in the First Quarter 2006 related to timing differences of invoice receipts, compared to the First Quarter 2005; an increase in deferred revenue of $1.7 million in the First Quarter 2006 compared to the First Quarter 2005 due to a higher sales volume in the last week of the thirteen week period which is deferred for revenue recognition purposes; offset by a net loss of $4.2 million in the First Quarter 2006 compared to net earnings of $0.9 million in the First Quarter 2005; an increase of $6.4 million in inventory in the First Quarter 2006 compared to the First Quarter 2005 to support studio growth; and an increase of $2.3 million in deferred income taxes in the First Quarter 2006 compared to the First Quarter 2005.

Net cash provided by and used in investing activities for First Quarter 2006 and 2005 were primarily related to purchases of property and equipment for our studios, the implementation of new information technology systems and liquidation of investments. Purchases of property and equipment, net, totaled $2.4 million and $4.7 million in First Quarters 2006 and 2005, respectively. Purchases of $4.7 million for property and equipment in the First Quarter 2005 were a result of opening 5 studios compared to the opening of 2 studios in the First Quarter of 2006. Also, in the First Quarter 2005, property and equipment expenditures were made for the implementation of a new information technology system. We also had net cash provided from the net purchases and sales of investments of $1.4 million and $9.1 million in First Quarter 2006 and 2005, respectively, to fund new studio growth.

In each fiscal years 2006 and 2007, we anticipate that our investment in opening 5 to 10 new studios will be between approximately $4.0 million and $7.0 million. We invested $14.3 million for the opening of 23 studios opened in fiscal year 2005.

Net cash provided by financing activities in the First Quarter 2006 was comprised of borrowings against our bank credit facility of $1.6 million and $158,000 in issuance of common stock pursuant to our employee stock option plan. 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 $898,000 in our second public offering, net of underwriting discounts and offering expenses.

For the remaining thirty-nine weeks ending December 30, 2006, our capital requirements are primarily to fund the opening of 5 to 10 new studios and to fund negative cash flows from operations.

As of April 1, 2006, we had available a total of approximately $12.6 million in unused capital resources, not including cash flows we expect to generate from operating activities, for our future cash needs as follows:

• approximately $9.2 million in cash and investments; and

• approximately $3.4 million in availability under our working capital line of credit.

We generated a net loss of $4.2 million in the First Quarter 2006 and used cash in operations of $3.2 million during this period. We expect to generate negative net cash flows from operating activities and to continue incurring operating losses at least through the third quarter of 2006. With the borrowings available under our working capital facility, and assuming continued compliance with the

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covenants under those facilities, we believe that we will have sufficient capital resources to carry on our business at least through fiscal year 2006 and to fund the cash requirements described above.

Our board of directors has asked our new chief executive officer to work with management to propose a new business plan that would allow us to achieve positive cash flows from operations through fiscal year 2006. We do not expect this plan to show us achieving compliance with the covenants under our working capital line of credit for at least the second and third quarters of fiscal year 2006. If we do not comply with those covenant requirements, we would likely need to obtain covenant waivers or amendments prior to the third quarter of 2006. We cannot provide assurances that any such covenant waivers or amendments will be obtained, or that the lender will not require additional collateral, significant cash payments or additional incentives in connection with any such waivers or amendments.

Other than our working capital facility, we do not have any significant available credit, bank financing or other external sources of liquidity. We are exploring potential public and private debt and equity financing alternatives, including the sale from time to time of debt and equity securities. There is no assurance that we will be able to raise the amount of debt or equity capital required to meet our objectives. Our challenging financial circumstances may make the terms, conditions and cost of any available capital relatively unfavorable. If additional debt or equity capital is not readily available, we will be forced to scale back our operations.

Commitments

We have a secured revolving line of credit with Wells Fargo HSBC Trade Bank, N.A., as amended on December 23, 2005. This facility provides an overall credit line of $10.0 million comprised of a $5.0 million operating line of credit for working capital and $5.0 million in standby letters of credit. The letters of credit are for $2.5 million each in an equipment line of credit for the importation of furniture and another to secure lease deposits for new retail space. The 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 expires on November 30, 2007. Amounts borrowed under this line of credit bear interest at an annual rate equal to the lender’s prime lending rate. Interest accrued on this line is payable on the last day of each month. As of April 1, 2006, the interest rate for the operating line of credit was 7.50%. Amounts borrowed under the credit agreement are secured by the Company’s accounts receivable, inventory and equipment. The credit agreement also sets forth a number of affirmative and negative covenants to which we must adhere, including financial covenants and limitations of capital expenditures. As of April 1, 2006, $1.6 million of borrowings and $1.0 million of stand-by letters of credit were outstanding under this facility and approximately $3.4 million was available to be drawn from the operating line of credit. As of April 1, 2006, we were not in compliance with financial covenants to achieve positive net earnings and adjusted leverage ratios under our credit agreement. We received a waiver of default on May 16, 2006 covering breaches incurred through the thirteen weeks ended April 1, 2006. As a result, our ability to borrow under the line was not interrupted. However, as a condition to the waiver, we are required to amend the credit facility by May 31, 2006 to provide monthly financial statements, monthly borrowing bases and an increase the interest rate to Wells Fargo’s Prime Rate plus 0.25%. We are also required to deliver monthly projections to Wells Fargo. Final inventory advance rates will be determined by Wells Fargo after a third party conducts an inventory appraisal and Wells Fargo examines our collateral under the credit facility. However, if we are unable to return to compliance and maintain compliance with the covenants in the credit agreement or mandated by Wells Fargo, we may, in the future, be restricted from borrowing until we return to compliance with the covenants or we obtain an additional waiver, which may or may not be available to us.

