AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON APRIL 23, 2002 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 --------------------- FORM S-1 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 --------------------- KIRKLAND'S, INC. (Exact name of Registrant as specified in its charter) <Table> TENNESSEE 5990 62-1287151 (State or other jurisdiction (Primary Standard Industrial (I.R.S. Employer of incorporation or organization) Classification Code Number) Identification No.) </Table> --------------------- 805 N. PARKWAY JACKSON, TENNESSEE 38305 (731) 668-2444 (Address, including zip code, and telephone number, including area code, of Registrant's principal executive offices) --------------------- ROBERT E. ALDERSON PRESIDENT AND CHIEF EXECUTIVE OFFICER 805 N. PARKWAY JACKSON, TENNESSEE 38305 (731) 668-2444 (Name, address, including zip code, and telephone number, including area code, or agent for service) --------------------- COPIES TO: <Table> BARRY M. ABELSON, ESQ. VALERIE FORD JACOB, ESQ. ROBERT A. FRIEDEL, ESQ. FRIED, FRANK, HARRIS, SHRIVER & JACOBSON PEPPER HAMILTON LLP ONE NEW YORK PLAZA 3000 TWO LOGAN SQUARE NEW YORK, NY 10004 18TH AND ARCH STREETS (212) 859-8000 PHILADELPHIA, PA 19103-2799 (215) 981-4000 </Table> --------------------- APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE TO THE PUBLIC: As soon as practicable after this Registration Statement becomes effective. --------------------- If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box. [ ] If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act of 1933, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [ ] If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act of 1933, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [ ] If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [ ] If delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box. [ ] CALCULATION OF REGISTRATION FEE <Table> <Caption> - ------------------------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------------------------- TITLE OF EACH CLASS OF PROPOSED MAXIMUM AMOUNT OF SECURITIES TO BE REGISTERED AGGREGATE OFFERING PRICE(1) REGISTRATION FEE(2) - ------------------------------------------------------------------------------------------------------------- Common stock, no par value.................................. $143,750,000 $13,225 - ------------------------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------------------------- </Table> (1) Estimated solely for purposes of determining the registration fee in accordance with Rule 457(o) under the Securities Act of 1933. Includes shares that the underwriters will have the right to purchase to cover overallotments, if any. (2) The Registrant previously paid a fee to the Commission of $18,658.75 in connection with the filing of its Registration Statement on Form S-1 (No. 333-51517), initially filed on May 1, 1998. That Registration Statement was withdrawn on October 12, 1999. Pursuant to Rule 457(p), $13,225 of the filing fee previously paid by the Registrant is to be offset against the currently due registration fee. ---------------------- THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(a) OF THE SECURITIES ACT OF 1933 OR UNTIL THIS REGISTRATION STATEMENT SHALL BECOME EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SECTION 8(a), MAY DETERMINE. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- THE INFORMATION IN THIS PROSPECTUS IS NOT COMPLETE AND MAY BE CHANGED. WE MAY NOT SELL THESE SECURITIES UNTIL THE REGISTRATION STATEMENT FILED WITH THE SECURITIES AND EXCHANGE COMMISSION IS EFFECTIVE. THIS PROSPECTUS IS NOT AN OFFER TO SELL THESE SECURITIES AND IT IS NOT SOLICITING AN OFFER TO BUY THESE SECURITIES IN ANY STATE WHERE THE OFFER OR SALE IS NOT PERMITTED. SUBJECT TO COMPLETION PRELIMINARY PROSPECTUS DATED APRIL 23, 2002 PROSPECTUS SHARES KIRLAND'S, INC. LOGO COMMON STOCK ---------------------- This is Kirkland's, Inc.'s initial public offering. We are selling shares and the selling shareholders are selling shares. The underwriters are offering all of the shares in the U.S. and Canada. We expect the public offering price to be between $ and $ per share. Currently, no public market exists for the shares. After pricing of the offering, we expect that the shares will be quoted on the Nasdaq National Market under the symbol "KIRK." INVESTING IN THE COMMON STOCK INVOLVES RISKS THAT ARE DESCRIBED IN THE "RISK FACTORS" SECTION BEGINNING ON PAGE 9 OF THIS PROSPECTUS. ---------------------- <Table> <Caption> PER SHARE TOTAL --------- ----- Public offering price....................................... $ $ Underwriting discount....................................... $ $ Proceeds, before expenses, to Kirkland's, Inc............... $ $ Proceeds, before expenses, to the selling shareholders...... $ $ </Table> Approximately $ million of Kirkland's net proceeds from this offering will be used to redeem shares of preferred stock held by affiliates of Kirkland's. See the "Use of Proceeds" section beginning on page 19 of this prospectus. The underwriters may also purchase up to an additional shares from the selling shareholders at the public offering price, less the underwriting discount, within 30 days from the date of this prospectus to cover overallotments. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. The shares will be ready for delivery on or about , 2002. ---------------------- MERRILL LYNCH & CO. CIBC WORLD MARKETS SUNTRUST ROBINSON HUMPHREY U.S. BANCORP PIPER JAFFRAY ---------------------- The date of this prospectus is , 2002. KIRKLAND'S, INC. STORE LOCATIONS [A map of the United States indicating the number of stores in each state] TABLE OF CONTENTS <Table> <Caption> PAGE ---- Prospectus Summary.......................................... 1 Risk Factors................................................ 9 Disclosure Regarding Forward-Looking Statements............. 18 About This Prospectus....................................... 18 Use of Proceeds............................................. 19 Dividend Policy............................................. 20 Dilution.................................................... 21 Capitalization.............................................. 23 Selected Consolidated Financial Data........................ 24 Management's Discussion and Analysis of Financial Condition and Results of Operations................................. 27 Business.................................................... 39 Management.................................................. 51 Certain Transactions........................................ 63 Principal and Selling Shareholders.......................... 68 Description of Capital Stock................................ 72 Shares Eligible for Future Sale............................. 77 United States Tax Consequences to Non-United States Holders................................................... 79 Underwriting................................................ 83 Legal Matters............................................... 86 Experts..................................................... 86 Where You Can Find More Information......................... 87 Index to Financial Statements............................... F-1 Unaudited Pro Forma Consolidated Condensed Financial Statements................................................ P-1 </Table> ---------------------- You should rely only on the information contained in this prospectus. We have not, and the underwriters have not, authorized any other person to provide you with different information. If anyone provides you with different or inconsistent information, you should not rely on it. We are not, and the underwriters are not, making an offer to sell these securities in any jurisdiction where the offer and sale is not permitted. You should assume that the information appearing in this prospectus is accurate only as of the date on the front cover of this prospectus. Our business, financial condition, results of operations and prospects may have changed since that date. i PROSPECTUS SUMMARY The following summary highlights information contained elsewhere in this prospectus. We urge you to read this entire prospectus carefully, including the "risk factors" section. In this prospectus, "Kirkland's," "we," "our" and "us" refer to Kirkland's, Inc. and its subsidiaries, unless the context requires otherwise. On January 1, 2001, we changed our fiscal reporting year from a calendar year to a 52/53-week basis ending on the Saturday closest to January 31. As used herein, the term "fiscal 2001" refers to the 52 weeks ended February 2, 2002 and any reference to any fiscal year prior to fiscal 2001 refers to the 12 months ended December 31 of that fiscal year. Adjusted EBITDA is defined in "Summary Consolidated Financial and Other Data." KIRKLAND'S We are a leading specialty retailer of home decor in the United States, operating 236 stores in 28 states. Our stores present a broad selection of distinctive merchandise, including framed art, mirrors, candles, lamps, picture frames, accent rugs, garden accessories and artificial floral products. Our stores also offer an extensive assortment of holiday merchandise, as well as items carried throughout the year suitable for giving as gifts. In addition, we use innovative design and packaging to market home decor items as gifts. We provide our predominantly female customers an engaging shopping experience characterized by a diverse, ever-changing merchandise selection at surprisingly attractive prices. Our stores offer a unique combination of style and value that has led to our emergence as a leader in home decor and has enabled us to develop a strong customer franchise. As a result, we have achieved substantial growth over the last five fiscal years. Since the beginning of 1997, our sales have grown at a compounded annual growth rate of 19%. For the fiscal year ended February 2, 2002, we recorded net sales of $307.2 million and Adjusted EBITDA of $35.5 million, or 11.6% of net sales. Kirkland's was co-founded in 1966 by our current Chairman, Carl Kirkland. We opened our first store in Jackson, Tennessee and have grown steadily thereafter. Although originally focused in enclosed malls in the Southeast, we have expanded beyond that region and also have begun to open stores in selected non-mall venues. Currently, over 40% of our stores are located outside the Southeast, including 60 of the 100 new stores opened since the beginning of fiscal 1997. We currently operate in major metropolitan markets like Houston, Texas and Atlanta, Georgia, middle markets such as Birmingham, Alabama and Buffalo, New York and smaller markets such as Appleton, Wisconsin and Panama City, Florida. As we more than doubled our store base from 104 stores at the end of fiscal 1995 to 226 stores at the end of fiscal 1999, we realized the need to strengthen our infrastructure and enhance several aspects of our operations in order to execute a rapid national expansion. Beginning in late 1999, we undertook a series of initiatives that enabled us to make faster and smarter inventory buying and distribution decisions, to manage the flow of merchandise to our stores more efficiently and to improve overall financial performance. These initiatives included: COMPLETING KEY INVESTMENTS IN INFORMATION TECHNOLOGY. Since late 1999, we have invested $6.5 million in several key information systems projects that provide our decision makers with better tools to increase sales, improve operational efficiency, control and distribute inventory and monitor critical performance indicators on a daily basis. DEVELOPING A MORE SCALABLE DISTRIBUTION INFRASTRUCTURE. In March 2001, we consolidated our central distribution operations into one 303,000-square-foot, leased facility in Jackson, Tennessee, which allowed us to increase our dollar volume of centrally distributed merchandise by 24% from fiscal 2000 to fiscal 2001. This modern facility, together with other improvements to our supply chain, has helped us to keep our stores stocked with fresh merchandise and to reduce significantly the cost of managing inventories at the store level. STRENGTHENING EXECUTIVE MANAGEMENT. Since the second half of 1999, we have added six senior managers, including key hires in merchandising, store operations and information technology. These 1 additions, along with several other key hires and promotions, have broadened the abilities of our management team and have provided leadership to key areas of our business. We believe our management team has valuable experience both from Kirkland's and from other national retailers. IMPROVING STORE-LEVEL OPERATING PERFORMANCE. In January 2001, we instituted a plan to improve sales, increase cash flow and return our stores to higher levels of profitability. The cornerstone of this plan was to reduce store-level inventories and improve inventory turnover. We also intensified our efforts to control and lower store operating expenses and close under-performing stores. We believe the convergence of these operational initiatives led to the significant improvement in our fiscal 2001 operating results as compared to fiscal 2000. For fiscal 2001, our comparable store net sales increased 13.3% over the 53-week period ended February 3, 2001 and our Adjusted EBITDA margin expanded to 11.6% from 7.5% in fiscal 2000. Net cash provided by operating activities increased to $37.5 million as compared to $1.3 million in fiscal 2000, and inventory turnover in fiscal 2001 increased to 3.48x as compared to 2.45x in fiscal 2000. As evidenced by the improvement in our operating results, we believe these initiatives have positioned us to expand our proven retail concept and strengthen our position as a leading specialty retailer of home decor in the United States. KEY OPERATING STRENGTHS Our goal is to be the leading specialty retailer of home decor in each of our markets. We believe the following elements of our business strategy differentiate us from our competitors and position us for profitable growth: ITEM-FOCUSED MERCHANDISING. While our stores contain items covering a broad range of complementary product categories, we emphasize key items within our targeted categories rather than merchandising complete product classifications. Although we do not attempt to be a fashion leader, our experienced buyers work closely with our vendors to identify and develop stylish merchandise reflecting the latest trends. We estimate that over 60% of our merchandise is designed or packaged exclusively for Kirkland's, which distinguishes us in the marketplace and enhances our margins. EVER-CHANGING MERCHANDISE MIX. We believe our ever-changing merchandise mix of over 5,000 stock keeping units, or "SKUs," creates an exciting "treasure hunt" environment, encouraging strong customer loyalty and frequent return visits to our stores. The merchandise in our stores typically is traditionally styled for broad market appeal, yet it reflects an understanding of our customer's desire for newness and freshness. STIMULATING VISUAL PRESENTATION. Our stores have a distinctive, "interior design" look that helps customers visualize the merchandise in their own homes and inspires decorating and gift-giving ideas. Using multiple merchandise arrangements to simulate home settings, we group complementary merchandise creatively throughout the store, rather than displaying products strictly by category or product type. We believe this cross-category merchandising strategy encourages customers to browse for longer periods of time, promoting add-on sales. STRONG VALUE PROPOSITION. Our customers regularly experience the satisfaction of paying noticeably less for items similar or identical to those sold by other retail stores or through catalogs. This strategy of providing a unique combination of style and value is an important element in making Kirkland's a destination store. While we carry items in our stores that sell for several hundred dollars, most items sell for under $50 and are perceived by our customers as affordable luxuries. FLEXIBLE APPROACH TO REAL ESTATE. Our stores operate successfully across a wide spectrum of different regions, market sizes and real estate venues. The flexibility of our concept enables us to select the most promising real estate opportunities that meet requisite economic and demographic criteria within our target markets. 2 GROWTH STRATEGY Key elements of our growth strategy are outlined below: OPENING NEW STORES USING OUR PROVEN STORE MODEL. Over the past five years, we have more than doubled our store base, principally through new store openings. We intend to continue opening new stores both in existing and new markets. We believe there are currently more than 800 additional locations in the United States that could support a Kirkland's store. We expect to open approximately 15 new stores during fiscal 2002 and approximately 35 new stores during fiscal 2003. We believe our proven store model produces strong store-level cash flow and provides an attractive store-level return on investment. In fiscal 2001, our average store generated net sales of approximately $1.3 million and store-level EBITDA of approximately $227,000, or 17.4% of net sales. The average first full year cash return on investment for the 93 stores opened from 1997 through 2000 was approximately 47%. INCREASING STORE PRODUCTIVITY. We plan to increase our sales per square foot and store profitability by leveraging our recent investments in information systems and central distribution, which together contributed to our 18.5% increase in net sales and our 15.1% increase in average net sales per square foot in fiscal 2001. We also believe that our store productivity will benefit from our strong customer franchise, our continuing efforts to enhance the Kirkland's brand, and favorable consumer and demographic trends. ---------------------- We are incorporated in Tennessee, our principal executive offices are located at 805 N. Parkway, Jackson, Tennessee 38305, and our telephone number is (731) 668-2444. Our Internet web site address is www.kirklands.com. The information contained or incorporated in our web site is not a part of this prospectus. 3 THE OFFERING Common stock offered: By us.......................... By the selling shareholders.... Total....................... Shares outstanding after the offering......................... Use of proceeds.................. We estimate that our net proceeds from this offering will be approximately $ million. We intend to use these net proceeds to: - repay certain indebtedness, including all of our outstanding subordinated debt and mandatorily redeemable Class C Preferred Stock and a portion of our new revolving credit facility; and - redeem a portion of the outstanding shares of Class A Preferred Stock, Class B Preferred Stock and Class D Preferred Stock. We will not receive any proceeds from the sale of shares of common stock by the selling shareholders. Risk factors..................... See "Risk Factors" and other information included in this prospectus for a discussion of factors you should carefully consider before deciding to invest in shares of the common stock. Proposed Nasdaq symbol........... "KIRK" The number of shares outstanding after the offering is based on an assumed initial public offering price of $ per share. The number of shares of common stock to be issued to existing shareholders upon conversion of their preferred stock will be determined by reference to the actual initial public offering price. See "Certain Transactions - Pre-Offering Transactions." The number of shares outstanding after the offering excludes an aggregate of shares of common stock reserved for issuance under our 1996 Executive Incentive and Non-Qualified Stock Option Plan, 2002 Incentive Plan and Employee Stock Purchase Plan. Options to purchase 15,570 shares of common stock will be outstanding under our 1996 Executive Incentive and Non-Qualified Stock Option Plan upon completion of this offering, of which options to purchase 6,370 shares will be exercisable upon completion of this offering. Unless the context otherwise requires, all information in this prospectus (i) gives retroactive effect to a -for-one stock split of the common stock which will occur immediately prior to the completion of this offering, and (ii) assumes that this offering is consummated at an initial public offering price of $ per share (the midpoint of the range on the front cover of this prospectus) on , 2002. See "Use of Proceeds" and "Certain Transactions - Pre-Offering Transactions." 4 PRE-OFFERING TRANSACTIONS The following transactions will occur immediately prior to the completion of this offering: (i) a -for-one stock split of the common stock, (ii) an amendment and restatement of our charter, which will provide for an authorized capitalization of 100 million shares of common stock and 10 million shares of preferred stock, (iii) the exercise of all of our outstanding warrants and the resulting purchase of an aggregate of 38,124 shares of common stock at an exercise price of $0.01 per share and (iv) the conversion of $ million of the aggregate stated value and accrued dividends of the outstanding shares of our Class A Preferred Stock, Class B Preferred Stock and Class D Preferred Stock into shares of common stock. The number of shares of common stock to be issued with respect to the preferred stock will equal the aggregate stated value of $ million plus accrued dividends on the preferred stock to be converted, divided by the actual initial public offering price. Assuming an initial public offering price of $ (the midpoint of the range on the front cover of this prospectus) and a consummation of this offering on , shares of common stock will be issued to existing shareholders for their preferred stock. All of these transactions are herein collectively referred to as the "Pre-Offering Transactions." See "Use of Proceeds" and "Certain Transactions - Pre-Offering Transactions." 5 SUMMARY CONSOLIDATED FINANCIAL AND OTHER DATA The following summary consolidated financial data for the fiscal years ended December 31, 1997, 1998, 1999 and 2000 and as of and for the fiscal year ended February 2, 2002 presented below under the captions "Statement of Operations Data," "Other Financial Data" and "Balance Sheet Data" have been derived from our audited consolidated financial statements as of those dates and for those periods. The following summary consolidated financial data for the fiscal years ended December 31, 1997, 1998, 1999 and 2000 and the fiscal year ended February 2, 2002 presented below under the caption "Store Data" have been derived from internal records of our operations. You should read the information set forth below in conjunction with other sections of this prospectus, including "Selected Consolidated Financial Data," "Management's Discussion and Analysis of Financial Condition and Results of Operations" and our consolidated financial statements and related notes. <Table> <Caption> YEAR ENDED DECEMBER 31, YEAR ENDED ----------------------------------------- FEBRUARY 2, 1997 1998 1999 2000 2002(1) -------- -------- -------- -------- ----------- (IN THOUSANDS, EXCEPT SHARE, PER SHARE AND STORE DATA) STATEMENT OF OPERATIONS DATA: Net sales........................................ $153,584 $192,250 $236,622 $259,240 $307,213 Gross profit..................................... 56,586 70,314 82,344 86,864 107,150 Non-cash stock compensation charge(2)............ -- -- -- -- 712 Depreciation and amortization.................... 4,142 5,410 7,276 7,827 7,678 Operating income................................. 16,684 19,084 17,174 11,636 27,138 Interest expense: Senior, subordinated and other notes payable... 7,990 9,254 10,232 11,221 9,759 Class C Preferred Stock........................ 1,800 1,541 1,647 1,850 2,007 Accretion of common stock warrants(3).......... 389 -- (879) -- 7,759 Net income (loss)................................ 3,922 6,427 4,639 (1,315) 4,298 PRO FORMA DATA: Pro forma as adjusted net income(4).............. $ ----------- Pro forma as adjusted earnings per common share(4)....................................... $ =========== Pro forma as adjusted shares outstanding(4)...... =========== OTHER FINANCIAL DATA: Gross profit margin(5)........................... 36.8% 36.6% 34.8% 33.5% 34.9% Adjusted EBITDA(6)............................... $ 20,826 $ 24,494 $ 24,450 $ 19,463 $ 35,528 Adjusted EBITDA margin(7)........................ 13.6% 12.7% 10.3% 7.5% 11.6% Net cash provided by operating activities........ $ 8,669 $ 4,326 $ 12,945 $ 1,336 $ 37,530 Net cash (used in) investing activities.......... (5,479) (14,669) (10,825) (5,981) (4,744) Net cash (used in) provided by financing activities..................................... (3,537) 13,658 (3,370) 19,855 (29,949) STORE DATA: Comparable store net sales increase(8)........... 5.2% 1.0% 3.7% 0.6% 13.3% Number of stores at the end of period(9)......... 138 198 226 240 234 Average net sales per store (in thousands)(10)... $ 1,178 $ 1,169 $ 1,111 $ 1,112 $ 1,307 Average gross square footage per store(11)....... 4,186 4,392 4,364 4,437 4,528 Average net sales per square foot(10)(11)........ $ 281 $ 266 $ 255 $ 251 $ 289 </Table> 6 <Table> <Caption> AS OF FEBRUARY 2, 2002 ------------------------------------------- PRO FORMA ACTUAL PRO FORMA(12) AS ADJUSTED(13) --------- ------------- --------------- (IN THOUSANDS) BALANCE SHEET DATA: Cash and cash equivalents................................... $ 29,751 $ $ Working capital(14)......................................... 1,020 Total assets................................................ 95,818 Total debt, including mandatorily redeemable preferred stock (Class C)................................................. 75,239 Common stock warrants....................................... 7,759 Redeemable convertible preferred stock (Class A, Class B, and Class D)(15).......................................... 86,812 Common stock................................................ 229 Accumulated (deficit) equity(16)............................ (111,439) </Table> - ------------------------------ (1) Effective January 1, 2001, we changed our fiscal reporting year from a calendar year to a 52/53-week basis ending on the Saturday closest to January 31. Our 2001 fiscal year began on February 4, 2001 and ended on February 2, 2002. (2) Reflects a non-cash stock compensation charge related to certain outstanding stock options. (3) Reflects the accretion to fair value of detachable put warrants to purchase common stock, issued by us in connection with our issuance of subordinated debt. The put rights associated with these warrants were terminated as of January 1, 1998, were restored as of December 31, 1999, and were terminated again as of February 3, 2002. (4) Assumes the following transactions were effected as of February 4, 2001: (i) the Pre-Offering Transactions, (ii) the termination of the put rights associated with the put warrants discussed in note (3) above, (iii) the refinancing of our existing senior credit facility with a new senior credit facility, as discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" and (iv) the sale by us of shares in this offering at an assumed initial public offering price of $ per share and the application of the estimated net proceeds from the sale after deducting estimated offering expenses and underwriting discounts and commissions. Pro forma as adjusted net income and pro forma as adjusted earnings per common share exclude the $0.7 million non-cash stock compensation charge in fiscal 2001 related to certain outstanding stock options. (5) Defined as gross profit as a percentage of net sales. Gross profit represents net sales less cost of product sold, freight, store occupancy and central distribution expenses. (6) The term Adjusted EBITDA as used herein represents operating income before depreciation and amortization expense and a non-cash stock compensation charge related to certain outstanding stock options. While Adjusted EBITDA should not be considered in isolation or as a substitute for net income, cash flow from operations or any other measure of income or cash flow that is prepared in accordance with generally accepted accounting principles or as a measure of a company's profitability or liquidity, Adjusted EBITDA has been presented because we believe it is commonly used in this or a similar format by investors to analyze and compare operating performance as well as to provide additional information with respect to our ability to meet our future debt service, capital expenditure and working capital requirements. Adjusted EBITDA may differ in method of calculation from similarly titled measures used by other companies. This information should be read in conjunction with our consolidated statements of cash flows contained in our consolidated financial statements and notes thereto included elsewhere in this prospectus. (7) Defined as Adjusted EBITDA as a percentage of net sales. (8) We include new stores in comparable store net sales calculations after the store has been in operation one full fiscal year. We exclude from comparable store net sales calculations each store that was expanded, remodeled or relocated during the applicable period. Each expanded, remodeled or relocated store is returned to the comparable store base after it has been excluded from the comparable store base for one full fiscal year. The comparable store net sales increase for fiscal 2001 reflects the increase in comparable store net sales for the 52-week period ended February 2, 2002 compared to the 53-week period ended February 3, 2001. 7 (9) Our store count excludes our warehouse outlet store located adjacent to our central distribution facility in Jackson, Tennessee. (10) Calculated using net sales of all stores open at both the beginning and the end of the period. (11) Calculated using gross square footage of all stores open at both the beginning and the end of the period. Gross square footage includes the storage, receiving and office space that generally occupies approximately 30% of total store space. (12) Assumes the following transactions were effected as of February 2, 2002: (i) the Pre-Offering Transactions and (ii) the refinancing of our existing senior credit facility with a new senior credit facility, as discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources." (13) Gives effect to the transactions described in note (12) as well as the sale by us of shares in this offering at an assumed initial public offering price of $ per share and the application of the estimated net proceeds from the sale after deducting estimated offering expenses and underwriting discounts and commissions. (14) Defined as current assets excluding cash and cash equivalents, less current liabilities excluding current maturities of long-term debt. (15) As of February 2, 2002, the liquidation value of our Class A, Class B and Class D Preferred Stock including $26.9 million of accrued dividends, was $88.4 million. The book value of this preferred stock has been adjusted from the liquidation value in connection with the reduction of the dividend rate on a portion of our Class B Preferred Stock. See Note 6 of the Notes to our consolidated financial statements. (16) In connection with our 1996 recapitalization, distributions of cash and securities to our pre-recapitalization shareholders were recorded as reductions in retained earnings, creating an accumulated deficit balance of $116 million at June 13, 1996. See "Certain Transactions - Recapitalization." 8 RISK FACTORS You should consider carefully the risks and uncertainties described below and other information included in this prospectus before you decide to buy our common stock. If any of the risks described below occur, our business, financial condition or results of operations could be adversely affected in a material way. This could cause the value of our common stock to decline, perhaps significantly, and you may lose all or part of your investment. RISKS RELATED TO OUR BUSINESS IF WE ARE UNABLE TO PROFITABLY OPEN AND OPERATE NEW STORES AND MAINTAIN THE PROFITABILITY OF OUR EXISTING STORES, OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS MAY BE HARMED. One of our strategies is to open new stores by focusing on both existing markets and by targeting new geographic markets. We have opened 100 new stores since the beginning of fiscal 1997. We intend to open approximately 15 new stores in fiscal 2002 and approximately 35 new stores in fiscal 2003, and our future operating results will depend to a substantial extent upon our ability to open and operate new stores successfully. To date we have signed leases for five new stores in fiscal 2002, two of which have already opened. We have not yet identified sites or signed leases for any new stores that we intend to open in fiscal 2003. We also have an ongoing expansion, remodeling and relocation program, and intend to expand, remodel or relocate four stores in fiscal 2002. There can be no assurance that we will be able to open, expand, remodel and relocate stores at this rate, or at all. Our ability to open new stores and to expand, remodel and relocate existing stores depends on a number of factors, including our ability to: - obtain adequate capital resources for leasehold improvements, fixtures and inventory on acceptable terms, or at all; - locate and obtain favorable store sites and negotiate acceptable lease terms; - construct or refurbish store sites; - obtain and distribute adequate product supplies to our stores; - maintain adequate warehousing and distribution capability at acceptable costs; - hire, train and retain skilled managers and personnel; and - continue to upgrade our information and other operating systems to control the anticipated growth and expanded operations. The rate of our expansion will also depend on the availability of adequate capital, which in turn will depend in large part on cash flow generated by our business and the availability of equity and debt capital. There can be no assurance that we will be able to obtain equity or debt capital on acceptable terms or at all. Moreover, our new senior credit facility will contain provisions that restrict the amount of debt we may incur in the future. In addition, the cost of opening, expanding, remodeling and relocating new or existing stores may increase in the future compared to historical costs. The increased cost could be material. If we are not successful in obtaining sufficient capital, we may be unable to open additional stores or expand, remodel and relocate existing stores as planned, which may adversely affect our results of operations. As a result, there can be no assurances that we will be able to achieve our current plans for the opening of new stores and the expansion, remodeling or relocation of existing stores. There also can be no assurance that our existing stores will maintain their current levels of sales and profitability or that new stores will generate sales levels necessary to achieve store-level profitability, much less profitability comparable to that of existing stores. New stores that we open in our existing markets may draw customers from our existing stores and may have lower sales growth relative to stores opened in new markets. New stores also may face greater competition and have lower anticipated sales 9 volumes relative to previously opened stores during their comparable years of operations. New stores opened in new markets, where we are less familiar with the target customer and less well known, may face different or additional risks and increased costs compared to stores operated in existing markets. Also, stores opened in non-mall locations may require greater marketing costs in order to attract customer traffic. These factors, together with increased pre-opening expenses at our new stores, may reduce our average store contribution and operating margins. If we are unable to profitably open and operate new stores and maintain the profitability of our existing stores, our business, financial condition and results of operations may be harmed. The success of our growth plan will be dependent on our ability to promote and/or recruit enough qualified district managers, store managers and sales associates to support the expected growth in the number of our stores, and the time and effort required to train and supervise a large number of new managers and associates may divert resources from our existing stores and adversely affect our operating and financial performance. Our operating results would also be adversely affected by any increase in the minimum wage or other factors that required increases in the compensation paid to our employees. THE AGREEMENTS GOVERNING OUR DEBT IMPOSE RESTRICTIONS ON OUR BUSINESS. We expect to enter into a new senior credit facility in May 2002. This new senior credit facility will contain a number of covenants imposing significant restrictions on our business. These restrictions may affect our ability to operate our business and consummate our business strategy and growth strategy, and may limit our ability to take advantage of potential business opportunities as they arise. These covenants place restrictions on our ability to, among other things: - incur additional indebtedness; - create liens; - pay dividends or make other distributions; - make investments; - sell assets; - make capital expenditures; and - enter into certain mergers and consolidations. The new credit facility is expected to have two financial covenants. One covenant will require us to maintain cash flow, net of capital expenditures, at specified levels. The other covenant will require us to keep our senior debt within a specified ratio of our cash flow. Any failure to comply with these or other financial covenants would allow the lenders to accelerate repayment of their debt, prohibit further borrowing under the revolving portion of the credit facility, declare an event of default, take possession of their collateral, or take other actions available to a secured senior creditor. If compliance with our debt obligations materially hinders our ability to operate our business and adapt to changing industry conditions, we may lose market share, our revenue may decline and our operating results may suffer. This would have a material adverse effect on the market value and marketability of our common stock. There is no assurance that the new senior credit facility will be successfully negotiated or that the indicated terms will be obtained. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources." WE MAY NOT BE ABLE TO SUCCESSFULLY ANTICIPATE CONSUMER TRENDS AND OUR FAILURE TO DO SO MAY LEAD TO LOSS OF NET SALES AND SIGNIFICANTLY HARM OUR OPERATING RESULTS. Our success depends on our ability to anticipate and respond to changing merchandise trends and consumer demands in a timely manner. If we fail to identify and respond to emerging trends, consumer 10 acceptance of the merchandise in our stores and our image with our customers may be harmed, which could materially adversely affect our results of operations. Additionally, if we misjudge market trends, we may significantly overstock unpopular products and be forced to take significant inventory markdowns, which would have a negative impact on our operating results and cash flow. Conversely, shortages of items that prove popular could have a material adverse effect on our operating results. In addition, a major shift in consumer demand away from home decor could also have a material adverse effect on our business, results of operations and financial condition. WE DEPEND ON A NUMBER OF VENDORS TO SUPPLY OUR MERCHANDISE, AND ANY DELAY IN MERCHANDISE DELIVERIES FROM CERTAIN VENDORS MAY LEAD TO A DECLINE IN INVENTORY WHICH COULD RESULT IN A LOSS OF NET SALES AND SIGNIFICANTLY HARM OUR OPERATING RESULTS. We purchase our products from approximately 200 vendors with which we have no long-term purchase commitments or exclusive contracts. None of our vendors supplied more than 13% of our merchandise purchases during the 12 months ended April 7, 2002. Historically, we have retained our vendors and we have generally not experienced difficulty in obtaining desired merchandise from vendors on acceptable terms. However, our arrangements with these vendors do not guarantee the availability of merchandise, establish guaranteed prices or provide for the continuation of particular pricing practices. Our current vendors may not continue to sell products to us on current terms or at all, and we may not be able to establish relationships with new vendors to ensure delivery of products in a timely manner or on terms acceptable to us. We may not be able to acquire desired merchandise in sufficient quantities on terms acceptable to us in the future. Also, our business would be adversely affected if there were delays in product shipments to us due to freight difficulties, strikes or other difficulties at our principal transport providers or otherwise. We have from time to time experienced delays of this nature. We are also dependent on vendors for assuring the quality of merchandise supplied to us. Our inability to acquire suitable merchandise in the future or the loss of one or more of our vendors and our failure to replace any one or more of them may have a material adverse effect on our business, results of operations and financial condition. WE ARE DEPENDENT ON FOREIGN IMPORTS FOR A SIGNIFICANT PORTION OF OUR MERCHANDISE, WHICH LEADS TO RISKS ARISING FROM POSSIBLE CHANGES IN THE TRADING RELATIONS AND CONDITIONS BETWEEN THE UNITED STATES AND THE RELEVANT FOREIGN COUNTRIES. Many of our vendors are importers of merchandise manufactured in the Far East and India. While we believe that buying from vendors instead of directly from manufacturers reduces or eliminates the risks involved with relying on products manufactured abroad, our vendors are subject to those risks, and we remain subject to those risks to the extent that their effects are passed through to us by our vendors or cause disruptions in supply. These risks include changes in import duties, quotas, loss of "most favored nation" ("MFN") trading status with the United States for a particular foreign country, work stoppages, delays in shipments, freight cost increases, economic uncertainties (including inflation, foreign government regulations, and political unrest) and trade restrictions (including the United States imposing antidumping or countervailing duty orders, safeguards, remedies or compensation and retaliation due to illegal foreign trade practices). If any of these or other factors were to cause a disruption of trade from the countries in which the suppliers of our vendors are located, our financial condition and results of operations could be materially adversely affected. We currently purchase a majority of our merchandise from importers of goods manufactured in China. China has been granted permanent normal trade relations by the United States effective January 1, 2002, based on its entry into the World Trade Organization ("WTO"), and now enjoys MFN trading status. China's recent entry into the WTO potentially stabilizes the trading relationship between it and the United States, but the possibility of trade disputes concerning merchandise currently imported from China continues to create risks. These risks could result in sanctions against China, and the imposition of new duties on certain imports from China, including products supplied to us. Any significant increase in duties 11 or any other increase in the cost of the products imported for us from China could have a material adverse effect on our results of operations and financial condition. Historically, instability in the political and economic environments of the countries in which our vendors obtain our products has not had a material adverse effect on our operations. However, we cannot predict the effect that future changes in economic or political conditions in such foreign countries may have on our operations. Although we believe that we could access alternative sources in the event of disruptions or delays in supply due to economic or political conditions in foreign countries on our vendors, such disruptions or delays may adversely affect our results of operations unless and until alternative supply arrangements could be made. In addition, merchandise purchased from alternative sources may be of lesser quality or more expensive than the merchandise we currently purchase abroad. Countries from which our vendors obtain these products may, from time to time, impose new or adjust prevailing quotas or other restrictions on exported products, and the United States may impose new duties, quotas and other restrictions on imported products. This could disrupt the supply of such products to us and adversely affect our operations. The United States Congress periodically considers other restrictions on the importation of products obtained for us by vendors. The cost of such products may increase for us if applicable duties are raised, or import quotas with respect to such products are imposed or made more restrictive. We are also subject to the risk that the manufacturers abroad who ultimately manufacture our products may employ labor practices that are not consistent with acceptable practices in the United States. In any such event we could be hurt by negative publicity with respect to those practices and, in some cases, face liability for those practices. To date we have not experienced any difficulties of this nature. OUR SUCCESS IS HIGHLY DEPENDENT ON OUR PLANNING AND CONTROL PROCESSES AND OUR SUPPLY CHAIN. An important part of our efforts to achieve efficiencies, cost reductions and sales growth is the continued identification and implementation of improvements to our planning, logistical and distribution infrastructure and our supply chain, including merchandise ordering, transportation and receipt processing. We also need to ensure that our distribution infrastructure and supply chain keep pace with our anticipated growth and increased number of stores. In particular, we may need to expand our existing infrastructure to the extent we open new stores in regions of the United States where we presently do not have stores. The cost of this enhanced infrastructure could be significant. In addition, a significant portion of the distribution to our stores is coordinated through our distribution facility in Jackson, Tennessee. Any significant disruption in the operations of this facility would have a material adverse effect on our operations. WE FACE AN EXTREMELY COMPETITIVE SPECIALTY RETAIL BUSINESS MARKET. The retail market is highly competitive. We compete against a diverse group of retailers, including specialty stores, department stores, discount stores and catalog retailers, which carry merchandise in one or more categories also carried by us. Our product offerings also compete with a variety of national, regional and local retailers, including such specialty retailers as Bed, Bath & Beyond, Cost Plus, Linens 'n Things, Michaels Stores, Pier 1 Imports and Williams-Sonoma. We also compete with these and other retailers for suitable retail locations, suppliers, qualified employees and management personnel. One or more of our competitors are present in substantially all of the malls in which we have stores. Many of our competitors are larger and have significantly greater financial, marketing and other resources than we do. This competition could result in the reduction of our prices and a loss of our market share. Our sales are also impacted by store liquidations of our competitors. We believe that our stores compete primarily on the basis of merchandise quality and selection, price, visual appeal of the merchandise and the store and convenience of location. There can be no assurance that we will continue to be able to compete successfully against existing or future competition. Our expansion into the markets served by our competitors, and the entry of new competitors or expansion of existing competitors into our markets, may have a material adverse effect on our business, financial condition and results of operations. 12 OUR BUSINESS IS HIGHLY SEASONAL AND OUR FOURTH QUARTER CONTRIBUTES A DISPROPORTIONATE AMOUNT OF OUR OPERATING INCOME AND NET INCOME. We have experienced, and expect to continue to experience, substantial seasonal fluctuations in our sales and operating results, which are typical of many mall-based specialty retailers and common to most retailers generally. Due to the importance of the fall selling season, which includes Thanksgiving and Christmas, the last quarter of our fiscal year has historically contributed, and is expected to continue to contribute, a disproportionate amount of our operating income and net income for the entire fiscal year. We expect this pattern to continue during the current fiscal year and anticipate that in subsequent fiscal years the last quarter of our fiscal year will continue to contribute disproportionately to our operating results. Any factors negatively affecting us during the last quarter of our fiscal year, including unfavorable economic conditions, could have a material adverse effect on our financial condition and results of operations, reducing our cash flow, leaving us with excess inventory and making it more difficult for us to finance our capital requirements. WE MAY EXPERIENCE SIGNIFICANT VARIATIONS IN OUR QUARTERLY RESULTS. Our quarterly results of operations may also fluctuate significantly based upon such factors as the timing of new store openings, pre-opening expenses associated with new stores, the relative proportion of new stores to mature stores, net sales contributed by new stores, increases or decreases in comparable store sales, adverse weather conditions, shifts in the timing of holidays, the timing and level of markdowns, changes in fuel and other shipping costs, changes in our product mix and actions taken by our competitors. A PROLONGED ECONOMIC DOWNTURN COULD RESULT IN REDUCED NET SALES AND PROFITABILITY. Our sales are also subject to a number of factors relating to consumer spending, including general economic conditions affecting disposable consumer income such as unemployment rates, business conditions, interest rates, levels of consumer confidence, energy prices, mortgage rates, the level of consumer debt and taxation. A weak retail environment could also adversely affect our sales. Purchases of home decor items may decline during recessionary periods or a prolonged recession may have a material adverse effect on our business, financial condition and results of operations. In addition, economic downturns during the last quarter of our fiscal year could adversely affect us to a greater extent than if such downturns occurred at other times of the year. There is also no assurance that consumers will continue to focus on their homes or on home-oriented products or that trends in favor of "cocooning" and new home purchases will continue. OUR COMPARABLE STORE NET SALES FLUCTUATE DUE TO A VARIETY OF FACTORS AND MAY NOT BE A MEANINGFUL INDICATOR OF FUTURE PERFORMANCE. Numerous factors affect our comparable store net sales results, including among others, weather conditions, retail trends, the retail sales environment, economic conditions, the impact of competition and our ability to execute our business strategy efficiently. Our comparable store net sales results have experienced fluctuations in the past. Our comparable store net sales increased 3.7% in fiscal 1999 over fiscal 1998, increased 0.6% in fiscal 2000 over fiscal 1999 and increased 13.3% in fiscal 2001 over the 53-week period ended February 3, 2001. In addition, we anticipate that opening new stores in existing markets may result in decreases in comparable store net sales for existing stores in such markets. Past comparable store net sales results may not be indicative of future results. Our comparable store net sales may not increase from quarter to quarter and may decline. As a result, the unpredictability of our comparable store net sales may cause our revenues and operating results to vary quarter to quarter, and an unanticipated decline in revenues or comparable store net sales may cause the price of our common stock to fluctuate significantly. 