Critical Accounting Policies

Our financial statements have been prepared in accordance with accounting principles generally accepted in the United States. 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. We record as deferred revenue any sales made in the last week of the reporting period for which we estimate delivery in the following period. Those estimated amounts are recorded as deferred revenue. We also record any payments received prior to the date goods are shipped to the customer as customer deposits. We use our third-party freight carrier information to estimate standard delivery times to various locations throughout the U.S. Sales are recorded net of estimated 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 estimated product returns was approximately $304,000 and $585,000 as of April 1, 2006 and April 2, 2005, respectively. 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.

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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 $1.9 million and $1.8 million for the thirteen weeks ended April 1, 2006 and April 2, 2005, respectively. 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.

Inventory. Inventory consists primarily of finished goods purchased from third-party manufacturers. Inventory on hand is carried at a computed average cost which approximates a first-in first-out method and the lower of cost or market. 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 April 1, 2006 and April 2, 2005, inventory reserves amounted to approximately $2.3 million and $1.2 million, respectively.

Stock-Based Compensation. In the First Quarter 2006, we adopted the modified prospective method for valuing stock options we grant in accordance with Statement of Financial Accounting Standards No. 123 (revised 2004),Share-Based Payment, or SFAS 123R. Under SFAS 123R, the Company recognized $487,000 or $0.03 per share, net of $116,000 tax benefit, of compensation expense related to stock options and employee stock purchases in the First Quarter 2006. Stock based compensation expense is classified in Selling, General and Administrative expenses. We calculate the value of each employee stock option, estimated on the date of grant, using the Black-Scholes model. The following assumptions are used in the model: (1) a blended volatility rate using a combination of historical stock price and market-implied volatility for traded and quoted options on the equities for the group of retail companies for which exchange traded options are observed, (2) a risk-free interest rate based upon the average daily closing rates during the quarter for U.S. treasury notes that have a life which approximates the expected life of the option, (3) a dividend yield based on historical and expected dividend payouts, (4) an expected life of employee stock options based on the simplified method allowed by SAB 107 and (5) a forfeiture rate based on historical data. We estimate forfeitures at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Prior to adopting SFAS 123R, we recorded deferred stock-based compensation charges in the amount by which the exercise prices of certain options were less than the fair value of our common stock at the date of grant under the intrinsic value method of accounting as defined by the provisions of Accounting Principles Board (“APB”) Statement No. 25, Accounting for Stock Issued to Employees. In the thirteen weeks ended April 2, 2005, we recognized approximately $155,000, or $0.01 per share, in deferred stock-based compensation expense. Upon adoption of SFAS 123R, the balance of $628,000 of deferred compensation was charged to additional paid-in capital.

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.

Advertising 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 $231,000 and $203,000 in the thirteen weeks ended April 1, 2006 and April 2, 2005, respectively.

Impairment 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. Management considers the following circumstances and events to assess the recoverability of carrying amounts: 1) a significant adverse change in the extent or manner in which long-lived assets are being used or in its physical condition, 2) an accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset, 3) a current-period operating or cash flow loss combined with a history of operating

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or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset, and 4) a current expectation that, more likely than not, a long-lived asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life. 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. In fiscal year 2005, we shortened the estimated useful lives for certain computer systems having a net book value of approximately $3.2 million from three years to 18 months as a result of our plans to replace them in fiscal year 2007. The impact of this change is anticipated to be an expense of approximately $1.2 million, or $0.09 per share, and $300,000, or $0.02 per share, in fiscal years 2006 and 2007, respectively. These amounts will reduce net income or increase net losses. The net book value as of April 1, 2006 is approximately $2.4 million.

Derivative and Hedging Activities.We record derivatives, particularly cash flow hedges for foreign currency, at fair value on our balance sheet, including embedded derivatives. We account for foreign currency option contracts on a monthly basis by recognizing the net cash settlement gain or loss on the call or put option in accumulated other comprehensive income (loss) and adjusting the carrying amount of the contract to market by recognizing any corresponding gain or loss in cost of goods sold as the underlying inventory which was hedged is sold in each reporting period. Our derivative positions are used only to manage identified exposures. Management evaluates our hedges for effectiveness at the time they are designated as well as throughout the hedge period. With respect to any derivative that is deemed ineffective, the ineffective portion is reported through earnings. Management evaluates the ineffectiveness of outstanding contracts when it is probable that the original forecasted transaction will change. The effective portion of changes in the fair value of cash flow hedges is recorded in other comprehensive income (loss) and is recognized in cost of sales when the underlying inventory is sold. We recorded approximately $29,000 for ineffectiveness in the first quarter of 2006. There were no amounts recorded for ineffectiveness in the first quarter of 2005.