13 REDUCED CONSUMER SPENDING IN THE SOUTHEASTERN PART OF THE UNITED STATES WHERE A MAJORITY OF OUR STORES ARE CONCENTRATED COULD HARM US. Approximately 55% of our stores are located in the southeastern region of the United States. Consequently, economic conditions, weather conditions, demographic and population changes and other factors specific to this region may have a greater impact on our results of operations than on the operations of our more geographically diversified competitors. In addition, changes in regional factors that reduce the appeal of our stores and merchandise to local consumers could have a material adverse effect on our business, results of operations and financial condition. WE ARE HIGHLY DEPENDENT ON CUSTOMER TRAFFIC IN MALLS. Substantially all of our existing stores are located in enclosed malls. As a result, we largely rely on the ability of mall anchor tenants and other tenants to generate customer traffic in the vicinity of our stores. Historically, we have not relied on extensive media advertising and promotion in order to attract customers to our stores. Our future operating results will also depend on many other factors that are beyond our control, including the overall level of mall traffic and general economic conditions affecting consumer confidence and spending. OUR HARDWARE AND SOFTWARE SYSTEMS ARE VULNERABLE TO DAMAGE THAT COULD HARM OUR BUSINESS. We rely upon our existing management information systems for operating and monitoring all major aspects of our business, including sales, warehousing, distribution, purchasing, inventory control, merchandise planning and replenishment, as well as various financial functions. These systems and our operations are vulnerable to damage or interruption from: - fire, flood and other natural disasters; - power loss, computer systems failures, internet and telecommunications or data network failure, operator negligence, improper operation by or supervision of employees, physical and electronic loss of data or security breaches, misappropriation and similar events; and - computer viruses. Any disruption in the operation of our management information systems, the loss of employees knowledgeable about such systems or our failure to continue to effectively modify such systems could interrupt our operations or interfere with our ability to monitor inventory, which could result in reduced net sales and affect our operations and financial performance. We also need to ensure that our systems are consistently adequate to handle our anticipated store growth and are upgraded as necessary to meet our needs. The cost of any such system upgrades or enhancements would be significant. WE DEPEND ON KEY PERSONNEL, AND IF WE LOSE THE SERVICES OF ANY OF OUR PRINCIPAL EXECUTIVE OFFICERS, INCLUDING CARL KIRKLAND, OUR CHAIRMAN, AND ROBERT E. ALDERSON, OUR CHIEF EXECUTIVE OFFICER, WE MAY NOT BE ABLE TO RUN OUR BUSINESS EFFECTIVELY. We have benefited substantially from the leadership and performance of our senior management, especially Carl Kirkland, our Chairman, and Robert E. Alderson, our President and Chief Executive Officer. Our success will depend on our ability to retain our current management and to attract and retain qualified personnel in the future. Competition for senior management personnel is intense and there can be no assurances that we will be able to retain our personnel. Although we maintain key man insurance in the amount of $3 million on each of Messrs. Kirkland and Alderson, the loss of the services of either of these individuals for any reason could have a material adverse effect on our business, financial condition and results of operations. In addition, the loss of certain of our other principal executive officers could affect our ability to run our business effectively. We have employment agreements with Mr. Kirkland and Mr. Alderson and other members of senior management. The employment agreements with Messrs. Kirkland and Alderson have been extended through June 12, 2002, and negotiations have commenced concerning the terms on which the agreements will be further extended. The loss of a member 14 of senior management would require the remaining executive officers to divert immediate and substantial attention to seeking a replacement. TERRORISM AND THE UNCERTAINTY OF WAR MAY HAVE A MATERIAL ADVERSE EFFECT ON OUR OPERATING RESULTS. Terrorist attacks and other acts of violence or war may affect the market on which our common stock will trade, the markets in which we operate, our operations and profitability and your investment. The potential near-term and long-term effects any terrorist or other attacks on the United States or U.S. businesses may have for our customers, the market for our common stock, the demand for merchandise sold by our stores and the U.S. economy are uncertain. The consequences of any terrorist attacks, or any armed conflicts which may result, are unpredictable, and we may not be able to foresee events that could have an adverse effect on our business or your investment. OUR CHARTER AND BYLAW PROVISIONS AND CERTAIN PROVISIONS OF TENNESSEE LAW MAY MAKE IT DIFFICULT IN SOME RESPECTS TO CAUSE A CHANGE IN CONTROL OF KIRKLAND'S AND REPLACE INCUMBENT MANAGEMENT. Our charter authorizes the issuance of "blank check" preferred stock with such designations, rights and preferences as may be determined from time to time by our Board of Directors. Accordingly, the Board of Directors is empowered, without shareholder approval, to issue preferred stock with dividend, liquidation, conversion, voting or other rights that could materially adversely affect the voting power or other rights of the holders of our common stock (including purchasers in this offering). Holders of the common stock will not have preemptive rights to subscribe for a pro rata portion of any capital stock which may be issued by us. In the event of issuance, such preferred stock could be utilized, under certain circumstances, as a method of discouraging, delaying or preventing a change in control of Kirkland's. Although we have no present intention to issue any new shares of preferred stock, we may do so in the future. Our charter and bylaws contain certain corporate governance provisions that may deter and inhibit unsolicited changes in control of Kirkland's. First, the charter provides for a classified Board of Directors, with directors (after the expiration of the terms of the initial classified board of directors in 2003, 2004 and 2005) serving three year terms from the year of their respective elections and being subject to removal only for cause and upon the vote of 80% of the voting power of all outstanding capital stock entitled to vote (the "Voting Power"). Second, our charter and bylaws do not generally permit shareholders to call, or require that the Board of Directors call, a special meeting. The charter and bylaws also limit the business permitted to be conducted at any such special meeting. In addition, Tennessee law permits action to be taken by the shareholders by written consent only if the action is consented to by holders of the number of shares required to authorize shareholder action and if all shareholders entitled to vote are parties to the written consent. Third, the bylaws establish an advance notice procedure for shareholders to nominate candidates for election as directors or to bring other business before meetings of the shareholders. Only those shareholder nominees who are nominated in accordance with this procedure will be eligible for election as directors of Kirkland's, and only such shareholder proposals may be considered at a meeting of shareholders as have been presented to Kirkland's in accordance with the procedure. Finally, the charter provides that the amendment or repeal of any of the foregoing provisions of the charter mentioned previously in this paragraph requires the affirmative vote of at least 80% of the Voting Power. In addition, the bylaws provide that the amendment or repeal by shareholders of any bylaws made by our Board of Directors requires the affirmative vote of at least 80% of the Voting Power. Furthermore, Kirkland's is subject to certain provisions of Tennessee law, including certain Tennessee corporate takeover acts that are, or may be, applicable to us. These acts include the Investor Protection Act, the Business Combination Act and the Tennessee Greenmail Act, and these acts seek to limit the parameters in which certain business combinations and share exchanges occur. The charter, bylaws and Tennessee law provisions may have an anti-takeover effect, including possibly discouraging takeover attempts that might result in a premium over the market price for our common stock. See "Description of Capital Stock - Anti-Takeover Effect of Charter and Bylaw Provisions and Tennessee Laws." 15 RISKS ASSOCIATED WITH THIS OFFERING AN ACTIVE PUBLIC MARKET FOR OUR COMMON STOCK MAY NOT DEVELOP OR BE SUSTAINED, AND THE MARKET PRICE OF OUR COMMON STOCK MAY FALL BELOW THE INITIAL PUBLIC OFFERING PRICE. Prior to this offering, you could not buy or sell our common stock publicly. An active public market for our common stock may not develop or be sustained after this offering, and the market price might fall below the initial public offering price. The initial public offering price may bear no relationship to, and may be higher than, the price at which our common stock will trade upon completion of this offering. The initial public offering price will be determined by negotiations between us and the representatives of the underwriters based on factors that may not be indicative of future performance. THE MARKET PRICE FOR OUR COMMON STOCK MIGHT BE VOLATILE AND COULD RESULT IN A DECLINE IN THE VALUE OF YOUR INVESTMENT. Following this offering, the price at which our common stock will trade may be volatile. The market price of our common stock could be subject to significant fluctuations in response to our operating results, general trends in prospects for the retail industry, announcements by our competitors, analyst recommendations, our ability to meet or exceed analysts' or investors' expectations, the condition of the financial markets and other factors. In addition, the stock market in recent years has experienced extreme price and volume fluctuations that often have been unrelated or disproportionate to the operating performance of companies. These fluctuations, as well as general economic and market conditions, may adversely affect the market price of our common stock notwithstanding our actual operating performance. FUTURE SALES OF SHARES OF OUR COMMON STOCK IN THE PUBLIC MARKET, OR THE PERCEPTION THAT SUCH SALES MAY OCCUR, MAY DEPRESS OUR STOCK PRICE AND MAKE IT DIFFICULT FOR YOU TO RECOVER THE FULL VALUE OF YOUR INVESTMENT IN OUR SHARES. If our existing shareholders sell substantial amounts of our common stock in the public market following this offering or if there is a perception that these sales may occur, the market price of our common stock could decline. Upon completion of this offering we will have outstanding approximately shares of common stock. Of these shares, only the shares of common stock (plus any of the shares purchased pursuant to the exercise of the underwriters' overallotment option) sold in this offering will be freely tradable, without restriction, in the public market. After the lockup agreements pertaining to this offering expire 180 days from the date of this prospectus, unless waived, an additional shares will be eligible for sale in the public market at various times, subject to volume limitations under Rule 144 of the Securities Act of 1933, as amended (the "Securities Act"). Holders of all of such shares of common stock have the right to require us to register the shares for sale under the Securities Act in certain circumstances and also have the right to include those shares in a registration initiated by us. If we are required to include the shares of common stock of these shareholders pursuant to these registration rights in a registration initiated by us, sales made by such shareholders may adversely affect the price of the common stock and our ability to raise needed capital. In addition, if these shareholders exercise their demand registration rights and cause a large number of shares to be registered and sold in the public market or demand that we register their shares on a shelf registration statement, such sales or shelf registration may have an adverse effect on the market price of the common stock. Following this offering, we also intend to file registration statements with the Securities and Exchange Commission covering shares of common stock issued or reserved for issuance under our 1996 Executive Incentive and Non-Qualified Stock Option Plan, 2002 Incentive Plan and Employee Stock Purchase Plan. Upon effectiveness of such registration statements, any shares subsequently issued under such plans will be eligible for sale in the public market, except to the extent that they are restricted by the lock-up agreements referred to above and subject to compliance with Rule 144 in the case of our affiliates. Sales of a large number of shares of common stock issued under these plans in the public market 16 may have an adverse effect on the market price of the common stock. For more information regarding the sale of shares subsequently issued under such plans and the permissible sale of common stock by existing shareholders after the closing of this offering, see "Shares Eligible for Future Sale." CONCENTRATION OF OWNERSHIP AMONG OUR EXISTING DIRECTORS, EXECUTIVE OFFICERS, AND SHAREHOLDERS MAY PREVENT NEW INVESTORS FROM INFLUENCING SIGNIFICANT CORPORATE DECISIONS. Upon completion of this offering, our current directors, executive officers, existing shareholders and their affiliates will, in the aggregate, beneficially own approximately % of our outstanding common stock, assuming no exercise of the underwriters' overallotment option. As a result, these shareholders will be able to exercise a controlling influence over matters requiring shareholder approval, including the election of directors and approval of significant corporate transactions, and will have significant control over our management and policies. These shareholders may support proposals and actions with which you may disagree or which are not in your interests. YOU WILL INCUR IMMEDIATE AND SUBSTANTIAL DILUTION AS A RESULT OF THIS OFFERING. The initial public offering price is substantially higher than the book value per share of the common stock. As a result, purchasers in this offering will experience immediate and substantial dilution of $ per share in the tangible book value of the common stock from the initial public offering price. In addition, to the extent that currently outstanding options to purchase common stock are exercised, there will be further dilution. See "Dilution." 17 DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS This prospectus contains forward-looking statements relating to future events or our future financial performance. Such statements may relate to, but are not limited to, expectations of future operating results or financial performance, capital expenditures, construction or expansion of facilities (including new stores), plans for growth and future operations, or financing, as well as assumptions relating to the foregoing. Forward-looking statements are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified. Such risks include, but are not limited to, the matters discussed in the foregoing paragraphs under "Risk Factors." Future events and actual results could differ materially from those set forth in, contemplated by or underlying the forward-looking statements. Except as required by applicable law, including the securities laws of the United States, and the rules and regulations of the Securities and Exchange Commission, we do not plan to publicly update or revise any forward-looking statements after we distribute this prospectus, whether as a result of any new information, future events or otherwise. ABOUT THIS PROSPECTUS Market data used throughout this prospectus, including information relating to our relative position in the specialty retailing industry, is based on the good faith estimates of management, which estimates are based upon their review of internal surveys, independent industry publications and other publicly available information. Although we believe that these sources are reliable, we do not guarantee the accuracy or completeness of this information, and we have not independently verified this information. The Kirkland's logo, the Kirkland Collection(R) and Cedar Creek(R) private label brand are registered trademarks and/or service marks of Kirkland's. We also claim common law trademark rights in Briar Patch(TM), Kirkland's Outlet(TM), Kirkland's Home(TM) and other marks. We are exploring the possibility of federal registration of several of these marks. All other trademarks or service marks appearing in this prospectus are trademarks or service marks of the companies that utilize them. 18 USE OF PROCEEDS We estimate that our net proceeds from the sale of the shares of common stock offered by us will be approximately $ million, at an assumed initial public offering price of $ , after deducting underwriting discounts and commissions and estimated offering expenses. We will not receive any proceeds from the sale of shares by the selling shareholders. We expect to use the net proceeds from this offering as follows: - $ million to repay outstanding indebtedness under a new revolving credit facility; - $ million to repay all of our outstanding subordinated debt, including accrued and unpaid interest; - $ million to redeem all of the outstanding shares of mandatorily redeemable Class C Preferred Stock (including approximately $ of amounts classified as interest associated with the Class C Preferred Stock) (all of the shares of Class C Preferred Stock are held by affiliates of Kirkland's); and - $ million to redeem $ million of aggregate stated value and accrued and unpaid dividends of Class A Preferred Stock, Class B Preferred Stock and Class D Preferred Stock (substantially all of the shares of Class A Preferred Stock, Class B Preferred Stock and Class D Preferred Stock are held by affiliates of Kirkland's). We expect to enter into a new three-year revolving credit facility in May 2002 that will include a $45 million revolving credit facility ($30 million for the first six months of each calendar year) bearing interest at a floating rate equal to the prime rate or 2.25% above LIBOR, at our election. We expect the amount outstanding under the revolving credit facility to be between $ million and $ million as of the consummation of this offering. The borrowing under our new revolving credit facility will be used to repay our prior credit facility. Our subordinated debt consists of $20.0 million subordinated notes bearing interest at 15.5% per year and maturing on June 30, 2003. Effective upon entering into our new credit facility and repaying accrued interest under the subordinated notes, the interest rate on the subordinated notes will be reduced to 12.5%. As of February 2, 2002, accrued and unpaid interest on the subordinated notes amounted to $3.8 million. By their terms, the subordinated notes are required to be repaid in full with the proceeds of this offering. We issued our Class C Preferred Stock in connection with our 1996 recapitalization and the Class C Preferred Stock has an aggregate stated value of $17.1 million at February 2, 2002. See "Management's Discussion & Analysis of Financial Condition and Results of Operations" and "Certain Transactions - Recapitalization." We accrue an annual amount equal to 9% of the outstanding stated value of the Class C Preferred Stock, which has been reflected as interest expense in our consolidated financial statements. As of February 2, 2002, the aggregate unpaid accrual with respect to the Class C Preferred Stock amounted to $7.2 million. The Class C Preferred Stock is required to be redeemed with the proceeds of this offering. We issued our Class A Preferred Stock, Class B Preferred Stock and Class D Preferred Stock in connection with various financings between 1996 and 2000. At February 2, 2002, the outstanding Class A, B and D Preferred Stock had an aggregate liquidation value of $88.4 million, including $26.9 million of accrued dividends. The Class A, B and D Preferred Stock currently accrue cumulative dividends at rates varying from 4% to 10% per year compounded quarterly. All outstanding shares of Class A, B and D Preferred Stock that are not being redeemed will be converted immediately into common stock prior to the completion of this offering. See "Prospectus Summary - Pre-Offering Transactions," "Management's Discussion & Analysis of Financial Condition and Results of Operations" and "Certain Transactions." 19 DIVIDEND POLICY We intend to retain all future earnings to finance the continued growth and development of our business, and do not, therefore, anticipate paying any cash dividends on our common stock in the foreseeable future. In addition, our new senior credit facility will likely include restrictions on the payment of cash dividends. No dividends have been paid on our common stock subsequent to 1995. Future cash dividends, if any, will be determined by our Board of Directors, and will be based upon our earnings, capital requirements, financial condition, debt covenants and other factors deemed relevant by our Board of Directors. 20 DILUTION If you invest in our common stock, your interest will be diluted to the extent of the difference between the public offering price per share of our common stock and the pro forma as adjusted net tangible book value per share of our common stock after this offering. Our pro forma net negative tangible book value as of February 2, 2002, after giving effect to the Pre-Offering Transactions, was $ million, or $ per share of outstanding common stock. Pro forma net negative tangible book value per share is determined by dividing our pro forma net negative tangible book value (total tangible assets less total liabilities) by the number of shares of common stock outstanding on a pro forma basis, giving effect to the Pre-Offering Transactions. Without taking into effect any changes in pro forma net negative tangible book value after February 2, 2002, other than to give effect to the sale by us of the shares of common stock offered by us in this offering and the application of the estimated net proceeds therefrom (after deducting estimated offering expenses and the underwriting discounts and commissions), our as adjusted pro forma net negative tangible book value as of February 2, 2002 would have been $ million, or $ per share. This represents an immediate increase in pro forma net tangible book value of $ per share to existing shareholders and an immediate dilution of $ per share to purchasers of common stock in this offering. The following table illustrates this per share dilution: <Table> Assumed initial public offering price per share........ $ Net negative tangible book value per share at February 2, 2002.................................. $ ( ) Adjustment for Pre-Offering Transactions............. -------- Pro forma net negative tangible book value per share before the Offering............................... ( ) Increase attributable to new shareholders............ -------- Adjusted pro forma net negative tangible book value per share after the offering...................... ( ) -------- Dilution per share to new shareholders................. $ </Table> The following table sets forth, on a pro forma basis as of February 2, 2002, giving effect to the Pre-Offering Transactions, the number of shares of common stock purchased from us, the total consideration paid to us, the average price per share paid by existing shareholders, and the average price per share to be paid by purchasers of common stock in this offering: <Table> <Caption> SHARES PURCHASED TOTAL CONSIDERATION ------------------- ---------------------- AVERAGE PRICE NUMBER PERCENT AMOUNT PERCENT PER SHARE --------- ------- ------------ ------- ------------- Existing shareholders(1)........ % $ % $ New investors............ $ --------- ----- ------------ ----- Total............... 100.0% 100.0% ========= ===== ============ ===== </Table> 21 - ------------------------------ (1) With respect to our executive officers, directors and greater-than-10% shareholders, and assuming the exercise of all outstanding stock options, the number of shares of common stock purchased from us, the total consideration paid to us, and the average price per share paid by such persons, are as follows: <Table> <Caption> SHARES PURCHASED TOTAL CONSIDERATION ------------------- ---------------------- AVERAGE PRICE NUMBER PERCENT AMOUNT PERCENT PER SHARE --------- ------- ------------ ------- ------------- % % </Table> Except as otherwise indicated, the foregoing tables do not include (i) 15,570 shares of common stock issuable upon exercise of options that will be outstanding upon completion of this offering at exercise prices ranging from $0.01 to $95.00 per share, of which 6,370 shares are subject to options which will be exercisable upon completion of this offering, and (ii) shares of common stock reserved for future issuance under our 1996 Executive Incentive and Non-Qualified Stock Option Plan, 2002 Incentive Plan and Employee Stock Purchase Plan. See "Management - Employee Benefit Plans." 22 CAPITALIZATION The following table describes our capitalization as of February 2, 2002. Our capitalization is presented: - on an actual basis; - on a pro forma basis to give effect to (i) the Pre-Offering Transactions and (ii) the refinancing of our existing senior credit facility with a new senior credit facility, as discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources;" and - on a pro forma as adjusted basis to give effect to (i) the transactions discussed in the preceding paragraph and (ii) the sale by us of shares in this offering at an assumed initial offering price of $ per share and the application of the estimated net proceeds from the sale (after deducting estimated offering expenses and underwriting discounts and commissions). This presentation should be read in conjunction with our consolidated financial statements and related notes appearing elsewhere in this prospectus. <Table> <Caption> AS OF FEBRUARY 2, 2002 ----------------------------------- PRO FORMA ACTUAL PRO FORMA AS ADJUSTED --------- --------- ----------- (IN THOUSANDS) Cash and cash equivalents.................... $ 29,751 $ $ ========= ==== ==== Long-term debt, including current portion: Existing senior credit facility(1)......... 39,497 New senior credit facility................. -- Subordinated debt(2)....................... 23,744 Mandatorily redeemable preferred stock (Class C)(3)............................ 24,319 --------- ---- ---- Total long-term debt, including current portion.................................... 87,560 --------- ---- ---- Common stock warrants........................ 7,759 Redeemable convertible preferred stock (Class A, Class B and Class D)(4)................. 86,812 Shareholders' equity (deficit): Common stock, at stated value: shares authorized, shares issued and outstanding, actual; shares authorized, shares issued and outstanding, pro forma; and 100,000,000 shares authorized, shares issued and outstanding, pro forma as adjusted(5)... 229 Additional paid-in capital................... -- Accumulated deficit.......................... (111,439) --------- ---- ---- Total shareholders' equity (deficit)......... (111,210) --------- ---- ---- Total capitalization......................... $ 70,921 $ $ ========= ==== ==== </Table> - ------------------------------ (1) Includes $1.3 million in the aggregate of accrued and unpaid interest on our senior term loan. (2) Includes $3.8 million in the aggregate of accrued and unpaid interest on our subordinated debt. (3) Includes $7.2 million in the aggregate of accrued and unpaid interest on our Class C Preferred Stock. (4) Includes $26.9 million in the aggregate of accrued and unpaid dividends on our Class A Preferred Stock, Class B Preferred Stock and Class D Preferred Stock. As of February 2, 2002, the liquidation value of our Class A, Class B and Class D Preferred Stock including $26.9 million of accrued dividends, was $88.4 million. The book value of this preferred stock has been adjusted from the liquidation value in connection with the reduction of the dividend rate on a portion of our Class B Preferred Stock. See Note 6 of the Notes to our consolidated financial statements. (5) Excludes approximately 23,470 shares of common stock reserved for issuance upon the exercise of options outstanding at February 2, 2002 (15,570 shares upon completion of this offering) at exercise prices ranging from $0.01 to $95.00 per share, of which 6,370 shares were subject to options which will be exercisable upon completion of this offering. 23 SELECTED CONSOLIDATED FINANCIAL DATA The selected "Statement of Operations Data" and the "Other Financial Data" for the fiscal years ended December 31, 1999 and December 31, 2000, the 34-day period ended February 3, 2001 and the fiscal year ended February 2, 2002 and the selected "Balance Sheet Data" as of December 31, 2000 and February 2, 2002 have been derived from our audited consolidated financial statements included elsewhere in this prospectus. The selected "Balance Sheet Data" as of December 31, 1997, 1998 and 1999 and the selected "Statement of Operations Data" and the "Other Financial Data" for the years ended December 31, 1997 and 1998 have been derived from our audited consolidated financial statements not included in this prospectus. The "Store Data" for all periods presented below have been derived from internal records of our operations. The selected consolidated financial data should be read in conjunction with our consolidated financial statements and notes thereto, and with "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere in this prospectus. <Table> <Caption> 34-DAY YEAR ENDED DECEMBER 31, PERIOD ENDED YEAR ENDED ----------------------------------------- FEBRUARY 3, FEBRUARY 2, 1997 1998 1999 2000 2001(1) 2002(2) -------- -------- -------- -------- ------------ ----------- (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) STATEMENT OF OPERATIONS DATA: Net sales...................... $153,584 $192,250 $236,622 $259,240 $23,875 $307,213 Cost of sales(3)............... 96,998 121,936 154,278 172,376 18,998 200,063 -------- -------- -------- -------- ------- -------- Gross profit................... 56,586 70,314 82,344 86,864 4,877 107,150 Operating expenses: Other operating expenses..... 35,760 45,820 57,894 67,401 7,388 71,622 Non-cash stock compensation charge(4).................. -- -- -- -- -- 712 Depreciation and amortization................. 4,142 5,410 7,276 7,827 601 7,678 -------- -------- -------- -------- ------- -------- Operating income (loss)........ 16,684 19,084 17,174 11,636 (3,112) 27,138 Interest expense: Senior, subordinated and other notes payable........ 7,990 9,254 10,232 11,221 1,043 9,759 Class C Preferred Stock...... 1,800 1,541 1,647 1,850 154 2,007 Accretion of common stock warrants(5)................ 389 -- (879) -- -- 7,759 Interest income................ (80) (113) (27) (1) -- (278) Offering and financing costs(6)..................... -- -- 852 782 -- -- Other expense (income), net.... (154) (245) (396) (328) (34) 262 Income tax provision (benefit).................... 2,817 2,220 1,106 (573) (1,806) 3,331 -------- -------- -------- -------- ------- -------- Net income (loss).............. 3,922 6,427 4,639 (1,315) (2,469) 4,298 Accretion of redeemable preferred stock and dividends accrued(7)................... (3,755) (3,832) (5,053) (6,555) (778) (6,352) -------- -------- -------- -------- ------- -------- Net income (loss) allocable to common stock................. $ 167 $ 2,595 $ (414) $ (7,870) $(3,247) $ (2,054) ======== ======== ======== ======== ======= ======== Income (loss) per common share Basic........................ $ 1.67 $ 28.13 $ (4.50) $ (71.49) $(23.74) $ (1.50) Diluted...................... $ 1.35 $ 21.99 $ (4.50) $ (71.49) $(23.74) $ (1.50) Weighted average number of common shares outstanding Basic........................ 100,000 92,252 92,101 110,084 136,751 136,752 Diluted...................... 123,549 292,305 92,101 110,084 136,751 136,752 </Table> 24 <Table> <Caption> YEAR ENDED DECEMBER 31, YEAR ENDED --------------------------------------------- FEBRUARY 2, 1997 1998 1999 2000 2002(2) --------- --------- --------- --------- ----------- (IN THOUSANDS, EXCEPT SHARE DATA) PRO FORMA DATA: Pro forma as adjusted net income(8)......................... $ -------- Pro forma as adjusted earnings per common share(8)................... $ ======== Pro forma as adjusted shares outstanding(8).................... $ ======== OTHER FINANCIAL DATA: Gross profit margin................. 36.8% 36.6% 34.8% 33.5% 34.9% Adjusted EBITDA(9).................. $ 20,826 $ 24,494 $ 24,450 $ 19,463 $ 35,528 Adjusted EBITDA margin(10).......... 13.6% 12.7% 10.3% 7.5% 11.6% Net cash provided by operating activities........................ $ 8,669 $ 4,326 $ 12,945 $ 1,336 $ 37,530 Net cash (used in) investing activities........................ (5,479) (14,669) (10,825) (5,981) (4,744) Net cash (used in) provided by financing activities.............. (3,537) 13,658 (3,370) 19,855 (29,949) STORE DATA: Comparable store net sales increase(11)...................... 5.2% 1.0% 3.7% 0.6% 13.3% Number of stores at the end of period(12)........................ 138 198 226 240 234 Average net sales per store (in thousands)(13).................... $ 1,178 $ 1,169 $ 1,111 $ 1,112 $ 1,307 Average gross square footage per store(14)......................... 4,186 4,392 4,364 4,437 4,528 Average net sales per square foot(13)(14)...................... $ 281 $ 266 $ 255 $ 251 $ 289 </Table> <Table> <Caption> AS OF DECEMBER 31, AS OF --------------------------------------------- FEBRUARY 2, 1997 1998 1999 2000 2002(2) --------- --------- --------- --------- ----------- (IN THOUSANDS) BALANCE SHEET DATA: Cash and cash equivalents.......... $ 10,881 $ 14,196 $ 12,946 $ 28,156 $ 29,751 Working capital(15)................ 9,332 14,368 11,417 18,418 1,020 Total assets....................... 49,884 82,474 92,600 113,382 95,818 Total debt, including mandatorily redeemable preferred stock (Class C)............................... 88,597 106,241 103,466 104,360 75,239 Common stock warrants.............. 879 879 -- -- 7,759 Redeemable convertible preferred stock (Class A, Class B and Class D)(16)........................... 50,591 50,418 55,471 81,909 86,812 Common stock....................... 210 229 229 229 229 Accumulated (deficit) equity(17)... (104,991) (100,103) (101,517) (108,387) (111,439) </Table> - ------------------------------ (1) Effective January 1, 2001, we changed our fiscal reporting year from a calendar year to a 52/53-week basis ending on the Saturday closest to January 31 resulting in a 34-day stub period as presented. At the beginning of 2001, we instituted a plan to improve sales, increase cash flow and return our stores to higher levels of profitability. The cornerstone of our plan was a strategy to reduce store-level inventories during January and February 2001. This strategy necessitated significant markdown activity that resulted in a reduced gross margin for January and February 2001. However, markdowns were offset by increased net sales, and, as a result, we believe our operating loss for the 34-day period ended February 3, 2001 of $3.1 million was substantially consistent with our operating loss for the 31-day period ended January 31, 2000 of $2.6 million. For the period 25 from February 1, 2000 through February 3, 2001, our net sales were $266.3 million, our gross profit was $87.8 million and our Adjusted EBITDA was $19.0 million. This approximately 53-week period is derived from our internal records and was not audited or reviewed by our auditors. (2) Effective January 1, 2001, we changed our fiscal reporting year from a calendar year to a 52/53-week basis ending on the Saturday closest to January 31. Our 2001 fiscal year began on February 4, 2001 and ended on February 2, 2002. (3) Cost of sales includes cost of product sold, freight, store occupancy and central distribution costs. (4) Reflects a non-cash stock compensation charge related to certain outstanding stock options. (5) Reflects the accretion to the fair value of detachable put warrants to purchase common stock, issued by us in connection with our issuance of subordinated debt. The put rights associated with these warrants were terminated as of January 1, 1998, were restored as of December 31, 1999 and were terminated again as of February 3, 2002. (6) Represents the write down of certain costs associated with a withdrawn equity offering in fiscal 1999 and an unsuccessful refinancing effort in fiscal 2000. (7) Reflects the accretion of the Class A Preferred Stock, Class B Preferred Stock and Class D Preferred Stock to its redemption value and the accrual of dividends on such preferred stock. (8) Assumes the following transactions were effected as of February 4, 2001: (i) the Pre-Offering Transactions, (ii) the termination of the put rights associated with the put warrants discussed in note (5) above, (iii) the refinancing of our existing senior credit facility with a new senior credit facility, as discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" and (iv) the sale by us of shares in this offering at an assumed initial public offering price of $ per share and the application of the estimated net proceeds from the sale after deducting estimated offering expenses and underwriting discounts and commissions. Pro forma as adjusted net income and pro forma as adjusted earnings per common share exclude the $0.7 million non-cash stock compensation charge in fiscal 2001 related to certain outstanding stock options. (9) The term Adjusted EBITDA as used herein represents operating income before depreciation and amortization expense and a non-cash stock compensation charge related to certain outstanding stock options. While Adjusted EBITDA should not be considered in isolation or as a substitute for net income, cash flow from operations or any other measure of income or cash flow that is prepared in accordance with generally accepted accounting principles or as a measure of a company's profitability or liquidity, Adjusted EBITDA has been presented because we believe it is commonly used in this or a similar format by investors to analyze and compare operating performance as well as to provide additional information with respect to our ability to meet our future debt service, capital expenditure and working capital requirements. Adjusted EBITDA may differ in method of calculation from similarly titled measures used by other companies. This information should be read in conjunction with our consolidated statements of cash flows contained in our consolidated financial statements and notes thereto included elsewhere in this prospectus. (10) Defined as Adjusted EBITDA as a percentage of net sales. (11) We include new stores in comparable store net sales calculations after the store has been in operation one full fiscal year. We exclude from comparable store net sales calculations each store that was expanded, remodeled or relocated during the applicable period. Each expanded, remodeled or relocated store is returned to the comparable store base after it has been excluded from the comparable store base for one full fiscal year. The comparable store net sales increase for fiscal 2001 reflects the increase in comparable store net sales for the 52-week period ended February 2, 2002 compared to the 53-week period ended February 3, 2001. (12) Our store count excludes our warehouse outlet store located adjacent to our central distribution facility in Jackson, Tennessee. (13) Calculated using net sales of all stores open at both the beginning and the end of the period. (14) Calculated using gross square footage of all stores open at both the beginning and the end of the period. Gross square footage includes the storage, receiving and office space that generally occupies approximately 30% of total store space. (15) Defined as current assets excluding cash and cash equivalents, less current liabilities excluding current maturities of long-term debt and revolving line of credit. (16) As of February 2, 2002, the liquidation value of our Class A, Class B and Class D Preferred Stock including $26.9 million of accrued dividends, was $88.4 million. The book value of this preferred stock has been adjusted from the liquidation value in connection with the reduction of the dividend rate on a portion of our Class B Preferred Stock. See Note 6 of the Notes to our Consolidated Financial Statements. (17) In connection with our 1996 recapitalization, distributions of cash and securities to our pre-recapitalization shareholders were recorded as reductions in retained earnings, creating an accumulated deficit balance of $116 million at June 13, 1996. See "Certain Transactions - Recapitalization." 26 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS A number of the matters and subject areas discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business" and elsewhere in this prospectus are not limited to historical or current facts and deal with potential future circumstances and developments, and are accordingly "forward-looking statements." You are cautioned that such forward-looking statements, which may be identified by words such as "anticipate," "believe," "expect," "estimate," "intend," "plan" and similar expressions, are only predictions and that actual events or results may differ materially. OVERVIEW We are a leading specialty retailer of home decor in the United States, operating 236 stores in 28 states. Our stores present a broad selection of distinctive merchandise, including framed art, mirrors, candles, lamps, picture frames, accent rugs, garden accessories and artificial floral products. Our stores also offer an extensive assortment of holiday merchandise, as well as items carried throughout the year suitable for giving as gifts. In addition, we use innovative design and packaging to market home decor as gifts. We provide our predominantly female customers an engaging shopping experience characterized by a diverse, ever-changing merchandise selection at surprisingly attractive prices. Our stores offer a unique combination of style and value that has led to our emergence as a leader in home decor and has enabled us to develop a strong customer franchise. As a result, we have achieved substantial growth over the last five fiscal years. Since the beginning of 1997, our sales have grown at a compounded annual growth rate of 19%. For the fiscal year ended February 2, 2002, we recorded net sales of $307.2 million and Adjusted EBITDA of $35.5 million, or 11.6% of net sales. Kirkland's was co-founded in 1966 by our current Chairman, Carl Kirkland. In 1996, we completed a recapitalization through which Advent International Group (through affiliated entities) became the largest beneficial owner of our equity. The 1996 recapitalization permitted the then-existing shareholders, consisting of Carl Kirkland, Robert E. Alderson, our current President and Chief Executive Officer, and two other shareholders, to realize a portion of the value of their interest in Kirkland's. As we more than doubled our store base from 104 stores at the end of fiscal 1995 to 226 stores at the end of fiscal 1999, we realized the need to strengthen our infrastructure and enhance several aspects of our operations in order to execute a rapid national expansion. Beginning in late 1999, we undertook a series of initiatives that enabled us to make faster and smarter inventory buying and distribution decisions, to manage the flow of merchandise to our stores more efficiently and to improve overall financial performance. These initiatives included: Completing Key Investments in Information Technology. Since late 1999, we have invested $6.5 million in several key information systems projects that provide our decision makers with better tools to increase sales, improve operational efficiency, control and distribute inventory and monitor critical performance indicators on a daily basis. Developing a More Scalable Distribution Infrastructure. Prior to 2000, we distributed our products primarily through direct shipments from our vendors to each of our individual stores. In March 2001, we consolidated our central distribution operations into one 303,000-square-foot, leased facility in Jackson, Tennessee, which allowed us to increase our dollar volume of centrally distributed merchandise by 24% from fiscal 2000 to fiscal 2001. This modern facility, together with other improvements to our distribution operations, have helped us to keep our stores stocked with fresh merchandise and to reduce significantly the cost of managing inventories at the store level. Strengthening Executive Management. Since the second half of 1999, we have added six senior managers, including key hires in merchandising, store operations and information technology. These additions, along with several other key hires and promotions, have broadened the abilities of our management team and have provided leadership to key areas of our business. We believe our management team has valuable experience both from Kirkland's and from other national retailers. 27 Improving Store-Level Operating Performance. In January 2001, we instituted a plan to improve sales, increase cash flow and return our stores to higher levels of profitability. The cornerstone of this plan was to reduce store-level inventories and improve inventory turnover. We also intensified our efforts to control and lower store operating expenses and close under-performing stores. We believe the convergence of these operational initiatives led to the significant improvement in our fiscal 2001 operating results as compared to fiscal 2000. For fiscal 2001, our comparable store net sales increased 13.3% over the 53-week period ended February 3, 2001 and our Adjusted EBITDA margin expanded to 11.6% from 7.5% in fiscal 2000. Net cash provided by operating activities increased to $37.5 million as compared to $1.3 million in fiscal 2000, and inventory turnover in fiscal 2001 increased to 3.48x as compared to 2.45x in fiscal 2000. As evidenced by the improvement in our operating results, we believe these initiatives have positioned us to expand our proven retail concept and strengthen our position as a leading specialty retailer of home decor in the United States. RESULTS OF OPERATIONS On January 1, 2001, we elected to change our fiscal reporting year from a calendar year basis to a 52/53-week year ending on the Saturday closest to January 31. Consequently, the results of operations table and discussion below compare the fifty-two weeks ended February 2, 2002 and the twelve months ended December 31, 2000. The results for the 34-day "stub period" ended February 3, 2001 are included separately in our consolidated financial statements. In January 2001, we implemented a plan to improve sales, increase cash flow and return our stores to higher levels of productivity. The cornerstone of our plan was a strategy to reduce store-level inventories during January and February 2001. This strategy necessitated significant markdown activity that resulted in a reduced gross margin for January and February 2001. However, markdowns were offset by increased net sales, and, as a result, we believe our operating loss for the 34-day period ended February 3, 2001 of $3.1 million was substantially consistent with our operating loss for the 31-day period ended January 31, 2000 of $2.6 million. For the period from February 1, 2000 through February 3, 2001, our net sales were $266.3 million, our gross profit was $87.8 million and our Adjusted EBITDA was $19.0 million. This approximately 53-week period is derived from our internal records and was not audited or reviewed by our auditors. 28 The table below sets forth selected results of our operations expressed as a percentage of net sales for the periods indicated. <Table> <Caption> FISCAL YEAR ENDED ----------------------------------------- DECEMBER 31, DECEMBER 31, FEBRUARY 2, 1999 2000 2002(1) ------------ ------------ ----------- Net sales.................................... 