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 the following: if we are unable to continue to increase our net sales while reducing our promotional discounts, our profitability may be impaired; if we fail to offer merchandise that our customers find attractive, the demand for our products may be limited; 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; our business depends, in part, on factors affecting consumer spending that are not within our control; our business will be harmed if we are unable to implement our growth strategy successfully; the expansion of our studio operations could result in increased expenses with no guarantee of increased earnings; if we do not manage our inventory levels successfully, our operating results will be adversely affected; we depend on domestic and foreign vendors, some of which are our competitors, for timely and effective sourcing of our merchandise; declines in the value of the U.S. dollar relative to foreign currencies could adversely affect our operating results; and we face intense competition and if we are unable to compete effectively, we may not be able to maintain profitability and the discussions set forth below under the caption “Risk Factors” and other factors detailed in this Quarterly Report on Form 10-Q for the thirteen weeks ended April 1, 2006.

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.

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

Foreign Currency 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, but we purchased approximately 39% of our product inventories from manufacturers in Europe, 35.4% of which were paid for in Euros. In fiscal year 2005, the value of the dollar increased approximately 10% relative to the Euro. However, we did not benefit significantly from this strengthening of the dollar because we made most of our fiscal year 2005 inventory purchases in the first part of the year when the dollar was still weak relative to the Euro and because of the costs associated with hedging contracts we purchased at a time when the dollar was relatively weak. The fact that much of our inventory was purchased in the early part of the year when the dollar was still weak relative to the Euro reflected an increased cost to us of merchandise sourced from Europe. Increases and decreases in the U.S. dollar relative to the Euro result in fluctuations in 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 option contracts with maturities of 12 months or less for purchases of merchandise based on forecasted demand at certain prices. We account for these contracts on a monthly basis in recognizing the net cash settlement gain or loss on the call or put option in accumulated other comprehensive income (loss) and adjusting the carrying amount of the contract to market by recognizing any corresponding gain or loss in cost of goods sold in each reporting period. Additionally, outstanding contracts are evaluated quarterly for ineffectiveness by evaluating changes in forecasted foreign purchases. In the first quarter 2006, our actual demand was less than our forecasted demand, and the amount of Euros we hedged was greater than the amount we needed for purchases of inventory. We are evaluating our currency hedging strategy going forward and will likely make changes to it later in fiscal year 2006. We are also working to diversify our mix of suppliers to reduce our dependence on Euro-denominated purchases. We plan to increase our efforts to develop products internally and include more exclusive items in our mix, and in doing so, we will strive to source products in other parts of the world, including Latin America and Asia. We believe this could favorably impact our product margins during fiscal year 2006, and help us better manage currency risk.

Future hedging transactions may or 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. Net activity on cash flow hedges reported in stockholders’ equity were approximately $432,000 and $911,000 during the First Quarters 2006 and 2005, respectively. The extent of this risk is not quantifiable or predictable because of the variability of the Euro and the forecasted demand of cost of goods.

With respect to any derivative that is deemed ineffective through management’s evaluation, the ineffective portion is reported through earnings by recording foreign currency losses in other expenses. Management evaluates the ineffectiveness of outstanding contracts when it is probable that the original forecasted transaction will change. The effective portion of changes in the fair value of cash flow hedges is recorded in other comprehensive income (loss) and is recognized in cost of sales when the underlying inventory is sold. We recorded approximately $29,000 for ineffectiveness in the first quarter 2006 and included that amount in other income (expense). There were no amounts recorded for ineffectiveness in the first quarter 2005.

Interest Rate Risk

Our investments are classified as available-for-sale. Available-for-sale securities are reported at market value. 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.

In addition, we have interest payable on our operating line of credit. Amounts borrowed under this line of credit bear interest at an annual rate equal to the lender’s prime lending rate. The extent of this risk is not quantifiable or predictable because of the variability of future interest rates and the future financing requirements. As of April 1, 2006, approximately $1.6 million borrowings were outstanding under this facility. Our interest expense would not increase or decrease materially for the thirteen weeks ended April 1, 2006 in the event of a 100 basis increase or decrease in interest rates.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We maintain “disclosure controls and procedures,” as such term is defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in United States Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to

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our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.

We carried out an evaluation, under the supervision and with the participation of management, including the chief executive officer and the chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rules 13a-15(b) and 15d-15(b). Based upon, and as of the date of this evaluation, the chief executive officer and the chief financial officer concluded that our disclosure controls and procedures were not effective because of the material weaknesses discussed in our Annual Report on Form 10-K as filed on April 14, 2006 for the year ended December 31, 2005, including our failure to maintain effective controls over or related to the following:

• Entity level controls;

• Period-end financial reporting processes;

• Segregation of duties;

• Access to our systems, financial applications, and data;

• Preparation of account analyses, account summaries and account reconciliations;

• Documentation of accounting policies and procedures;

• Records retention;

• Inventory management and merchandise accounts payable;

• Non-merchandise accounts payable;

• Costing and valuation of inventory;

• Recording of, and accounting for, fixed assets;

• Taxes computed by third-party experts;

• Revenue recognition and accounts receivable;

• Payroll processing;

• Treasury functions; and

• Spreadsheets used in our financial reporting process.