100.0% 100.0% 100.0% Cost of sales(2)............................. 65.2 66.5 65.1 ----- ----- ----- Gross profit................................. 34.8 33.5 34.9 Operating expenses: Other operating expenses................... 24.5 26.0 23.3 Non-cash stock compensation charge......... -- -- 0.2 Depreciation and amortization................ 3.1 3.0 2.5 ----- ----- ----- Operating income............................. 7.2 4.5 8.9 Interest expense: Senior, subordinated and other notes payable................................. 4.3 4.3 3.2 Class C Preferred Stock.................... 0.7 0.7 0.7 Accretion of common stock warrants......... (0.4) -- 2.5 Interest income.............................. 0.0 0.0 (0.1) Offering and financing costs(3).............. 0.4 0.3 -- Other expense (income), net.................. (0.2) (0.1) 0.1 ----- ----- ----- Income (loss) before income taxes............ 2.4 (0.7) 2.5 Income tax provision (benefit)............... 0.4 (0.2) 1.1 ----- ----- ----- Net income (loss)............................ 2.0% (0.5)% 1.4% ===== ===== ===== </Table> - ------------------------------ (1) Effective January 1, 2001, we changed our fiscal year from a calendar year basis to a 52/53-week year ending on the Saturday closest to January 31. Accordingly, the fiscal year ended February 2, 2002 encompasses the 52-week period beginning on February 4, 2001 and ending on February 2, 2002. (2) Cost of sales includes cost of product sold, freight, store occupancy and central distribution costs. (3) During the year ended December 31, 2000, we recorded an impairment of deferred financing costs that were connected with a refinancing effort that was not consummated. Additionally, during the year ended December 31, 1999, we indefinitely postponed plans for an initial public offering that resulted in the impairment of previously deferred offering costs. FISCAL YEAR ENDED FEBRUARY 2, 2002 COMPARED TO FISCAL YEAR ENDED DECEMBER 31, 2000 Net Sales. Net sales increased by 18.5% to $307.2 million for fiscal 2001 from $259.2 million for fiscal 2000. The net sales increase in fiscal 2001 resulted primarily from an increase in comparable store net sales. Also, the addition of five new stores in fiscal 2001 and the full year impact of the 17 new stores added in fiscal 2000 offset by the closure of 11 stores after fiscal 2000 and three stores in fiscal 2000 contributed to the overall net sales increase. The increase in comparable store net sales accounted for approximately $36.8 million of the total net sales increase, or 76.7%, and the net increase in the store base over the last two fiscal years accounted for approximately $11.2 million, or 23.3%, of the total net sales increase. One of our key operating initiatives during 2001 was a concerted effort to reduce inventory levels and SKU counts to offer a better, sharper array of merchandise without changing the core categories of merchandise that we offer. Much of this inventory reduction was accomplished from January through April 2001 through markdowns and promotional activities. As a result of this effort, merchandise flow improved during the balance of the year, allowing our customers to experience a steady flow of fresh product. In addition, the installation of a fully integrated retail information management system at our home office in April 2001 significantly increased our ability to maintain a fresh merchandise mix and appropriate 29 inventory levels in our stores. The comparable store net sales increase was primarily the result of increased unit sales and customer traffic, although we did experience favorable trends in our average retail price per item sold. Gross Profit. Gross profit, defined as net sales less the cost of sales including cost of product sold, freight, store occupancy and central distribution costs, increased $20.2 million, or 23.2%, to $107.1 million for fiscal 2001 from $86.9 million for fiscal 2000. Gross profit expressed as a percentage of net sales increased to 34.9% for fiscal 2001, from 33.5% for fiscal 2000. The increase in gross profit as a percentage of net sales resulted primarily from the leveraging of store occupancy costs through higher net sales. Additionally, as a result of our aggressive inventory reduction in the first quarter of fiscal 2001, product cost of sales, including freight expenses, declined as a percentage of net sales particularly in the second half of fiscal 2001, due to the strong sell-through and fresher merchandise mix. These factors were partially offset by an increase in central distribution costs as a percentage of net sales as we leased additional distribution center space and increased staffing levels during fiscal 2001. Other Operating Expenses. Other operating expenses, including both store and corporate costs, were $71.6 million, or 23.3% of net sales, for fiscal 2001 as compared to $67.4 million, or 26.0% of net sales, for fiscal 2000. The decline in these operating expenses as a percentage of net sales was primarily the result of strong sales that leveraged the fixed component of operating expenses. The percentage decrease in operating expenses also benefited from several expense control initiatives at the store and corporate levels. Two of the most significant initiatives were directly related to our fiscal 2001 plan to improve store-level operating performance. First, we initiated a concerted effort to restrain growth in store payroll expense. By operating stores with lower inventory levels and improving merchandise distribution and allocation, we were able to reduce store payroll expense to 12.2% of net sales for fiscal 2001 as compared to 13.6% of net sales for fiscal 2000. This improvement is partially the result of our completion of a planned reduction in the number of store assistant manager positions. Second, we were able to save over $1 million by reducing our stores' use of local storage facilities and related truck rentals. During fiscal 2002, we will seek to further reduce the costs associated with these local storage facilities as we continue to increase the volume of our centrally distributed merchandise. Non-Cash Stock Compensation Charge. In fiscal 2001, we incurred a non-cash stock compensation charge related to certain outstanding stock options of $0.7 million, or 0.2% of net sales. No such charge was incurred in fiscal 2000. See Notes 8 and 12 of the Notes to our consolidated financial statements. Depreciation and Amortization. Depreciation and amortization expense was $7.7 million, or 2.5% of net sales, for fiscal 2001 as compared to $7.8 million, or 3.0% of net sales, for fiscal 2000. The decline as a percentage of net sales was the result of the strong sales performance as well as a decline in capital expenditures over the last two fiscal years in relation to previous fiscal years. Interest Expense. Interest expense on senior, subordinated and other notes payable was $9.8 million, or 3.2% of net sales, for fiscal 2001 as compared to $11.2 million, or 4.3% of net sales, for fiscal 2000. The decrease was the result of significantly improved operating cash flow which led to lower average debt balances in fiscal 2001 in comparison to fiscal 2000 combined with lower interest rates. Interest expense associated with the mandatorily redeemable Class C Preferred Stock was $2.0 million, or 0.7% of net sales, for fiscal 2001 as compared to $1.9 million, or 0.7% of net sales, for fiscal 2000. The accretion of common stock warrants of $7.8 million, or 2.5% of net sales, reflects the accretion to fair value of detachable put warrants issued by us in connection with our issuance of subordinated debt in 1996. No such charge was recorded in fiscal 2000. Income Taxes. Income tax expense was $3.3 million, or 43.7% of pre-tax income, for fiscal 2001 as compared to a benefit of $0.6 million, or 30.3% of pre-tax loss, for fiscal 2000. Net Income. As a result of the foregoing, net income was $4.3 million, or 1.4% of net sales, for fiscal 2001 compared to a net loss of $1.3 million, or 0.5% of net sales for fiscal 2000. 30 FISCAL YEAR ENDED DECEMBER 31, 2000 COMPARED TO FISCAL YEAR ENDED DECEMBER 31, 1999 Net Sales. Net sales increased by 9.6% to $259.2 million for fiscal 2000 from $236.6 million for fiscal 1999. The net sales increase in fiscal 2000 resulted primarily from the addition of 17 new stores in fiscal 2000 and the full year impact of the 29 new stores added in fiscal 1999 offset by the closure of three stores in fiscal 2000 and one store in fiscal 1999. Comparable store net sales increased 0.6% in fiscal 2000. The increase in comparable store net sales accounted for $1.1 million, or 4.9%, of the increase in net sales and the net increase in the number of stores over the last two fiscal years accounted for $21.5 million, or 95.1% of the increase. During the first two quarters of fiscal 2000, comparable store net sales increased 7.7% due to successful promotions in select categories. Comparable store net sales decreased 3.9% for the last two quarters of fiscal 2000 and were down 5.4% in the fourth quarter of fiscal 2000. We believe that many factors contributed to the weak second half net sales performance including supply chain inefficiencies, an overall lackluster retail holiday season and a build-up of inventory at the store level as holiday sales did not materialize. Gross Profit. Gross profit increased $4.6 million, or 5.6%, to $86.9 million for fiscal 2000 from $82.3 million for fiscal 1999. Gross profit expressed as a percentage of net sales decreased to 33.5% for fiscal 2000, from 34.8% for fiscal 1999. The decline in gross profit as a percentage of net sales was primarily the result of increases in store occupancy and central distribution costs outpacing the relatively small comparable store net sales growth experienced in fiscal 2000. Expense increases in central distribution resulting from additional throughput volume contributed to the decline in gross profit as a percentage of net sales. Additionally, product cost of sales, including freight expenses, increased as a percentage of net sales due to fourth quarter markdowns taken in an effort to generate sales momentum. Operating Expenses. Operating expenses were $67.4 million, or 26.0% of net sales, for fiscal 2000 as compared to $57.9 million, or 24.5% of net sales, for fiscal 1999. The increase as a percentage of net sales was primarily the result of increases in store payroll and occupancy costs outpacing the modest increase in comparable store net sales. Store payroll expense increased to 13.6% of net sales for fiscal 2000 as compared to 12.8% of net sales for fiscal 1999. The increase in store payroll expense was primarily the result of an increase in the average compensation for store managers along with an increase in the average hourly wage. We also experienced increases in certain corporate operating expenses, including payroll expense in information technology and store operations management. Depreciation and Amortization. Depreciation and amortization expense was $7.8 million, or 3.0% of net sales, for fiscal 2000 as compared to $7.3 million, or 3.1% of net sales, for fiscal 1999. The increase in depreciation expense was the result of relatively high capital expenditures in the years prior to fiscal 2000. As a percentage of net sales, the expense ratio declined as net sales growth generated by new stores outpaced the increase in depreciation and amortization. Interest Expense. Interest expense on senior, subordinated and other notes payable was $11.2 million, or 4.3% of net sales, for fiscal 2000 as compared to $10.2 million, or 4.3% of net sales, for fiscal 1999. The increase was the result of higher average debt balances in comparison to the prior year combined with higher interest rates. Interest expense associated with the mandatorily redeemable Class C Preferred Stock was $1.9 million, or 0.7% of net sales, for fiscal 2000 as compared to $1.6 million, or 0.7% of net sales, for fiscal 1999. The negative accretion of common stock warrants of $0.9 million during fiscal 1999, or 0.4% of net sales, reflects the reduction in fair value of detachable put warrants issued by us in connection with our issuance of subordinated debt in 1996. No such charge was recorded in fiscal 2000. Income Taxes. For fiscal 2000, we recorded an income tax benefit in the amount of $0.6 million, or 30.3% of pre-tax loss, as compared to an expense of $1.1 million, or 19.2% of pre-tax income, for fiscal 1999. In fiscal 1999, we received a tax benefit from surtax exemptions that lowered the statutory rate by 18.6% of pre-tax income. As a result of our December 31, 1999 reorganization (see "Certain Transactions - Reorganization"), this benefit was not available to us in fiscal 2000, nor will it be available to us in the future due to our consolidated corporate structure. 31 Net Income. As a result of the foregoing, we recorded a net loss of $1.3 million, or 0.5%, of net sales for fiscal 2000, as compared to net income of $4.6 million or 2.0% of net sales for fiscal 1999. LIQUIDITY AND CAPITAL RESOURCES Most of our capital requirements relate to new store openings, existing store expansions, remodelings or relocations, seasonal working capital and payment of interest on our outstanding indebtedness. Our working capital requirements are primarily for merchandise inventories, which typically reach their peak by the end of the third quarter of each fiscal year. Historically, we have funded our store openings, expansions, remodelings and relocations and met our working capital requirements from internally generated funds, borrowings under our credit facilities and proceeds from the sale of equity securities. During fiscal 1999, 2000 and 2001, net cash provided by operating activities was $12.9 million, $1.3 million and $37.5 million, respectively. All of our revenues are realized at the point-of-sale in our stores. Thus, our sales are essentially on a cash basis. The cash flow from operating our stores is a significant source of liquidity. This operating cash flow is used primarily to purchase inventory, make interest payments on our indebtedness and pay income taxes. During fiscal 1999, 2000 and 2001, net cash used in investing activities was $10.8 million, $6.0 million, and $4.7 million, respectively. We use cash in investing activities to build new stores and expand, remodel or relocate existing stores. Furthermore, net cash used in investing activities includes purchases of information technology assets and equipment for our distribution facility and corporate headquarters. During fiscal 1999, 2000 and 2001, we opened 29, 17 and five new stores, respectively, and expanded or remodeled 14, four and two stores, respectively. We expect to open approximately 15 new stores during fiscal 2002, two of which were opened prior to the date of this prospectus. Capital expenditures, including leasehold improvements and furniture and fixtures, for the five new stores opened during fiscal 2001 averaged approximately $148,000 (net of landlord allowances), and initial gross inventory requirements (which were partially financed by trade credit) averaged approximately $142,000 per store. Opening inventory requirements at new stores vary significantly depending upon the time of year when the store is opened, expected sales volume and store size. We also intend to expand or remodel four stores in fiscal 2002 and perform minor refurbishments on several other stores. The cost of remodeling two stores in fiscal 2001 was approximately $153,000 per store. Our total planned capital expenditures for fiscal 2002 are $8.5 million. In addition to providing for new stores, together with expanded, relocated and remodeled stores, these planned capital expenditures include $0.6 million for equipment in our distribution facility and $2.4 million for various investments in information technology assets. Our principal indebtedness during the past three fiscal years consisted of (i) our principal credit facility, which included a term loan of $57 million and a $20 million revolver, (ii) $20 million of senior subordinated notes due in June 2003, (iii) a $5 million subordinated note payable to our Chairman and (iv) our mandatorily redeemable Class C Preferred Stock, with a stated value of $17.1 million as of February 2, 2002, originally issued in connection with our 1996 recapitalization. See "Certain Transactions - Recapitalization." During fiscal 1999, cash of $3.4 million was used in financing activities. During fiscal 1999, we made $5.8 million of principal payments on our long-term debt and repaid $7 million under our revolving line of credit. In addition, in July 1999 we borrowed an additional $7.5 million, including $3.4 million from certain of our shareholders and $4.1 million from our existing senior lenders. The $4.1 million was collateralized with cash and letters of credit supplied by certain of our shareholders. Our shareholders who participated in this loan financing received warrants to purchase 15,847 shares of our common stock as consideration. During fiscal 1999 we also incurred $2.5 million in additional long-term borrowings. In fiscal 2000, financing activities contributed cash of $19.9 million. During fiscal 2000, we drew $20.0 million under our revolving line of credit and received $7.4 million of net proceeds (net of 32 $0.1 million of transaction expenses) from an equity investment by certain of our shareholders. We also repaid the $5 million note due to our Chairman through his conversion of the loan into additional equity. In addition, the $7.5 million of borrowings from July 1999 was repaid as our lenders drew on the $4.1 million of cash collateral posted by certain shareholders, in consideration of which we issued additional equity to these shareholders, and other shareholders converted $3.4 million of these borrowings into additional equity. See "Certain Transactions - 2000 Equity Transaction." In fiscal 2001, $30.0 million was used in financing activities. In fiscal 2001, the principal uses of cash in financing activities were repayments on the line of credit of $20.0 million and term loan principal payments of $9.2 million. See "Certain Transactions" for a description of various financing transactions from 1996 through 2000 involving related parties. Due to our failure to comply with certain financial covenants in our principal credit agreement during fiscal 2000, our existing senior lenders prevented us from continuing to pay current cash interest to our subordinated lenders. We subsequently entered into negotiations with our existing senior and subordinated lenders to amend our agreements with those respective lenders. Pursuant to these negotiations, in June 2001 we entered into amended credit agreements with our existing senior and subordinated lenders and these lenders waived the events of default under their respective facilities. With respect to the existing senior credit facility, the maturity date remained June 30, 2002 and the covenants were made less restrictive. With respect to the subordinated loan agreement, the maturity date remained June 30, 2003 and the interest rate was increased from 12.5% to 15% effective January 1, 2001 and 15.5% effective January 1, 2002. We also reduced the dividend rate on our Class A and Class D Preferred Stock and most of our Class B Preferred Stock from 10% to 4%. Since June 2001 we have complied with all covenants in our existing senior credit agreement and subordinated loan agreement, and we are currently in compliance with all of our lending agreements. In May 2002, we expect to enter into a new, three-year senior secured credit facility that will include a $45 million revolving credit facility ($30 million for the first six months of each calendar year) and a $15 million term loan. The revolving credit facility is expected to bear interest at a floating rate equal to the prime rate or LIBOR plus 2.25%, at our election. Borrowings under the new revolving credit facility are expected to be subject to certain customary conditions and contain customary events of default. The term loan is expected to bear interest at the prime rate plus 7.25%. We will use the proceeds of the term loan, together with a total of approximately $ million of a combination of available cash and borrowings under the revolving credit facility, (1) to repay all indebtedness (including accrued interest outstanding) outstanding under our existing senior secured credit facility under which $39.5 million was outstanding at February 2, 2002, and (2) to pay all accrued and unpaid interest on institutional subordinated debt, of which there was $3.8 million as of February 2, 2002. As a result, the interest rate on the subordinated notes will be reduced from 15.5% to 12.5% and the dividend rate on the Class A, Class B and Class D Preferred Stock will increase from 4% to 10%. There can be no assurance that the new revolving credit facility and term loan will be successfully negotiated. A portion of the proceeds from this offering will be used to pay down the balance expected to be outstanding on the new revolving credit facility. We issued Class A Preferred Stock, Class B Preferred Stock and Class C Preferred Stock in June 1996 and December 1999 and Class D Preferred Stock in August 2000. As of February 2, 2002, the liquidation value, including accrued dividends, on our Class A Preferred Stock, Class B Preferred Stock and Class D Preferred Stock was $48.9 million, $17.2 million and $22.3 million, respectively. Dividends accrue at an annual rate of 4% for the Class A Preferred Stock and Class D Preferred Stock and at an annual rate of 4% or 10% for the Class B Preferred Stock. Dividends on the Class A Preferred Stock, Class B Preferred Stock and Class D Preferred Stock have accrued and have not been paid. The Class A Preferred Stock, Class B Preferred Stock and Class D Preferred Stock are redeemable at our option or at the option of the holders after the earliest to occur of June 12, 2004 or the closing of a liquidity event (which includes this offering). At the option of 60% of the holders, all of the outstanding Class A Preferred Stock, Class B Preferred Stock and Class D Preferred Stock, other than any shares being redeemed at our option, will automatically convert into common stock upon the occurrence of this offering 33 at a rate equal to the liquidation value of the preferred stock plus accrued dividends, divided by the initial public offering price. The Class C Preferred Stock is mandatorily redeemable at the earliest to occur of July 2004 or the closing of a liquidity event (including this offering). The Class C Preferred Stock has no conversion privileges. The liquidation value of the Class C Preferred Stock, including accrued interest, was $24.3 million at February 2, 2002. Interest on the Class C Preferred Stock accrues at 9% annually on the outstanding balance of the Class C Preferred Stock plus accrued interest. The payments representing such interest accrued after 1997 have not been made as a result of subordination provisions under our existing senior credit facility. The following table summarizes our material contractual obligations, including both on- and off-balance sheet arrangements in effect at February 2, 2002, and as adjusted to give effect to the sale by us of shares of common stock in this offering at an assumed initial public offering price of $ per share and the application of the net proceeds from the sale (after deducting estimated offering expenses and underwriting discounts and commissions): <Table> <Caption> CONTRACTUAL OBLIGATIONS FISCAL 2002 FISCAL 2003 FISCAL 2004 THEREAFTER TOTAL AS ADJUSTED - ----------------------- ----------- ----------- ----------- ---------- ------ ----------- (IN MILLIONS) Lease financing: Operating lease obligations (store leases)............ $21.7 $20.2 $ 19.6 $66.1 $127.6 $127.6 Operating lease obligations (other)................... 0.7 0.4 0.2 -- 1.3 1.3 Employment and consulting contracts................... 0.3 -- -- -- 0.3 0.3 Long-term borrowings: Senior credit facility(a)... 39.5 -- -- -- 39.5 15.0 Subordinated debt(b)........ -- 23.8 -- -- 23.8 -- Class C preferred stock(b).................. -- -- 24.3 -- 24.3 -- Redeemable convertible preferred stock: Class D preferred stock(c).................. -- -- 22.3 -- 22.3 -- Class A preferred stock(c).................. -- -- 48.9 -- 48.9 -- Class B preferred stock(c).................. -- -- 17.2 -- 17.2 -- ----- ----- ------ ----- ------ ------ Total obligations....... $62.2 $44.4 $132.5 $66.1 $305.2 $144.2 ===== ===== ====== ===== ====== ====== </Table> - ------------------------------ (a) Amounts outstanding under our existing senior credit facility are expected to be refinanced and replaced by a new senior credit facility we expect to enter into in May 2002. (b) Includes accrued and unpaid interest. (c) Represents liquidation value of preferred stock, including accrued and unpaid dividends. We believe that net cash provided by operations and availability under our proposed new credit facility, together with the anticipated proceeds from this offering, will be adequate to carry out our fiscal 2002 growth plans in full and fund our planned capital expenditures, interest payments and working capital requirements for at least the next 12 months. To the extent we seek to accelerate our growth plans, and with respect to periods beyond fiscal 2002, we may need to raise additional capital either through the issuance of debt or equity securities or through additional credit facilities. We cannot assure you that such capital would be available on acceptable terms or at all. SEASONALITY AND QUARTERLY FLUCTUATIONS We have historically experienced and expect to continue to experience substantial seasonal fluctuations in our net sales and operating income. We believe this is the general pattern typical of our segment of the retail industry and, as a result, expect that this pattern will continue in the future. Our 34 quarterly results of operations may also fluctuate significantly as a result of a variety of other factors, including the timing of new store openings, net sales contributed by new stores, shifts in the timing of certain holidays and competition. Consequently, comparisons between quarters are not necessarily meaningful and the results for any quarter are not necessarily indicative of future results. Our strongest sales period is the winter holiday season. We generally realize a disproportionate amount of our net sales and a substantial majority of our operating and net income during the fourth quarter of our fiscal year. In anticipation of the increased sales activity during the fourth quarter of our fiscal year, we purchase large amounts of inventory and hire temporary staffing help for our stores. Our operating performance could suffer if net sales were below seasonal norms during the fourth quarter of our fiscal year. Our net sales, operating income and net income are typically weakest in the first quarter of our fiscal year. We expect this trend to continue. The following table sets forth certain unaudited financial and operating data for Kirkland's in each fiscal quarter during fiscal 2000 and fiscal 2001. The unaudited quarterly information includes all normal recurring adjustments that we consider necessary for a fair presentation of the information shown. <Table> <Caption> FISCAL QUARTER ENDED(1) ---------------------------------------------------------------------------------- MAR. 31, JUNE 30, SEP. 30, DEC. 31, MAY 5, AUG. 4, NOV. 3, FEB. 2, 2000 2000 2000 2000 2001 2001 2001 2002 -------- -------- -------- -------- ------- ------- ------- -------- (IN THOUSANDS, EXCEPT STORE AND PERCENTAGE DATA) Net sales................ $50,094 $53,869 $55,291 $99,986 $55,961 $63,614 $66,822 $120,816 Gross profit............. 14,890 16,442 16,539 38,993 15,239 20,820 22,093 48,998 Operating income (loss)................. (3,136) (1,334) (1,510) 17,616 (1,725) 2,303 2,691 23,869 Net income (loss)........ (3,560) (2,796) (3,020) 8,061 (2,725) (1,078) (42) 8,143 Adjusted EBITDA(2)....... (1,104) 703 414 19,450 (101) 4,298 4,743 26,588 Stores open at end of period................. 226 231 233 240 235 233 234 234 Comparable store net sales increase (decrease)(3).......... 6.4% 9.0% (1.1)% (5.4)% 3.9% 11.9% 22.9% 18.8% </Table> <Table> <Caption> FISCAL QUARTER ENDED(1) -------------------------------------------------------------------------------- MAR. 31, JUNE 30, SEP. 30, DEC. 31, MAY 5, AUG. 4, NOV. 3, FEB. 2, 2000 2000 2000 2000 2001 2001 2001 2002 -------- -------- -------- -------- ------ ------- ------- ------- As a percentage of sales: Net sales..................... 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% Gross profit.................. 29.7 30.5 29.9 39.0 27.2 32.7 33.1 40.6 Operating income (loss)....... (6.3) (2.5) (2.7) 17.6 (3.1) 3.6 4.0 19.8 Net income (loss)............. (7.1) (5.2) (5.5) 8.1 (4.9) (1.7) (0.1) 6.7 Adjusted EBITDA(2)............ (2.2) 1.3 0.7 19.5 (0.2) 6.8 7.1 22.0 </Table> - ------------------------------ (1) Effective January 1, 2001, we changed our fiscal reporting year to a 52-53 week basis ending on the Saturday closest to January 31. Previously, we had reported our results on a calendar year basis. Consequently, the quarterly data for fiscal 2000 were prepared according to the calendar year. The quarterly results for fiscal 2001 were prepared using the 52-53 week basis. The financial and operating data for the 34-day period ended February 3, 2001 is not presented as this period is not included in any of our fiscal quarters. (2) The term Adjusted EBITDA as used herein represents operating income before depreciation and amortization expense and a non-cash stock compensation charge related to certain outstanding stock options. While Adjusted EBITDA should not be considered in isolation or as a substitute for net income, cash flow from operations or any other measure of income or cash flow that is prepared in accordance with generally accepted accounting principles or as a measure of a company's profitability or liquidity, Adjusted EBITDA has been presented because we believe it is commonly used in this or a similar format by investors to analyze and compare operating performance as well as to provide additional information with respect to our ability to meet our future debt service, capital expenditure and working capital requirements. Adjusted EBITDA may differ in method of calculation from similarly titled measures used by other companies. This information should be read in conjunction with our consolidated statement of cash flows contained in our consolidated financial statements and notes thereto included elsewhere in this prospectus. (3) We include new stores in comparable store net sales calculations after the store has been in operation one full fiscal year. We exclude from comparable store net sales calculations each store that was expanded, remodeled or relocated during the applicable period. Each expanded, remodeled or relocated store is returned to the comparable store base after it has been excluded from the comparable store base for one full fiscal year. The comparable store net sales calculations for the fiscal 2001 quarters reflect the results of comparing our net sales for each quarter in fiscal 2001 to the corresponding quarter in the prior year, where the 2000 fiscal quarters are measured on a 35 4/5-week basis ending on the Saturday closest to April 30, 2000, July 31, 2000, October 31, 2000 and January 31, 2001. INFLATION We do not believe that our operating results have been materially affected by inflation during the preceding three fiscal years. There can be no assurance, however, that our operating results will not be adversely affected by inflation in the future. CRITICAL ACCOUNTING POLICIES Our critical accounting policies are discussed in the notes to our consolidated financial statements. Certain judgments and estimates utilized in implementing these accounting policies are likewise discussed in each of the notes to our consolidated financial statements. The following discussion aggregates the various critical accounting policies addressed throughout the financial statements, the judgments and uncertainties affecting the application of these policies and the likelihood that materially different amounts would be reported under varying conditions and assumptions. Revenue Recognition - Sales and the related gross profit are recorded at the time our customers provide a satisfactory form of payment and take ownership of the merchandise. There are minimal accounting judgments and uncertainties affecting the application of this policy. We estimate the amount of merchandise that will be returned for a refund and reduce net sales and gross profit by that amount. Given that the vast majority of returns occur within a matter of days of the selling transaction, the risk of us realizing a materially different amount for net sales and gross profit than reported in the consolidated financial statements is minimal. Cost of Sales and Inventory Valuation - Our inventory is stated at the lower of cost or market with cost determined using the average cost method with average cost approximating current cost. We estimate the amount of shrinkage that has occurred through theft or damage and adjust that to actual at the time of our physical inventory counts which occur near our fiscal year-end. We also evaluate the cost of our inventory in relation to the estimated sales price giving consideration to markdowns that will occur prior to or at the point of sale. This evaluation is performed to ensure that we do not carry inventory at a value in excess of the amount we expect to realize upon the sale of the merchandise. Depreciation and Recoverability of Assets - Approximately 26% of our assets at February 2, 2002 represent investments in property and equipment and goodwill. Determining appropriate depreciable lives and reasonable assumptions in evaluating the carrying value of capital assets requires judgments and estimates. - We utilize the straight-line method of depreciation and a variety of depreciable lives. Land is not depreciated. Buildings are depreciated over 40 years. Furniture, fixtures and equipment are depreciated over 5 to 7 years. Leasehold improvements are amortized over the shorter of the useful lives of the asset or the lease term. Our average lease term is 10 years. - To the extent we replace or dispose of fixtures or equipment prior to the end of its assigned depreciable life, we could realize a loss or gain on the disposition. To the extent our assets are used beyond their assigned depreciable life, no depreciation expense is being realized. We reassess the depreciable lives in an effort to reduce the risk of significant losses or gains arising from either the disposition of our assets or the utilization of assets with no depreciation charges. - Recoverability of the carrying value of store assets is assessed annually and upon the occurrence of certain events such as store closings. The assessment requires judgment and estimates for future store generated cash flows. The underlying estimates for cash flows include estimates for future net sales, gross profit, and store expense increases and decreases. During fiscal 2001 and fiscal 2000, we recorded impairments of $82,000 and $103,000, respectively. 36 Insurance Reserves - Workers' compensation, general liability and employee medical insurance programs are partially self-insured. It is our policy to record a self-insurance liability using estimates of claims incurred but not yet reported or paid, based on historical trends. Actual results can vary from estimates for many reasons, including, among others, inflation rates, claim settlement patterns, litigation trends, and legal interpretations. Offering and Financing Costs - In previous years, we have incurred costs related to refinancing efforts and an offering of our common stock. Costs incurred related to financing activities are typically capitalized and amortized over the life of the debt. Costs incurred related to common stock offerings are deducted from the proceeds of the successful offering. Occasionally, the anticipated financing activity or stock offering is not consummated. When that occurs, we expense the costs related to such activities that had been previously deferred in anticipation of the transaction. Stock Options and Warrants - Certain of our stock options require us to record a non-cash stock compensation charge in our financial statements. The amount of the charge is determined based upon the fair value of our common stock. Other options have been granted to employees with an exercise price that is equal to or greater than the fair value of our common stock on the date of grant. Stock options, which have been granted to non-employees in exchange for services, must be valued using an option-pricing model. Stock warrants have been issued in connection with several of our debt issuances and in some cases the warrants contain a feature allowing the holder to put the warrant to us for fair value. In each of these cases, the fair value of our common stock is a significant element of determining the value of the stock option or warrant, or the amount of the non-cash stock compensation charge to be recorded for our variable stock option awards or for non-employee stock option grants. Since our common stock is not traded on a stock exchange, the market value of our stock is not easily determinable. To determine the value of our common stock we first consider the amount paid to us for our common stock in a recent transaction for the sale of our common stock. Absent a recent sale of our common stock, we obtain a valuation from an independent appraiser. In each case, the determination of the fair value of our common stock requires judgment and the valuation has a direct impact on our financial statements. We believe that reasonable methods and assumptions have been used for determining the fair value of our common stock. IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In June 2001, the Financial Accounting Standards Board issued SFAS No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets", effective for fiscal years beginning after December 15, 2001. SFAS 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. Under SFAS 142, goodwill (and intangible assets deemed to have indefinite lives) will no longer be amortized but will be subject to annual impairment tests. Other intangible assets will continue to be amortized over their useful lives. As of February 2, 2002, we had goodwill, net of accumulated amortization, in the amount of $1.4 million recorded on our balance sheet. For fiscal 2001, we recorded $83,000 in amortization expense on our consolidated statement of operations. We will apply the new rules of accounting for goodwill and other intangible assets beginning in the first quarter of fiscal 2002. We will cease to amortize goodwill in accordance with SFAS 142 and will perform a test for impairment when events and circumstances indicate that an impairment may have occurred. The application of SFAS 141 and SFAS 142 is not expected to have a significant impact on our financial condition or results of operations. In August 2001, the Financial Accounting Standards Board issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which addresses financial accounting and reporting for the impairment or disposal of long-lived assets and supersedes SFAS No. 121, "Accounting for the Impairment or Disposal of Long-Lived Assets and for Long-Lived Assets to be Disposed Of," and the accounting and reporting provisions of Accounting Principles Board (APB) Opinion No. 30, "Reporting the Results of Operations" for a disposal of a segment of a business. SFAS 144 is effective for fiscal years beginning December 15, 2001. We do not anticipate that the adoption of this standard will have a significant impact on our financial condition or results of operations. 37 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risks related to our operations result primarily from changes in short-term London Interbank Offered Rates, or LIBOR, as our new senior credit facility will utilizes short-term LIBOR contracts. LIBOR contracts are fixed rate instruments for a period of between one and six months, at our discretion. From time to time, we enter into one or more LIBOR contracts. These LIBOR contracts vary in length and interest rate, such that adverse changes in short-term interest rates could affect our overall borrowing rate when contracts are renewed. As of February 2, 2002, we had no borrowings outstanding under our existing line of credit facility. As of February 2, 2002, we had one LIBOR contract outstanding for $37.2 million for our entire existing term loan facility. Based on this debt level for the existing term loan facility, a hypothetical 10% increase in LIBOR from the applicable rate at February 2, 2002 would increase net interest expense by approximately $75,000 on an annual basis, and likewise would decrease both net income and cash flows for that annual period by a corresponding amount. We cannot predict market fluctuations in interest rates and their impact on debt, nor can there be any assurance that long-term fixed-rate debt will be available at favorable rates, if at all. Consequently, our future results may differ materially from estimated results due to adverse changes in interest rates or debt availability. We did not have any material foreign exchange or other significant market risk as of February 2, 2002. 38 BUSINESS GENERAL We are a leading specialty retailer of home decor in the United States, operating 236 stores in 28 states. Our stores present a broad selection of distinctive merchandise, including framed art, mirrors, candles, lamps, picture frames, accent rugs, garden accessories and artificial floral products. Our stores also offer an extensive assortment of holiday merchandise, as well as items carried throughout the year suitable for giving as gifts. In addition, we use innovative design and packaging to market home decor items as gifts. We provide our predominantly female customers an engaging shopping experience characterized by a diverse, ever-changing merchandise selection at surprisingly attractive prices. Our stores offer a unique combination of style and value that has led to our emergence as a leader in home decor and has enabled us to develop a strong customer franchise. As a result, we have achieved substantial growth over the last five fiscal years. Since the beginning of 1997, our sales have grown at a compounded annual growth rate of 19%. For the fiscal year ended February 2, 2002, we recorded net sales of $307.2 million and Adjusted EBITDA of $35.5 million, or 11.6% of net sales. CORPORATE HISTORY AND RECENT INITIATIVES Kirkland's was co-founded in 1966 by our current Chairman, Carl Kirkland. Although originally focused in enclosed malls in the Southeast, we have grown beyond that region and also have begun to open stores in selected non-mall venues. We accelerated our expansion in fiscal 1995, more than doubling our store base from 104 stores at the end of fiscal 1995 to 226 stores at the beginning of fiscal 2000. We also expanded our geography during this period by opening 66 stores outside our core Southeastern base. We operate in major metropolitan markets such as Houston, Texas and Atlanta, Georgia, middle markets such as Birmingham, Alabama and Buffalo, New York and smaller markets such as Appleton, Wisconsin and Panama City, Florida. Beginning in late 1999, we undertook a series of initiatives with the goals of strengthening our infrastructure and enhancing several aspects of our operations in order to position ourselves for profitable growth. These measures have enabled us to make faster and smarter inventory buying and distribution decisions, to manage the flow of merchandise to our stores more efficiently and to improve overall financial performance. These initiatives included: Completing Key Investments in Information Technology. Since late 1999, we have invested $6.5 million in several key information systems projects that provide our decision makers with better tools to increase sales, improve operational efficiency, control and distribute inventory and monitor critical performance indicators on a daily basis. We installed new, state-of-the-art POS software and servers in all of our stores in November 1999. In April 2001, we installed an integrated retail management system at our home office. This system provides greatly enhanced functionality to our merchandise buyers and planners. For example, although our buyers have had access to basic daily sales data for many years, our new retail management system produces much more detailed information via our nightly polling process. This information includes daily sales, inventory and gross margin analyzed by merchandise category, classification or SKU for every store. Finally, in March 2002, we completed the installation of new cash registers in approximately two-thirds of our stores. Developing a More Scalable Distribution Infrastructure. Prior to 2000, we distributed our products primarily through direct shipments from our vendors to each of our individual stores. As our store base grew, we decided to develop a more scalable central distribution strategy. In March 2001, we consolidated our central distribution operations into one 303,000-square-foot, leased facility in Jackson, Tennessee, which allowed us to increase our dollar volume of centrally distributed merchandise by 24% from fiscal 2000 to fiscal 2001. We plan to continue expanding our proportion of centrally distributed merchandise, from 62% of total inventory purchases in fiscal 2001 to 90% by fiscal 2005. Our modern central distribution facility, together with other improvements to our supply chain, has helped us to keep our stores stocked with fresh merchandise and to reduce significantly the cost of 39 managing inventories at the store level. We believe our distribution facility, which we have the option to expand, provides us with adequate distribution capacity at least until fiscal 2004. Strengthening Executive Management. Since the second half of 1999, we have added six senior managers, including key hires in merchandising, store operations and information technology. These additions, along with several other key hires and promotions, have broadened the abilities of our management team and have provided leadership to key areas of our business. In addition, in March 2001 we elevated Robert Alderson, a 16-year Kirkland's veteran and previously our Chief Operating Officer, to the position of Chief Executive Officer. Carl Kirkland, our co-founder and author of the Kirkland's concept, serves as Chairman of the Board and is a strategic advisor to our Merchandising team. We believe our management team has valuable experience both from Kirkland's and from other national retailers. Improving Store-Level Operating Performance. In January 2001, we instituted a plan to improve sales, increase cash flow and return our stores to higher levels of profitability. Key components of the plan included: - Reducing Store-Level Inventories. We aggressively marked down inventory in January and February 2001 resulting in a significant reduction in store-level inventory. These reduced inventory levels, in conjunction with our central distribution and systems investments, facilitated the flow of fresh inventory to our stores. As a result, store management has been able to spend more of their time focusing on our customers and the appearance of the store and less time on the management of inventory in the stockroom and local storage facilities. - Controlling and Reducing Store Operating Expenses. We intensified our efforts to control and reduce store operating expenses. In particular, significant savings were achieved by slowing the growth of store payroll expenses and reducing the costs associated with local storage facilities and related truck rentals. - Closing Under-Performing Stores. We closely reviewed our store base and, as a result, we closed 11 stores after fiscal 2000. Of our stores that were open during all of fiscal 2001, only nine were not profitable at the store level. We believe the convergence of these operational initiatives led to the significant improvement in our fiscal 2001 operating results as compared to fiscal 2000. Financial highlights included: - A 13.3% increase in comparable store net sales over the 53-week period ended February 3, 2001. - An 18% reduction in average inventory per store from $214,000 to $176,000 and an increase in average inventory turnover to 3.48x from 2.45x. - An 83% increase in Adjusted EBITDA to $35.5 million, or 11.6% of net sales. - An increase in net cash provided by operating activities to $37.5 million from $1.3 million. As evidenced by the improvement in our operating results, we believe these initiatives have positioned us to expand our proven retail concept and strengthen our position as a leading specialty retailer of home decor in the United States. KEY OPERATING STRENGTHS Our goal is to be the leading specialty retailer of home decor in each of our markets. We believe the following elements of our business strategy differentiate us from our competitors and position us for profitable growth: Item-Focused Merchandising. While our stores contain items covering a broad range of complementary product categories, we emphasize key items within our targeted categories rather than merchandising complete product classifications. Although we do not attempt to be a fashion leader, our 40 experienced buyers work closely with our vendors to identify and develop stylish merchandise reflecting the latest trends. We take a disciplined approach to test-marketing products and monitoring individual item sales, which enables us to identify and quickly reorder appropriate items in order to maximize sales of popular products. We also evaluate market trends and merchandise sales data to help us develop additional products to be made by our vendors and marketed in our stores, frequently on an exclusive basis. In most cases, this exclusive merchandise is the result of our buying team's experience in interpreting market and merchandise trends in a way that appeals to our customer. We estimate that over 60% of our merchandise is designed or packaged exclusively for Kirkland's, which distinguishes us in the marketplace and enhances our margins. Ever-Changing Merchandise Mix. We believe our ever-changing merchandise mix of over 5,000 SKUs creates an exciting "treasure hunt" environment, encouraging strong customer loyalty and frequent return visits to our stores. The merchandise in our stores is typically traditionally styled for broad market appeal, yet it reflects an understanding of our customer's desire for newness and freshness. Our information systems permit close tracking of individual item sales, enabling us to react quickly to both fast-selling and slow-moving items. Accordingly, we actively change our merchandise throughout the year in response to market trends, sales results, and changes in seasons. We also strategically increase selling space devoted to gifts and seasonal merchandise in advance of holidays. Stimulating Visual Presentation. Our stores have a distinctive, "interior design" look that helps customers visualize the merchandise in their own homes and inspires decorating and gift-giving ideas. Using multiple merchandise arrangements to simulate home settings, we group complementary merchandise creatively throughout the store, rather than displaying products strictly by category or product type. We believe this cross-category merchandising strategy encourages customers to browse for longer periods of time, promoting add-on sales. Strong Value Proposition. Our customers regularly experience the satisfaction of paying noticeably less for items similar or identical to those sold by other retail stores or through catalogs. This strategy of providing a unique combination of style and value is an important element in making Kirkland's a destination store. While we carry items in our stores that sell for several hundred dollars, most items sell for under $50 and are perceived by our customers as affordable luxuries. Our longstanding relationships with vendors and our ability to place large orders of a single item enhances our ability to attain favorable product pricing from vendors. Flexible Approach to Real Estate. Our stores operate successfully across a wide spectrum of different regions, market sizes and real estate venues. We operate our stores in 28 states, and over 40% of our stores are located outside the Southeast. We operate successfully in major metropolitan markets such as Houston, Texas and Atlanta, Georgia, middle markets such as Birmingham, Alabama and Buffalo, New York and smaller markets such as Appleton, Wisconsin and Panama City, Florida. In addition, although our stores are predominantly located in enclosed malls, we also operate successfully in non-mall venues, including selected outlet centers and strip centers. The flexibility of our concept enables us to select the most promising real estate opportunities that meet requisite economic and demographic criteria within our target markets. GROWTH STRATEGY Our growth strategy is to continue to build on our position as a leading specialty retailer of home decor in the United States by: Opening New Stores Using our Proven Store Model. Over the past five years, we have more than doubled our store base, principally through new store openings. We intend to continue opening new stores both in existing and new markets. We anticipate our growth will include mall and non-mall locations in major metropolitan markets, middle markets and in selected smaller communities. We believe there are currently more than 800 additional locations in the United States that could support a Kirkland's store. We expect to open approximately 15 new stores during fiscal 2002 and approximately 35 new stores during fiscal 2003. As of the date of this prospectus, we have opened two new stores in fiscal 2002. 41 Our proven store model produces strong store-level cash flow and provides an attractive store-level return on investment. In fiscal 2001, our average store generated net sales of approximately $1.3 million and store-level Adjusted EBITDA of approximately $227,000, or 17.4% of net sales. These results were relatively consistent across a wide spectrum of different regions, market sizes and real estate venues. Our stores typically achieve profitability in their first full year of operation. From 1997 to 2000, we opened 93 new stores and all but six produced positive store-level Adjusted EBITDA in their first full fiscal year. The average first full year cash return on investment of these stores was approximately 47%. For the stores we opened in fiscal 2000, our first year cash return on investment was significantly higher than the four-year average, which we believe is due largely to the improvements in management, systems and distribution instituted since late 1999. Increasing Store Productivity. We plan to increase our sales per square foot and store profitability by leveraging our recent investments in information systems and central distribution, which together contributed to our 18.5% increase in net sales and our 15.1% increase in average net sales per square foot in fiscal 2001. In fiscal 2001, we installed an advanced merchandise management system, relocated our central distribution operations to a more modern facility and increased the volume of centrally distributed merchandise. Furthermore, we believe that the sales productivity of our stores will benefit from our strong existing customer franchise and our continuing efforts to enhance the Kirkland's brand. Our distinctive and often proprietary merchandise offering, together with carefully coordinated in-store marketing, visual presentation and product packaging, enables us to establish a distinct brand identity and to solidify our bond with customers, further enhancing our store-level productivity. We also believe our comparable store sales will continue to benefit from the discretionary income available to consumers in their prime earning years as well as other consumer and demographic trends favoring home-oriented purchases. INDUSTRY OVERVIEW We compete in the U.S. home accessories and gifts market, which encompasses such varied product groups as candles, framed art, table top decoration, wall decor, figurines, decorative pillows, accent rugs and holiday merchandise. According to industry research, sales in the U.S. retail market for decorative home accessories and gifts were approximately $55 billion in 2000. Within this market, we estimate that sales in the principal product categories carried by our stores were approximately $29 billion in 2000. We believe that the industry will continue to benefit from the following characteristics and trends: Highly Fragmented Industry. The market for home furnishings is highly fragmented with no single company holding a dominant market position. The market includes numerous smaller specialty retailers, as well as department stores, larger mass merchandisers and home furnishings stores, with department stores commanding a decreasing percentage of the home furnishings industry compared to specialty retailers. Favorable Demographic Trends. The U.S. Census Bureau reports that the percentage of the U.S. population represented by people between the ages of 40 and 64 was approximately 30.9% at July 1, 2001 and is expected to increase to approximately 32.7% by 2005. We believe that our industry will benefit as individuals in this group become homeowners (and second home-owners) and reach their peak earnings potential. New and existing single family home sales have been steadily increasing since 1995 and reached a record 6.15 million homes in 2001. Increased Lifestyle Focus on Home and Family. The "cocooning" trend continues to have a significant impact on our market. More consumers have been retreating to their homes to spend more time with family and friends, new home-related magazines have seen increased circulation and television programming related to the home has been increasing. Value-Focused Retailing. We believe that consumers are increasingly seeking retailers who offer value. For example, between 1995 and 2000, retail sales in discount department stores grew at a compounded annual rate of 8.9% compared to 2.1% for conventional department store chains, according to 42 the U.S. Census Bureau. We believe that this consumer-driven emphasis on value should continue to positively impact our growth opportunity. MERCHANDISING Merchandising Strategy. Our merchandising strategy is to (i) offer distinctive, and often exclusive, high quality home decor at affordable prices, (ii) maintain a breadth of product categories, (iii) provide a carefully edited selection of key items within targeted categories, rather than merchandising complete product classifications, (iv) emphasize new and fresh merchandise by continually updating our merchandise mix and (v) present merchandise in a visually appealing manner to create an inviting atmosphere which inspires decorating and gift-giving ideas. We believe that this strategy creates a shopping experience that appeals to shoppers, both style-conscious and price-conscious. Although we do not attempt to be a fashion leader, we identify and capitalize on existing or emerging trends when identifying or developing merchandise for sale. Our information systems permit close tracking of individual item sales, which enables us to react quickly to market trends and best sellers. As a result, we minimize the accumulation of slow-moving inventory and resulting markdowns. Regional differences in home decor are addressed by tailoring inventories to geographic considerations and store net sales results. We continuously introduce new and often exclusive products to our merchandise assortment in order to (i) maintain customer interest due to the freshness of our product selections, encouraging frequent return visits to our stores, (ii) enhance our reputation as a leader in identifying or developing high quality, fashionable products and (iii) allow merchandise which has peaked in sales to be quickly discontinued and replaced by new items. In addition, we strategically increase selling space devoted to gifts and holiday merchandise during the third and fourth quarters of the calendar year. Our flexible store design and layout allow for selling space changes as needed to capitalize on selling trends. While our stores generally carry over 5,000 SKUs, we are constantly monitoring the sell-through on each item and are typically reordering approximately 2,500 active SKUs at any point in time. The make-up of our active SKUs is likewise constantly changing based on changes in selling trends. New and different SKUs are introduced to our stores on a weekly or more frequent basis, and a substantial portion of the inventory carried in our stores is replaced with new SKUs every few months. We purchase merchandise from approximately 200 vendors, and our buying team works closely with many of these vendors to differentiate Kirkland's merchandise from that of our competitors. We estimate that over 60% of our merchandise assortment is designed or packaged exclusively for Kirkland's, generally based on our buyers' experience in modifying certain merchandise characteristics or interpreting market trends into a product and price point that will appeal to our customer. For products that are not manufactured specifically for Kirkland's, we may create custom packaging as a way to differentiate our merchandise offering and reinforce our brand names. Exclusive or proprietary products distinguish us from our competition, enhance the value of our merchandise, and improve our net sales and gross margin. We market a substantial portion of our exclusive or custom-packaged merchandise assortment under the Cedar Creek private label brand and other proprietary names. Our strategy is to continue to grow our exclusive and proprietary products and custom-packaged products within our merchandise mix. Product Assortment. Our major merchandise categories include wall decor (framed art and mirrors), lamps, candles and various holders, photo frames, textiles, garden accessories, floral products and decorative accessories. Our stores also offer an extensive assortment of holiday merchandise, as well as items carried throughout the year suitable for giving as gifts. Consistent with our item-focused strategy, a vital part of the product mix is a variety of home decor and other assorted merchandise that does not necessarily fit into a specific product category. Decorative accessories consist of such varied products as sconces, vases, and clocks. Other merchandise includes accent furniture, novelty items and housewares. Throughout the year and especially in the fourth quarter of the calendar year, our buying team uses its experience in home decor to develop products that are as appropriate for gift-giving as they are for personal purchase. Innovative product design and packaging are important elements of this effort. 43 The following table presents the percentage of fiscal 2001 net sales contributed by our major merchandise categories: <Table> <Caption> PERCENTAGE OF FISCAL 2001 MERCHANDISE CATEGORY NET SALES - -------------------- ------------- Wall Decor (including framed art and mirrors)............................... 24% Holiday.................................. 11 Lamps.................................... 11 Decorative Accessories................... 10 Garden................................... 10 Candles.................................. 9 Floral................................... 5 Frames................................... 5 Other.................................... 15 --- Total............................... 100% === </Table> Value to Customer. Through our distinctive merchandising, together with carefully coordinated in-store marketing, visual presentation and product packaging, we continually strive to increase the perceived value of our products to our customers. Our shoppers regularly experience the satisfaction of paying noticeably less for items similar or identical to those sold by other retail stores or through catalogs. Our stores typically have two semi-annual clearance events, one in January and one in July. We also run category promotions periodically throughout the year. We believe our value-oriented pricing strategy, coupled with an adherence to high quality standards, is an important element in establishing our distinct brand identity and solidifying our connection with our customers. STORE OPERATIONS General. We currently operate 236 stores in 28 states, all of which are open seven days a week. In addition to corporate management, five Regional Managers and 27 District Managers (who generally have responsibility for eight to ten stores within a geographic district) manage store operations. A Store Manager and one or two Assistant Store Managers manage individual stores. The Store Manager is responsible for the day-to-day operation of the store, including sales, merchandise display and control, personnel functions, and store security. A typical store has one full-time sales associate, one full-time stock person and six to 12 part-time sales associates, depending on the season. Additional part-time sales associates are typically hired to assist with increased traffic and sales volume in the fourth quarter of the calendar year. Format. The prototype Kirkland's store is between 4,200 and 4,800 square feet, of which approximately 70% typically represents selling space. Merchandise is generally displayed according to display guidelines and directives given to each store from the Visual Merchandising team with input from Merchandising and Store Operations personnel. This procedure ensures uniform display standards throughout the chain. Using multiple types of fixtures, we group complementary merchandise creatively throughout the store, rather than displaying products strictly by category or product type. Visual Merchandising. Because of the nature of our merchandise and our focus on identifying and developing best-selling items, we believe adherence to our visual merchandising standards is an important responsibility of our store and field supervisory management. We emphasize visual merchandising in our training efforts and our dedicated team of visual merchants provides valuable leadership and support to this aspect of Store Operations. The Visual Merchandising team provides Store Managers with recommended display directives such as photographs and drawings, weekly placement guides and display manuals. In addition, each Store Manager has some flexibility to creatively highlight those products that are expected to have the greatest appeal to local shoppers. The Visual Merchandising team also assists 44 Regional Managers and District Managers in opening new stores. We believe effective and consistent visual merchandising enhances a store's ability to reach its full sales potential. Personnel Recruitment and Training. We believe our continued success is dependent in part on our ability to attract, retain and motivate quality employees. In particular, the success of our expansion program depends on our ability to promote and/or recruit qualified District and Store Managers and maintain quality sales associates. To date, the majority of our District Managers previously have been Kirkland's Store Managers. A nine-week training program is provided for new District Managers. Store Managers and Assistant Managers, many of whom begin their Kirkland's career as sales associates, currently complete a formal training program before taking responsibility for a store. This training program includes five to 10 days in a designated "training store," working directly with a qualified Store Manager. District Managers are primarily responsible for recruiting new Store Managers. Store Managers are responsible for the hiring and training of new sales associates, assisted where appropriate by a full-time recruiter. We constantly look for motivated and talented people to promote from within Kirkland's, in addition to recruiting from outside Kirkland's. Compensation and Incentives. We compensate our Regional, District and Store Managers with a base salary plus a quarterly performance bonus based on store sales and store-level profit contribution. Sales associates are compensated on an hourly basis. In addition, we regularly run a variety of contests that reward associates for outstanding sales achievement. BRIAR PATCH In July 1998, we acquired The Briar Patch Management Corporation, a specialty retailer of home accessories and gifts based in Savannah, Georgia. Briar Patch operated 35 stores in six southeastern states primarily in markets that were smaller than Kirkland's markets. We applied our merchandising expertise, management, operational disciplines and financial resources to improve the performance of these stores. Under our management, the average net sales per Briar Patch store increased 34% to $1.1 million for fiscal 2001 from approximately $800,000 in the first 12 full months that we owned the stores (August 1998 through July 1999). Furthermore, the store-level profitability of the Briar Patch stores in fiscal 2001 was approximately the same as the store-level profitability of the other Kirkland's stores. We currently operate the Briar Patch stores under the name "Briar Patch by Kirkland's." These stores are operated and merchandised in the same fashion as our stores operated under the "Kirkland's" name. As these stores are remodeled or relocated, we intend to change the name of these stores to "Kirkland's." As of the date of this prospectus, five of the 35 stores acquired from Briar Patch have been remodeled or relocated and are now operating under the "Kirkland's" name, and two of the 35 stores have been closed. REAL ESTATE Strategy. Our real estate strategy is to identify retail properties that are convenient and attractive to our target female customer. The flexibility and broad appeal of our stores and our merchandise allows us to operate successfully in major metropolitan markets such as Houston, Texas and Atlanta, Georgia middle markets such as Birmingham, Alabama and Buffalo, New York and smaller markets such as Appleton, Wisconsin and Panama City, Florida. Site Selection. We locate our stores in enclosed malls or non-mall venues which are destinations for large numbers of shoppers and which reinforce our quality image and brand. To assess potential new locations, we review financial and demographic criteria and analyze the quality of tenants and competitive factors, square footage availability, frontage space and other relevant criteria to determine the overall acceptability of a property and the optimal locations within it. Until recent years, we preferred to locate stores in regional or super-regional malls with a history of high sales per square foot and multiple national department stores as anchors, and generally we sought approximate store frontage of 35 to 40 feet on average. Today, we operate 217 of our 236 stores in 45 enclosed malls, but our flexible store format has allowed us to successfully operate stores in a variety of venues including outlet centers, "lifestyle" strip centers and community strip centers. We believe we are a desirable tenant to developers because of our long and successful operating history, sales productivity, ability to attract customers and our strong position in the home decor category. The following table provides a history of our store openings and closings since the beginning of fiscal 1997. <Table> <Caption> FISCAL FISCAL FISCAL FISCAL FISCAL 1997 1998 1999 2000 2001(1) ------ ------ ------ ------ ------- Stores open at beginning of period...... 120 138 198 226 240 New stores opened(2).................... 20 27 29 17 5 Briar Patch stores acquired............. -- 35 -- -- -- Stores closed........................... (2) (2) (1) (3) (11) ----- ----- ----- ----- ----- Stores open at end of period............ 138 198 226 240 234 Average gross square footage per store(3).............................. 4,186 4,392 4,364 4,437 4,528 </Table> - ------------------------------ (1) Also includes the period beginning on January 1, 2001 and ending on February 3, 2001. (2) Excludes our warehouse outlet store located adjacent to our central distribution facility in Jackson, Tennessee. (3) Calculated using gross square footage of all stores open at both the beginning and the end of the period. Gross square footage includes the storage, receiving and office space that generally occupies approximately 30% of total store space. PURCHASING AND INVENTORY MANAGEMENT Merchandise Sourcing and Product Development. Our merchandise team purchases inventory on a centralized basis to take advantage of our technology and our consolidated buying power and to closely control the merchandise mix in our stores. Our buying team selects all of our products, negotiates with all of our vendors and works closely with our planning and allocation team to optimize store-level merchandise mix by category, classification and item. The seven members of our buying team have an average of 14 years of retail experience, and four of the seven have tenure with Kirkland's ranging from eight to 33 years. We believe this level of experience gives us a competitive advantage in understanding our customer and identifying or developing merchandise suitable to her tastes and budget. We estimate that over 60% of our merchandise assortment is designed or packaged exclusively for Kirkland's, generally based on our buyers' experience in modifying certain merchandise characteristics or interpreting market trends into a product and price point that will appeal to our customer. The amount of exclusively designed or packaged merchandise continues to grow annually. Non-exclusive merchandise is often boxed or packaged exclusively for Kirkland's utilizing Kirkland's proprietary brands. We purchase merchandise from approximately 200 vendors. Approximately 75% of our total purchases are from importers of merchandise manufactured primarily in the Far East and India, with the balance purchased from domestic manufacturers and wholesalers. For our purchases of merchandise manufactured abroad, we believe buying from importers or U.S.-based representatives of foreign manufacturers rather than directly from foreign manufacturers enables us to maximize flexibility and minimize product liability and credit risks. Further, we believe our executive management and buyers are more effective by focusing on managing the retail business and allowing importers to handle the procurement and shipment of foreign-manufactured merchandise for our stores. For certain categories and items, the strategic use of domestic manufacturers and wholesalers enables us to reduce the lead times between ordering products and offering them in our stores. Planning and Allocation. Our merchandise planning and allocation team works closely with our buying team, field management and store personnel to meet the requirements of individual stores for appropriate merchandise in sufficient quantities. This team also manages inventory levels, allocates merchandise to stores and replenishes inventory based upon information generated by our management information systems. Our inventory control systems monitor current inventory levels at each store and for our operations as a whole. If necessary, we can shift slow-moving inventory to other stores for sell-through 46 prior to instituting corporate-wide markdowns. We also continually monitor recent selling history within each store by category, classification and item to properly allocate further purchases to maximize sales and gross margin. Each of our stores is internally classified for merchandising purposes based on certain criteria including store sales, size, location and historical performance. Although all of our stores carry similar merchandise, the variety and depth of products in a given store may vary depending on the store's rank and classification. Inventory purchases and allocation are also tailored based on regional or demographic differences between stores. In April 2001, we installed a state-of-the-art merchandise management system improving the efficiency of our planning and allocation process. This system provides our buyers and planners with daily information on sales, gross margin and inventory by category, classification and item. This information is available for each store, permitting our planners to assess merchandise trends and manage inventory levels and flow at the individual store level. DISTRIBUTION Prior to fiscal 2000, we distributed our products primarily through direct shipments from our vendors to each of our individual stores. Inventory backstock was held both in the store's stockroom and in local storage facilities managed by each Store Manager. We maintained a modest central distribution capability in Jackson, Tennessee through a collection of low-cost warehouses to process certain merchandise shipments and to hold inventory for new store openings. As our store base grew, this legacy distribution system became cumbersome and inefficient, and we recognized the need to develop a more scalable central distribution strategy to permit greater inventory control and to reduce freight costs. During fiscal 2000, we began working with Kurt Salmon & Associates, a leading supply chain consulting firm, to improve our distribution practices and to formulate a long-term distribution strategy. In March 2001, we consolidated our central distribution operations into one modern, 303,000-square-foot facility in Jackson, Tennessee, which allowed us to increase our dollar volume of centrally distributed merchandise by 24% from fiscal 2000 to fiscal 2001. In fiscal 2001, we distributed approximately 62% of our merchandise purchases centrally while the remaining 38% of our purchases were shipped directly from vendors to our stores. Central distribution offers a number of important benefits. In addition to allowing us to reduce freight costs and to manage the flow of merchandise to our stores more efficiently, central distribution allows us to increase the percentage of our purchases that are pre-ticketed by vendors (approximately 90% as of April 2002). Increased use of central distribution has enabled us to significantly reduce the use of costly local storage facilities, which our stores traditionally have used to store surplus inventory, and has also resulted in reduced truck rental costs. Our overall distribution expense decreased as a percentage of net sales from 6.5% in fiscal 2000 to 5.7% in fiscal 2001. We will seek to expand our proportion of centrally distributed merchandise to 90% by fiscal 2005, which we believe will facilitate further reductions in our use of local storage facilities during fiscal 2002 and fiscal 2003. We believe that our existing distribution facilities provide us with adequate distribution capacity at least until fiscal 2004. As we continue to capitalize on the benefits of central distribution, we will continue to take advantage of the benefits that direct shipment capability offers, such as maximizing sales during the late fall season. E-COMMERCE We believe the Internet offers opportunities to complement our "brick-and-mortar" stores and to increase our retail commerce and consumer brand awareness of our products. We maintain a web site at www.kirklands.com, which provides our customers with a resource to locate a store, preview our merchandise and purchase products online. We sell a modest amount of merchandise through our web site and we have a small customer service department to handle e-mail and phone inquiries from our store and 47 e-commerce customers. The information contained or incorporated in our web site is not a part of this prospectus. MANAGEMENT INFORMATION SYSTEMS We have invested significant resources developing an information systems infrastructure to support our business. These investments included $6.5 million of software and hardware replacements or upgrades since late 1999. Recent projects included new point-of-sale (POS) software and servers in all stores (fiscal 1999), integrated retail management software at our home office (fiscal 2001) and an upgrade of POS hardware in approximately two-thirds of our stores (fiscal 2001/fiscal 2002). We believe these newly enhanced systems provide our key decision makers, both in stores and at our home office, with the timely information needed to drive our sales and profitability. Our store information systems include a server in each store that runs our automated POS application on multiple POS registers. The server provides managers with convenient access to detailed sales and inventory information for the store. Our POS registers provide price look-up (all merchandise is bar-coded), time and attendance and automated check and credit card processing. Through automated nightly two-way electronic communication with each store, we upload SKU-level sales, gross margin information and payroll hours to our home office system and download new merchandise pricing, price changes for existing merchandise, purchase orders and system maintenance tasks to the store server. Based upon the evaluation of information obtained through daily polling, our planning and allocation team implements merchandising decisions regarding inventory levels, reorders, price changes and allocation of merchandise to our stores. The core of our home office information system is the integrated GERS retail management software installed in April 2001. This system integrates all merchandising and financial applications, including category, classification and SKU inventory tracking, purchase order management, automated ticket making, general ledger, sales audit, accounts payable and fixed asset management. Our distribution center also uses certain elements of the GERS software package. We utilize a Lawson Software package for our payroll and human resource functions. MARKETING Our marketing efforts emphasize in-store signage, store and window banners and displays and other techniques to attract customers and provide an exciting shopping experience. Historically, we have not engaged in extensive media advertising because we believe that we have benefited from our strategic locations in high-traffic shopping malls and valuable "word-of-mouth" advertising by our customers. Many shopping mall leases historically required some advertising, although an industry shift to "media funds" has largely been implemented, whereby a retailer contributes at agreed levels to the shopping mall's advertising fund based on the square footage of the store. We supplement our in-store marketing efforts with periodic local newspaper advertisements to promote specific events in our stores, including our semi-annual clearance events. TRADEMARKS All of our stores operate under the name "Kirkland's" other than 28 stores which operate under the name "Briar Patch by Kirkland's." We acquired these stores in 1998. As these stores are remodeled or relocated, we intend to change the name of these stores to the "Kirkland's" name. We registered our "Kirkland's" logo with the United States Patent and Trademark Office on the Principal Register. In addition, we hold several trademark registrations in connection with our Cedar Creek private label brand as well as a registration of "the Kirkland Collection." We believe the "Kirkland's" logo, "the Kirkland Collection" and the Cedar Creek private label brand have become important components in our merchandising and marketing strategy. We also claim common law trademark rights in Briar Patch, Kirkland's Outlet, Kirkland's Home and other marks. We are exploring the possibility of 48 federal registration of several of these marks. We are not aware of any claims of infringement or other challenges to our right to use our marks in the United States. COMPETITION The retail market for home decor is highly competitive. Accordingly, we compete with a variety of specialty stores, department stores, discount stores and catalog retailers that carry merchandise in one or more categories also carried by our stores. Our product offerings also compete with a variety of national, regional and local retailers, including such specialty retailers as Bed, Bath & Beyond, Cost Plus, Linens 'n Things, Michaels Stores, Pier 1 Imports and Williams-Sonoma. We believe that the principal competitive factors influencing our business are merchandise quality and selection, price, visual appeal of the merchandise and the store and the convenience of location. Although we face competition from a broad range of retailers, we believe that few competitors focus exclusively on home decor, primarily in a mall environment. Specialty retailers tend to have higher prices and a narrower assortment of products than our stores. Department stores typically have higher prices than our stores for similar merchandise. Wholesale clubs may have lower prices than our stores, but the product assortment is generally considerably more limited. The number of companies offering a selection of home decor products that overlaps generally with our product assortment has increased over the last five years. However, we believe that our stores still occupy a distinct niche in the marketplace: traditionally styled merchandise, reflective of current market trends typically offered at a discount to catalog and department store prices. We believe we compete effectively with other retailers due to our experience in identifying a broad collection of distinctive merchandise, pricing it to be attractive to the target Kirkland's customer and presenting it in a visually appealing manner. In addition to competing for customers, we compete with other retailers for suitable store locations and qualified management personnel. Many of our competitors are larger and have substantially greater financial, marketing and other resources than we do. See "Risk Factors - We face an extremely competitive specialty retail business market." PROPERTIES We lease all of our store locations and expect to continue our policy of leasing rather than owning. Our leases typically provide for 10-year terms, many with the ability for Kirkland's (or the landlord) to terminate the lease in the middle of the term if sales at the leased premises do not reach a certain annual level. The leases typically provide for payment of percentage rent (i.e., a percentage of sales in excess of a specified level) and the rate of increase in key ancillary charges is generally capped. As current leases expire, we believe we will be able either to obtain lease renewals if desired for present store locations or to obtain leases for equivalent or better locations in the same general area. To date, we have not experienced unusual difficulty in either renewing leases for existing locations or securing leases for suitable locations for new stores. A majority of our store leases contain provisions permitting the landlord to terminate the lease upon a change in control of Kirkland's. We own our corporate headquarters in Jackson, Tennessee, which currently consists of approximately 40,000 square feet of office space. We lease our 303,000-square-foot distribution center, also located in Jackson, Tennessee. 49 The following table indicates the states and cities where our stores are located and the number of stores within each state: ALABAMA(14) Auburn Birmingham Decatur Dothan Florence Gadsden Hoover Huntsville Mobile Montgomery(2) Oxford Prattville Tuscaloosa ARKANSAS(3) Fayetteville Little Rock North Little Rock FLORIDA(31) Altamonte Springs Boynton Beach Bradenton Brandon Clearwater Coral Springs Daytona Beach Destin Ft. Myers Gainesville Jacksonville(2) Lake Wales Mary Esther Naples Ocoee Orange Park Oviedo Panama City Pembroke Pines Pensacola Sanford Sarasota Sebring St. Petersburg Sunrise Tallahassee Tampa(3) Vero Beach GEORGIA(21) Albany Alpharetta Athens Atlanta(2) Augusta Buford Columbus Commerce Douglasville Duluth Kennesaw Lithonia Macon(2) Morrow Peachtree City Rome Savannah(2) Valdosta ILLINOIS(6) Aurora Bloomington Fairview Heights Gurnee Moline Orland Park INDIANA(7) Evansville Ft. Wayne Greenwood Indianapolis Lafayette Mishawaka Terre Haute IOWA(4) Cedar Rapids Coralville Davenport West Des Moines KANSAS(4) Leawood Overland Park Topeka Wichita KENTUCKY(7) Bowling Green Florence Lexington Louisville(2) Owensboro Paducah LOUISIANA(10) Baton Rouge(2) Gretna Houma Kenner Lafayette Lake Charles Monroe Shreveport Slidell MARYLAND(5) Baltimore Frederick Glen Burnie Hanover Waldorf MICHIGAN(3) Auburn Hills Grandville Okemos MISSISSIPPI(10) Biloxi Columbus Flowood Greenville Hattiesburg Jackson McComb Meridian Ridgeland Tupelo MISSOURI(3) Joplin Springfield St. Louis NEBRASKA(1) Lincoln NEW JERSEY(1) Elizabeth NEW MEXICO(2) Albuquerque(2) NEW YORK(2) Buffalo West Nyack NORTH CAROLINA(16) Asheville Cary Charlotte Concord Durham(2) Fayetteville Greensboro(2) Hickory High Point Pineville Raleigh Rocky Mt. Wilmington Winston-Salem OHIO(10) Akron Beaver Creek Canton Cincinnati(2) Dublin Niles Parma St. Clairsville Youngstown OKLAHOMA(2) Oklahoma City Tulsa PENNSYLVANIA(6) Altoona Camp Hill Erie Exton Lancaster Pittsburgh SOUTH CAROLINA(11) Anderson Bluffton Charleston(2) Columbia(3) Florence Greenville Myrtle Beach Spartanburg TENNESSEE(14) Chattanooga Clarksville Franklin Goodlettsville Jackson Johnson City Knoxville(2) Memphis(3) Nashville(2) Sevierville TEXAS(27) Amarillo Arlington Austin Cedar Park Corpus Christi El Paso Friendswood Frisco Grapevine Houston(4) Humble Hurst Katy Lubbock McAllen Mesquite Midland Plano San Antonio San Marcos Sugar Land The Woodlands Tyler Waco VIRGINIA(11) Charlottesville Chesapeake Colonial Heights Dulles Glen Allen Lynchburg Newport News Norfolk Richmond Roanoke Winchester WEST VIRGINIA(3) Barboursville Bridgeport Charleston WISCONSIN(2) Appleton Eau Claire EMPLOYEES We employed approximately 1,600 full-time and approximately 2,200 part-time employees at December 1, 2001. Of these, approximately 200 were corporate and warehouse center personnel and 3,600 were store employees. The number of part-time employees fluctuates with seasonal needs. None of our employees is covered by a collective bargaining agreement. We believe our employee relations are good. LEGAL PROCEEDINGS We are involved in various routine legal proceedings incidental to the conduct of our business. We believe any resulting liability from existing legal proceedings, individually or in the aggregate, will not have a material adverse effect on our operations or financial condition. 50 MANAGEMENT DIRECTORS, EXECUTIVE OFFICERS AND KEY EMPLOYEES Our directors, executive officers and key employees and their respective ages as of February 2, 2002, are as follows: <Table> <Caption> NAME AGE POSITION ---- --- -------- DIRECTORS AND EXECUTIVE OFFICERS: Carl Kirkland(a)............. 61 Chairman of the Board Robert E. Alderson........... 55 President, Chief Executive Officer and Director Reynolds C. Faulkner......... 38 Executive Vice President, Chief Financial Officer and Director H.R. Harvey.................. 44 Senior Vice President of Merchandising C. Edmond Wise, Jr........... 51 Senior Vice President of Store Operations Alexander S. McGrath......... 40 Director David M. Mussafer(a)......... 38 Director R. Wilson Orr, III(a,b)...... 39 Director John P. Oswald(b)............ 42 Director Murray Spain(b).............. 58 Director KEY EMPLOYEES: Chris T. LaFont.............. 41 Vice President of Merchandising - Product Development Grey W. Satterfield.......... 39 Vice President of Merchandising - Planning Toni F. Warren............... 46 Vice President of Merchandising - Replenishment James W. Harris.............. 55 Vice President of Operations and Personnel Deborah A. McDonald.......... 35 Vice President of Visual Merchandising Connie L. Scoggins........... 47 Vice President of Finance and Treasurer/ Controller Lowell E. Pugh, II........... 45 Vice President and General Counsel </Table> - --------------- (a) Member of Compensation Committee (b) Member of Audit Committee DIRECTORS AND EXECUTIVE OFFICERS Carl Kirkland has been Chairman of the Board since June 1996. Mr. Kirkland co-founded Kirkland's in 1966 and served as Chief Executive Officer from 1966 through March 2001 and President from 1966 through November 1997. He has over 30 years of experience in the retail industry. Mr. Kirkland also serves on the board of directors of Hibbett Sporting Goods, Inc. Robert E. Alderson has been a Director of Kirkland's since September 1986, President of Kirkland's since November 1997 and Chief Executive Officer of Kirkland's since March 2001. He served as Chief Operating Officer of Kirkland's from November 1997 through March 2001 and as Senior Vice President of Kirkland's since joining in 1986 through November 1997. He also served as Chief Administrative Officer of Kirkland's from 1986 to 1997. Prior to joining Kirkland's, he was a senior partner at the law firm of Menzies, Rainey, Kizer & Alderson. Reynolds C. Faulkner has been a Director of Kirkland's since September 1996 and joined Kirkland's as Senior Vice President and Chief Financial Officer in February 1998. He was promoted to Executive Vice President in February 2002. Prior to joining Kirkland's, from July 1989 to January 1998, 51 Mr. Faulkner was an investment banker in the corporate finance department of The Robinson-Humphrey Company, LLC, most recently serving as a Managing Director and head of the retail practice group. In this capacity, Mr. Faulkner was involved in numerous public and private financings and mergers and acquisitions of companies in the retail industry. H.R. Harvey has been Senior Vice President of Merchandising since joining Kirkland's in June 2001. Prior to joining Kirkland's, Mr. Harvey was Vice President of Merchandising at Homeplace of America from July 2000 to June 2001 and Senior Vice President of Merchandising at Saks Incorporated from February 1996 to July 2000. Prior to that, he was with Federated Department Stores for over 16 years, most recently as Merchandising Vice President. C. Edmond Wise, Jr. has been Senior Vice President of Store Operations since joining Kirkland's in December 2000. Prior to joining Kirkland's, Mr. Wise was a Director of Retail Operations for Payless ShoeSource from October 1998 to November 2000. Prior to that, Mr. Wise had 26 years of retail operations experience, including eight years with Edison Brothers Stores from October 1990 to October 1998. Alexander S. McGrath has been a director of Kirkland's since June 1996. Mr. McGrath is currently a general partner of Capital Resource Partners II, L.P., a mezzanine and private equity investment firm which is the general partner of Capital Resource Lenders II, L.P., a warrantholder of and subordinated lender to Kirkland's. He joined Capital Resource Lenders in 1988 as an associate, and has been a general partner of Capital Resource Partners II, L.P. since 1993. Prior to that, he was an associate at Investments Orange Nassau Inc., a private equity investment firm. See "Principal and Selling Shareholders." David M. Mussafer has been a Director of Kirkland's since June 1996. Mr. Mussafer is currently a Managing Director of Advent International Corporation and is responsible for Advent's North American private equity operations. Advent is a private equity investment firm which beneficially owns common stock of Kirkland's through its interests in certain members of Kirkland Holdings L.L.C., one of Kirkland's principal shareholders. Mr. Mussafer joined Advent in 1991 and has been a principal of the firm since 1993. Prior to joining Advent, Mr. Mussafer worked as a Vice President in corporate lending at Chemical Bank from 1985 to 1988. See "Principal and Selling Shareholders." R. Wilson Orr, III has been a Director of Kirkland's since June 1996. Since 1993, Mr. Orr has been a principal of SSM Corporation, a private equity investment firm and an affiliate of SSM Venture Partners, L.P. which is a member of Kirkland Holdings L.L.C., one of Kirkland's principal shareholders. He joined SSM Corporation in 1988 as a Vice President and partner. From 1984 to 1988, he worked in corporate lending at Chemical Bank. See "Principal and Selling Shareholders." John P. Oswald has been a Director of Kirkland's since June 1996. Since 1994, Mr. Oswald has been a partner of the Capital Trust Group, a private equity investment firm and an affiliate of CT/ Kirkland Equity Partners, L.P., which is a member of Kirkland Holdings L.L.C., one of Kirkland's principal shareholders. Mr. Oswald is a beneficial owner of Capital Trust Investments, Ltd., a warrantholder of and subordinated lender to Kirkland's. He is also President and Chief Executive Officer of Bridge East Capital, a private equity investment partnership, which is an affiliate of the Capital Trust Group. Prior to joining Capital Trust Group he was a partner with the law firm of Lord, Day & Lord from 1986 to 1994 and an associate with Arthur Andersen LLP from 1984 to 1986. See "Principal and Selling Shareholders." Murray Spain has been a Director of Kirkland's since September 2001. In September 2000, Mr. Spain co-founded World Wide Basics, an importer of general merchandise, and has served as its President since inception. Prior to this, he was the co-founder of Dollar Express, Inc. and acted as Dollar Express's President and Chief Operating Officer from its inception in 1961 until May 2000, when Dollar Express merged with Dollar Tree Stores, Inc. At that time, Dollar Express was a chain of 126 retail stores in 5 states. Mr. Spain was not working from May to September 2000. 52 KEY EMPLOYEES Chris T. LaFont has been Vice President of Merchandising since September 1997. Mr. LaFont is responsible for all merchandise buying decisions for Kirkland's. From 1988 to September 1997, he served as Vice President of Visual Merchandising for Kirkland's. Mr. LaFont started his career with Kirkland's in 1981 as a management trainee. Grey W. Satterfield has been Vice President of Merchandising since joining Kirkland's in January 2000. Mr. Satterfield is responsible for merchandise planning and inventory management efforts, including receipt flow management and the maintenance of all open-to-buy reports. Prior to joining Kirkland's, Mr. Satterfield was with Saks Incorporated from October 1996 to December 1999, most recently as Vice President of Product Development. Prior to that, Mr. Satterfield had nine years of buying experience with the Macy's and Federated Stores organizations. Toni F. Warren has been Vice President of Merchandising since January 2000. Ms. Warren is responsible for merchandise allocation and replenishment. Ms. Warren has been with Kirkland's for over 30 years and her experience includes 16 years in store operations and 14 years in purchasing, allocation and merchandise information systems. James W. Harris has been Vice President of Operations and Personnel since 1987. Mr. Harris is responsible for store personnel recruitment and training as well as general store operations. Prior to joining Kirkland's, Mr. Harris was with Goldsmith's, a division of Federated Department Stores, from 1972 to 1987, where he held various positions in store operations. Deborah A. McDonald has been Vice President of Visual Merchandising since August 2000 and has been with Kirkland's since 1984. She has served as Store Manager, Corporate Specialist and most recently as Director of Visual Merchandising. Ms. McDonald is responsible for creation and implementation of all visual merchandising plans for new and existing stores. Connie L. Scoggins has been Vice President of Finance since January 2000. Ms. Scoggins has been with Kirkland's since 1986 serving as Treasurer and Controller. Prior to joining Kirkland's, Ms. Scoggins was employed by Owens Corning Fiberglass as Accounting Manager. Lowell E. Pugh, II, has been a Vice President since January 2000. He has also served as Secretary since November 1997. Mr. Pugh joined Kirkland's in August 1996 and has served since that time as Assistant Vice President and General Counsel. Prior to that Mr. Pugh served as General Counsel to United Foods, Inc., and prior to that he was a partner with Johnson & Gibbs, a Dallas, Texas law firm. CLASSIFIED BOARD OF DIRECTORS Upon completion of this offering, our Board of Directors will be divided into three classes of directors, each containing, as nearly as possible, an equal number of directors. Directors within each class are elected to serve three-year terms and approximately one-third of the directors sit for election at each annual meeting of our shareholders. The terms of Messrs. McGrath, Orr and Oswald will expire in 2003, the terms of Messrs. Faulkner and Spain will expire in 2004 and the terms of Messrs. Kirkland, Alderson and Mussafer will expire in 2005. A classified board of directors may have the effect of deterring or delaying any attempt by any person or group to obtain control of us by a proxy contest since such third party would be required to have its nominees elected at two separate annual meetings of the Board of Directors in order to elect a majority of the members of the Board of Directors. Directors who are elected to fill a vacancy (including vacancies created by an increase in the number of directors) must be confirmed by the shareholders at the next annual meeting of shareholders whether or not such director's term expires at such annual meeting. See "Risk Factors - Our charter and bylaw provisions and certain provisions of Tennessee law may make it difficult in some respects to cause a change in control of Kirkland's and replace incumbent management." 