In light of these material weaknesses described more fully in our Annual Report on Form 10-K, we performed additional analysis and other post-closing procedures to ensure our consolidated financial statements are prepared in accordance with generally accepted accounting principles (GAAP) in the United States. Accordingly, management believes that the financial statements included in this report fairly present in all material respects our financial condition, results of operations and cash flows for the periods presented.

The certifications of our principal executive officer and principal financial officer required in accordance with Section 302 of the Sarbanes-Oxley Act of 2002 are attached as exhibits to this Quarterly Report on Form 10-Q. The disclosures set forth in this Item 4 contain information concerning the evaluation of our disclosure controls and procedures, internal control over financial reporting and changes in internal control over financial reporting referred to in those certifications. Those certifications should be read in conjunction with this Item 4 for a more complete understanding of the matters covered by the certifications.

Changes in Internal Control Over Financial Reporting

There was no significant change in our internal control over financial reporting that occurred during the first quarter of 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. Our management has discussed the material weaknesses as previously disclosed in Item 9A in our Annual Report on Form 10-K for the year ended

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December 31, 2005 and other deficiencies with our audit committee. In an effort to remediate the identified material weaknesses and other deficiencies, beginning in the second quarter of 2006, we intend to implement or are currently in the process of implementing remedial measures, including, but not limited to the following:

Entity level controls

• In early 2006, we actively began searches and interviews for candidates to fill accounting and finance positions and filled the position for vice president—finance and corporate controller with a permanent hire. We will seek to hire additional personnel as needed to focus on our ongoing remediation initiatives and compliance efforts.

Inadequate controls over period-end financial reporting process

• We will continue to enhance and adhere to financial closing procedures, including the use of checklists, established schedules and other monitoring tools to ensure financial statements are accurate, complete and timely compiled.

• We plan to establish and implement a journal entry processing policy to ensure the proper segregation of duties and that review and approval activities occur for all transactions recorded in the general ledger.

• We plan to establish more robust benchmarks and monitoring activities to evaluate historical information used in reserve calculations.

• We plan to establish review and follow-up procedures prior to the approval of significant reserves.

• We plan to perform timely cash application activities and reconciliations.

Inadequate segregation of duties

• We plan to re-allocate and/or reassign duties of employees by providing clear job descriptions to enhance segregation of duties.

• We plan to restrict access to systems applications to eliminate incompatible duties and ensure employees’ access is limited to only those activities needed to perform designated job responsibilities.

Inadequate control over systems, financial applications and data access

• We will apply user access restrictions within critical systems and financial applications to prevent unauthorized access and/or establish monitoring mechanisms and procedures to properly detect unauthorized system access and provide follow up when needed to ensure adherence to the proper segregation of duties.

• At the end of the first quarter of 2006, we established and documented a corporate purchasing policy and approval matrix, which specifies the dollar limits for approval of various types of purchases and authorization of banking arrangements and treasury activities. At the same time, we also established a capitalization policy that specifies specific duties and authorizations for those employees specifically accounting for and handling fixed assets.

Account analyses, account summaries and account reconciliations

• As of the end of the first quarter 2006, we have completed comprehensive account analyses, account summaries and reconciliations as remediated in the fourth quarter of fiscal year 2005.

Documentation of account policies and procedures

• We plan to establish accounting policies and procedures to ensure finance and accounting staff are provided with adequate guidance for calculating and recording non-routine transactions and estimates related to significant balance sheet accounts. We will provide proper training in conjunction with the development and implementation of such policies.

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Records retention

• We plan to establish a records retention policy which outlines the requirements and procedures for retaining the appropriate supporting documentation for financial transactions and plan to implement procedures designed to ensure compliance with the related policy.

Inventory management and merchandise accounts payable

• We plan to establish and implement procedures to capture inventory receipt documentation to ensure the timely matching of purchase documents and recording of complete inventory amounts.

• We plan to establish a customer returns policy outlining the procedures for the issuance of customer refunds and credits and receipt of returned merchandise. Additionally, we plan to add system restrictions or other monitoring controls to ensure returns are authorized and that refunds and credits are issued only upon the receipt of returned products.

• We plan to establish formal accounts payable procedures designed to ensure proper comparisons of purchase orders, receiving documents and vendor invoices, timely recording of merchandise and invoices received, and accurate processing of vendor payments.

• We plan to establish and implement formal policies and procedures for handling stock adjustments to ensure that significant adjustments are properly reviewed and authorized by management and properly documented with adequate support and that adjustments are monitored by management for reasonableness.

• We plan to establish procedures for updating and maintaining current inventory cost data to ensure accurate and complete product costs.

Non-merchandise accounts payable

• We will implement our corporate purchasing policy and approval matrix, established in the first quarter of 2006, which specifies the dollar limits for approval of various types of purchases and required documentation to support transactions. Concurrently, we plan to establish an accounts payable policy and procedures to ensure consistent application of payable processing activities and to establish methodologies for consistently recording accrued liabilities and ensuring the proper cut-off of liabilities.