53 DIRECTOR COMPENSATION To date, directors who are affiliated with us or any of our shareholders have not received separate compensation for their services in that capacity. In the future, we intend to compensate our non-employee directors. The amount of such compensation has not been determined but will be consistent with amounts paid by comparable public companies. COMMITTEES OF THE BOARD The audit committee of the Board of Directors is composed of Messrs. Orr, Oswald and Spain. The principal functions of the audit committee include: - making recommendations to the Board of Directors regarding the selection of our independent public accountants to audit annually our books and records; - reviewing the proposed scope of each audit; - meeting periodically with the independent public accountants and our Chief Financial Officer to review matters relating to our financial statements, our accounting principles and our system of internal accounting controls; and - reporting its recommendations as to the approval of our financial statements to the Board of Directors. The compensation committee of the Board of Directors is composed of Messrs. Kirkland, Mussafer and Orr. The compensation committee is responsible for establishing the salaries of our executive officers, incentives and other forms of compensation and for administering our employee benefit plans. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION Other than Carl Kirkland, the members of the compensation committee of the Board of Directors, Messrs. Mussafer and Orr, have not at any time served as officers or employees of Kirkland's, but are affiliated with entities that participated in our 1996 recapitalization, in subsequent equity financings and in the Pre-Offering Transactions. We rent aircraft for business travel from a company owned by Carl Kirkland. We spent $23,000 for the rental of aircraft from this company for fiscal 2001, $92,000 in fiscal 2000 and $63,000 in fiscal 1999. See "Certain Transactions." None of our executive officers presently serves, or in the past has served, on the board of directors or compensation committee of any other entity that has an executive officer who is serving, or who in the past has served, as a member of our Board of Directors or our compensation committee. 54 EXECUTIVE COMPENSATION The following table sets forth certain compensation information with respect to our Chief Executive Officer and our other executive officers whose salary and bonus exceeded $100,000 for our fiscal year ended February 2, 2002 (the "Named Executive Officers"): SUMMARY COMPENSATION TABLE <Table> <Caption> LONG TERM COMPENSATION ------------ AWARDS ANNUAL COMPENSATION ------------ ------------------------------------------------------- SECURITIES ALL OTHER OTHER ANNUAL UNDERLYING COMPENSATION NAME AND PRINCIPAL POSITION FISCAL YEAR SALARY($) BONUS($) COMPENSATION($)(4) OPTIONS(#) ($)(5) - --------------------------- ----------- --------- -------- ------------------ ------------ ------------ Carl Kirkland............. 2001 103,125 -- -- -- 867 Chairman of the Board(1) Robert E. Alderson........ 2001 275,000 40,000 -- 2,500 867 President and Chief Executive Officer(2) Reynolds C. Faulkner...... 2001 226,250 40,000 -- 1,000 867 Executive Vice President and Chief Financial Officer H.R. Harvey............... 2001 140,625 30,000 -- 550 -- Senior Vice President of Merchandising(3) C. Edmond Wise, Jr........ 2001 176,250 30,000 37,855 550 -- Senior Vice President of Store Operations </Table> - ------------------------------ (1) Mr. Kirkland also served as our Chief Executive Officer until March 2001. (2) Mr. Alderson became our Chief Executive Officer in March 2001. Mr. Alderson also served as our Chief Operating Officer until March 2001. (3) Mr. Harvey became our Senior Vice President of Merchandising in June 2001. (4) Amounts for Mr. Wise consists of $30,655 in relocation expenses and $7,200 in automobile allowance. (5) Represents amounts contributed under our 401(k) plan for the benefit of Messrs. Kirkland, Alderson and Faulkner. STOCK OPTIONS GRANTED TO CERTAIN EXECUTIVE OFFICERS DURING FISCAL YEAR 2001 The following table sets forth certain information regarding options for the purchase of common stock that were awarded to our Named Executive Officers during the fiscal year ended February 2, 2002: OPTION GRANTS IN FISCAL 2001 <Table> <Caption> POTENTIAL REALIZABLE VALUE AT ASSUMED PERCENT OF ANNUAL RATES OF STOCK NUMBER OF TOTAL PRICE SECURITIES OPTIONS APPRECIATION FOR UNDERLYING GRANTED EXERCISE OR OPTION TERM($)(2) OPTIONS TO EMPLOYEES BASE PRICE EXPIRATION --------------------- NAME GRANTED(#)(1) IN FISCAL 2001 ($/SH) DATE 5% 10% - ---- ------------- -------------- ----------- ---------- --------- --------- Carl Kirkland............ -- -- -- -- Robert E. Alderson....... 2,500 27% $71.00 11/29/2011 $111,629 $282,889 Reynolds C. Faulkner..... 1,000 11% $71.00 11/29/2011 $ 44,652 $113,156 H.R. Harvey.............. 550 6% $71.00 11/29/2011 $ 24,558 $ 62,236 C. Edmond Wise, Jr....... 550 6% $71.00 11/29/2011 $ 24,558 $ 62,236 </Table> 55 - ------------------------------ (1) These options will become exercisable as to 33% of such shares on the first anniversary of the option grant date and then will become exercisable for an additional 8.33% on each of our next eight quarter ends. (2) These amounts represent assumed rates of appreciation in the price of our common stock during the terms of the options in accordance with rates specified in applicable federal securities regulations. Actual gains, if any, on stock option exercises will depend on the future price of our common stock and overall stock market conditions. There is no representation that the rates of appreciation reflected in this table will be achieved. STOCK OPTIONS EXERCISED BY CERTAIN EXECUTIVE OFFICERS DURING FISCAL 2001 AND YEAR-END OPTION VALUES. The following table sets forth certain information regarding options for the purchase of common stock that were held by our Named Executive Officers during the fiscal year ended February 2, 2002. None of the Named Executive Officers exercised stock options during the fiscal year ended February 2, 2002. AGGREGATED OPTION EXERCISES IN FISCAL YEAR ENDED FEBRUARY 2, 2002 AND YEAR-END OPTION VALUES <Table> <Caption> NUMBER OF SECURITIES VALUE OF UNEXERCISED UNDERLYING UNEXERCISED IN-THE-MONEY OPTIONS AT OPTIONS AT SHARES FEBRUARY 2, 2002(#) FEBRUARY 2, 2002($) ACQUIRED ON VALUE --------------------------- ------------------------------- NAME EXERCISE(#) REALIZED($) EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE (1) - ---- ----------- ----------- ----------- ------------- ----------- ----------------- Carl Kirkland(2)....... -- -- 0 3,950 0 1,372,823 Robert E. Alderson(2).......... -- -- 0 6,450 0 2,065,323 Reynolds C. Faulkner... -- -- 2,283 1,000 577,599 277,000 H.R. Harvey............ -- -- 0 550 0 152,350 C. Edmond Wise, Jr..... -- -- 0 550 0 152,350 </Table> - ------------------------------ (1) There was no public trading market for our common stock as of February 2, 2002. Accordingly, these values have been calculated based on our board of directors' determination of the fair market values of the underlying shares as of February 2, 2002 of $348 per share, less the applicable exercise price per share, multiplied by the underlying shares. (2) Upon completion of this offering, the options held by each of Messrs. Kirkland and Alderson to purchase 3,950 shares of common stock, with a value of $1,372,823 as of February 2, 2002, will automatically terminate. EMPLOYEE BENEFIT PLANS 1996 EXECUTIVE INCENTIVE AND NON-QUALIFIED STOCK OPTION PLAN We maintain the Kirkland's, Inc. 1996 Executive Incentive and Non-Qualified Stock Option Plan (as amended, the "1996 Plan"). We believe the 1996 Plan promotes our long-term growth and profitability by providing key employees with incentives to improve shareholder value and to contribute to our growth and financial success. Moreover, we believe the 1996 Plan helps us attract, retain and reward quality employees. The Board of Directors or a committee of the Board of Directors administers the 1996 Plan. Under the terms of the 1996 Plan, the committee will be composed of three directors. The Board of Directors or the committee interprets the 1996 Plan, selects option recipients and determines the number of shares subject to each option and establishes the price, vesting and other terms of each option. While there are no predetermined performance formulas or measures or other specific criteria used to determine recipients of options under the 1996 Plan, grants are based generally upon consideration of the grantee's position and responsibilities, the nature of services provided, the value of the services to us, the present and potential contribution of the grantee to our success, the anticipated number of years of service remaining and other factors which the Board of Directors or the committee deems relevant. Participation in the 1996 Plan is limited to our employees or any of our subsidiaries' employees. Awards under the 1996 Plan may be in the form of incentive stock options or non-qualified stock options. 56 In the event of any stock split, reverse stock split, stock dividend, recapitalization, reclassification or other similar event, appropriate proportional adjustments may be made to the number of shares reserved for issuance under the 1996 Plan and the number, kind and price of shares covered by outstanding options. Stock options may not be exercised more than 10 years after the date of grant. Shares subject to forfeited, cancelled or expired stock options become available for grant again under the 1996 Plan. Stock options grants under the 1996 Plan are not transferable by the participants, except upon death. The exercise price of an incentive stock option must be not less than the fair market value of the common stock on the date the option is granted. Although the 1996 Plan permits the exercise price of a non-qualified stock option to be less than the fair market value of the common stock on the date the option is granted, the exercise price of all non-qualified stock options granted under the 1996 Plan to date have been equal to the fair market value of the common stock on the date of grant. The exercise price of stock options granted under the 1996 Plan may be paid in cash or by tender of previously acquired shares of our common stock. As of the date of this prospectus, options to purchase 15,570 shares of common stock are outstanding under the 1996 Plan at exercise prices ranging from $.01 to $95.00 per share, and no additional options may be granted under the 1996 Plan. Of these options, 6,370 have vested as of the date of the prospectus. No additional shares of common stock are available for issuance in connection with future grants under the 1996 Plan. 2002 INCENTIVE PLAN Prior to the completion of this offering, we intend to adopt the Kirkland's, Inc. 2002 Incentive Plan (the "Incentive Plan"). The Incentive Plan provides for the award of restricted shares of common stock, and incentive stock options, non-qualified stock options and stock appreciation rights with respect to shares of common stock, to our employees, directors, consultants and other individuals who perform services for us. The maximum number of shares of common stock with respect to which awards may be made under the Incentive Plan is . No Participant will receive an award of stock options or stock appreciation rights under the Incentive Plan with respect to more than shares of common stock in any calendar year. In the event of any stock split, reverse stock split, stock dividend, recapitalization, reclassification or other similar event, adjustments may be made at the Board of Directors' discretion to the number of shares reserved for issuance under the Incentive Plan, to the limit on the number of shares that may be subject to stock options or stock appreciation rights granted to a single person in any calendar year and to the number, kind and price of shares covered by outstanding awards. Shares subject to forfeited, cancelled or expired awards become available for grant again under the Incentive Plan. In addition, shares surrendered in payment of any exercise price or in satisfaction of any withholding obligation arising in connection with an award granted under the Incentive Plan become available for grant again under the Incentive Plan. The Board of Directors or the compensation committee of the Board of Directors administers the Incentive Plan. Under the terms of the Incentive Plan, the compensation committee must consist of two or more directors. The Board of Directors or the compensation committee interprets the Incentive Plan, selects award recipients, determines the number of shares subject to each award and establishes the price, vesting and other terms of each award. While there are no predetermined performance formulas or measures or other specific criteria used to determine recipients of awards under the Incentive Plan, awards are based generally upon consideration of the grantee's position and responsibilities, the nature of services provided, the value of the services to us, the present and potential contribution of the grantee to our success, the anticipated number of years of service remaining and other factors which the Board of Directors or the compensation committee deems relevant. The Incentive Plan has no specified term, although incentive stock options will not be granted more than 10 years after the adoption of the Incentive Plan. 57 Stock Options. The Incentive Plan permits the grant of incentive stock options to our employees and the employees of our subsidiaries. The Incentive Plan also provides for the grant of non-qualified stock options to our employees, directors, and consultants and other individuals who perform services for us (as well as to employees, directors, consultants and service providers of our subsidiaries). The exercise price of any incentive stock options granted under the Incentive Plan may not be less than 100% of the fair market value of our common stock on the date of grant. There is no restriction applicable to the exercise price of non-qualified options granted under the Incentive Plan. Options granted under the Incentive Plan may be exercised for cash or in exchange for shares of common stock owned by the option holder for more than six months having a fair market value on the date of exercise equal to the option exercise price. Under the Incentive Plan, each option is exercisable at such time and to such extent as specified in the pertinent option agreement between the option recipient and us. However, no award shall be exercisable with respect to any shares of common stock later than ten years after the date of such award. Unless otherwise specified by the Board of Directors or the compensation committee with respect to a particular option, all options are non-transferable, except upon death. Upon or in anticipation of a change of control in Kirkland's, the Board of Directors or the compensation committee may: (i) cause outstanding options to become immediately exercisable, (ii) provide for the cancellation of options in exchange for comparable options to purchase shares in a successor corporation, or (iii) provide for the cancellation of options in exchange for a cash and/or other substitute consideration. Stock Appreciation Rights. The Incentive Plan also provides for the grant of stock appreciation rights, either alone or in tandem with a stock option. A stock appreciation right entitles its holder to a cash payment of the excess of the fair market value of our common stock on the date of exercise, over the fair market value of our common stock on the date of grant. No stock appreciation right issued under the Incentive Plan will have a term of more than ten years. Upon or in anticipation of a change of control in Kirkland's, the Board of Directors or the compensation committee may: (i) cause outstanding stock appreciation rights to become immediately exercisable or (ii) provide for the cancellation of stock appreciation rights in exchange for a cash and/or other substitute consideration. Restricted Stock. Restricted stock consists of shares of our common stock issued to an employee that will be forfeited to us if certain vesting conditions established by the Board of Directors or the compensation committee at the time of grant (such as a specified period of continued employment or the fulfillment of specified individual or corporate performance goals) are not met. Restricted stock may be sold under the Incentive Plan (at its full value or at a discount) or may be granted solely in consideration for services. Upon or in anticipation of an event of a change of control in Kirkland's, the Board of Directors or the compensation committee may: (i) cause restrictions on shares of restricted stock to lapse, (ii) cancel restricted stock in exchange for shares of restricted stock of a successor corporation or (iii) redeem restricted stock for cash or other substitute consideration. EMPLOYEE STOCK PURCHASE PLAN Prior to the completion of this offering, we intend to adopt an Employee Stock Purchase Plan (the "Stock Purchase Plan"), which allows substantially all of our full-time employees who have been employees for 12 consecutive months, subject to certain limitations, to purchase shares of our common stock at a discount from the prevailing market price at the time of purchase. These shares are either issued by us from our authorized and unissued common stock or purchased by us on the open market. Any employee owning (or having a right to acquire) five percent or more of our voting power or value will not be eligible to participate in the Stock Purchase Plan. shares of our common stock will be available for purchase under the Stock Purchase Plan (subject to adjustment in the event of a stock dividend, split, reverse split or distribution, or other similar change in our common stock). Any future increase in the 58 number of shares of our common stock subject to the Stock Purchase Plan will require shareholder approval. An eligible employee will be eligible to participate in offerings under the Stock Purchase Plan. Offerings under the Stock Purchase Plan will begin upon the completion of this offering and on each subsequent February 1st and August 1st. Each offering will be 24 months long (except for the first offering, which will begin upon completion of this offering and will end on July 31, 2004), so that offerings under the Stock Purchase Plan will overlap. Each offering will include four six-month purchase periods, ending on each July 31st and January 31st (except for the first offering, which will have five purchase periods, the first of which will begin upon completion of this offering and end on July 31, 2002). Once enrolled in a specific offering, an eligible employee will be able to specify an amount (not greater than 15% of pay) to be withheld from his or her paycheck and credited to a bookkeeping account established for him or her (the "Participation Account"). Amounts in the Participation Account will be applied to the purchase of shares of our common stock on the last day of each purchase period. The price of such shares will be equal to 85% of the lesser of: (i) the price of our shares on the last day of the purchase period and (ii) the price of our shares on the first day of the offering (or, for purposes of the first offering, the public offering price). No employee may purchase more than $25,000 worth of common stock (determined based on the price on the first day of the offering) in any calendar year under the Stock Purchase Plan (and any other employee stock purchase plans later established by us or our subsidiaries), with amounts not used in any one year transferable to the following year. In addition, no employee may purchase more than shares of our common stock under the Stock Purchase Plan in any purchase period. Once enrolled in a specific offering, that offering will continue to apply to an eligible employee until he or she withdraws from the offering or terminates from employment, unless the price of our common stock is lower at the end of any purchase period than at the start of the offering. If the price of our common stock is lower at the end of any purchase period than at the start of the offering, then, after the completion of that purchase period, each eligible employee's participation in that offering will terminate and those employees will be enrolled automatically in the offering beginning immediately after that purchase period. Only whole shares of common stock may be purchased under the Stock Purchase Plan. Amounts withheld from an employee's paycheck and that are insufficient to purchase a whole share of common stock will remain credited to the employee's Participation Account. A participating employee may change the rate of his or her payroll withholding under the Stock Purchase Plan from time to time, and may cease participation in any offering altogether by requesting a withdrawal of his or her Participation Account. However, once an employee has withdrawn from an offering, he or she may not resume participation in the Stock Purchase Plan until the start of the next offering. Upon termination of an employee's employment, all amounts credited to his or her Participation Account will be returned to him or her (without interest). If we merge or consolidate with another company, if we sell substantially all our assets, or if we liquidate or dissolve, the end of the then-current purchase period will be accelerated and shares will be purchased under the Stock Purchase Plan immediately before the merger, consolidation, asset sale, liquidation or dissolution (unless the Stock Purchase Plan is assumed by a successor entity). The compensation committee of the Board of Directors will administer the Stock Purchase Plan. The Board of Directors may amend or terminate the Stock Purchase Plan. The Stock Purchase Plan is intended to comply with the requirements of Section 423 of the Internal Revenue of 1986, as amended (the "Code"). The Board of Directors may terminate the Plan at any time. 401(K) PLAN We maintain the Kirkland's, Inc. Retirement Plan ("401(k) Plan") for the benefit of our eligible employees. The 401(k) Plan is intended to be qualified under Code section 401(a) and consists of a 59 401(k) component, a 401(m) matching component and a profit-sharing component. Employees eligible to participate in the 401(k) Plan are those employees who have completed at least one year of service and attained the age of 21. Under the 401(k) component, participants may elect to defer up to the maximum permitted by the Code per year to the 401(k) Plan. Under the 401(m) matching component, we may match each participant's elective deferrals, up to 6% of compensation. Currently, we match 50% of each participant's elective deferrals. Under the profit-sharing component, we may make additional contributions in amounts to be determined by us in our sole discretion. Our profit-sharing contributions are allocated among eligible participants in proportion to each participant's compensation. Matching contributions and profit-sharing contributions vest ratably over six years, or earlier upon attainment of the appropriate retirement age, upon retirement for disability, upon death, or upon termination of the 401(k) Plan. All assets of the 401(k) Plan are currently invested, subject to participant-directed elections, in annuity contracts underwritten by ING Aetna Financial Services. Payment of 401(k) Plan benefits are made in cash in the form of a single lump sum, periodic installments or an annuity. Distribution of a participant's vested interest generally occurs upon termination of employment (including by reason of retirement, death or disability). SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN Following the completion of this offering, we intend to adopt a non-qualified deferred compensation plan known as a supplemental executive retirement plan ("SERP"). Only a select group of highly compensated management employees chosen by the Board of Directors will be eligible to participate in the SERP. Pursuant to the SERP, participants will be entitled to elect, in advance, to reduce salary or bonus income and have that reduction credited to an account under the SERP. To the extent all or a portion of the participant's deferral relates to amounts that could have been contributed to the 401(k) Plan, but for the application of certain legal restrictions, we will also credit a matching contribution amount to the SERP equal to what would have been contributed to the 401(k) Plan, in the absence of those restrictions. EMPLOYMENT AGREEMENTS CARL KIRKLAND AND ROBERT E. ALDERSON In connection with our 1996 recapitalization, we entered into employment agreements with Carl Kirkland and Robert E. Alderson. Under the terms of these employment agreements, Mr. Kirkland and Mr. Alderson were employed as officers of Kirkland's. The employment agreements with Messrs. Kirkland and Alderson have been extended through June 12, 2002 and negotiations have commenced concerning the terms on which the agreements will be further extended. Mr. Kirkland's current salary is $137,500, and he is also entitled to receive $712,500 which represents interest on his shares of Class C Preferred Stock. Mr. Alderson's current salary is $275,000, and he is also entitled to receive $149,500 which represents interest on his shares of Class C Preferred Stock. The payments representing interest on the Class C Preferred Stock is payable every February 1 in arrears. The payments representing such interest accrued after 1997 have not been made as a result of subordination provisions under our existing senior credit facility. A portion of the proceeds of this offering will be used to pay the stated value of the Class C Preferred Stock and all accrued and unpaid interest amounts associated with the Class C Preferred Stock, after which no further interest payments associated with the Class C Preferred Stock will be paid. The employment agreements with Messrs. Kirkland and Alderson also provide for each executive to receive an annual bonus beginning with the fiscal year ended December 31, 1996. The bonus includes a performance-based component of up to $175,000 based on our achievement of projected Adjusted EBITDA targets established by the Board of Directors, as well as a discretionary component of up to $75,000. Each executive is entitled to receive the full $175,000 performance-based component of the bonus if we achieve at least 95% of our projected Adjusted EBITDA target for a particular fiscal year, none of 60 the bonus for achievement of the target for the year at a level of 85% or less, and a pro rata portion of $175,000 for achievement of the target for the year at a level of between 85% and 95%. There are no limits on the projected Adjusted EBITDA target to be established by the Board of Directors. The Board of Directors may consider performance measures such as team leadership, new store openings and customer satisfaction in determining the discretionary bonus component. Each of Messrs. Kirkland and Alderson received an option currently representing the right to purchase 3,950 shares of common stock at a per share exercise price of $0.45 in connection with our 1996 recapitalization. The vesting of these options requires that the investors in our 1996 recapitalization achieve a specified internal rate of return on their invested funds upon an initial public offering or sale of Kirkland's. Because this offering will not result in the specified internal rate of return, these options will automatically terminate upon completion of this offering. Each of the employment agreements described above also contains non-competition provisions prohibiting the executive from competing against us during the term of the employment agreement and for three years thereafter without our prior written consent. Messrs. Kirkland and Alderson are also entitled to certain additional benefits (beyond those generally available to our employees) including an automobile allowance and additional life insurance. REYNOLDS C. FAULKNER In February 1998, we entered into an employment agreement with Reynolds C. Faulkner. Mr. Faulkner currently serves as our Executive Vice President and Chief Financial Officer. Mr. Faulkner currently receives an annual salary of $240,000 and is eligible to receive an annual bonus of up to $100,000 at the discretion of the Board of Directors. In addition, Mr. Faulkner received a signing bonus of $100,000 upon commencement of his employment. The term of Mr. Faulkner's agreement has been extended through June 12, 2002, and negotiations have commenced concerning the terms on which the agreement will be further extended. If Mr. Faulkner's employment is terminated prior to June 12, 2002 by us without cause or by Mr. Faulkner under specified circumstances, Mr. Faulkner is entitled to a severance payment equal to the discounted present value of 12 months' salary and benefits, together with a pro-rated annual bonus. On February 2, 1998, Mr. Faulkner received a fully vested option for 2,283 shares of our common stock under the 1996 Plan, which is currently exercisable at a per share exercise price of $95.00. A portion of the shares purchased upon the exercise of Mr. Faulkner's option will be subject to transfer restrictions and repurchase rights at our option at the fair market value of the shares until February 1, 2004. All or part of the transfer restrictions and repurchase rights will lapse following this offering upon the occurrence of certain events, such as our sale or a change of control or the termination of Mr. Faulkner's employment with us by reason of death, disability, termination without cause or termination by Mr. Faulkner under specified circumstances. Mr. Faulkner's employment agreement also contains a non-competition provision prohibiting him from competing against us during the term of the employment agreement and for three years thereafter without our prior written consent. Mr. Faulkner is also entitled to certain additional benefits (beyond those generally available to our employees) including an automobile allowance and additional life insurance. C. EDMOND WISE, JR. AND H.R. HARVEY In December 2000, we entered into an employment agreement with C. Edmond Wise, Jr. Under the terms of that agreement, Mr. Wise serves as our Senior Vice President of Store Operations. Mr. Wise currently receives an annual salary of $190,000, and will be eligible to receive an annual bonus dependent upon the achievement of budgeted Adjusted EBITDA and other financial performance criteria. In addition, Mr. Wise received a signing bonus of $20,000. The term of Mr. Wise's agreement extends until termination by either party at any time with or without cause. 61 In June 2001, we entered into an employment agreement with H.R. Harvey. Under the terms of that agreement, Mr. Harvey serves as our Senior Vice President of Merchandising at an annual salary of $225,000, and will be eligible to receive an annual bonus dependent upon the achievement of budgeted Adjusted EBITDA and other financial performance criteria. In addition, Mr. Harvey received a signing bonus of $20,000. The term of Mr. Harvey's agreement extends until termination by either party at any time with or without cause. The employment agreements for Mr. Wise and Mr. Harvey also contain non-competition provisions prohibiting the executive from being, for a period of two years following termination, connected with management or control of any business similar to ours involving national or regional chain retail operations specializing in or having a substantial inventory mix involving home decor. These non-competition provisions do not restrict the ability of these executives from working in management positions for department stores. 62 CERTAIN TRANSACTIONS RECAPITALIZATION On June 12, 1996, we completed a recapitalization whereby Advent International Group (through affiliated entities (the "Advent Funds")) became the largest beneficial owner of our equity. The 1996 recapitalization permitted certain founding and management shareholders, consisting of Carl Kirkland, Robert E. Alderson and two other shareholders (collectively, the "Principal Shareholders"), to realize a portion of the value of their interest in Kirkland's. In connection with our 1996 recapitalization: - The Advent Funds together with other investors purchased a majority of our common stock and all of our Class A Preferred Stock; - We redeemed a portion of our common stock held by the Principal Shareholders and all of our common stock held by all of our other shareholders; and - We reclassified certain shares of our common stock held by the Principal Shareholders into shares of our Class B Preferred Stock and our Class C Preferred Stock. Concurrent with the consummation of our 1996 recapitalization, we issued an aggregate of $20 million of subordinated notes to a group of institutional lenders. As of February 2, 2002, the aggregate balance of such subordinated notes, including accrued and unpaid interest, was $23.8 million. These notes mature in June 2003 and will be redeemed with a portion of the proceeds of this offering. We also issued to these institutional lenders warrants to purchase 16,722 shares of our common stock at an exercise price of $0.01 per share. The lender of $9.5 million of the outstanding subordinated debt is a mezzanine and private equity firm with which a member of our Board of Directors, Alexander S. McGrath, is affiliated. In fiscal 2001, interest in the amount of $1.5 million was paid to or accrued in favor of the lender affiliated with Mr. McGrath. In connection with the issuance of the subordinated note to the lender affiliated with Mr. McGrath, we issued 6,689 warrants to purchase common stock. These and other warrants held by such lender will be exercised at a price per share of $0.01 immediately prior to the completion of this offering. The lender of $2.1 million of the outstanding subordinated debt is a private equity investment firm with which another member of our Board of Directors, John P. Oswald, is affiliated. In fiscal 2001, interest in the amount of $0.3 million was paid to or accrued in favor of the lender affiliated with Mr. Oswald. In connection with the issuance of the subordinated note to the lender affiliated with Mr. Oswald, we issued 1,505 warrants to purchase common stock. These and other warrants held by such lender will be exercised at a price per share of $0.01 immediately prior to the completion of this offering. INDEBTEDNESS TO OFFICER On October 15, 1998, we borrowed $5 million from Carl Kirkland, our current Chairman, pursuant to an unsecured promissory note that was subordinated to all of our senior indebtedness. The note was originally due as soon as we would have sufficient cash following the pay down of our existing senior revolving line of credit, and originally bore interest at the same rate as our existing senior revolving line of credit. The note was amended and restated on July 7, 1999 to change the maturity date to June 30, 2001 and the timing of the interest payments. The note was again amended and restated on December 31, 1999 to change the maturity date to June 30, 2003, to change the interest rate to 12.5% and to provide that, in the event the note was not repaid in full on or before June 30, 2000, Carl Kirkland would receive warrants to purchase 3,200 shares of our common stock. In August 2000, the loan, together with accrued interest in the amount of approximately $754,000, was discharged through our issuance to Mr. Kirkland of 11,111 shares of common stock, 11,111 shares of Class D Preferred Stock and warrants to purchase 1,389 shares of common stock at a per share purchase price of $.01. At that time, Mr. Kirkland also 63 purchased additional securities for cash. See "- 2000 Equity Transaction." In connection with this transaction, Mr. Kirkland agreed to forego receipt of the warrants to purchase 3,200 shares provided for under the note. 1999 DEBT/EQUITY TRANSACTION On July 7, 1999, we borrowed an aggregate of $7.5 million, of which $3.4 million was borrowed from the Advent Funds and $4.1 million was borrowed from our existing senior lenders. The $4.1 million borrowed from our existing senior lenders was collateralized by cash and letters of credit supplied by certain of our shareholders. In connection with this transaction, we issued warrants to purchase 15,847 shares of common stock to certain of our shareholders as consideration for their loan (in the case of the Advent Funds) or for posting cash or a letter of credit as collateral to secure the loan from the senior lenders. In connection with this borrowing, the following shareholders who are or were affiliated with members of our Board of Directors or who are or were holders of at least five percent of our common stock received the following number of warrants to purchase shares of common stock at a price per share of $0.01: <Table> <Caption> DOLLAR AMOUNT OF LOAN OR COLLATERAL SHAREHOLDER WARRANTS PROVIDED - ----------- -------- ------------------ Carl Kirkland........................................ 1,287 $ 608,940 Robert Kirkland...................................... 1,287 $ 608,940 Global Private Equity II Limited Partnership......... 5,018 $2,375,373 Advent Direct Investment Program Limited Partnership........................................ 1,962 $ 926,992 Advent Partners Limited Partnership.................. 179 $ 85,642 CT/Kirkland Equity Partners, L.P..................... 1,448 $ 685,434 SSM/Kirkland Equity Partners, L.P.................... 1,738 $ 822,485 Capital Resource Lenders II, L.P..................... 1,089 $ 515,580 Capital Trust Investments, Ltd....................... 245 $ 115,975 </Table> REORGANIZATION Prior to December 31, 1999, we operated our stores through separate corporations (ranging as high as 206 corporations) under common ownership and through a wholly-owned subsidiary. On December 31, 1999, we reorganized by merging each of the separate corporations that operated our stores and a wholly-owned subsidiary into a newly formed subsidiary of Kirkland's. In conjunction with the reorganization, we issued 206 additional shares of our common stock, 2,939,230 additional shares of our Class A Preferred Stock, 1,019,535 additional shares of our Class B Preferred Stock and 541,771 additional shares of our Class C Preferred Stock to all of our then-existing shareholders in the same proportion as their ownership interests in each such class prior to the merger. 2000 EQUITY TRANSACTION On August 8, 2000, we issued $20 million of our Class D Preferred Stock and common stock to certain of our then-existing shareholders. In this transaction, (1) we received $7.5 million in cash, including $3.8 million from the Advent Funds and $3.7 million from Carl Kirkland, and issued 16,667 shares of common stock and 16,667 shares of Class D Preferred Stock, (2) Carl Kirkland's $5 million note originally issued on October 15, 1998 was cancelled and we issued to him 11,111 shares of common stock and 11,111 shares of Class D Preferred Stock and (3) the $7.5 million loan from July 7, 1999 was repaid through our existing senior lenders drawing on the $4.1 million of cash collateral posted by certain of our shareholders in exchange for our issuance of securities to the shareholders, and the Advent Funds converting their $3.4 million loan into newly issued securities. In these transactions, we issued 16,667 shares of common stock and 16,667 shares of Class D Preferred Stock to our shareholders at a purchase price of $0.01 per share for the 44,445 shares of common stock and $449.99 per share for the 64 44,445 shares of Class D Preferred Stock. In consideration for the purchase of these shares, we also issued 5,555 warrants to purchase common stock at a price per share of $0.01. The following table lists the number of shares of common stock, shares of Class D Preferred Stock and warrants issued to shareholders who are or were affiliated with members of our Board of Directors or who are or were holders of at least five percent of our common stock: <Table> <Caption> COMMON CLASS D PURCHASE SHAREHOLDER STOCK PREFERRED STOCK WARRANTS PRICE PAID - ----------- ------ --------------- -------- ---------- Carl Kirkland(1)........................ 20,686 20,686 2,586 $9,308,940 Robert Kirkland......................... 1,353 1,353 169 $ 608,940 Global Private Equity II Limited Partnership .......................... 13,510 13,510 1,688 $6,079,317 Advent Direct Investment Program Limited Partnership........................... 2,060 2,060 51 $1,023,048 Advent Partners Limited Partnership..... 403 403 257 $ 85,642 CT/Kirkland Equity Partners, L.P. ...... 1,781 1,781 223 $ 801,409 SSM/Kirkland Equity Partners, L.P. ..... 1,828 1,828 228 $ 822,485 Capital Resource Lenders II, L.P. ...... 1,146 1,146 143 $ 515,580 </Table> - ------------------------------ (1) $5 million of the purchase price for Carl Kirkland was paid through the cancellation of $5 million of subordinated indebtedness owed by Kirkland's to Mr. Kirkland. See " - Indebtedness to Officer." 2001 DIVIDEND AGREEMENT In connection with the June 2001 amendment to our senior subordinated notes, we amended our charter in order to reduce the dividend rate on our Class A Preferred Stock and Class D Preferred Stock from 10% to 4%. We also agreed to use our best efforts to obtain the necessary shareholder consent to amend the charter to similarly reduce the dividend on our Class B Preferred Stock. Although we could not get the requisite shareholder consent, in October 2001 we entered into a Dividend Rate Agreement with Carl Kirkland and Robert E. Alderson in which these two shareholders agreed to reduce the dividend on their Class B Preferred Stock to 4%. PRE-OFFERING TRANSACTIONS Preferred Stock. As of the date of this prospectus, we have four classes of preferred stock. The Class A Preferred Stock, the Class B Preferred Stock and the Class D Preferred Stock currently accrue dividends at rates varying from 4% to 10% per year compounded quarterly. Interest associated with the Class C Preferred Stock currently accrues at a rate of 9% per year, compounded semi-annually. No dividends have been paid on the Class A Preferred Stock, the Class B Preferred Stock or the Class D Preferred Stock. The interest associated with the outstanding Class C Preferred Stock that has accrued after 1997 has not been paid as a result of subordination provisions under our existing senior credit facility. Upon completion of this offering, the Class A Preferred Stock, the Class B Preferred Stock and the Class D Preferred Stock become convertible into common stock at the election of the holders and redeemable at our election, and the Class C Preferred Stock becomes mandatorily redeemable. Kirkland Holdings LLC owns all of the Class A Preferred Stock. Carl Kirkland, Robert E. Alderson and Robert Kirkland own all of the Class B Preferred Stock and Class C Preferred Stock. Carl Kirkland, Robert Kirkland, the Advent Funds, certain other shareholders and certain of our subordinated lenders own the Class D Preferred Stock. Conversion and Redemption of Preferred Stock. Pursuant to the terms of our charter, immediately prior to completion of this offering and as a part of the Pre-Offering Transactions, $ million of the aggregate stated value and accrued dividends of the outstanding shares of Class A Preferred Stock, Class B Preferred Stock and Class D Preferred Stock will be converted into shares of common stock. In addition, immediately prior to the completion of this offering, our warrantholders will exercise all outstanding warrants to purchase 38,124 shares of common stock at a 65 nominal exercise price. Also pursuant to our charter, although not part of the Pre-Offering Transactions, we will redeem from our current shareholders all of the outstanding shares of Class C Preferred Stock for an aggregate of $ million (including approximately $ of amounts classified as interest associated with the Class C Preferred Stock), to be paid from the net proceeds of this offering. See "Use of Proceeds." The number of shares of common stock issuable upon conversion of $ million of the aggregate stated value and accrued dividends of the Class A Preferred Stock, the Class B Preferred Stock and the Class D Preferred Stock will equal the aggregate stated value of $ million plus accrued dividends ($ million at February 2, 2002) on the preferred stock, divided by the actual initial public offering price. Assuming an initial public offering price of $ and a consummation of this offering on , shares of common stock will be issued to our current shareholders for their Class A Preferred Stock, Class B Preferred Stock and Class D Preferred Stock. If the initial public offering price is $ (i.e., the top of the estimated initial public offering price range), the number of shares of common stock issuable upon such conversion will be , and if the initial public offering price is $ (i.e., the bottom of the estimated initial public offering price range), the number of shares of common stock issuable upon such conversion will be . Charter Amendment and Stock Split. In order to implement the above transactions, we will affect a -for-one stock split of our common stock prior to the consummation of this offering and we will amend and restate our charter to provide for an authorized capitalization of 100,000,000 shares of common stock and 10,000,000 shares of preferred stock. Following the consummation of this offering and the redemption of the Class C Preferred Stock, there will be shares of common stock outstanding and no shares of preferred stock outstanding. USE OF PROCEEDS Carl Kirkland, Robert E. Alderson and Robert Kirkland own all of the shares of the Class C Preferred Stock. A portion of the proceeds to Kirkland's from this offering will be used to redeem all of the Class C Preferred Stock. As a result, Carl Kirkland will receive $ , Robert E. Alderson will receive $ and Robert Kirkland will receive $ . A portion of the proceeds to Kirkland's from this offering will be used to redeem a portion of the outstanding shares of Class A Preferred Stock, Class B Preferred Stock and Class D Preferred Stock. The following table lists the number of shares of Class A Preferred Stock, Class B Preferred Stock and Class D Preferred Stock being redeemed, as well as the amount of proceeds from this offering being received, from shareholders who are affiliated with members of our Board of Directors or who are holders of at least five percent of our common stock: <Table> <Caption> CLASS A PREFERRED CLASS B PREFERRED CLASS D PREFERRED SHAREHOLDER STOCK STOCK STOCK PROCEEDS - ----------- ----------------- ----------------- ----------------- -------- Carl Kirkland............... $ Robert E. Alderson.......... $ Robert Kirkland............. $ Global Private Equity II Limited Partnership ...... $ Advent Direct Investment Program Limited Partnership............... $ Advent Partners Limited Partnership............... $ CT/Kirkland Equity Partners, L.P. ..................... $ SSM Venture Partners, L.P. ..................... $ Capital Resource Lenders II, L.P. ..................... $ </Table> 66 SHAREHOLDERS AGREEMENT We have entered into a shareholders agreement with our shareholders. Pursuant to this agreement, certain seats on our Board of Directors have historically been reserved for nominees of certain shareholders. We have agreed to take all necessary actions to cause the Board of Directors to be comprised of, subject to certain conditions, (1) two representatives nominated by Advent International Group and (2) one nominee of each of Capital Trust Investments, Ltd., Carl Kirkland, Robert E. Alderson, SSM Venture Partners, L.P. and Capital Resource Lenders II, L.P. The agreement will terminate upon consummation of this offering. CONSULTING AGREEMENT In connection with our 1996 recapitalization, we entered into a consulting agreement with Robert Kirkland, a shareholder of Kirkland's and a cousin of our Chairman. Under the provisions of the consulting agreement, Mr. Kirkland provides consulting services and advice regarding purchasing and marketing of merchandise, leasing, store selection, operations, internal management and other matters. The agreement provides for an annual consulting fee of $679,000 and a term expiring in June 2003. The consulting fee is classified as interest associated with the Class C Preferred Stock held by Mr. Kirkland. The consulting agreement automatically terminates upon the occurrence of certain events, including our sale, a change of control or a Qualified Public Offering. This offering will constitute a Qualified Public Offering, and, accordingly, Mr. Kirkland's consulting agreement will automatically terminate upon the completion of this offering. We do not intend to renew the consulting arrangement with Mr. Kirkland following this offering. INVENTORY PURCHASES FROM SIGNIFICANT SHAREHOLDER We purchase inventory from a wholesaler previously owned by Robert Kirkland, a shareholder of Kirkland's and a cousin of our Chairman. See "Principal and Selling Shareholders." These purchases aggregated approximately $332,000 during fiscal 2001, $128,000 during fiscal 2000 and $237,000 during fiscal 1999. INVENTORY PURCHASES FROM A FORMER AFFILIATE In past years we purchased inventory from a manufacturer of which Advent International Group was a significant shareholder until November 1999. These purchases aggregated approximately $5,000 during fiscal 2000 and $292,000 during fiscal 1999. We purchased no inventory from such manufacturer in fiscal 2001 and no longer purchase inventory from them. Advent International Group, which (through the Advent Funds) is a member in Kirkland Holdings L.L.C., one of our principal shareholders, used to be a significant shareholder of such manufacturer. Two of our directors, David M. Mussafer and John P. Oswald, were members of the Board of Directors of such manufacturer until November 1999. Mr. Mussafer and Mr. Oswald are also affiliated with members of Kirkland Holdings L.L.C. See "Principal and Selling Shareholders." CHARTER OF AIRPLANES We rent aircraft for business travel from a company owned by Carl Kirkland. We spent $23,000 for the rental of aircraft from this company in fiscal 2001, $92,000 in fiscal 2000 and $63,000 in fiscal 1999. RELATIONSHIP WITH SUNTRUST ROBINSON HUMPHREY SunTrust Robinson Humphrey, a division of SunTrust Capital Markets, Inc., is one of the underwriters in this offering and it or its predecessor firm, The Robinson-Humphrey Company, LLC, has from time to time provided us investment banking services, including services rendered in connection with our 1996 recapitalization, and may continue to provide such services in the future. We consider the terms of our transactions described in the preceding four paragraphs to be at arms length and reasonably equivalent to terms we could obtain through negotiations with an unaffiliated third party under similar economic conditions. 