• We plan to establish an accounts payable policy setting forth formal accounts payable procedures designed to ensure a proper three-way matching of non-merchandise documents or adequate support to evidence amounts, approval and receipt. The policy will further dictate that all necessary review activities shall be performed prior to the approval of disbursements to ensure proper amounts are recorded and paid and that the corporate purchasing policy and approval matrix are being followed.

• The accounts payable policy also will specify formal accounts payable procedures for setting up and maintaining vendor data and related master files. The procedures will include required monitoring activities to ensure that changes made to vendor data are valid, accurate and complete.

Merchandise inventory costing and valuation procedures

• We plan to enhance system applications to ensure that automated processing of inventory transactions record receipts using the proper cost tables and the cost tables obtain real-time or current and accurate foreign currency rates. Additional enhancements will include revisions to existing account mapping of automated transactions and the establishment of new account mappings to ensure the proper general ledger accounts are recorded for batch-processed inventory transactions.

• We plan to establish and implement monitoring activities of product tables and master files in the system to ensure costs are accurate and complete and that changes made to the master files are properly authorized. We will make periodic comparisons of the differences between the estimated landing costs based on a point-to-point rate and the actual landing costs.

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• We plan to establish formal accounts payable procedures designed to ensure proper comparisons of purchase orders, receiving documents and vendor invoices, the timely recordation of merchandise and invoices received, and accurate processing of vendor payments.

• We plan to establish procedures for updating and maintaining current inventory cost data to ensure accurate and complete product costs. Monitoring and review activities will be specifically assigned to improve our ability to detect on a timely basis any unauthorized and/or invalid changes made to product costs. The policies will require these activities to be performed on a regular, scheduled basis to ensure costs and freight amounts are current.

• We plan to establish and implement a journal entry processing policy to ensure the proper segregation of duties and to ensure that review and approval activities occur for all transactions recorded in the general ledger.

• We plan to continue the implementation of comprehensive account analyses, account summaries and reconciliations we started to remediate in the fourth quarter of fiscal year 2005.

Recording of, and accounting for, fixed assets

• We plan to continue to implement the capitalization policy we established in the first quarter of 2006 by developing procedures for taking physical inventory of certain fixed assets; obtaining authorizations for purchases and the initiation of major construction projects; accounting for acquisitions, disposals, impairment, and depreciation; and monitoring budgets.

• We plan to review, and revise, if necessary, our methodologies for evaluating construction-in-progress and practices for accounting for and recording transactions on a regular basis.

• We plan to continue to enhance and adhere to financial closing procedures through the use of checklists and other monitoring tools to ensure that the necessary reconciliation activities are being performed and reviewed in a timely manner by management.

Tax computations outsourced to third-party experts.

• We plan to establish review procedures designed to ensure the accuracy and completeness of financial information provided to third-party experts who compute tax amounts and to ensure the accuracy of tax amounts recorded in the general ledger.

Revenue recognition and accounts receivable

• We plan to establish review and follow up procedures prior to the approval of significant reserves.

• We plan to establish more robust benchmarks and monitoring activities to effectively evaluate historical information used in reserve calculations.

• We plan to perform timely cash application activities and reconciliations.

Payroll transactions

• We plan to implement the segregation of duties remediation action items noted above to ensure that payroll activities are not incompatibly performed.

Treasury functions

• We plan to establish monitoring activities over banking and investing activities.

• We plan to continue to follow and enhance financial closing procedures through the use of checklists and other monitoring tools to ensure that the necessary reconciliation activities are being performed and reviewed in a timely manner by management.

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Spreadsheets used in the financial reporting process

• We plan to establish a spreadsheet control policy and implement the necessary procedures to comply with such policy.

While we believe that the remedial actions will ultimately result in correcting the material weaknesses in our internal controls, the exact timing of when the conditions will be corrected is dependent upon future events, which may or may not occur. We intend to remediate the majority of material weaknesses by hiring additional permanent employees with the necessary skills to carry out the plan. Contractors and temporary resources will be obtained on an as-needed basis to remediate areas which require a specific technical expertise or as time and resource constraints arise. Our SEC Compliance Manager will monitor the progress of remediation and may prescribe the necessary remedial actions to be taken as needed.

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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. The following Risk Factors do not reflect any material changes to the Risk Factors set forth in our Annual Report on Form 10-K for the fiscal year ended December 31, 2005 other than the update of the tenth risk factor to address concerns relating to our liquidity and capital resources to reflect our default (since waived) under our credit agreement, the revision of the fifteenth risk factor to address the impact on us of our adoption of SFAS No. 123R, and the revision of the twenty-sixth and twenty-seventh risk factors to update for recent changes in management.

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 58 studios as of April 1, 2006. 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. In fiscal year 2006, we plan to offer substantially fewer promotional discounts than in fiscal year 2005. We have reduced the number of promotions in an effort to improve our gross margins, but this approach might harm our net sales and might not result in an increase in gross profit or operating income.

We believe that our future growth will be substantially dependent on the continued increase in sales growth of existing core products, such as the Aeron^® Chair and the Eames^® Lounge Chair and Ottoman manufactured by Herman Miller, Inc. 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.

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

We plan to open between 5 to 10 new studios in each of fiscal year 2006 and 2007. We anticipate the costs associated with opening these new studios will be between approximately $4.0 million and $7.0 million in each of fiscal years 2006 and 2007. 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;

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• 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 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.