67 PRINCIPAL AND SELLING SHAREHOLDERS The following table sets forth certain information regarding the beneficial ownership of our common stock at February 2, 2002 (assuming that the Pre-Offering Transactions had occurred as of February 2, 2002) by (i) each director and Named Executive Officer, (ii) each person known by us to beneficially own more than 5% of our common stock, (iii) each selling shareholder and (iv) all directors and executive officers as a group, both before and after giving effect to the sale of common stock in this offering. As of such date, and based on the foregoing assumption, there were shares of common stock outstanding before giving effect to the sale of common stock in this offering and shares outstanding after giving effect to the sale of common stock in this offering and the redemption of certain shares with a portion of the proceeds of this offering. <Table> <Caption> SHARES BENEFICIALLY OWNED AFTER THE NUMBER OF SHARES OFFERING BENEFICIALLY OWNED SHARES TO BE SOLD -------------------- NAME PRIOR TO THE OFFERING IN THE OFFERING NUMBER PERCENTAGE - ---- --------------------- ----------------- ------- ---------- Carl Kirkland(1)........................ 5,877 805 N. Parkway Jackson, TN 38305 Robert E. Alderson(2)................... 34,518 805 N. Parkway Jackson, TN 38305 Reynolds C. Faulkner(3)................. 2,283 H.R. Harvey............................. -- -- * C. Edmond Wise, Jr...................... -- -- * David M. Mussafer(4).................... 69,181 75 State Street Boston, MA 02109 R. Wilson Orr, III(5)................... 9,660 845 Crossover Lane, Suite 140 Memphis, TN 38117 John P. Oswald(6)....................... 14,114 757 Fifth Avenue, 22nd Floor New York, NY 10017 Alexander S. McGrath(7)................. 9,067 Murray Spain............................ -- -- * Kirkland Holdings L.L.C.(8)............. 68,553 75 State Street Boston, MA 02109 Advent International Group(9)(10)(11)... 69,181 75 State Street Boston, MA 02109 Capital Trust Investments, Ltd.(12)..... 1,750 CT/Kirkland Equity Partners, L.P.(13)... 12,364 757 Fifth Avenue, 22nd Floor New York, NY 10017 R-H Capital Partners, L.P.(14).......... 4,524 SSM Venture Partners, L.P.(15).......... 9,660 845 Crossover Lane, Suite 140 Memphis, TN 38117 TCW/Kirkland Equity Partners, L.P.(16).............................. 1,505 </Table> 68 <Table> <Caption> SHARES BENEFICIALLY OWNED AFTER THE NUMBER OF SHARES OFFERING BENEFICIALLY OWNED SHARES TO BE SOLD -------------------- NAME PRIOR TO THE OFFERING IN THE OFFERING NUMBER PERCENTAGE - ---- --------------------- ----------------- ------- ---------- The Marlborough Capital Investment Fund, L.P.(17).............................. 3,177 Robert E. Kirkland(18).................. 10,727 c/o Kirkland's, Inc. 805 N. Parkway Jackson, TN 38305 Capital Resource Lenders II, L.P.(19)... 9,067 Allied Capital Corporation(20).......... 7,254 All executive officers and directors as a group (10 persons)(21).............. 144,700 </Table> - ------------------------------ * Represents less than 1% of the outstanding shares of common stock. (1) Includes warrants to purchase 3,873 shares of common stock and shares of common stock to be issued upon conversion of Class B Preferred Stock and Class D Preferred Stock. Also includes 2,004 shares of common stock held by Mr. Kirkland as Trustee for the benefit of the children of Robert E. Alderson. (2) Includes 5,914 shares of common stock and shares of common stock to be issued upon conversion of Class B Preferred Stock. Also includes 28,604 shares of common stock held by Mr. Alderson as Trustee for the benefit of the children of Carl Kirkland. (3) All of the shares of common stock beneficially owned by Mr. Faulkner are issuable upon exercise of stock options granted by Kirkland's. (4) In its capacity as the manager of funds affiliated with Advent International Group, Advent International Corporation exercises sole voting and investment power with respect to the 60,026 shares of common stock, warrants to purchase 9,155 shares of common stock and shares of common stock issuable upon the conversion of Class A Preferred Stock and Class D Preferred Stock beneficially owned by the Advent Funds and, accordingly, Advent International Group may be deemed to beneficially own such shares. As a result, Mr. Mussafer, one of our directors and a Managing Director of Advent International Corporation, may be deemed to beneficially own these shares. See also note (8) below. If the underwriters' overallotment option is exercised in full, of the shares which may be deemed to be beneficially owned by Advent International Group will be sold, as a result of which Mr. Mussafer may be deemed to beneficially own shares of common stock, or % of the common stock then outstanding, following this offering. Mr. Mussafer disclaims beneficial ownership of all shares held by the Advent Funds other than the 148 shares that are indirectly beneficially owned by Mr. Mussafer. (5) Mr. Orr may be deemed to beneficially own 1,219 shares of common stock, warrants to purchase 1,311 shares of common stock and shares of common stock issuable upon conversion of Class D Preferred Stock held by SSM Venture Partners, L.P. and 7,130 shares of common stock and shares of common stock issuable upon conversion of Class A Preferred Stock which SSM Venture Partners, L.P. beneficially owns as a member of Kirkland Holdings L.L.C. Mr. Orr, one of our directors, is a partner of SSM Corporation which is an affiliate of SSM Venture Partners, L.P. If the underwriters' overallotment option is exercised in full, of the shares owned by SSM Venture Partners, L.P. will be sold, as a result of which Mr. Orr may be deemed to beneficially own shares of common stock, or % of the common stock then outstanding, after this offering. (6) Mr. Oswald may be deemed to beneficially own warrants to purchase 1,750 shares of common stock held by Capital Trust Investments, Ltd., 1,781 shares of common stock, warrants to purchase 1,671 shares of common stock and shares of common stock issuable upon conversion of Class D Preferred Stock held by CT/Kirkland Equity Partners, L.P. and 8,912 shares of common stock and shares of common stock issuable upon conversion of Class A Preferred Stock which CT/Kirkland Equity Partners, L.P. beneficially owns as a member of Kirkland Holdings L.L.C. Mr. Oswald, one of our directors, is a partner of CT Capital International which is an affiliate of Capital Trust Investments, Ltd. and CT/Kirkland Equity Partners, L.P. If the underwriters' overallotment option is exercised in full, of the shares owned by CT/Kirkland Equity Partners, L.P. will be sold, as a result of which Mr. Oswald may be deemed to beneficially own shares of common stock, or % of the common stock then outstanding, following this offering. 69 (7) Mr. McGrath may be deemed to beneficially own 1,146 shares of common stock, warrants to purchase 7,921 shares of common stock and shares of common stock issuable upon the conversion of Class D Preferred Stock held by Capital Resource Lenders II, L.P. Mr. McGrath, one of our directors, is a general partner of Capital Resource Partners II, L.P., the general partner of Capital Resource Lenders II, L.P. If the underwriters' overallotment option is exercised in full of the shares owned by Capital Resource Lenders II, L.P. will be sold, as a result of which Mr. McGrath may be deemed to beneficially own shares of common stock, or % of the common stock then outstanding, following this offering. (8) Includes 68,553 shares of common stock and shares of common stock issuable upon conversion of Class A Preferred Stock. The members of Kirkland Holdings L.L.C. which are affiliated with us, and their beneficial ownership of the shares of common stock held by Kirkland Holdings L.L.C. (expressed as a percentage), are Advent Direct Investment Program Limited Partnership (17.58%), Global Private Equity II Limited Partnership (45.06%), Advent Partners Limited Partnership (1.62%), SSM Venture Partners, L.P. (10.40052%) and CT/Kirkland Equity Partners, L.P. (13.00%). Kirkland Holdings L.L.C. will be dissolved immediately prior to completion of this offering and all of our shares that are owned by Kirkland Holdings L.L.C. will be distributed to its members. (9) Includes 13,510 shares of common stock, shares of common stock issuable upon exercise of Class D Preferred Stock and warrants to purchase 6,706 shares of common stock and 30,890 shares of common stock and shares of common stock issuable upon the conversion of Class A Preferred Stock which Global Private Equity II Limited Partnership beneficially owns as a member of Kirkland Holdings L.L.C. David Mussafer, one of our directors, is an affiliate of Global Private Equity II Limited Partnership. See Note 4. If the underwriters' overallotment option is exercised in full, of the shares beneficially owned by Global Private Equity II Limited Partnership will be sold, as a result of which it will beneficially own shares of common stock, or % of the common stock then outstanding, following this offering. (10) Includes 2,060 shares of common stock, shares of common stock issuable upon exercise of Class D Preferred Stock and warrants to purchase 2,013 shares of common stock and 12,052 shares of common stock and shares of common stock issuable upon the conversion of Class A Preferred Stock which Advent Direct Investment Program Limited Partnership beneficially owns as a member of Kirkland Holdings L.L.C. David Mussafer, one of our directors, is an affiliate of Advent Direct Investment Program Limited Partnership. See Note 4. If the underwriters' overallotment option is exercised in full, of the shares beneficially owned by Advent Direct Investment Program Limited Partnership will be sold, as a result of which it will beneficially own shares of common stock, or % of the common stock then outstanding, following this offering. (11) Includes 403 shares of common stock, shares of common stock issuable upon exercise of Class D Preferred Stock and warrants to purchase 436 shares of common stock and 1,111 shares of common stock and shares of common stock issuable upon the conversion of Class A Preferred Stock which Advent Partners Limited Partnership beneficially owns as a member of Kirkland Holdings L.L.C. David Mussafer, one of our directors, is an affiliate of Advent Partners Limited Partnership. See Note 4. If the underwriters' overallotment option is exercised in full, of the shares beneficially owned by Advent Partners Limited Partnership will be sold, as a result of which it will beneficially own shares of common stock, or % of the common stock then outstanding, following this offering. (12) Consists of warrants to purchase 1,750 shares of common stock. John Oswald, one of our directors, is an affiliate of Capital Trust Investments, Ltd. See Note 6. If the underwriters' overallotment option is exercised in full, of the shares owned by Capital Trust Investments, Ltd. will be sold, as a result of which it will own shares of common stock, or % of the common stock then outstanding. (13) Includes 1,781 shares of common stock, shares of common stock issuable upon exercise of Class D Preferred Stock and warrants to purchase 1,671 shares of common stock and 8,912 shares of common stock and shares of common stock issuable upon the conversion of Class A Preferred Stock which CT/Kirkland Equity Partners, L.P. beneficially owns as a member of Kirkland Holdings L.L.C. John Oswald, one of our directors, is an affiliate of CT/Kirkland Equity Partners, L.P. See Note 6. If the underwriters' overallotment option is exercised in full, of the shares beneficially owned by CT/Kirkland Equity Partners, L.P. will be sold, as a result of which it will beneficially own shares of common stock, or % of the common stock then outstanding, following this offering. (14) Includes 571 shares of common stock, shares of common stock issuable upon exercise of Class D Preferred Stock and warrants to purchase 614 shares of common stock and 3,339 shares of common stock and shares of common stock issuable upon the conversion of Class A Preferred Stock which 70 R-H Capital Partners, L.P. beneficially owns as a member of Kirkland Holdings L.L.C. If the underwriters' overallotment option is exercised in full, of the shares beneficially owned by R-H Capital Partners, L.P. will be sold, as a result of which it will beneficially own shares of common stock, or % of the common stock then outstanding, following this offering. (15) Includes 1,219 shares of common stock, shares of common stock issuable upon exercise of Class D Preferred Stock and warrants to purchase 1,311 shares of common stock and 7,130 shares of common stock and shares of common stock issuable upon the conversion of Class A Preferred Stock which SSM Venture Partners, L.P. beneficially owns as a member of Kirkland Holdings L.L.C. R. Wilson Orr III, one of our directors, is an affiliate of SSM Venture Partners, L.P. See Note 5. If the underwriters' overallotment option is exercised in full, of the shares beneficially owned by SSM Venture Partners, L.P. will be sold, as a result of which it will beneficially own shares of common stock, or % of the common stock then outstanding, following this offering. (16) Includes 190 shares of common stock, shares of common stock issuable upon exercise of Class D Preferred Stock and warrants to purchase 204 shares of common stock and 1,111 shares of common stock and shares of common stock issuable upon the conversion of Class A Preferred Stock which TCW/Kirkland Equity Partners, L.P. beneficially owns as a member of Kirkland Holdings L.L.C. If the underwriters' overallotment option is exercised in full, of the shares beneficially owned by TCW/Kirkland Equity Partners, L.P. will be sold, as a result of which it will beneficially own shares of common stock, or % of the common stock then outstanding, following this offering. (17) Consists of warrants to purchase 3,177 shares of common stock. If the underwriters' overallotment option is exercised in full, of the shares owned by The Marlborough Capital Investment Fund, L.P. will be sold, as a result of which it will own shares of common stock, or % of the common stock then outstanding, following this offering. (18) Includes 9,271 shares of common stock, 1,456 shares of common stock issuable upon the exercise of warrants and shares of common stock upon the conversion of Class B Preferred Stock and Class D Preferred Stock. If the underwriters' overallotment option is exercised in full, of the shares owned by Mr. Kirkland will be sold, as a result of which he will own shares of common stock, or % of the common stock then outstanding, following this offering. (19) Includes 1,146 shares of common stock, 7,921 shares of common stock issuable upon the exercise of warrants and shares of common stock upon the conversion of Class D Preferred Stock. Alexander McGrath, one of our directors, is an affiliate of Capital Resource Lenders II, L.P. See Note 7. If the underwriters' overallotment option is exercised in full, of the shares owned by Capital Resource Lenders II, L.P. will be sold, as a result of which it will own shares of common stock, or % of the common stock then outstanding, following this offering. (20) Includes 917 shares of common stock, shares of common stock issuable upon exercise of Class D Preferred Stock and warrants to purchase 6,337 shares of common stock. If the underwriters' overallotment option is exercised in full, of the shares owned by Allied Capital Corporation will be sold, as a result of which it will own shares of common stock, or % of the common stock then outstanding, following this offering. (21) Includes 125,891 shares of common stock, 2,283 shares of common stock issuable upon the exercise of stock options, 16,526 shares of common stock issuable upon the exercise of warrants and shares of common stock issuable upon the conversion of Class A Preferred Stock, Class B Preferred Stock and Class D Preferred Stock beneficially owned in the aggregate by our executive officers and our directors. If the underwriters' overallotment option is exercised in full, of the shares subject thereto beneficially owned by our directors and our executive officers will be sold, as a result of which they will beneficially own shares of common stock, or % of the common stock then outstanding, following this offering. 71 DESCRIPTION OF CAPITAL STOCK GENERAL Upon completion of this offering, our authorized capital stock will consist of 100,000,000 shares of common stock, no par value, and 10,000,000 shares of preferred stock, no par value. Upon completion of this offering, there will be no preferred stock outstanding, as all of the outstanding preferred stock will be converted into shares of common stock or will be redeemed with a portion of the net proceeds of this offering. See "Use of Proceeds" and "Certain Transactions - Pre-Offering Transactions." Upon the completion of this offering, there will be shares of common stock issued and outstanding and shares of common stock reserved for issuance under our employee benefits plans, including 15,570 shares issuable upon the exercise of options that will be outstanding upon the completion of this offering. As of the date of this prospectus, we have 136,981 shares of common stock, 38,124 warrants to purchase common stock, 3,007,630 shares of Class A Preferred Stock, 1,043,235 shares of Class B Preferred Stock, 558,893 shares of Class C Preferred Stock and 44,445 shares of Class D Preferred Stock issued and outstanding. Pursuant to the Pre-Offering Transactions which will take place immediately prior to completion of this offering, $ million of the aggregate stated value and accrued dividends of the outstanding shares of Class A Preferred Stock, Class B Preferred Stock and Class D Preferred Stock will be converted into shares of common stock. All of our outstanding warrants will be exercised for common stock and then all outstanding shares of common stock will be split on a -for-one basis into shares of common stock. All of the outstanding shares of the Class C Preferred Stock will be redeemed with a portion of our net proceeds of this offering. See "Use of Proceeds" and "Certain Transactions - Pre-Offering Transactions." COMMON STOCK The holders of common stock are entitled to one vote for each share held of record on each matter submitted to a vote of shareholders. All holders of common stock are entitled to share equally in dividends declared on our common stock. See "Dividend Policy." Stock dividends may be paid on common stock, whether or not there are shares of preferred stock outstanding. In the event of any voluntary or involuntary liquidation, dissolution or winding up of Kirkland's, after payment has been made to the holders of shares of preferred stock, if any, for the full amount to which they are entitled, the holders of the shares of common stock are entitled to share equally in the assets available for distribution. We and the selling shareholders are selling common stock in this offering. All currently outstanding shares of common stock are, and upon issuance, the shares of common stock being sold by us in this offering will be, duly authorized, validly issued, fully paid and non-assessable. The rights, preferences and privileges of holders of common stock are subject to, and may be adversely affected by, the rights of the holders of shares of any series of preferred stock that we may designate and issue in the future. See "Risk Factors - Our charter and bylaw provisions and certain provisions of Tennessee law may make it difficult in some respects to cause a change in control of Kirkland's and replace incumbent management." PREFERRED STOCK Pursuant to our amended and restated charter to be filed prior to the completion of this offering, the Board of Directors will be authorized, without further action by the shareholders, to issue up to 10,000,000 shares of preferred stock in one or more series or classes and to establish the designations, preferences, qualifications, privileges, limitations, restrictions, options, conversion rights and other special or relative rights of any series of preferred stock so issued. The issuance of shares of preferred stock could adversely affect the voting power and other rights of holders of common stock. Because the Board of Directors without shareholder action may fix the terms of the preferred stock, the preferred stock could be issued quickly with terms designed to defeat a proposed takeover of Kirkland's, or to make the removal of our management more difficult. The authority to issue preferred stock or rights to purchase preferred stock 72 could be used to discourage a change in control of Kirkland's. Our management is not aware of any such threatened transaction to obtain control of Kirkland's, and the Board of Directors has no current plans to designate and issue any shares of preferred stock. WARRANTS There are currently an aggregate of 38,124 warrants to purchase shares of common stock outstanding. All of these warrants are currently exercisable and their exercise price is $0.01 per share, subject to certain anti-dilution adjustment provisions. Prior to the consummation of this offering, all of our warrantholders will exercise all of their warrants. This offering will not trigger any of the anti-dilution adjustment provisions in the warrants. "See Certain Transactions -- Pre-Offering Transactions." LIMITATION OF DIRECTORS' LIABILITY The charter provides that none of our directors will be personally liable to us or any of our shareholders for monetary damages for breach of any fiduciary duty except for liability arising from (i) any breach of a director's duty of loyalty to us or our shareholders, (ii) any acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law or (iii) any unlawful distributions. We believe this provision will assist us in securing and maintaining the services of qualified non-employee directors. REGISTRATION RIGHTS Pursuant to a registration rights agreement, by and among us and our shareholders, the holders of shares of our common stock will be entitled to register these shares under the Securities Act. Under the registration rights agreement, holders may demand that we file a registration statement under the Securities Act covering some or all of the holders' registrable securities. The registration rights agreement limits the number of demand registrations that we are required to make on behalf of the holders, and also requires a minimum anticipated price to the public of $5 million. In an underwritten offering, the managing underwriter has the right, subject to specified conditions, to limit the number of registrable securities if it is believed such registrations will exceed the number that can be sold at the desired price. In such a case, mezzanine warrantholders have priority in registration over other holders of registrable securities. In addition, holders have "piggyback" registration rights. If we propose to register any of our equity securities under the Securities Act other than pursuant to demand registration rights noted above or specified excluded registrations, holders may require us to include all or a portion of their registrable securities in the registration and in any related underwriting. In an underwritten offering, the managing underwriter, if any, has the right, subject to specified conditions, to limit the number of registrable securities. Additionally, such piggyback registrations are subject to delay or termination of the registration. Holders have requested that of their shares of common stock be registered for sale in this offering. The holders also have unlimited rights to require us to register their shares on Form S-3 once we are eligible to use such form. In general, we will bear all fees, costs and expenses of registrations, other than underwriting discounts and commissions. ANTI-TAKEOVER EFFECT OF CHARTER AND BYLAW PROVISIONS AND TENNESSEE LAWS Our charter and bylaws as well as Tennessee law contain various provisions intended to (i) promote stability of our shareholder base and (ii) render more difficult certain unsolicited or hostile attempts to take us over which could disrupt us, divert the attention of our directors, officers and employees and adversely affect the independence and integrity of our business. A summary of these provisions of the charter, bylaws and Tennessee law is set forth below. 73 Classified Board; Removal of Directors. Pursuant to the charter, our Board of Directors may consist of between three and 15 members, as determined from time to time by the Board of Directors. The directors will be divided into three classes, each class to consist as nearly as possible of one-third of the directors. Directors elected by shareholders at an annual meeting of shareholders will be elected by a plurality of all votes cast at such annual meeting. Initially, the terms of office of the three classes of directors will expire, respectively, at the annual meeting of shareholders in 2003, 2004 and 2005. After the expiration of the terms of the initial classified Board of Directors, the terms of the successors of each of the three classes of directors will expire three years from the year of their respective election. The charter provides that except as otherwise provided for or fixed by or pursuant to an amendment to the charter setting forth the rights of the holders of any class or series of preferred stock, newly created directorships resulting from any increase in the number of directors and any vacancies on our Board of Directors resulting from death, resignation, disqualification, removal or other cause will be filled by the affirmative vote of a majority of the remaining directors then in office, even though less than a quorum of the Board of Directors, or by a sole remaining director. Any director elected in accordance with the preceding sentence will hold office until the next annual meeting of shareholders and until such director's successor is elected and qualified. At such next annual meeting, the shareholders shall elect a director to serve the remaining term of the newly created or vacated directorship and until such director's successor shall have been duly elected and qualified. No decrease in the number of directors constituting our Board of Directors will shorten the term of any incumbent director. Subject to the rights of holders of any preferred stock, any director may be removed from office only for cause and only after a finding of cause by a majority of the Board of Directors (excluding the director subject to removal) followed by the affirmative vote of the holders of at least 80% of the voting power of all of our outstanding capital stock entitled to vote generally in the election of directors, voting together as a single class. These provisions of the charter preclude a third party from removing incumbent directors and simultaneously gaining control of our Board of Directors by filling the vacancies created by removal with its own nominees. Under the classified board provisions described above, it would take at least two elections of directors for any individual or group to gain control of our Board of Directors. Accordingly, these provisions could discourage a third party from initiating a proxy contest, making a tender offer or otherwise attempting to gain control of Kirkland's. Special Shareholders' Meetings and Right to Act by Written Consent. The charter and the bylaws provide that a special meeting of shareholders may be called only by our Chairman or our President or upon a resolution adopted by a majority of the entire Board of Directors. Shareholders are not generally permitted to call, or to require that the Board of Directors call, a special meeting of shareholders pursuant to the terms of the charter. Moreover, the business permitted to be conducted at any special meeting of shareholders is limited to the business brought before the meeting pursuant to the notice of the meeting given by Kirkland's. Tennessee law provides that shareholders may act by written consent if all shareholders entitled to vote are parties to the written consent. The affirmative vote of the number of shares necessary to authorize shareholder action, evidenced by such written consent, constitutes the act of the shareholders. Procedures for Shareholder Nominations and Proposals. The bylaws establish an advance notice procedure for shareholders to nominate candidates for election as directors and to propose any new business at any annual meeting. Only persons nominated in accordance with our shareholder notice procedure are eligible to serve as directors, and only business brought before the annual meeting in accordance with our shareholder notice procedure may be conducted at the annual meeting. Under the shareholder notice procedure, notice of shareholder nominations and proposals for new business at the annual meeting must be delivered to our Secretary, subject to certain exceptions, not in less than 60 days nor more than 90 days prior to the first anniversary of the previous year's annual meeting; provided, however that in the event the date of the annual meeting is more than 30 days before or more than 60 days after such anniversary date, notice by the shareholder must be received not earlier than the 90th day prior to the annual meeting and not later than the 60th day prior to the annual meeting or the 15th day following public announcement of such meeting. For nominations and proposals for any special 74 meetings, the bylaws require notice not more than 90 days nor less than 60 days before the special meeting, or the 15th day following the day on which public announcement is first made of the special meeting and of the nominees proposed by the Board of Directors to be elected at such meeting. The bylaws provide that notice to our Secretary with respect to any shareholder nomination or proposal must include certain information regarding the nominee, the proposal and the shareholder nominating a director or proposing business. According to the bylaws, the Chairman has the power to determine whether a shareholder nomination or proposal was brought in accordance with our shareholder notice procedure. By requiring advance notice of nominations by shareholders, our shareholder notice procedure affords the Board of Directors an opportunity to consider the qualifications of the proposed nominees and, to the extent deemed necessary or desirable by the Board of Directors, to inform shareholders about such qualifications. By requiring advance notice of other proposed business, our shareholder notice procedure provides a more orderly procedure for conducting annual meetings of shareholders and, to the extent deemed necessary or desirable by the Board of Directors, provides the Board of Directors with an opportunity to inform shareholders, prior to such meetings, of the Board of Directors' position regarding action to be taken with respect to such business, so that shareholders can better decide whether to attend such a meeting or to grant a proxy regarding the disposition of any such business. Although the bylaws do not give the Board of Directors any power to approve or disapprove shareholder nominations for the election of directors or proposals for action, the Chairman has the power to determine compliance with our shareholder notice procedure. The bylaws also may have the effect of precluding a contest for the election of directors or the consideration of shareholder proposals if the proper procedures are not followed, and of discouraging or deterring a third party from conducting a solicitation of proxies to elect its own slate of directors or to approve its own proposal, without regard to whether consideration of such nominees or proposals might be harmful or beneficial to Kirkland's and its shareholders. Amendment of Kirkland's Charter and Bylaws. The charter provides that, unless previously approved by the Board of Directors, the affirmative vote of at least 80% of all of our outstanding capital stock entitled to vote generally in the election of directors ("Voting Power"), voting together as a single class, would be required to (i) amend or repeal the provisions of the charter with respect to the election of directors and the right to call a special shareholders' meeting, (ii) adopt any provision inconsistent with such provisions and (iii) amend or repeal the provisions of the charter with respect to amendments to the charter or the bylaws. With the previous approval of the Board of Directors, a majority of the Voting Power is required to amend these charter provisions. In addition, the bylaws provide that the amendment or repeal by shareholders of any bylaws made by the Board of Directors would require the affirmative vote of at least 80% of all of our outstanding capital stock entitled to vote generally in the election of directors, voting together as a single class. Tennessee Corporate Takeover Acts. Tennessee has enacted several corporate takeover acts for the purpose of protecting its substantial interest in domestic corporations conducting a significant amount of business within the state. Business Combination Act. Tennessee's Business Combination Act provides that a party (such party is called an "interested shareholder") owning 10% or more of the stock in a "resident domestic corporation" (which we are) cannot engage in a business combination with the resident domestic corporation unless the combination (i) takes place at least five years after the interested shareholder first acquired 10% or more of the resident domestic corporation, and (ii) either (A) is approved by at least two-thirds of the non-interested voting shares of the resident domestic corporation or (B) satisfies certain fairness conditions specified in the Business Combination Act. These provisions apply unless one of two events occurs. A business combination with an entity can proceed without delay when approved by the target corporation's board of directors before that entity becomes an interested shareholder, or the resident domestic corporation may enact a charter amendment or bylaw to remove itself entirely from the Business Combination Act. This charter amendment or bylaw must be approved by a majority of the shareholders who have held shares for more than one year prior to 75 the vote. It may not take effect for at least two years after the vote. We have not adopted a charter or bylaw amendment removing us from coverage under the Business Combination Act. The Business Combination Act further provides an exemption from liability for officers and directors of resident domestic corporations who do not approve proposed business combinations or charter amendments and bylaws removing their corporations from the Business Combination Act's coverage as long as the officers and directors act in "good faith belief" that the proposed business combination would adversely affect their corporation's employees, customers, suppliers or the communities in which their corporation operates and such factors are permitted to be considered by the board of directors under the applicable charter. Investor Protection Act. Tennessee's Investor Protection Act ("Investor Protection Act") applies to tender offers directed at corporations (called "offeree companies") that have "substantial assets" in Tennessee and that are either incorporated in or have a principal office in Tennessee. We satisfy both of these requirements. The Investor Protection Act requires an offeror making a tender offer for an offeree company to file with the Commissioner of Commerce and Insurance (the "Commissioner") a registration statement. When the offeror intends to gain control of the offeree company, the registration statement must indicate any plans the offeror has for the offeree. The Commissioner may require additional information material concerning the takeover offer and may call for hearings. The Investor Protection Act does not apply to an offer that the offeree company's board of directors recommends to shareholders. In addition to requiring the offeror to file a registration statement with the Commissioner, the Investor Protection Act requires the offeror and the offeree company to deliver to the Commissioner all solicitation materials used in connection with the tender offer. The Investor Protection Act prohibits "fraudulent, deceptive, or manipulative acts or practices" by either side, and gives the Commissioner standing to apply for equitable relief to the Chancery Court of Davidson County, Tennessee, or to any other chancery court having jurisdiction whenever it appears to the Commissioner that the offeror, the offeree company or any of its respective affiliates has engaged in or is about to engage in a violation of the Investor Protection Act. Upon proper showing, the chancery court may grant injunctive relief. The Investor Protection Act further provides civil and criminal penalties for violations. Greenmail Act. The Tennessee Greenmail Act ("Greenmail Act") applies to any corporation chartered under the laws of Tennessee that has a class of voting stock registered or traded on a national securities exchange or registered with the Securities and Exchange Commission pursuant to Section 12(g) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). The Greenmail Act provides that it is unlawful for any corporation or subsidiary to purchase, either directly or indirectly, any of its shares at a price above the market value, as defined in the Greenmail Act, from any person who holds more than 3% of the class of the securities purchased if such person has held such shares for less than two years, unless either the purchase is first approved by the affirmative vote of a majority of the outstanding shares of each class of voting stock or the corporation makes an offer of at least equal value per share to all holders of shares of such class. TRANSFER AGENT AND REGISTRAR The transfer agent and registrar for the common stock is StockTrans, Inc. 76 SHARES ELIGIBLE FOR FUTURE SALE Prior to this offering, there has been no public market for our securities. No predictions can be made of the effect, if any, that the sale or availability for sale of shares of additional common stock will have on the market price of the common stock. Nevertheless, sales of a substantial number of such shares by existing shareholders or by shareholders purchasing in this offering or the perception that such sales may occur could have an adverse effect on the market price of the common stock. SALE OF RESTRICTED SHARES Upon completion of this offering, we will have shares of common stock outstanding. Of these shares, the shares of common stock offered in this offering will be freely tradeable without restriction or further registration, except for shares purchased by our "affiliates" or our "underwriters" (as those terms are defined under the Securities Act), which will become eligible for sale in the public market subject to compliance with Rule 144 under the Securities Act. The remaining outstanding shares of common stock ( shares if the underwriters' overallotment option is exercised in full) will be restricted securities (the "Restricted Shares") and may not be sold unless they are registered under the Securities Act or are sold pursuant to an exemption from registration, such as the exemption provided by Rule 144 under the Securities Act. All of the Restricted Shares will be subject to the 180-day "lock-up" agreements described below. Upon expiration of the lock-up agreements, of the Restricted Shares will be eligible for sale immediately in the public market without restriction pursuant to Rule 144(k), and of the Restricted Shares will become eligible for sale, subject to compliance with the volume limitations and manner of sale requirements of Rule 144. The remaining Restricted Shares will become eligible for sale commencing one year after the date of this prospectus. Holders of all of these Restricted Shares have the right to require us to register the shares for sale under the Securities Act in certain circumstances and have the right to include those shares in a Kirkland's initiated registration. See "Description of Capital Stock - Registration Rights." RULE 144 In general, Rule 144 allows a person who has beneficially owned Restricted Shares for at least one year, including persons who may be deemed our affiliates, to sell, within any three-month period, up to the number of Restricted Shares that does not exceed the greater of: - 1% of the then outstanding shares of common stock and - our average weekly trading volume during the four calendar weeks preceding the date on which notice of the sale is filed with the Securities and Exchange Commission. A person who is not deemed to have been our affiliate at any time during the three months preceding a sale and who has beneficially owned his or her Restricted Shares for at least two years would be entitled to sell such Restricted Shares without regard to the volume limitations described above and certain other conditions of Rule 144. LOCK-UP AGREEMENTS We and our executive officers, directors and all of the holders of our common stock before this offering (who will hold, in the aggregate, % of our common stock after this offering) have agreed, except in limited circumstances, not to sell or transfer any shares of our common stock for 180 days after the date of this prospectus without first obtaining the written consent of Merrill Lynch. See "Underwriting - No Sales of Similar Securities." RULE 701 Under Rule 701, any of our employees, officers or directors or consultants who purchased shares pursuant to a written compensatory plan or contract, including our 1996 Plan and our Incentive Plan, who is not our affiliate, is entitled to sell such shares without having to comply with the public information, 77 holding period, volume limitation or notice provisions of Rule 144 commencing 90 days after the date of effectiveness (the "Effective Date") of the registration statement of which this prospectus is a part (the "registration statement"). In addition, under Rule 701, any of our affiliates who purchased shares pursuant to a written compensatory plan or contract is entitled to sell such shares without having to comply with the Rule 144 holding period restrictions commencing 90 days after the Effective Date, subject to the "lock-up" agreements described above. OPTION GRANTS/S-8 REGISTRATION STATEMENT The shares underlying certain options which will be exercisable upon completion of this offering will also, upon exercise of the options, become eligible for sale subject to the applicable "lock-up" agreements, as described above, and compliance with Rule 144. An additional shares underlying options which will become exercisable periodically beginning in will become eligible for sale subject to compliance with Rule 144. In addition, we may issue up to additional shares of common stock pursuant to our 1996 Plan, the Incentive Plan and the Stock Purchase Plan. See "Management - Employee Benefit Plans." We intend to file one or more registration statements under the Securities Act to register common stock to be issued pursuant to these plans, which would allow the shares issued thereunder to be freely tradeable without restriction or further registration, except for shares purchased by our "affiliates" or our "underwriters." 78 UNITED STATES TAX CONSEQUENCES TO NON-UNITED STATES HOLDERS The following is a general discussion of the material United States federal income and estate tax consequences of the acquisition, ownership and disposition of our common stock by a non-U.S. holder. As used in this discussion, the term "non-U.S. holder" means a beneficial owner of our common stock that is not, for United States federal income tax purposes: - an individual who is a citizen or resident of the United States; - a corporation or partnership (or entity classified as a corporation or partnership for such purposes) created or organized in or under the laws of the United States or of any political subdivision of the United States; - an estate whose income is includible in gross income for U.S. federal income tax purposes regardless of its source; or - a trust, if a U.S. court is able to exercise primary supervision over the administration of the trust and one or more U.S. persons have authority to control all substantial decisions of the trust or if the trust has a valid election in effect under applicable U.S. Treasury regulations to be treated as a "United States person" for such purposes. This discussion does not consider: - U.S. state and local or non-U.S. tax consequences; - specific facts and circumstances that may be relevant to a particular non-U.S. holder's tax position, including, if the non-U.S. holder is a partnership or trust that the United States federal income tax consequences of holding and disposing of our common stock may be affected by certain determinations made at the partner or beneficiary level; - the United States federal income tax consequences for the shareholders, partners or beneficiaries of a non-U.S. holder; - special United States federal income tax rules that may apply to particular non-U.S. holders, such as financial institutions, insurance companies, tax-exempt organizations, U.S. expatriates, broker-dealers, and traders in securities; and - special United States federal income tax rules that may apply to a non-U.S. holder that holds our common stock as part of a "straddle," "hedge," "conversion transaction," "synthetic security" or other integrated investment. The following discussion is based on provisions of the U.S. Internal Revenue Code of 1986, as amended, applicable U.S. Treasury regulations and administrative and judicial interpretations, all as in effect on the date of this prospectus, and all of which are subject to change, retroactively or prospectively. The following summary assumes that a non-U.S. holder holds our common stock as a capital asset. Each non-U.S. holder should consult a tax advisor regarding the United States federal, state, local and non-U.S. income and other tax consequences of acquiring, holding and disposing of shares of our common stock. DIVIDENDS We do not anticipate paying cash dividends on our common stock in the foreseeable future. See "Dividend Policy." In the event, however, that we pay dividends on our common stock, we will have to withhold a United States federal withholding tax at a rate of 30%, or a lower rate under an applicable income tax treaty, from the gross amount of the dividends paid to a non-U.S. holder. Non-U.S. holders should consult their own tax advisors regarding their entitlement to benefits under a relevant income tax treaty. 79 Dividends that are effectively connected with a non-U.S. holder's conduct of a trade or business in the United States and, if an income tax treaty applies, that are attributable to a permanent establishment in the United States, will be taxed on a net income basis at the regular graduated rates and in the manner applicable to United States persons. In that case, we will not have to withhold U.S. federal withholding tax if the non-U.S. holder complies with applicable certification and disclosure requirements. In addition, a "branch profits tax" may be imposed at a 30% rate, or a lower rate under an applicable income tax treaty, on dividends received by a foreign corporation that are effectively connected with the conduct of a trade or business in the United States. In order to claim the benefit of an applicable income tax treaty to either reduce the withholding tax, or eliminate it because the dividend is attributable to a US permanent establishment, a non-U.S. holder will be required to satisfy applicable certification and other requirements. However, - in the case of our common stock held by a foreign partnership, the certification requirement will generally be applied to the partners of the partnership and the partnership will be required to provide us certain information; - if you hold our common stock through an intermediary (as defined in the Treasury regulations, the certification requirement may be applied to you, and not to the intermediary, and the intermediary may be obligated to provide us certain information; - in the case of our common stock held by a foreign trust, the certification requirement will generally be applied to the trust or the beneficial owners of the trust depending on whether the trust is a "foreign complex trust," "foreign simple trust," or "foreign grantor trust" as defined in the applicable U.S. Treasury regulations; and - look-through rules will apply for tiered partnerships, foreign simple trusts and foreign grantor trusts. A non-U.S. holder that is a foreign partnership or a foreign trust is urged to consult its own tax advisor regarding its status under these U.S. Treasury regulations and the certification requirements applicable to it. If we withhold tax on dividends at 30%, but you are a non-U.S. holder that is eligible for a reduced rate of U.S. federal withholding tax under an income tax treaty, you may obtain a refund or credit of any excess amounts withheld by filing an appropriate claim for a refund with the U.S. Internal Revenue Service. GAIN ON DISPOSITION OF COMMON STOCK A non-U.S. holder generally will not be taxed on gain recognized on a disposition of our common stock unless: - the gain is effectively connected with the non-U.S. holder's conduct of a trade or business in the United States and, if an income tax treaty applies, is attributable to a permanent establishment maintained by the non-U.S. holder in the United States; in these cases, the gain will be taxed on a net income basis at the regular graduated rates and in the manner applicable to United States persons (unless an applicable income tax treaty provides otherwise) and, if the non-U.S. holder is a foreign corporation, the "branch profits tax" described above may also apply; - the non-U.S. holder is an individual who holds our common stock as a capital asset, is present in the United States for more than 182 days in the taxable year of the disposition and meets other requirements; or - we are or have been a "U.S. real property holding corporation" for U.S. federal income tax purposes at any time during the shorter of the five-year period ending on the date of disposition or the period that the non-U.S. holder held our common stock. 