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.

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.

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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. In First Quarter 2006, phone sales totaled $4.3 million, representing 12.3% of our total net sales during such period. We believe that the success of our catalog operations 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;

• 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 have made and will continue to make certain systems changes that might disrupt our supply chain operations and delay our release of financial results.

Our success depends on our ability to source merchandise efficiently through appropriate systems and procedures. In May 2005, we converted our then existing information technology system to a new, custom-built system supporting our product sourcing, merchandise planning, forecasting, inventory management, product distribution and transportation and price management. These information technology systems also are used to generate information for our financial reporting. 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. These system problems resulted in our being unable to complete our fiscal year 2005 audit and file this Form 10-K in a timely manner. During the third quarter of 2005, we hired a consulting firm to assess the inadequacies of the system. As a result of that review process, we have decided to replace our current system.

During the first quarter of 2006, we hired another consulting firm to clearly define and document the requirements for the new system. During the second quarter of 2006, we expect to finalize the specifications for the new system, hire a consulting firm and begin the process of developing, testing and implementing the new system. We are currently targeting an installation of the new system by early 2007.

There are inherent risks associated with replacing our core systems, including supply chain disruptions that affect our ability to deliver products to our customers and delays in obtaining the information necessary for our financial reporting. We may not be able to successfully launch these new systems or launch them without supply chain disruptions or delays in releasing our financial results in the future. Any resulting supply chain disruptions could have a material adverse effect on our operating results. If we cannot produce timely and 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.

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Management has identified material weaknesses in internal controls over financial reporting. 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.

As required by Securities and Exchange Commission 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 operation of our disclosure controls and procedures as of December 31, 2005. Based on that evaluation, our chief executive officer and chief financial officer concluded that control deficiencies which constituted material weaknesses existed in our internal control over financial reporting as of December 31, 2005. As a result of these material weaknesses, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were not effective as of December 31, 2005 at the reasonable assurance level. A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the financial statements will not be prevented or detected. Management identified material weaknesses relating both to our control environment and our control activities.

Management determined that we had material weaknesses in our control environment because as of December 31, 2005 we did not have (1) a sufficient number of personnel or appropriate depth of experience for our accounting, finance and information technology departments to ensure the preparation of interim and annual financial statements in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”), (2) robust risk assessment processes, including strategic plans, budgets and clearly defined and communicated goals and objectives, (3) adequate monitoring of our existing control activities over financial reporting, (4) the ability to produce financial statements and deliver information to decision makers in a timely manner, and (5) the ability to remediate previously communicated weaknesses. In addition, we placed heavy reliance on manual procedures and detective controls without quality control review and other monitoring controls in place to adequately identify and assess significant risks that may impact financial statements and related disclosures. These conditions were exacerbated by problems encountered with the recent major systems implementation and significant turnover of personnel in several key finance and accounting and information technology positions, including the chief financial officer, controller and chief information officer. These control deficiencies could result in material misstatements of the annual or interim financial statements that would not be prevented or detected.

Management also identified numerous material weaknesses in our control activities, including the following:

• We did not maintain effective controls over period-end financial reporting processes;

• We did not maintain adequate segregation of duties;

• We did not maintain effective controls over access to our systems, financial applications, and data;

• We had deficiencies relating to the preparation of account analyses, account summaries and account reconciliations;

• We had deficiencies relating to the documentation of accounting policies and procedures;

• We had deficiencies relating to records retention;

• We had deficiencies relating to inventory management and merchandise accounts payable;

• We had deficiencies relating to non-merchandise accounts payable;

• We did not maintain effective control over the costing and valuation of inventory;

• We had deficiencies relating to the recording of, and accounting for, fixed assets;

• We did not maintain effective controls over taxes computed by third-party experts;

• We did not maintain an effective controls related to the invoicing of customers with credit terms and the collection and application of payments and credits to accounts receivable;

• We did not maintain effective control over payroll processing;

• We identified deficiencies in our treasury functions which were considered material weaknesses; and

• We did not maintain effective control over spreadsheets used in our financial reporting process.

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Any of these control deficiencies could result in material misstatements of the annual or interim financial statements that would not be prevented or detected. For more information about the material weaknesses identified by management, please see Part I, Item 4, “Controls and Procedures.”

We have begun to take steps to strengthen our internal control processes to address the matters identified by us. These measures may not, however, completely eliminate the material weaknesses we identified, and we may have additional material weaknesses or significant deficiencies in our internal controls that neither they nor our management has yet identified. The existence of one or more material weaknesses or significant deficiencies could result in material errors in our financial statements, and we may incur substantial costs and may be required to devote substantial resources 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 timely and 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 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 generated a net loss of $4.2 million in the First Quarter 2006 and used cash in operations of $3.2 million during this period. We expect to generate negative net cash flows from operating activities at least through the third quarter of 2006 and to continue incurring operating losses. We currently have a credit agreement with Wells Fargo HSBC Trade Bank, N.A., as amended on December 23, 2005, which provides for a $10.0 million operating line of credit. As of April 1, 2006, we were not in compliance with various financial covenants under our credit agreement. We received a waiver of default on May 16, 2006.

Our board of directors has asked our new chief executive officer to work with management to propose a new business plan that would allow us to achieve positive cash flows from operations through fiscal year 2006. We do not expect this plan to show us achieving compliance with the covenants under our working capital line of credit for at least the second and third quarters of fiscal year 2006. If we do not comply with those covenant requirements, we would likely need to obtain covenant waivers or amendments prior to the third quarter of 2006. We cannot provide assurances that any such covenant waivers or amendments will be obtained, or that the lender will not require additional collateral, significant cash payments or additional incentives in connection with any such waivers or amendments.

Other than our working capital facility, we do not have any significant available credit, bank financing or other external sources of liquidity. We may need to raise additional capital in the future to fund our working capital requirements, open additional studios, to facilitate long-term expansion, to respond to competitive pressures or to respond to unanticipated financial requirements. The amount of financing that we will require for these efforts will vary depending on our financial results, our ability to generate cash from internal operations, and the number and speed at which we open additional studios. We are exploring potential public and private debt and equity financing alternatives, including the sale from time to time of debt and equity securities. There is no assurance that we will be able to raise the amount of debt or equity capital required to meet our objectives. Our challenging financial circumstances may make the terms, conditions and cost of any available capital relatively unfavorable. If additional debt or equity capital is not readily available, we will be forced to scale back, or fail to address opportunities for expansion or enhancement of, our operations.

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. In First Quarter 2006, online sales totaled $6.4 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.

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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.

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 First Quarter 2006, products supplied by our five largest vendors represented approximately 59.7% 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 First Quarter 2006, products supplied by Herman Miller, Inc., Vitra Inc. and Kartell US Inc. represented approximately 20.7% 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.

New accounting pronouncements may impact our future results of operations.

In First Quarter 2006, we adopted Statement of Financial Accounting Standards, or SFAS, No. 123R, “Share-Based Payment” issued by the Financial Accounting Standards Board, or FASB. SFAS No. 123R requires us to recognize share-based compensation as compensation expense in the statement of operations based on the fair values of such equity on the date of the grant, with the compensation expense recognized over the period in which the recipient is required to provide service in exchange for the equity award. In accordance with SFAS 123R, we adopted a fair value-based method for measuring the compensation expense related to share-based compensation. In the First Quarter 2006, we recognized $487,000 in expense related to stock-based compensation under SFAS 123R. Future financial impact is difficult to predict because it will depend on levels of share-based payments granted in the future, assumptions used to determine fair value and forfeiture rates used to calculate the expense.

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. During 2005, we discontinued selling reproductions of Barcelona merchandise currently being manufactured

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by Knoll, Inc. and agreed to carry the Barcelona merchandise instead. We were selling the reproductions, which we referred to as “Pavillion” merchandise, at substantially lower prices than the Barcelona merchandise. 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 from our vendors.

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 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.

In First Quarter 2006, our sales of products supplied by Herman Miller, Inc., the manufacturer of, among other items, the Aeron Chair, the Eames Lounge Chair and Ottoman, the Eames^® Aluminum Management Chair and the Noguchi Table, constituted approximately 6% of our total net sales. Sales of products supplied by our top five vendors constituted approximately 59.7% of our total net sales in First Quarter 2006. 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.

Changes in the value of the U.S. dollar relative to foreign currencies and/or any failure by us to adopt and implement an effective hedging strategy could adversely affect our operating results.

In First Quarter 2006, we generated all of our net sales in U.S. dollars, but we purchased approximately 39% of our product inventories from manufacturers in Europe, 35.4% of which were paid for in Euros. Increases and decreases in the U.S. dollar relative to the Euro result in fluctuations in 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. Specifically, as the value of the U.S. dollar declines relative to the Euro, our effective cost of supplies of product increases. As a result, 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.

In fiscal year 2005, the value of the dollar increased approximately 10% relative to the Euro. However, we did not benefit significantly from this strengthening of the dollar because we made most of our fiscal year 2005 inventory purchases in the first part of the year when the dollar was still weak relative to the Euro and because of the hedging contracts we purchased at a time when the dollar was relatively weak. Under our hedging strategy, we purchased foreign currency option contracts with maturities of 12 months or less to hedge our currency risk on anticipated purchases of merchandise based on our forecasted demand. We account for hedging contracts on a monthly basis by recognizing the net cash settlement gain or loss on the call or put option in accumulated other comprehensive income (loss) and adjusting the carrying amount of the contract to market by recognizing any corresponding gain or loss in cost of goods sold as the underlying inventory which was hedged is sold in each reporting period. However, when derivative positions exceed identified exposures, such contracts are considered “ineffective” and reported through earnings (loss). In First Quarter 2006, our actual demand was less than our forecasted demand, and the amount of Euros we hedged was greater than the

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amount we needed for purchases of inventory. As a result, we recorded approximately $29,000 for ineffectiveness during First Quarter 2006.

Although we are evaluating and plan to revise our hedging strategy, we will not be able to eliminate all fluctuations in our cost of goods caused by changes in currency exchange rates. If our revised hedging strategy does not help reduce fluctuations in our cost of goods and mitigate the impact of strengthening of the Euro relative to the U.S. dollar, we will continue to have difficulties in accurately predicting our costs of goods and our cost of goods may increase, adversely impacting our gross margin. In addition, if our forecasted demand exceeds actual demand, we may have expenses associated with hedging that are not associated with inventory purchases.

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, Denmark, Germany, Italy, The Netherlands, Spain, 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 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 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

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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.

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.

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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 October 2005, our then President and Chief Executive Officer, Wayne Badovinus, resigned his employment from the Company. As a result, Tara Poseley, previously serving as Vice President—Merchandising, was promoted to the position. In May 2006, Ms. Poseley resigned her employment from the Company. In May 2006, Ray Brunner, who previously served as the Executive Vice President—Real Estate and Studio Operations, accepted the position as President and Chief Executive Officer. Other key personnel turnover in the last twelve months include our Chief Information Officer, Vice President—Human Resources (position subsequently filled), Vice President—Inventory Planning and Executive Vice President—Merchandising and Marketing.

In particular, we are dependent on the services of Ray Brunner, our President and Chief Executive Officer, Ken La Honta, our Chief Financial Officer and Secretary and Robert Forbes, Jr., our founder, who currently serves as a director and consultant. We do not have long-term employment agreements with any of our key personnel. The loss of the services of Mr. Brunner, 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 senior management team has limited experience working together as a group, and may not be able to manage our business effectively.

Several members of our senior management team, including our Chief Executive Officer, Chief Financial Officer and Secretary, Vice President—Merchandising and Vice President—Human Resources have served in their positions for less than one year. In addition, we have had three different Chief Executive Officers since October 2005, the first having tenured the Company over several years and the latter two previously having experience with our Company and were promoted from Vice President positions. As a result, our senior management team has limited experience working together as a group. This lack of shared experience could impact our senior management team’s ability to quickly and efficiently respond to problems and effectively manage 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, patents, trade secrets and other intellectual property as critical to our success. Our principal intellectual property rights include trademark registrations or applications for our name, “Design Within

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Reach,” our logo, and the acronym, “DWR,” among others; copyrights and trade dress rights in our catalogs, website and certain of our products, such as our commissioned designs, and packaging; rights to our domain name, www.dwr.com, and our databases and information management systems; and patent registrations or applications, and other proprietary rights, in certain product designs. We rely on trademark, copyright, patent, unfair competition and trade secret laws, 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. If we are unable to protect or preserve the value of our trademarks, copyrights, patents, trade secrets or other proprietary rights for any reason, our brand and reputation could be impaired and we could lose customers. In addition, the costs of defending our intellectual property may adversely affect our operating results.

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 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.

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

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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. During fiscal year 2005 and through First Quarter 2006, the Company has been subject to sales and use tax audits by various states as well as a current Internal Revenue Service audit for fiscal year 2003. Although any adverse results for completed audits have not been material to us, there is a risk that federal, state and local jurisdictions may challenge the characterization of certain transactions and assess additional amounts, including interest and penalties. In the event that transactions are challenged by tax authorities, the review process would divert management attention and resources and we may incur substantial costs.

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.

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 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.

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.

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.

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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:

• to finance the opening of additional studios;

• to pay any and all of the indebtedness outstanding under our bank credit facility

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

Item 3. Defaults Upon Senior Securities.

We have a secured revolving line of credit with Wells Fargo HSBC Trade Bank, N.A. (“the Bank”), as amended on December 23, 2005. This facility provides an overall credit line of $10.0 million comprised of a $5.0 million operating line of credit for working capital and $5.0 million in standby letters of credit. As of April 1, 2006, $1.6 million borrowings and $1.0 million of stand-by letters of credit were outstanding under this facility and approximately $3.4 million was available to be drawn from the operating line of credit. However, we were not in compliance with various financial covenants under the credit agreement. As of April 1, 2006, we were not in compliance with financial covenants to achieve positive net earnings and adjusted leverage ratios under our credit agreement. We received a waiver of default on May 16, 2006 covering breaches incurred through the thirteen weeks ended April 1, 2006. As a result, our ability to borrow under the line was not interrupted. However, if we are unable to return to compliance and maintain such compliance with these covenants and other covenants defined in the credit agreement or mandated by the Bank, we may, in the future, be restricted from borrowing until we return to compliance with the covenants or we obtain an additional waiver which may or may not be available to us.

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

None.

Item 5. Other Information

None.

Item 6. Exhibits

Exhibit Number	Exhibit Title
3.01(1)	Amended and Restated Certificate of Incorporation
3.02(2)	Amended and Restated Bylaws
4.01(3)	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

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4.04(1)	Amendment to Investors’ Rights Agreement, dated May 8, 2003, by and among Design Within Reach, Inc. and the investors named therein
31.1	Certification of Chief Executive Officer pursuant to Rules 13a-14 and 15d-14 promulgated under the Securities Exchange Act of 1934
31.2	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.

(2) 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.

(3) 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.

* These certifications are being furnished solely to accompany this quarterly 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: May 16, 2006

/s/ KEN LA HONTA

Ken La Honta

Chief Financial Officer and Secretary

(Duly authorized Officer and

Principal Financial Officer)

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