80 Generally, a corporation is a "U.S. real property holding corporation" if the fair market value of its "U.S. real property interests" equals or exceeds 50% of the sum of the fair market value of its worldwide real property interests plus its other assets used or held for use in a trade or business. We believe that we are not currently, and we do not anticipate becoming in the future, a U.S. real property holding corporation. However, even if we are or have been a U.S. real property holding corporation, a non-U.S. holder which did not beneficially own, directly or indirectly, more than 5% of the total fair market value of our common stock at any time during the shorter of the five-year period ending on the date of disposition or the period that our common stock was held by the non-U.S. holder (a "non-5% holder") and which is not otherwise taxed under any other circumstances described above, generally will not be taxed on any gain realized on the disposition of our common stock if, at any time during the calendar year of the disposition, our common stock was regularly traded on an established securities market within the meaning of the applicable U.S. Treasury regulations. FEDERAL ESTATE TAX Our common stock that is owned or treated as owned by an individual who is a non-U.S. holder (as specially defined for U.S. federal estate tax purposes) at the time of death will be included in the individual's gross estate for U.S. federal estate tax purposes, unless an applicable estate tax or other treaty provides otherwise and, therefore, may be subject to U.S. federal estate tax. INFORMATION REPORTING AND BACKUP WITHHOLDING TAX Dividends paid to you may be subject to information reporting and United States backup withholding tax. If you are a non-U.S. holder, you will be exempt from such backup withholding tax if you provide a Form W-8BEN or otherwise meet documentary evidence requirements for establishing that you are a non-U.S. holder or otherwise establish an exemption. If you are a U.S. Holder, you will be exempt from back up withholding if you provide a completed and executed form W-9 and the IRS has not advised us that you are subject to back up withholding, or you meet certain other exemptions from back up withholding. The gross proceeds from the disposition of our common stock may be subject to information reporting and backup withholding tax. If you sell your common stock outside the United States through a non-U.S. office of a non-U.S. broker and the sales proceeds are paid to you outside the United States, then the United States backup withholding and information reporting requirements generally will not apply to that payment. However, U.S. information reporting, but not backup withholding, will apply to a payment of sales proceeds, even if that payment is made outside the United States, if you sell your common stock through a non-U.S. office of a broker that: - is a United States person; - derives 50% or more of its gross income in specific periods from the conduct of a trade or business in the United States; - is a "controlled foreign corporation" for United States federal income tax purposes; or - is a foreign partnership, if at any time during its tax year: - one or more of its partners are United States persons who in the aggregate hold more than 50% of the income or capital interests in the partnership; or - the foreign partnership is engaged in a United States trade or business, unless the broker has documentary evidence in its files that you are a non-U.S. person and certain other conditions are met or you otherwise establish an exemption. 81 If you receive payments of the proceeds of a sale of our common stock to or through a United States office of a broker, the payment is subject to both United States backup withholding and information reporting unless you are a non-US person and provide a Form W-8BEN certifying that you are a non-U.S. person or you are a US person and you provide a completed and executed Form W-9, and the IRS has not advised us that you are subject to back up withholding, or you otherwise establish an exemption. You generally may obtain a refund of any amounts withheld under the backup withholding rules that exceed your income tax liability by filing a refund claim with the U.S. Internal Revenue Service. 82 UNDERWRITING We intend to offer the shares in the U.S. and Canada through the underwriters. Merrill Lynch, Pierce, Fenner & Smith Incorporated, CIBC World Markets Corp., SunTrust Capital Markets, Inc. and U.S. Bancorp Piper Jaffray Inc. are acting as representatives of the underwriters named below. Subject to the terms and conditions described in a purchase agreement among us, the selling shareholders and the underwriters, we and the selling shareholders have agreed to sell to the underwriters, and the underwriters severally have agreed to purchase from us and the selling shareholders, the number of shares listed opposite their names below. <Table> <Caption> NUMBER UNDERWRITERS OF SHARES ------------ --------- Merrill Lynch, Pierce, Fenner & Smith Incorporated................................... CIBC World Markets Corp. ................................... SunTrust Capital Markets, Inc. ............................. U.S. Bancorp Piper Jaffray Inc. ............................ -------- Total.......................................... ======== </Table> The underwriters have agreed to purchase all of the shares sold under the purchase agreement if any of these shares are purchased. If an underwriter defaults, the purchase agreement provides that the purchase commitments of the nondefaulting underwriters may be increased or the purchase agreement may be terminated. We and the selling shareholders have agreed to indemnify the underwriters against certain liabilities, including liabilities under the Securities Act, or to contribute to payments the underwriters may be required to make in respect of those liabilities. The underwriters are offering the shares, subject to prior sale, when, as and if issued to and accepted by them, subject to approval of legal matters by their counsel, including the validity of the shares, and other conditions contained in the purchase agreement, such as the receipt by the underwriters of officer's certificates and legal opinions. The underwriters reserve the right to withdraw, cancel or modify offers to the public and to reject orders in whole or in part. COMMISSIONS AND DISCOUNTS The representatives have advised us and the selling shareholders that the underwriters propose initially to offer the shares to the public at the initial public offering price on the cover page of this prospectus and to dealers at that price less a concession not in excess of $ per share. The underwriters may allow, and the dealers may reallow, a discount not in excess of $ per share to other dealers. After the initial public offering, the public offering price, concession and discount may be changed. The following table shows the public offering price, underwriting discount and proceeds before expenses to Kirkland's and the selling shareholders. The information assumes either no exercise or full exercise by the underwriters of their overallotment option. <Table> <Caption> PER SHARE WITHOUT OPTION WITH OPTION --------- -------------- ----------- Public offering price...................... Underwriting discount...................... Proceeds, before expenses, to Kirkland's... Proceeds, before expenses, to the selling shareholders............................. </Table> The expenses of the offering, not including the underwriting discount, are estimated at $ and are payable by Kirkland's. 83 OVERALLOTMENT OPTION The selling shareholders have granted an option to the underwriters to purchase up to additional shares at the public offering price less the underwriting discount. The underwriters may exercise this option for 30 days from the date of this prospectus solely to cover any overallotments. If the underwriters exercise this option, each will be obligated, subject to conditions contained in the purchase agreement, to purchase a number of additional shares proportionate to that underwriter's initial amount reflected in the above table. RESERVED SHARES At our request, the underwriters have reserved for sale, at the initial public offering price, up to shares offered by this prospectus for sale to some of our directors, officers, employees and related persons. If these persons purchase reserved shares, this will reduce the number of shares available for sale to the general public. Any reserved shares that are not orally confirmed for purchase within one day of the pricing of this offering will be offered by the underwriters to the general public on the same terms as the other shares offered by this prospectus. NO SALES OF SIMILAR SECURITIES We, our executive officers and directors and all of our existing shareholders have agreed, with exceptions, not to sell or transfer any common stock for 180 days after the date of this prospectus without first obtaining the written consent of Merrill Lynch. Specifically, we and these other individuals have agreed not to directly or indirectly - offer, pledge, sell or contract to sell any common stock, - sell any option or contract to purchase any common stock, - purchase any option or contract to sell any common stock, - grant any option, right or warrant for the sale of any common stock, - lend or otherwise dispose of or transfer any common stock, - request or demand that we file a registration statement related to the common stock, or - enter into any swap or other agreement that transfers, in whole or in part, the economic consequence of ownership of any common stock whether any such swap or transaction is to be settled by delivery of shares or other securities, in cash or otherwise. This lockup provision applies to common stock and to securities convertible into or exchangeable or exercisable for or repayable with common stock. It also applies to common stock owned now or acquired later by the person executing the agreement or for which the person executing the agreement later acquires the power of disposition. QUOTATION ON THE NASDAQ NATIONAL MARKET We expect the shares to be approved for quotation on the Nasdaq National Market, subject to notice of issuance, under the symbol "KIRK." Before this offering, there has been no public market for our common stock. The initial public offering price will be determined through negotiations among us, the selling shareholders and the representatives. In addition to prevailing market conditions, the factors to be considered in determining the initial public offering price are - the valuation multiples of publicly traded companies that the representatives believe to be comparable to us, - our financial information, 84 - the history of, and the prospects for, our company and the industry in which we compete, - an assessment of our management, its past and present operations, and the prospects for, and timing of, our future revenues, - the present state of our development, and - the above factors in relation to market values and various valuation measures of other companies engaged in activities similar to ours. An active trading market for the shares may not develop. It is also possible that after this offering the shares will not trade in the public market at or above the initial public offering price. The underwriters do not expect to sell more than 5% of the shares in the aggregate to accounts over which they exercise discretionary authority. PRICE STABILIZATION, SHORT POSITIONS AND PENALTY BIDS Until the distribution of the shares is completed, Securities and Exchange Commission rules may limit underwriters and selling group members from bidding for and purchasing our common stock. However, the representatives may engage in transactions that stabilize the price of the common stock, such as bids or purchases to peg, fix or maintain that price. If the underwriters create a short position in the common stock in connection with this offering, i.e., if they sell more shares than are listed on the cover of this prospectus, the representatives may reduce that short position by purchasing shares in the open market. The representatives may also elect to reduce any short position by exercising all of part of the overallotment option described above. Purchases of the common stock to stabilize its price or to reduce a short position may cause the price of the common stock to be higher that it might be in the absence of such purchases. The representatives may also impose a penalty bid on underwriters and selling group members. This means that if the representatives purchase shares in the open market to reduce the underwriter's short position or to stabilize the price of such shares, they may reclaim the amount of the selling concession from the underwriters and selling group members who sold those shares. The imposition of a penalty bid may also affect the price of the shares in that it discourages resales of those shares. Neither we nor any of the underwriters makes any representation or prediction as to the direction or magnitude of any effect that the transactions described above may have on the price of the common stock. In addition, neither we nor any of the underwriters makes any representation that the representatives will engage in these transactions or that these transactions, once commenced, will not be discontinued without notice. INTERNET DISTRIBUTION Merrill Lynch will be facilitating Internet distribution for this offering to certain of its Internet subscription customers. Merrill Lynch intends to allocate a limited number of shares for sale to its online brokerage customers. An electronic prospectus is available on the Internet Web site maintained by Merrill Lynch. Other than the prospectus in electronic format, the information on the Merrill Lynch Web site is not part of this prospectus. OTHER RELATIONSHIPS SunTrust Robinson Humphrey, a division of SunTrust Capital Markets, Inc., or its predecessor firm, The Robinson-Humphrey Company, LLC, has from time to time provided us with investment banking services, including services rendered in connection with our 1996 recapitalization, and may continue to provide such services in the future. 85 LEGAL MATTERS The validity of the shares of common stock offered hereby is being passed upon for us by Pepper Hamilton LLP and the underwriters are being represented by Fried, Frank, Harris, Shriver & Jacobson (a partnership including professional corporations). Pepper Hamilton LLP and Fried, Frank, Harris, Shriver & Jacobson will rely upon Baker, Donelson, Bearman & Caldwell with respect to matters governed by Tennessee law. EXPERTS The consolidated balance sheets of Kirkland's as of February 2, 2002, February 3, 2001 and December 31, 2000, and the related consolidated statements of operations, changes in shareholders' deficit and cash flows for the year ended February 2, 2002, the 34 days ended February 3, 2001 and each of the two years in the period ended December 31, 2000, included in this prospectus and elsewhere in the registration statement have been so included in reliance upon the report of PricewaterhouseCoopers LLP, independent accountants, given on the authority of said firm as experts in auditing and accounting. 86 WHERE YOU CAN FIND MORE INFORMATION We filed with the Securities and Exchange Commission a registration statement on Form S-1 under the Securities Act for the shares of common stock to be sold in this offering. This prospectus does not contain all of the information in the registration statement and the exhibits and schedule that were filed with the registration statement. For further information with respect to us and our common stock, we refer you to the registration statement and the exhibits and schedules that were filed with the registration statement. Statements contained in this prospectus about the contents of any contract or any other document that is filed as an exhibit to the registration statement are not necessarily complete, and we refer you to the full text of the contract or other document filed as an exhibit to the registration statement. A copy of the registration statement and the exhibits and schedules that were filed with the registration statement may be inspected without charge at the public reference facilities maintained by the Securities and Exchange Commission in Room 1024, 450 Fifth Street, N.W., Washington, D.C. 20549, and copies of all or any part of the registration statement may be obtained from the Securities and Exchange Commission upon payment of the prescribed fee. Information on the operation of the public reference facilities may be obtained by calling the Securities and Exchange Commission at 1-800-SEC-0330. The Securities and Exchange Commission maintains a World Wide Web site that contains reports, proxy and information statements and other information regarding registrants that file electronically with the Securities and Exchange Commission. The address of the site is http://www.sec.gov. You may also request copies of these filings, at no cost, by telephone at (731) 668-2444 or by mail to: Kirkland's, Inc., 805 N. Parkway, Jackson, TN 38305, Attention: General Counsel. Upon completion of this offering, we will become subject to the information and periodic reporting requirements of the Exchange Act, and, in accordance with such requirements, will file periodic reports, proxy statements and other information with the Securities and Exchange Commission. These periodic reports, proxy statements and other information will be available for inspection and copying at the regional offices, public reference facilities and web site of the Securities and Exchange Commission referred to above. We intend to furnish our shareholders with annual reports containing financial statements audited by our independent accountants. 87 INDEX TO FINANCIAL STATEMENTS INDEX TO CONSOLIDATED FINANCIAL STATEMENTS <Table> <Caption> PAGE ---- Report of the Independent Accountants....................... F-2 Consolidated Statements of Operations for the years ended December 31, 1999 and 2000, 34 days ended February 3, 2001 and year ended February 2, 2002........................... F-3 Consolidated Balance Sheets as of December 31, 2000, February 3, 2001 and February 2, 2002..................... F-4 Consolidated Statements of Changes in Shareholders' Deficit for the years ended December 31, 1999 and 2000, 34 days ended February 3, 2001 and year ended February 2, 2002.... F-5 Consolidated Statements of Cash Flows for the years ended December 31, 1999 and 2000, 34 days ended February 3, 2001 and year ended February 2, 2002........................... F-6 Notes to Consolidated Financial Statements.................. F-7 </Table> F-1 REPORT OF THE INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Kirkland's, Inc. The stock split described in Note 13 to the consolidated financial statements has not been consummated at April 22, 2002. When it has been consummated, we will be in a position to furnish the following report: "In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of changes in shareholders' deficit and of cash flows present fairly, in all material respects, the financial position of Kirkland's, Inc. at December 31, 2000, February 3, 2001, and February 2, 2002, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2000, the 34 days ended February 3, 2001, and the year ended February 2, 2002 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these consolidated financial statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion." PricewaterhouseCoopers LLP Memphis, TN April 19, 2002, except for Note 13 as to which the date is , 2002 F-2 KIRKLAND'S, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS EXCEPT SHARE AND PER SHARE AMOUNTS) <Table> <Caption> YEAR ENDED --------------------------- 34 DAYS ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, FEBRUARY 3, FEBRUARY 2, 1999 2000 2001 2002 ------------ ------------ ------------- ----------- Net sales.................................. $236,622 $259,240 $ 23,875 $307,213 Cost of sales.............................. 154,278 172,376 18,998 200,063 -------- -------- -------- -------- Gross profit............................. 82,344 86,864 4,877 107,150 Operating expenses: Other operating expenses................. 57,894 67,401 7,388 71,622 Non-cash stock compensation charge....... -- -- -- 712 -------- -------- -------- -------- Total operating expenses.............. 57,894 67,401 7,388 72,334 Depreciation and amortization.............. 7,276 7,827 601 7,678 -------- -------- -------- -------- Operating income (loss).................. 17,174 11,636 (3,112) 27,138 Interest expense: Senior, subordinated and other notes payable............................... 10,232 11,221 1,043 9,759 Class C Preferred Stock.................. 1,647 1,850 154 2,007 Accretion of common stock warrants....... (879) -- -- 7,759 -------- -------- -------- -------- Total interest expense................ 11,000 13,071 1,197 19,525 Interest income............................ (27) (1) -- (278) Offering and financing costs (Note 1)...... 852 782 -- -- Other expense (income), net................ (396) (328) (34) 262 -------- -------- -------- -------- Income (loss) before income taxes........ 5,745 (1,888) (4,275) 7,629 Income tax provision (benefit)............. 1,106 (573) (1,806) 3,331 -------- -------- -------- -------- Net income (loss)........................ 4,639 (1,315) (2,469) 4,298 Accretion of redeemable preferred stock and dividends accrued........................ (5,053) (6,555) (778) (6,352) -------- -------- -------- -------- Net loss allocable to common stock......... $ (414) $ (7,870) $ (3,247) $ (2,054) ======== ======== ======== ======== Loss per common share: Basic.................................... $ (4.50) $ (71.49) $ (23.74) $ (1.50) ======== ======== ======== ======== Diluted.................................. $ (4.50) $ (71.49) $ (23.74) $ (1.50) ======== ======== ======== ======== Weighted average number of common shares outstanding: Basic.................................... 92,101 110,084 136,751 136,752 ======== ======== ======== ======== Diluted.................................. 92,101 110,084 136,751 136,752 ======== ======== ======== ======== Pro Forma Earnings Per Share (Note 14): Earnings Per Common Share: Basic................................. ======== Diluted............................... ======== Weighted average number of common shares outstanding: Basic................................. ======== Diluted............................... ======== </Table> The accompanying notes are an integral part of these consolidated financial statements. F-3 KIRKLAND'S, INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT FOR SHARE AMOUNTS) <Table> <Caption> PRO FORMA AS OF FEBRUARY 2, 2002 DECEMBER 31, FEBRUARY 3, FEBRUARY 2, (UNAUDITED) 2000 2001 2002 (NOTE 14) ------------ ----------- ----------- ------------- ASSETS Current assets: Cash and cash equivalents.................. $ 28,156 $ 26,914 $ 29,751 $ 29,751 Inventories................................ 47,993 45,330 32,763 32,763 Prepaid expenses and other current assets.................................. 1,999 2,006 1,902 1,902 Deferred income taxes...................... 2,139 1,381 1,375 1,375 -------- -------- --------- -------- Total current assets.................... 80,287 75,631 65,791 65,791 Property and equipment, net.................. 26,047 25,682 23,748 23,748 Noncurrent deferred income taxes............. 4,210 6,774 4,140 4,140 Debt issue costs, net........................ 1,345 1,261 757 757 Goodwill, net................................ 1,472 1,465 1,382 1,382 Other assets................................. 21 14 -- -- -------- -------- --------- -------- Total assets............................ $113,382 $110,827 $ 95,818 $ 95,818 ======== ======== ========= ======== LIABILITIES, REDEEMABLE PREFERRED STOCK AND SHAREHOLDERS' DEFICIT Current liabilities: Current maturities of long-term debt....... $ 9,167 $ 9,167 $ 38,177 $ 38,177 Revolving line of credit................... 20,000 20,000 -- -- Accounts payable........................... 19,072 19,110 12,530 12,530 Income taxes payable....................... 399 413 429 429 Accrued expenses........................... 14,242 14,075 21,349 21,349 Accrued stock compensation................. -- -- 712 712 -------- -------- --------- -------- Total current liabilities............... 62,880 62,765 73,197 73,197 -------- -------- --------- -------- Long-term debt: Senior credit facility..................... 38,177 38,177 -- -- Subordinated debt.......................... 19,894 19,897 19,940 19,940 Mandatorily redeemable preferred stock (Class C)............................... 17,122 17,122 17,122 17,122 Other liabilities............................ 1,558 1,584 2,198 2,198 Common stock warrants........................ -- -- 7,759 -- Commitments and Contingencies, note 10 Redeemable convertible preferred stock, no par value: Class D.................................... 20,680 20,879 22,293 -- Class A.................................... 45,460 45,890 48,901 -- Class B.................................... 15,769 15,918 15,618 -- Shareholders' deficit: Common stock, at stated value; 92,306, 136,751 and 136,981 shares issued and outstanding at December 31, 2000, February 3, 2001 and February 2, 2002, respectively............................ 229 229 229 229 Additional paid-in capital................. -- -- -- 94,571 Accumulated deficit........................ (108,387) (111,634) (111,439) (111,439) -------- -------- --------- -------- Total liabilities, redeemable preferred stock, and shareholders' deficit...... $113,382 $110,827 $ 95,818 $ 95,818 ======== ======== ========= ======== </Table> The accompanying notes are an integral part of these consolidated financial statements. F-4 KIRKLAND'S, INC. CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' DEFICIT (IN THOUSANDS, EXCEPT FOR SHARE AMOUNTS) <Table> <Caption> COMMON STOCK ---------------- ADDITIONAL ACCUMULATED SHARES AMOUNT PAID IN CAPITAL DEFICIT ------- ------ --------------- ----------- Balance at December 31, 1998..................... 92,100 $229 $ -- $(100,103) Accretion of redeemable preferred stock and dividends accrued.............................. (5,053) Issuance of common stock......................... 206 Net income....................................... 4,639 ------- ---- ---- --------- Balance at December 31, 1999..................... 92,306 229 -- (101,517) Accretion of redeemable preferred stock and dividends accrued.............................. (6,555) Issuance of common stock (see Note 2)............ 44,445 Net loss......................................... (1,315) ------- ---- ---- --------- Balance at December 31, 2000..................... 136,751 229 -- (108,387) Accretion of redeemable preferred stock and dividends accrued.............................. (778) Net loss......................................... (2,469) ------- ---- ---- --------- Balance at February 3, 2001...................... 136,751 229 -- (111,634) Fair value adjustment for dividend rate change on preferred stock (see Note 6)................... 2,227 Accretion of redeemable preferred stock and dividends accrued.............................. (22) (6,330) Exercise of stock options........................ 230 22 Net income....................................... 4,298 ------- ---- ---- --------- Balance at February 2, 2002...................... 136,981 $229 $ -- $(111,439) ======= ==== ==== ========= </Table> The accompanying notes are an integral part of these consolidated financial statements. F-5 KIRKLAND'S, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) <Table> <Caption> YEAR ENDED --------------------------- 34 DAYS ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, FEBRUARY 3, FEBRUARY 2, 1999 2000 2001 2002 ------------ ------------ ------------- ----------- Cash flows from operating activities: Net income (loss)....................................... $ 4,639 $(1,315) $(2,469) $ 4,298 Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation of property and equipment.................. 5,892 6,439 504 6,296 Amortization of debt issue costs, debt discount and goodwill.............................................. 1,384 1,430 94 1,434 Loss on disposal of property and equipment.............. -- 21 7 382 Accretion of common stock warrants...................... (879) -- -- 7,759 Write-off of debt issue costs........................... -- 782 -- -- Write-off of offering costs............................. 852 -- -- -- Deferred tax expense (benefit).......................... (2,385) (1,015) (1,806) 2,640 Changes in assets and liabilities: Inventories........................................... (5,091) (6,146) 2,663 12,567 Prepaid expenses and other current assets............. (593) (179) (7) 104 Other noncurrent assets............................... (15) -- 7 14 Accounts payable...................................... 6,405 1,369 38 (6,580) Income taxes payable.................................. 505 (2,591) 14 16 Accrued expenses and other noncurrent liabilities..... 2,231 2,541 (141) 7,888 Accrued stock compensation............................ -- -- -- 712 -------- ------- ------- -------- Net cash provided by (used in) operating activities........................................ 12,945 1,336 (1,096) 37,530 -------- ------- ------- -------- Cash flows from investing activities: Proceeds from sale of property and equipment............ -- 60 -- -- Capital expenditures.................................... (10,825) (6,041) (146) (4,744) -------- ------- ------- -------- Net cash used in investing activities............... (10,825) (5,981) (146) (4,744) -------- ------- ------- -------- Cash flows from financing activities: Net borrowings (repayments) on revolving line of credit................................................ (7,000) 20,000 -- (20,000) Proceeds from issuance of short-term debt............... 7,500 -- -- -- Proceeds from issuance of long-term debt................ 2,500 -- -- -- Debt issue and offering costs........................... (595) (881) -- (804) Principal payments on long-term debt.................... (5,775) (6,648) -- (9,167) Proceeds from equity contribution, net of issue costs... -- 7,384 -- -- Exercise of options..................................... -- -- -- 22 -------- ------- ------- -------- Net cash (used in) provided by financing activities........................................ (3,370) 19,855 -- (29,949) -------- ------- ------- -------- Cash and cash equivalents Net (decrease) increase............................. (1,250) 15,210 (1,242) 2,837 Beginning of period................................. 14,196 12,946 28,156 26,914 -------- ------- ------- -------- End of period....................................... $ 12,946 $28,156 $26,914 $ 29,751 ======== ======= ======= ======== Supplemental disclosures: Interest paid........................................... $ 10,211 $10,992 $ -- $ 7,298 ======== ======= ======= ======== Income taxes paid....................................... $ 3,132 $ 3,033 $ (16) $ 613 ======== ======= ======= ======== </Table> The accompanying notes are an integral part of these consolidated financial statements. F-6 KIRKLAND'S, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - DESCRIPTION OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES Kirkland's, Inc. (the "Company") is a leading specialty retailer of home decor with stores in 28 states. The consolidated financial statements of the Company include the accounts of Kirkland's, Inc. and its wholly owned subsidiaries Kirkland's Stores, Inc. and kirklands.com, inc. Significant intercompany accounts and transactions have been eliminated. Fiscal Year - Effective January 1, 2001, the Company elected to change its fiscal year from a calendar basis to a 52/53-week year ending on the Saturday closest to January 31. The 34-day transition period ended February 3, 2001 is presented separately in these consolidated financial statements. Unless specifically indicated otherwise, any reference herein to "1999" and "2000" or "Fiscal 1999" and "Fiscal 2000" relates to as of or for the years ended December 31, 1999 and 2000, respectively. Any reference to "2001" or "Fiscal 2001" relates to as of or for the year ended February 2, 2002. Cash Equivalents - Cash equivalents consist of investments with maturities of 90 days or less at the date of purchase. Inventories - Inventories are stated at the lower of cost or market with cost being determined using the average cost method which approximates current cost. Property and Equipment - Property and equipment are stated at cost. Tenant allowances provided by the lessors for reimbursement of construction costs incurred in connection with store openings and remodelings are recorded as reductions to the basis of the respective tenant improvements. Depreciation is computed on a straight-line basis over the estimated useful lives of the respective assets. Furniture, fixtures and equipment are depreciated over 5-7 years. Buildings are depreciated over 40 years. Leasehold improvements are amortized over the shorter of the useful life of the asset or the lease term. Maintenance and repairs are expensed as incurred and improvements are capitalized. Debt Issue Costs - Debt issue costs are amortized using the straight-line method over the life of the debt and are shown net of accumulated amortization of $5,224,000 at December 31, 2000, $4,702,000 at February 3, 2001 and $3,676,000 at February 2, 2002. The Company recorded amortization expense of $1,305,000 at December 31, 2000, $84,000 at February 3, 2001, and $1,308,000 at February 2, 2002. Goodwill - During 1998, the Company purchased 100% of the stock of Briar Patch Management Corporation ("Briar Patch"). In connection with this purchase, the Company recorded goodwill in the amount of the excess of the purchase price over the fair market value of the net assets of Briar Patch. The goodwill is being amortized on a straight-line basis over 20 years. The Company recorded amortization expense of $79,000 for December 31, 1999, $83,000 at both December 31, 2000 and February 2, 2002, and $7,000 for the 34-day period ended February 3, 2001. Long-Lived Assets - The Company periodically reviews the recoverability of property and equipment, goodwill, and other long-lived assets whenever an event or change in circumstances indicates the carrying amount of an asset or group of assets may not be recoverable. The impairment review includes comparison of future cash flows expected to be generated by the asset or group of assets with their associated carrying value. If the carrying value of the asset or group of assets exceeds the expected cash flows (undiscounted and without interest charges), an impairment loss is recognized to the extent the carrying amount of the asset exceeds its fair value. The Company recorded an impairment of $103,000 and $82,000 at December 31, 2000 and February 2, 2002, respectively, relating to the leasehold improvements of stores anticipated to be closed. This charge is included in depreciation and amortization on the consolidated statement of operations. F-7 KIRKLAND'S, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Cost of Sales - Cost of sales includes cost of product sold, freight, store occupancy and central distribution costs. Offering and Financing Costs - During 2000, the Company expensed offering and financing costs on the Company's statement of operations of $782,000 for costs related to a refinancing effort that was not consummated. Additionally, during 1999, the Company indefinitely postponed plans for an offering of its common stock resulting in an expense of $852,000 for costs previously anticipated to be deducted from the proceeds of the offering. Preopening Expenses - Preopening expenses, which consist primarily of payroll and occupancy costs, are expensed as incurred. Advertising Expenses - Advertising costs are expensed as incurred. Advertising expense, including lease-required advertising, was $1,553,000, $2,595,000 and $3,743,000 for fiscal years 1999, 2000 and 2001, respectively, and $402,000 for the 34-day period ended February 3, 2001. Income Taxes - Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Authorized Capital - At February 2, 2002, the authorized capital of Kirkland's, Inc. consisted of 500,000 shares of common stock; 3,100,000 shares of Class A Preferred Stock; 1,100,000 shares of Class B Preferred Stock; 600,000 shares of Class C Preferred Stock; and 75,000 shares of Class D Preferred Stock. See Notes 2 and 6 for a description of the terms of each issue. Stock Options and Warrants - The Company applies Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, in accounting for its stock compensation plans. Compensation cost on stock options is measured as the excess, if any, of the fair value of the Company's stock at the date of the grant over the exercise price. The Company has provided pro forma disclosures of net income as if the fair value based method of accounting for the plan, as prescribed by Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, had been applied (see Note 8). The fair value of detachable put warrants is initially recorded as a discount to the related debt and is amortized to interest expense, using the straight-line method, over the term of the related debt. The put warrants are adjusted to their current fair value at each balance sheet date. Use of Estimates - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of certain assets and liabilities and disclosure of contingencies at the date of the financial statements and the related reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Insurance Reserves - Workers' compensation, general liability and employee medical insurance programs are partially self-insured. It is the Company's policy to record its self-insurance liability using estimates of claims incurred but not yet reported or paid, based on historical trends. Actual results can vary from estimates for many reasons, including, among others, inflation rates, claim settlement patterns, litigation trends and legal interpretations. Fair Value of Financial Instruments - At December 31, 2000, February 3, 2001 and February 2, 2002, the Company did not have any outstanding financial derivative instruments. Financial instruments include cash, accounts payable, a revolving credit agreement and long-term debt. The carrying amounts of these financial instruments, except for long-term debt, approximate fair value because of their short maturities. Long-term debt approximates fair value based on the short periods of interest rate repricing for F-8 KIRKLAND'S, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) variable rate long-term debt and estimates based on the current borrowing rates available to the Company for bank loans with similar terms and average maturities for fixed rate long-term debt. Non-cash Supplemental Disclosure - Accretion and dividends accrued for redeemable Class A Preferred Stock; Class B Preferred Stock; and Class D Preferred Stock of $5,053,000, $6,555,000 and $6,352,000 have been excluded from the Statements of Cash Flows for the years ended December 31, 1999, December 31, 2000 and February 2, 2002, respectively. Accretion and dividends accrued of $778,000 have been excluded from the Statement of Cash Flows for the 34-day period ended February 3, 2001. The effect of the fair value adjustment to the Class B Preferred Stock of $2,227,000, as more fully discussed in Note 6, was excluded from the Statement of Cash Flows for the year ended February 2, 2002. Revenue Recognition - The Company recognizes revenue at the time of sale of merchandise to the Company's customers. Sales include the sale of merchandise, net of returns, and exclusive of sales taxes. Earnings Per Share - Earnings per share is presented on a basic and diluted basis. Basic earnings per share excludes dilution and is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Company. Comprehensive income - Comprehensive income is reported in accordance with SFAS No. 130, Reporting Comprehensive Income. Comprehensive income does not differ from the consolidated net income presented in the consolidated statements of operations. Recent Accounting Pronouncements - In June 2001, the Financial Accounting Standards Board issued SFAS No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets", effective for fiscal years beginning after December 15, 2001. SFAS 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. Under SFAS 142 goodwill (and intangible assets deemed to have indefinite lives) will no longer be amortized but will be subject to annual impairment tests. Other intangible assets will continue to be amortized over their useful lives. As of February 2, 2002, the Company had goodwill, net of accumulated amortization, with a net book value of approximately $1,382,000 and recorded amortization expense of $83,000 for the year then ended. The Company will apply the new rules of accounting for goodwill and other intangible assets beginning in the first quarter of fiscal 2002. The Company will cease to amortize goodwill in accordance with SFAS 142 and will perform a test for impairment when events and circumstances indicate that an impairment may have occurred. The application of SFAS 141 and SFAS 142 is not expected to have a significant impact on the Company's financial condition or results of operations. In August 2001, the Financial Accounting Standards Board issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which addresses financial accounting and reporting for the impairment or disposal of long-lived assets and supersedes SFAS No. 121, "Accounting for the Impairment or Disposal of Long-Lived Assets and for Long-Lived Assets to be Disposed Of," and the accounting and reporting provisions of Accounting Principles Board (APB) Opinion No. 30, "Reporting the Results of Operations" for a disposal of a segment of a business. SFAS 144 is effective for fiscal years beginning after December 15, 2001. The Company does not anticipate that the adoption of this standard will have a significant impact on its financial condition or results of operations. F-9 KIRKLAND'S, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 2 - EQUITY TRANSACTIONS AND CAPITAL STRUCTURE EQUITY TRANSACTIONS Recapitalization On June 12, 1996, the Company completed a leveraged recapitalization (the "Recapitalization") pursuant to which Advent International Group, through affiliated entities, ("Advent"), a private equity investment firm, became the largest beneficial owner of the Company. The Recapitalization permitted the founding shareholders of the Company to realize a portion of their investment in cash. As a result of the Recapitalization, the capital structure of the Company changed to consist of two classes of redeemable convertible preferred stock ("Class A Preferred Stock" and "Class B Preferred Stock"), a class of mandatorily redeemable preferred stock ("Class C Preferred Stock") and common stock. At the time of the Recapitalization, the Company discontinued its subchapter S corporation election and became a C corporation for federal income tax purposes. Since a new capital structure was formed, the existing retained earnings of the Company were transferred to additional paid-in capital so that a new historical accumulation of earnings could begin post-recapitalization. Distributions of cash and securities to the former shareholders of the Company made immediately subsequent to the Recapitalization were recorded to retained earnings, creating a negative retained earnings balance of $116 million at the beginning of the post-recapitalization period. August 2000 Equity Offering On August 8, 2000, the Company and certain of its existing shareholders completed an additional equity offering of $20 million. Investors in the offering received shares of Class D Preferred Stock ("Class D Preferred Stock") and common stock. The new equity offering included the following components: - A contribution of $7.5 million in cash from shareholders affiliated with Advent ($3.8 million) and a management employee of the Company ($3.7 million) in exchange for a total of 16,667 shares of common stock at $0.01 per share and 16,667 shares of Class D Preferred Stock at $449.99 per share. - A conversion of a $5.0 million note held by a management employee of the Company to equity through an exchange of the principal on the note for 11,111 shares of common stock at $0.01 per share and 11,111 shares of Class D Preferred Stock at $449.99 per share. - The repayment of a $7.5 million term note. The term note had been provided to the Company in conjunction with an amendment (see Note 6) to its Senior Debt Agreement and Supplemental Loan Agreement. Of the $7.5 million advanced under the term note, $4.1 million had been collateralized by a pledge from certain shareholders of the Company, and $3.4 million had been loaned to the Company by shareholders affiliated with Advent. The $7.5 million principal on the note was repaid through the surrender of the collateral provided by shareholders in exchange for equity, and conversion into equity of the loan advanced by shareholders affiliated with Advent. Total consideration received by shareholders in connection with the term note repayment was 16,667 shares of common stock at $0.01 per share and 16,667 shares of Class D Preferred Stock at $449.99 per share. In conjunction with the equity offering, the Company also issued warrants to purchase an aggregate of 5,555 shares of the Company's common stock for $0.01 per share. The warrants were issued to the investors in the equity offering on a pro-rata basis in relation to their participation in the total offering. The warrants were considered to have no value at August 8, 2000, based upon the market value received in exchange for common shares in the equity offering. F-10 KIRKLAND'S, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Capital Structure - As a result of the aforementioned capital transactions, the charter of Kirkland's, Inc. was amended to establish the following capital structure. Common Stock The authorized capital of Kirkland's, Inc. includes 500,000 shares of voting common stock. The holders of the common stock have one vote per share and are not entitled to cumulative voting in the election of directors. Redeemable Convertible Preferred Stock (Class A, Class B and Class D) The Class A Preferred Stock, Class B Preferred Stock and Class D Preferred Stock have voting privileges on par with common shareholders and have liquidation values of $30,749,000; $14,206,000; and $20,000,000, respectively, plus accrued dividends. The dividends are cumulative and accrue at 4% compounded quarterly for the Class A Preferred Stock and Class D Preferred Stock, and ranging from 4% to 10% for the Class B Preferred Stock (see Note 6). The Class D Preferred Stock has a redemption preference over all other classes of stock of the Company. The Class A Preferred Stock and Class B Preferred Stock can be redeemed in whole or in part at the option of the Company once all Class D Preferred Stock and Class C Preferred Stock have been redeemed. The Class A Preferred Stock, Class B Preferred Stock and Class D Preferred Stock are redeemable at our option or at the option of the holders after the earliest to occur of June 12, 2004 or the closing of a liquidity event (as defined). The Class A Preferred Stock and Class B Preferred Stock must be redeemed in equal proportions. Additionally, at the option of 60% of the holders, all of the outstanding the Class A Preferred Stock, Class B Preferred Stock and Class D Preferred Stock, other than any shares being redeemed at our option, will automatically convert into common stock upon the occurrence of an initial public offering of the Company's common stock at a rate equal to the liquidation value plus accrued dividends, divided by the initial public offering price. NOTE 3 - PROPERTY AND EQUIPMENT Property and equipment is comprised of the following (in thousands): <Table> <Caption> DECEMBER 31, FEBRUARY 3, FEBRUARY 2, 2000 2001 2002 ------------ ----------- ----------- Land........................................ $ 402 $ 402 $ 402 Buildings................................... 3,460 3,460 3,460 Equipment................................... 10,430 10,438 12,916 Furniture and fixtures...................... 25,889 25,850 23,706 Leasehold improvements...................... 15,791 15,786 12,406 Projects in process......................... 2,088 2,143 623 ------- ------- ------- 58,060 58,079 53,513 Less accumulated depreciation............... 32,013 32,397 29,765 ------- ------- ------- $26,047 $25,682 $23,748 ======= ======= ======= </Table> F-11 KIRKLAND'S, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 4 - ACCRUED EXPENSES Accrued expenses are comprised of the following (in thousands): <Table> <Caption> DECEMBER 31, FEBRUARY 3, FEBRUARY 2, 2000 2001 2002 ------------ ----------- ----------- Accrued compensation........................ $ 759 $ 891 $ 2,618 Sales taxes payable......................... 3,458 1,678 1,234 Percentage rent accrual..................... 441 460 827 Gift certificates and store credits......... 2,597 2,323 2,992 Accrued interest payable.................... 6,416 7,613 12,352 Other....................................... 571 1,110 1,326 ------- ------- ------- $14,242 $14,075 $21,349 ======= ======= ======= </Table> NOTE 5 - INCOME TAXES The provision (benefit) for income taxes consists of the following (in thousands): <Table> <Caption> YEAR ENDED --------------------------- 34 DAYS ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, FEBRUARY 3, FEBRUARY 2, 1999 2000 2001 2002 ------------ ------------ ------------- ----------- Current Federal.................... $ 2,862 $ 318 $ -- $ 397 State...................... 629 124 -- 293 ------- ------- ------- ------ 3,491 442 -- 690 ------- ------- ------- ------ Deferred Federal.................... (2,008) (1,092) (1,461) 2,388 State...................... (377) 77 (345) 252 ------- ------- ------- ------ (2,385) (1,015) (1,806) 2,640 ------- ------- ------- ------ $ 1,106 $ (573) $(1,806) $3,331 ======= ======= ======= ====== </Table> F-12 KIRKLAND'S, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Significant components of the Company's deferred tax assets are as follows (in thousands): <Table> <Caption> DECEMBER 31, FEBRUARY 3, FEBRUARY 2, 2000 2001 2002 ------------ ----------- ----------- Current deferred tax assets Inventory valuation methods............... $ 772 $ 663 $ 502 Accruals.................................. 1,367 718 873 ------ ------ ------ 2,139 1,381 1,375 ------ ------ ------ Noncurrent deferred tax assets Property and equipment.................... 546 601 -- Stock options and warrants valuation...... -- -- 3,215 Other..................................... 630 603 835 Net operating loss and credit carryforwards.......................... 3,234 5,770 2,136 Valuation allowance....................... (200) (200) (200) ------ ------ ------ 4,210 6,774 5,986 ------ ------ ------ Noncurrent deferred tax liability Property and equipment.................... -- -- 1,846 ------ ------ ------ Net noncurrent deferred tax asset........... 4,210 6,774 4,140 ------ ------ ------ Total deferred tax assets................... $6,349 $8,155 $5,515 ====== ====== ====== </Table> A reconciliation of the provision for income taxes to the amount computed by applying the federal statutory tax rate of 35.0% to income before income taxes for the periods indicated below, respectively, is as follows: <Table> <Caption> YEAR ENDED --------------------------- 34 DAYS ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, FEBRUARY 3, FEBRUARY 2, 1999 2000 2001 2002 ------------ ------------ ------------- ----------- Statutory Federal income tax rate....................... 35.0% (35.0)% (35.0)% 35.0% State income taxes, net of Federal income tax effect..................... 3.4 (4.2) (3.9) 4.7 Benefit from surtax exemptions................. (18.6) 1.0 1.0 -- Deferred taxes: impact of merger on state NOL's...... 0.0 4.4 0.0 -- Other........................ (0.6) 3.5 (4.3) 4.0 ----- ----- ----- ----- 19.2% (30.3)% (42.2)% 43.7% ===== ===== ===== ===== </Table> At December 31, 2000, February 3, 2001, and February 2, 2002, the Company was in a net operating loss carryforward position for federal taxes and in certain states. These loss carryforwards aggregated approximately $10.8 million and $14.5 million for federal purposes and $6.7 million and $10.0 million for state purposes as of December 31, 2000 and February 3, 2001, respectively. As of February 2, 2002, the Company had $4.7 million in net operating loss carryforwards for federal purposes and $4.3 million in certain states. These carryforwards will expire, if unused, in 2004 through 2021. During the year ended December 31, 2000, certain state loss carryforwards were disallowed. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax assets will not be realized. F-13 KIRKLAND'S, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Company has established a valuation allowance, as it is more likely than not that certain net operating loss carryforward items will expire unused. NOTE 6 - INDEBTEDNESS Indebtedness consists of the following (in thousands): <Table> <Caption> DECEMBER 31, FEBRUARY 3, FEBRUARY 2, 2000 2001 2002 ------------ ----------- ----------- Senior Credit Facility: Senior Debt (Tranche A), principal and interest payable quarterly at varying amounts through June 2002, interest at a floating rate, as defined in the credit agreement (average rate of 9.8% in 2000, 11.9% in the 34-day period ended February 3, 2001 and 5.6% in 2001)...... $ 1,667 $ 1,667 $ -- Senior Debt (Tranche B), principal and interest payable quarterly at varying amounts through June 2002, interest at a floating rate, as defined in the credit agreement (average rate of 10.8% in 2000, 12.4% in the 34-day period ended February 3, 2001 and 8.5% in 2001)...... 45,677 45,677 38,177 Revolving credit facility, interest at a floating rate, as defined in the credit agreement (average rate of 9.2% in 2000, 11.9% in the 34-day period ended February 3, 2001 and 8.2% in 2001)............................. 20,000 20,000 -- -------- -------- ------- 67,344 67,344 38,177 Senior Subordinated Notes, interest payable quarterly, principal due in June 2003 (average rate of 13.5% in 2000, 15.0% in the 34-day period ended February 3, 2001 and 15.0% in 2001)........................................... 20,000 20,000 20,000 Mandatorily redeemable preferred stock, Class C, interest at 9% annually......................... 17,122 17,122 17,122 -------- -------- ------- 104,360 104,363 75,239 Less: Unamortized debt discount....................... 106 103 60 Current portion................................. 29,167 29,167 38,177 -------- -------- ------- Total long-term indebtedness.................... $ 75,193 $ 75,196 $37,062 ======== ======== ======= </Table> Senior Credit Facility - The senior credit facility as amended (the "Senior Debt Agreement") entered into in connection with the Recapitalization (see Note 2), with a syndicate bank group provides for $65 million in senior term debt (Tranche A $20 million and Tranche B $45 million) and a $20 million revolving line of credit ("Line of Credit"). The Line of Credit requires a 30-day consecutive zero balance between January 1 and March 1 of each year. The Company is required to pay a commitment fee to the bank at a rate per annum equal to .5% of the unused portion of the Line of Credit. Borrowings under the Tranche A term loan and the Line of Credit bear interest at a floating rate (the higher of the federal funds rate plus .5% or the prime rate) plus 2.25% or a Eurodollar Rate, as defined in the Senior Debt Agreement, plus 3.25%. Borrowings under the Tranche B term loan bear interest at a floating rate (the higher of the federal funds rate plus .5% or the prime rate) plus 2.95% or a Eurodollar Rate, as defined, plus 3.95%. F-14 KIRKLAND'S, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) On July 7, 1999, the Company entered an amendment to its Senior Debt Agreement and Supplemental Loan Agreement. The amendment provided an additional $2.5 million in borrowings under the Tranche B term loan and a term note (the "Term Note") for $7.5 million due June 2000. Of the $7.5 million advanced under the Term Note, $3.4 million was loaned by shareholders affiliated with Advent and $4.1 million was collaterized by cash and letters of credit supplied by other shareholders of the Company. In conjunction with the amendment, the Company issued warrants to purchase an aggregate of 15,847 shares of common stock of the Company for $0.01 per share. The warrants were issued to certain shareholders of the Company in consideration for collateralizing the principal on the Term Note or advancing a portion of the borrowings represented by the Term Note. The warrants were considered to have no value at July 7, 1999, based upon a fair value analysis of the Company's common stock at July 7, 1999. On August 8, 2000, the Term Note was repaid through the surrender of the collateral provided by shareholders in exchange for equity and conversion into equity of the loan advanced by shareholders affiliated with Advent (see Note 2). Effective June 19, 2001, the Company completed an amendment to its Senior Debt Agreement with its senior bank syndicate, whereby all previous financial covenant violations were waived and new financial covenant requirements were established for the duration of the amended agreement. As of February 2, 2002, the Company was in compliance with all financial covenants. Subordinated Note Agreement - Concurrent with the Senior Debt Agreement, the Company entered into a Senior Subordinated Note and Warrant Purchase Agreement (the "Subordinated Note Agreement") with a group of preferred shareholders providing for $20 million in subordinated notes. The notes have a maturity date of June 30, 2003 and bear interest at the rate of 12.50% per annum. The holders of the subordinated notes also received warrants to purchase, for $0.01 per share, 11,905 shares of common stock of the Company. Additional warrants ("Incentive Warrants") were reserved for the holders of the notes, entitling them to purchase, for $0.01 per share, an additional 4,817 shares of common stock of the Company if a liquidity event achieving certain valuation targets had not occurred prior to December 31, 1999. This condition not having been met, the Incentive Warrants became exercisable to the holders of the notes effective January 1, 2000. Under the original provisions of this agreement, all of these warrants could be sold back (i.e. put) to the Company at the holders' option on the maturity date of the debt for fair market value, as defined in the Subordinated Note Agreement. An initial value of $300,000 was allocated to the 16,722 warrants and recorded as a discount on the related debt. This discount is being amortized over the life of the notes. Prior to January 1, 1998, at which time the holders of the warrants agreed to terminate their put option, the warrants were marked to market based upon the fair value of the underlying common stock as of each period end. Upon termination of the put option the recorded liability of $879,000 was reclassified as temporary equity. The put option was reinstated on December 31, 1999. The 16,722 warrants were determined to have no value based upon a fair value analysis of the Company's common stock, and the $879,000 previously recorded as temporary equity was adjusted through the statement of operations. At December 31, 2000 and February 2, 2002, the warrants were marked to market resulting in accretion of $0 and $7,759,000, respectively, based upon the fair value of the underlying common stock. The put option was terminated again on February 3, 2002. Concurrent with the June 19, 2001 amendment to the senior credit facilities, the Company also entered into an amendment of its Subordinated Note Agreement (the "Subordinated Amendment"). Pursuant to the Subordinated Amendment, all previous events of default were waived and new financial covenant requirements were established for the duration of the facility. Effective January 1, 2001, the interest rate on the subordinated notes, plus accrued interest, was increased to 15.0% per annum compounded quarterly. Effective January 1, 2002, the interest rate on the subordinated notes, plus accrued interest, was increased to 15.5% per annum. Additionally, as a condition of the Subordinated Amendment, F-15 KIRKLAND'S, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) the Company agreed to amend its charter to reduce the dividend rate on the Class A Preferred Stock and Class D Preferred Stock to 4% effective June 30, 2001. Further, the Company agreed to use its best efforts to file an amendment to the same effect with respect to the Class B Preferred Stock on or before June 30, 2001. Although the Company could not get the requisite shareholder consent, in October 2001 the Company entered into an agreement with two of the shareholders of the Class B Preferred Stock whereby the dividend rate for these two shareholders was reduced to 4% effective June 30, 2001. The Company recorded a $2,227,000 writedown of the Class B Preferred Stock to reflect the fair value adjustment for the reduction in the dividend rate from 10% to 4% at July 1, 2001. Under the Company's amended credit agreements (both senior and subordinated), the Company is required to maintain stated levels of net worth as well as comply with certain coverage ratios and limits on capital expenditures. The borrowings are collateralized by substantially all of the Company's assets. Mandatorily Redeemable Preferred Stock - The Class C Preferred Stock issued in conjunction with the recapitalization (see Note 2) has a liquidation preference to the Class A Preferred Stock and the Class B Preferred Stock and had a liquidation value of $17,122,000 at December 31, 2000, February 3, 2001 and February 2, 2002. The Class C Preferred Stock has no conversion privileges, is non-voting and can be redeemed in whole or in part at the option of the Company at any time provided that all of the Class D Preferred Stock has been redeemed, and is mandatorily redeemable in whole at the earliest to occur of July 2004 or the closing of a liquidity event, as defined. In connection with the Class C Preferred Stock, the Company incurs interest expense equal to 9% per annum of the outstanding balance, including accrued interest compounded semi-annually. This has been reflected in interest expense in the accompanying consolidated statements of operations. At December 31, 2000, February 3, 2001 and February 2, 2002, accrued interest expense related to the Class C Preferred Stock was $5,036,000, $5,190,000, and $7,197,000, respectively. Other Indebtedness - On October 15, 1998, the Company entered into a Subordinated Promissory Note Agreement (the "Promissory Note Agreement") with a management employee of the Company. Under the Promissory Note Agreement, the Company was permitted to borrow up to $5 million from this employee at an interest rate equal to the rate specified in the Company's Line of Credit. After May 1, 1999, the rate increased to 2.0% higher than the rate specified in the Line of Credit. On August 8, 2000, the management employee exchanged the principal of this note for equity in the Company (see Note 2). The principal maturities of long-term debt outstanding at February 2, 2002 including unamortized discounts in years subsequent to 2001 are as follows: $38,177,000 in 2002; $20,000,000 in 2003; and $17,122,000 in 2004. NOTE 7 - LONG-TERM LEASES The Company leases retail store facilities and certain equipment under operating leases with terms ranging up to ten years and expiring at various dates through 2013. Most of the retail store lease agreements include renewal options and provide for minimum rentals and contingent rentals based on sales performance in excess of specified minimums. Rent expense under operating leases was $19,570,000, $22,371,000 and $24,344,000 in fiscal years 1999, 2000 and 2001, respectively, and $1,936,000 for the 34 days ended February 3, 2001. Contingent rental expense was $435,000, $199,000 and $752,000 for fiscal years 1999, 2000 and 2001, respectively, and $57,000 for the 34-day period ended February 3, 2001. Future minimum lease payments under all operating leases with initial terms of one year or more are as follows: $22,392,000 in 2002; $20,636,000 in 2003; $19,778,000 in 2004; $18,520,000 in 2005; $15,767,000 in 2006; and $31,797,000 thereafter. F-16 KIRKLAND'S, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 8 - EMPLOYEE BENEFIT PLANS Stock Options - On June 12, 1996, the Company adopted the "1996 Executive Incentive and Non-Qualified Stock Option Plan" (the "Plan") which provides employees and officers with opportunities to purchase shares of the Company's common stock. The Plan authorizes the grant of incentive and non-qualified stock options and requires that the exercise price of incentive stock options be at least 100% of the fair market value of the stock at the date of the grant. In connection with the 1996 recapitalization, the Company entered into agreements to grant options to two management employees. The agreements provide that each of the two management employees will receive option grants representing 2% of the fully diluted shares. The agreements further provide that future issuances of common stock shall not dilute the management employees' position and that additional grants will be awarded upon each issuance of common stock. These options become 100% vested 24 hours prior to an asset sale, public offering, or stock sale, in which the investors in the 1996 recapitalization achieve a specified internal rate of return on their invested funds. If the specified internal rate of return targets are not met upon a liquidity event, the options automatically terminate and are forfeited. Options outstanding under these agreements were 4,762, 4,762, and 7,900 at December 31, 2000, February 3, 2001, and February 2, 2002, respectively. No compensation expense has been recognized since the options have not vested and management believes the likelihood of exercise is remote. On September 28, 1999, the Company's Board of Directors re-priced certain options granted in 1998 to $95.00 per share, which was not less than the fair value of the Company's stock at the date of the re-pricing, as determined by the Company's Board of Directors. These options to purchase 2,283 shares remained outstanding at February 2, 2002. The repricing resulted in variable accounting under the provisions of APB 25 and FIN 44. Accordingly, the Company has recognized a non-cash stock compensation charge of approximately $578,000 in the consolidated financial statements in connection with these options. Transactions under the Company's stock option plans in each of the periods indicated are as follows: <Table> <Caption> WEIGHTED AVERAGE NUMBER EXERCISE OF SHARES PRICE --------- -------- Outstanding at December 31, 1999........................... 9,800 $49.06 Granted.................................................. -- -- Exercised................................................ -- -- Forfeited................................................ (258) 95.00 ------ ------ Outstanding at December 31, 2000........................... 9,542 $47.81 Granted.................................................. -- -- Exercised................................................ -- -- Forfeited................................................ -- -- ------ ------ </Table> F-17 KIRKLAND'S, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) <Table> <Caption> WEIGHTED AVERAGE NUMBER EXERCISE OF SHARES PRICE --------- -------- Outstanding at February 3, 2001............................ 9,542 $47.81 Granted.................................................. 14,226 46.02 Exercised................................................ (230) 95.00 Forfeited................................................ (68) 95.00 ------ ------ Outstanding at February 2, 2002............................ 23,470 $46.13 ====== ====== </Table> Options to purchase 4,780, 4,780, and 6,370 shares of common stock were exercisable at December 31, 2000, February 3, 2001, and February 2, 2002, respectively. The weighted average exercise price of these options was $95 per share. Had compensation expense for the Company's stock option plan been determined based on the fair values at the grant date for stock option awards granted during the fiscal years 1999, 2000 and 2001, the Company's pro forma net income (loss) would have been approximately $3,999,000, $(1,325,000) and $4,293,000, respectively. Net loss for the 34-day period ended February 3, 2001, on a pro forma basis would have been approximately $(2,469,000). The earnings per share would have been: <Table> <Caption> YEAR ENDED 34 DAYS --------------------------- ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, FEBRUARY 3, FEBRUARY 2, 1999 2000 2001 2002 ------------ ------------ ------------- ----------- Basic............................... $(5.15) $(71.58) $(23.74) $(1.50) ====== ======= ======= ====== Diluted............................. $(5.15) $(71.58) $(23.74) $(1.50) ====== ======= ======= ====== </Table> The fair value of each option grant was estimated on the date of grant using the Black-Scholes option pricing model based upon the following assumptions: expected volatility of 55%; risk-free interest rates of 5.5%; expected lives of 5 years, and no expected dividend payments. The weighted average remaining contractual life of the options was 7.2 years, 6.2 years, and 7.9 years for the fiscal years ended 1999, 2000 and 2001, respectively. The weighted average contractual life of the options was 6.1 years at February 3, 2001. 401(k) Savings Plan - The Company maintains a defined contribution 401(k) employee benefit plan, which covers all employees meeting certain age and service requirements. Up to 6% of the employee's compensation may be matched at the Company's discretion. This discretionary percentage was 50% of an employee's contribution subject to Plan maximums in 2001. The Company's matching contributions were approximately $82,000, $102,000 and $249,000 in 1999, 2000 and 2001, respectively. The Company has the option to make additional contributions to the Plan on behalf of covered employees; however, no such contributions were made in 1999, 2000 or 2001. NOTE 9 - EARNINGS PER SHARE Basic earnings per share are based upon the weighted average number of shares outstanding. Diluted earnings per share are based upon the weighted average number of shares outstanding plus the shares that would be outstanding assuming exercise of dilutive stock options and warrants. F-18 KIRKLAND'S, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The computations for basic and diluted earnings per share are as follows (in thousands, except for per share amounts): <Table> <Caption> YEAR ENDED --------------------------- 34-DAY PERIOD YEAR ENDED DECEMBER 31, DECEMBER 31, ENDED FEBRUARY 3, FEBRUARY 2, 1999 2000 2001 2002 ------------ ------------ ----------------- ----------- Numerator: Net loss allocable to common stock.......... $ (414) $ (7,870) $ (3,247) $ (2,054) ======= ======== ======== ======== Denominator for basic earnings per share: Average number of common shares outstanding.... 92,101 110,084 136,751 136,752 ======= ======== ======== ======== Denominator for diluted earnings per share: Average number of common shares outstanding.... 92,101 110,084 136,751 136,752 ------- -------- -------- -------- 92,101 110,084 136,751 136,752 ======= ======== ======== ======== Basic earnings per share................. $ (4.50) $ (71.49) $ (23.74) $ (1.50) ======= ======== ======== ======== Diluted earnings per share................. $ (4.50) $ (71.49) $ (23.74) $ (1.50) ======= ======== ======== ======== </Table> The calculation of fully diluted earnings per share for December 31, 1999, December 31, 2000, and February 3, 2001 and February 2, 2002 excludes stock options outstanding of 9,800, 9,542, 9,542 and 23,470 respectively and outstanding warrants of 38,124 as their effect would be anti-dilutive. NOTE 10 - RELATED PARTIES Inventory is purchased in the ordinary course of business from an entity formerly owned by a substantial shareholder of the Company. Purchases approximated $237,000, $128,000 and $332,000 in 1999, 2000 and 2001, respectively. The Company purchases inventory from a manufacturer in which one of the shareholders had a significant ownership interest. Purchases from this manufacturer totaled $292,000 and $5,000 in 1999 and 2000, respectively. The Company purchased no inventory from this manufacturer in 2001. The Company rents aircraft from an entity owned by a substantial shareholder. Rental expense approximated $63,000, $92,000 and $23,000 in 1999, 2000 and 2001, respectively. NOTE 11 - COMMITMENTS AND CONTINGENCIES Financial instruments which potentially subject the Company to concentration of risk are primarily cash and cash equivalents. The Company places its cash and cash equivalents in insured depository institutions and attempts to limit the amount of credit exposure to any one institution within the covenant restrictions imposed by the Company's debt agreements. The Company has employment agreements with two key management employees and a consulting agreement with another individual, all of whom were shareholders of the Company prior to the Recapitalization. The employment agreements expire on June 12, 2002 and require annual aggregate salary payments of $550,000. These three individuals own all of the outstanding Class C Preferred Stock. These agreements also require the Company to pay an annual interest amount equal to 9% of the outstanding F-19 KIRKLAND'S, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) balance of this preferred stock (see Note 6). Payments representing such interest accrued after 1997 have not been made as a result of subordination provisions under the Company's senior credit facility. The consulting agreement expires June 12, 2003. The Company is party to pending legal proceedings and claims. Although the outcome of such proceedings and claims cannot be determined with certainty, the Company's management is of the opinion that it is unlikely that these proceedings and claims will have a material effect on the financial condition, operating results or cash flows of the Company. NOTE 12 - CONSULTING CONTRACT In July 2001, the Company entered into an agreement with a consultant to provide services to the Company. Under the terms of the agreement, the consultant was granted the option to purchase 1,888 shares of common stock at $.01. As the options were granted to a non-employee, the Company has recorded a non-cash stock compensation charge of $134,000 in the consolidated financial statements, equal to the fair market value of the options determined using the Black-Scholes option pricing model on the date of grant. NOTE 13 - PRE-OFFERING STOCK SPLIT Prior to the completion of the Company's planned public offering, the Company intends to effect a split of its common stock. All share and per share information in the consolidated financial statements will be retroactively restated to reflect the stock split for all periods presented. NOTE 14 - UNAUDITED PRO FORMA BALANCE SHEET AND EARNINGS PER SHARE INFORMATION The unaudited pro forma balance sheet information as of February 2, 2002 gives effect to the conversion or redemption of the Class A, Class B, and Class D redeemable convertible preferred stock, the redemption of the Class C redeemable preferred stock, and the exercise of all outstanding common stock warrants that is expected to occur upon the consummation of the initial public offering of the Company's common stock. The unaudited pro forma earnings per share information for the year ended February 2, 2002 gives effect to the conversion of the Class A, Class B, and Class D redeemable convertible preferred stock and the exercise of all outstanding common stock warrants that is expected to occur upon the consummation of the initial public offering of the Company's common stock, as if they had occurred as of February 4, 2001. The unaudited pro forma balance sheet and pro forma earnings information does not give effect to the sale of shares by the Company in its planned public offering. F-20 UNAUDITED PRO FORMA CONSOLIDATED CONDENSED FINANCIAL STATEMENTS Immediately prior to completion of this offering as a part of the Pre-Offering Transactions, $ million of aggregate stated value and accrued dividends on the outstanding shares of our Class A Preferred Stock, Class B Preferred Stock and Class D Preferred Stock will be converted into an aggregate of shares of common stock (at an assumed initial public offering price of $ per share). Additionally, prior to completion of this offering, our warrantholders will exercise all of our outstanding warrants to purchase 38,124 shares of common stock. See "Certain Transactions - Pre-Offering Transactions." Using a portion of the net proceeds of this offering we will purchase or redeem from current shareholders all of the outstanding shares of our Class C Preferred Stock and $ million of aggregate stated value and accrued dividends on the outstanding shares of Class A Preferred Stock, Class B Preferred Stock and Class D Preferred Stock. The pro forma consolidated condensed balance sheet as of February 2, 2002 and the pro forma consolidated condensed statements of operations for the year ended February 2, 2002 which follow give effect to: (i) the Pre-Offering Transactions, and (ii) this offering and the application of the estimated net proceeds therefrom as if such transactions had occurred as of the beginning of the period. In our opinion all adjustments necessary to present fairly such pro forma consolidated condensed statements of operations have been made. These unaudited pro forma consolidated condensed statements of operations are not necessarily indicative of what actual results would have been had the transactions occurred at the beginning of the respective periods nor do they purport to indicate the results of our future operations. These unaudited pro forma financial statements should be read in conjunction with the accompanying notes. P-1 UNAUDITED PRO FORMA CONSOLIDATED CONDENSED STATEMENT OF INCOME FOR THE YEAR ENDED FEBRUARY 2, 2002 <Table> <Caption> PRE-OFFERING OFFERING PRO FORMA HISTORICAL ADJUSTMENTS SUBTOTAL ADJUSTMENTS AS ADJUSTED ---------- ------------ -------- ----------- ----------- (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) Net sales.................................... $307,213 $307,213 $307,213 Cost of sales................................ 200,063 200,063 200,063 -------- -------- -------- Gross profit............................... 107,150 107,150 107,150 Operating expenses: Other operating expenses................... 71,622 71,622 71,622 Non-cash stock compensation charge......... 712 712 712 Depreciation and amortization................ 7,678 7,678 7,678 -------- -------- -------- Operating income........................... 27,138 27,138 27,138 Interest expense: Senior credit facility and other indebtedness............................. 5,835 5,835 5,835 Subordinated debt.......................... 3,924 3,924 (3,924)(e) -- Class C Preferred Stock.................... 2,007 2,007 (2,007)(f) -- Accretion of common stock warrants......... 7,759 (7,759)(b) -- -- Interest income.............................. (278) (278) (278) Other income, net............................ 262 262 262 -------- -------- -------- Income before income taxes............... 7,629 15,388 21,319 Income tax provision......................... 3,331 3,390(c) 6,721 2,581(c) 9,302 -------- -------- -------- Net income............................... 4,298 8,667 12,017 Accretion of redeemable preferred stock and dividends accrued.......................... (6,352) 6,352(d) -- -- -------- -------- -------- Net income allocable to common stock(a)...... (2,054) 8,667 12,017 -------- -------- -------- Income per common share(a): Basic...................................... $ (1.50) $ $ -------- -------- -------- Diluted.................................... $ (1.50) $ $ -------- -------- -------- Weighted average number of common shares outstanding(a): Basic...................................... 136,752 -------- -------- -------- Diluted.................................... 136,752 -------- -------- -------- </Table> - ------------------------------ (a) Assumes the Pre-Offering Transactions (as defined on page 5) were effected as of the beginning of the period, at an assumed initial public offering price of $ per share. At a different initial public offering price, the pro forma number of shares outstanding and pro forma net income per share would be different. See "Certain Transactions - Pre-Offering Transactions." (b) Represents the reduction in accretion of common stock warrants of $7.8 million resulting from the exercise of warrants as part of the Pre-Offering Transactions. (c) Represents the tax effect of the foregoing adjustments, resulting in an effective statutory tax rate of approximately 43.7%, excluding the accretion of common stock warrants for 2001. (d) Represents the reduction in accretion and dividends accrued of $6.4 million resulting from the issuance of shares of Common Stock upon the conversion and/or redemption of all $88.4 million of aggregate stated value and accrued dividends on our outstanding Class A Preferred Stock, Class B Preferred Stock and Class D Preferred Stock (at an assumed initial public offering price of $ per share). (e) Represents the interest and amortization expense reduction of $3.9 million resulting from repayment of approximately $20.0 million of subordinated debt from the estimated net proceeds of this Offering. See "Use of Proceeds." (f) Represents the interest expense reduction of $2 million resulting from repayment of all outstanding mandatorily redeemable Class C Preferred Stock and amounts classified as interest associated with such preferred stock from the estimated net proceeds of this Offering. See "Use of Proceeds." P-2 UNAUDITED PRO FORMA CONSOLIDATED CONDENSED BALANCE SHEET FEBRUARY 2, 2002 <Table> <Caption> PRE-OFFERING OFFERING PRO FORMA HISTORICAL ADJUSTMENTS SUBTOTAL ADJUSTMENTS AS ADJUSTED ---------- ------------ --------- ----------- ----------- (IN THOUSANDS) ASSETS Current assets: Cash and cash equivalents................... $ 29,751 $(28,301)(a) $ 1,450 $ 5,681(d) $ 7,131 Inventories................................. 32,763 32,763 32,763 Other current assets........................ 3,277 3,277 3,277 --------- --------- --------- Total current assets...................... 65,791 37,490 43,171 Property and equipment, net................... 23,748 23,748 23,748 Other noncurrent assets....................... 6,279 6,279 6,279 --------- --------- --------- Total assets.............................. $ 95,818 $ 67,517 $ 73,198 ========= ========= ========= LIABILITIES, REDEEMABLE PREFERRED STOCK AND SHAREHOLDERS' DEFICIT Current liabilities: Current maturities of long-term debt........ 38,177 (38,177)(a) -- -- Accounts payable............................ 12,530 12,530 12,530 Other current liabilities................... 22,490 (3,804)(a) 17,366 (7,197)(d) 10,169 (1,320)(a) Total current liabilities..................... 73,197 29,896 22,699 --------- --------- --------- Senior credit facility........................ -- 15,000 (a) 15,000 15,000 Subordinated debt............................. 19,940 19,940 (20,000)(d) -- 60 (e) Class C Preferred Stock....................... 17,122 17,122 (17,122)(d) -- Other liabilities............................. 2,198 2,198 2,198 Common stock warrants......................... 7,759 (7,759)(b) -- -- --------- --------- --------- Redeemable convertible preferred stock: Class D..................................... 22,293 (22,293)(c) -- -- Class A..................................... 48,901 (48,901)(c) -- -- Class B..................................... 15,618 (15,618)(c) -- -- Shareholders' deficit: Common Stock................................ 229 229 229 Paid-in capital............................. -- 7,759 (b) 94,571 50,000 (d) 144,571 86,812 (c) Accumulated deficit......................... (111,439) (111,439) (60)(e) (111,499) --------- --------- --------- Total liabilities, redeemable preferred stock and shareholders' deficit......... $ 95,818 $ 67,517 $ 73,198 ========= ========= ========= </Table> - ------------------------------ (a) Represents the repayment of our existing senior credit facility of $39.5 million (which consists of $38.2 million of current maturities of long-term debt and $1.3 million of other current liabilities) and $3.8 million of accrued interest on subordinated debt with the proceeds from a new credit facility consisting of a $15 million term loan and a revolving line of credit. We anticipate this facility will close in May 2002. If this refinancing transaction had closed on February 2, 2002, then there would have been no borrowings under the new line of credit at closing, but rather a use of $28.3 million from existing cash balances. (b) Assumes the exercise of all common stock warrants. (c) Assumes conversion and/or redemption of all redeemable convertible preferred stock (Class A, Class B and Class D), resulting in an increase to paid-in capital in an amount equal to the stated value and accrued dividends on such stock. (d) Assumes net proceeds from this offering of $50 million, of which $20.0 million is used to retire subordinated debt, $24.3 million is used to retire the mandatorily redeemable Class C Preferred Stock ($17.1 million of stated value of Class C Preferred Stock and $7.2 million of interest associated with the Class C Preferred Stock) and $5.7 million is allocated to cash and cash equivalents. (e) Relates to the accretion of debt discount of $60,000 associated with the early extinguishment of the subordinated debt. P-3 [photographs of stores, customers and merchandise] - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Through and including , 2002 (the 25th day after the date of this prospectus), all dealers effecting transactions in these securities, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to the dealers' obligation to deliver a prospectus when acting as underwriters and with respect to their unsold allotments or subscriptions. SHARES KIRLAND'S, INC. LOGO COMMON STOCK --------------------- PROSPECTUS --------------------- MERRILL LYNCH & CO. CIBC WORLD MARKETS SUNTRUST ROBINSON HUMPHREY U.S. BANCORP PIPER JAFFRAY , 2002 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- PART II INFORMATION NOT REQUIRED IN PROSPECTUS ITEM 13. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION. The following table sets forth an itemization of all estimated expenses, all of which will be paid by us in connection with the issuance and distribution of the securities being registered: <Table> <Caption> NATURE OF EXPENSE AMOUNT - ----------------- ------ SEC Registration Fee........................................ $ 13,225 Nasdaq National Market Listing Fee.......................... 95,000 NASD Fee.................................................... 14,875 Printing and engraving fees................................. 150,000 Registrant's counsel fees and expenses...................... * Selling shareholders' counsel fees and expenses............. * Accounting fees and expenses................................ * Officers and Directors Liability Insurance.................. * Blue Sky expenses and counsel fees.......................... 5,000 Transfer agent and registrar fees........................... 10,000 Miscellaneous............................................... * -------- Total..................................................... $ * ======== </Table> - --------------- * To be filed by amendment. ITEM 14. INDEMNIFICATION OF DIRECTORS AND OFFICERS. The Tennessee Business Corporation Act ("TBCA") sets forth in Sections 48-18-502 through 48-18-508 the circumstances governing the indemnification of directors, officers, employees and agents of a corporation against liability incurred in the course of their official capacities. Section 48-18-502 of the TBCA provides that a corporation may indemnify any director against liability incurred in connection with a proceeding if (i) the director acted in good faith, (ii) the director reasonably believed, in the case of conduct in his or her official capacity with the corporation, that such conduct was in the corporation's best interest, or, in all other cases, that his or her conduct was not opposed to the best interests of the corporation and (iii) in connection with any criminal proceeding, the director had no reasonable cause to believe that his or her conduct was unlawful. In actions brought by or in the right of the corporation, however, the TBCA provides that no indemnification may be made if the director or officer is adjudged to be liable to the corporation. Similarly, the TBCA prohibits indemnification in connection with any proceeding charging improper personal benefit to a director, if such director is adjudged liable on the basis that a personal benefit was improperly received. In cases where the director is wholly successful, on the merits or otherwise, in the defense of any proceeding instigated because of his or her status as a director of a corporation, Section 48-18-503 of the TBCA mandates that the corporation indemnify the director against reasonable expenses incurred in the proceeding. Notwithstanding the foregoing, Section 48-18-505 of the TBCA provides that a court of competent jurisdiction, upon application, may order that a director or officer be indemnified for reasonable expense if, in consideration of all relevant circumstances, the court determines that such individual is fairly and reasonably entitled to indemnification, whether or not the standard of conduct set forth above was met. Officers, employees, and agents who are not directors are entitled, through the provisions of Section 48-18-507 of the TBCA to the same degree of indemnification afforded to directors under Sections 48-18-503 and 48-18-505. Our charter and our bylaws will provide that we will indemnify from liability, and advance expenses to, any of our present or former directors or officers to the fullest extent allowed by the TBCA, II-1 as amended from time to time, or any subsequent law, rule, or regulation adopted. Additionally, the charter will provide that none of our directors will be personally liable to us or any of our shareholders for monetary damages for breach of any fiduciary duty except for liability arising from (i) any breach of a director's duty of loyalty to us or our shareholders, (ii) any acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law, (iii) any unlawful distributions, or (iv) receiving any improper personal benefit. ITEM 15. RECENT SALES OF UNREGISTERED SECURITIES. Since April 1999, we sold the following securities (giving retroactive effect to a -for-one stock split to be effected in connection with the Pre-Offering Transactions) without registration under the Securities Act: 1. In July 1999, in connection with an additional loan from our then-existing senior lenders, certain of our then-existing shareholders collateralized a portion of the additional loan or loaned funds directly to us. In consideration for this, we issued to such shareholders warrants to purchase an aggregate of 15,847 shares of common stock at $0.01 per share. 2. In December 1999, we reorganized by merging each of the separate corporations that operated our stores and Briar Patch Management Corporation, our wholly-owned subsidiary, into Kirkland's Stores, Inc., a wholly owned subsidiary of Kirkland's. In conjunction with the merger, we issued 206 additional shares of our common stock, 2,939,230 additional shares of our Class A Preferred Stock, 1,019,535 additional shares of our Class B Preferred Stock and 541,771 additional shares of our Class C Preferred Stock to all of our then-existing shareholders in the same proportion as their ownership interests in each such class prior to the merger. 3. In August 2000, we sold to certain then-existing shareholders, including a management shareholder, 44,445 shares of common stock, 44,445 shares of Class D Preferred Stock and warrants to purchase an aggregate of 5,555 shares of common stock for $0.01 per share, for an aggregate of $7.5 million in cash, the surrender of a $5.0 million note held by a management shareholder and the repayment of a $7.5 million note held by our then-existing senior lenders. 4. In July 2001, we granted a stock option to a consultant to purchase 1,888 shares of common stock at an exercise price of $0.01 per share. 5. In November 2001, we granted stock options to 30 of our employees to purchase an aggregate of 9,200 shares of common stock under our 1996 Plan at an exercise price of $71.00 per share. We believe that the transactions described in paragraphs 1 through 5 above were exempt from registration under Section 3(b) or 4(2) of the Securities Act because the subject securities were either (i) issued pursuant to a compensatory benefit plan pursuant to Rule 701 under the Securities Act or (ii) sold to a limited group of persons, each of whom was believed to have been a sophisticated investor or to have had a preexisting business or personal relationship with us or our management and to have been purchasing for investment without a view to further distribution. II-2 ITEM 16. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES. (a) Exhibits: <Table> <Caption> EXHIBIT NO. DESCRIPTION - ------- ----------- *1.1 Form of Underwriting Agreement 2.1 Recapitalization Agreement dated June 12, 1996, by and among Kirkland Holdings L.L.C., Kirkland's, Inc., Certain Companies Affiliated with Kirkland's, Inc., Carl Kirkland, Robert Kirkland, Bruce Moore and Robert E. Alderson (Certain exhibits and schedules have been omitted in accordance with Item 601(b)(2) of Regulation S-K. A copy of such exhibits and schedules shall be furnished supplementally to the Securities and Exchange Commission upon request.) (Incorporated herein by reference to Exhibit 2.1 to the registration statement on Form S-1 of Kirkland's filed on May 5, 1998 Registration No. 333-51517 [the "1998 Form S-1"]) 3.1 Amended and Restated Charter of Kirkland's, Inc. 3.2 Form of Amended and Restated Charter of Kirkland's, Inc. (to become effective immediately prior to completion of this offering) 3.3 Bylaws of Kirkland's, Inc. 3.4 Form of Amended and Restated Bylaws of Kirkland's, Inc. (to become effective immediately prior to completion of this offering) *4.1 Form of Specimen Stock Certificate *5.1 Opinion of Pepper Hamilton LLP 10.1 Amended and Restated Credit Agreement dated as of June 19, 2001, among Kirkland's Holdings, L.L.C., the entities listed on Schedule 1.1A thereto, the several banks and other financial institutions or entities from time to time parties to the agreement, the First National Bank of Boston, and Lehman Commercial Paper Inc. 10.2 Senior Subordinated Note Due 2003 in the amount of $8,000,000 dated June 12, 1996 issued to Capital Resource Lenders II, L.P. (Identical Senior Subordinated Notes Due 2003, except as to the payee and the amount of the notes, were issued to The Marlborough Capital Investment Fund, L.P. ($3,800,000), Allied Capital Corporation ($3,600,000), Allied Capital Corporation II ($2,800,000), and Capital Trust Investments, Ltd. ($1,800,000) (Incorporated herein by reference to Exhibit 10.2 to the 1998 Form S-1) 10.3 Form of Amended and Restated Registration Rights Agreement dated as of April 15, 2002, 2002, by and among Kirkland Holdings L.L.C., Kirkland's, Inc., SSM Venture Partners, L.P., Joseph R. Hyde III, Johnston C. Adams, Jr., John H. Pontius, CT/Kirkland Equity Partners, L.P., R-H Capital Partners, L.P., TCW/Kirkland Equity Partners, L.P., Capital Resource Lenders II, L.P., Allied Capital Corporation, The Marlborough Capital Investment Fund, L.P., Capital Trust Investments, Ltd., Global Private Equity II Limited Partnership, Advent Direct Investment Program Limited Partnership, Advent Partners Limited Partnership, Carl Kirkland, Robert Kirkland, Robert E. Alderson, The Amy Katherine Alderson Trust, The Allison Leigh Alderson Trust, The Carl T. Kirkland Grantor Retained Annuity Trust 2001-1 and Steven Collins 10.4 Consulting Agreement by and between Kirkland's and Robert Kirkland dated June 12, 1996 (Incorporated herein by reference to Exhibit 10.5 to the 1998 Form S-1) 10.5 Employment Agreement by and between Kirkland's and Carl Kirkland dated June 12, 1996, as amended through July 31, 2000 10.6 Employment Agreement by and between Kirkland's and Robert E. Alderson dated June 12, 1996, as amended through July 31, 2000 10.7 Employment Agreement by and between Kirkland's and Reynolds C. Faulkner dated as of February 2, 1998, as amended through July 31, 2000 10.8 Employment Agreement by and between Kirkland's and H.R. Harvey dated June 18, 2001 10.9 Employment Agreement by and between Kirkland's and C. Edmond Wise, Jr. dated December 4, 2000 10.10 1996 Executive Incentive and Non-Qualified Stock Option Plan, as amended through April 17, 2002 10.11 2002 Incentive Plan 10.12 Employee Stock Purchase Plan </Table> II-3 <Table> <Caption> EXHIBIT NO. DESCRIPTION - ------- ----------- 10.13 Form of Amended and Restated Shareholders Agreement dated as of April 15, 2002, by and among Kirkland Holdings L.L.C., Kirkland's, Inc., SSM Venture Partners, L.P., Joseph R. Hyde III, Johnston C. Adams, Jr., John H. Pontius, CT/Kirkland Equity Partners, L.P., R-H Capital Partners, L.P., TCW/Kirkland Equity Partners, L.P., Capital Resource Lenders II, L.P., Allied Capital Corporation, The Marlborough Capital Investment Fund, L.P., Capital Trust Investments, Ltd., Global Private Equity II Limited Partnership, Advent Direct Investment Program Limited Partnership, Advent Partners Limited Partnership, Carl Kirkland, Robert Kirkland, Robert E. Alderson, The Amy Katherine Alderson Trust, The Allison Leigh Alderson Trust, The Carl T. Kirkland Grantor Retained Annuity Trust 2001-1 and Steven Collins 10.14 Stock Option Agreement by and between Kirkland's and Carl Kirkland dated June 11, 1996 as amended through April 17, 2002 10.15 Stock Option Agreement by and between Kirkland's and Reynolds C. Faulkner dated as of February 2, 1998 (Incorporated herein by reference to Exhibit 10.16 to the registration statement on Form S-1/A of Kirkland's filed on July 16, 1998 Registration No. 333-51517 1998 Amendment No. 1 to Form S-1) 10.16 Sublease Agreement by and between Southwind Properties and Kirkland's dated March 5, 2001 21 Subsidiaries of Kirkland's 23.1 Consent of PricewaterhouseCoopers LLP *23.2 Consent of Pepper Hamilton LLP (included in Exhibit 5.1) 24.1 Power of Attorney (included on signature pages) </Table> - --------------- * To be filed by amendment. (b) Financial Statement Schedules: All schedules have been omitted because they are not applicable, not required or the required information is included in the Financial Statements or the notes thereto. ITEM 17. UNDERTAKINGS. The undersigned registrant hereby undertakes to provide to the underwriters at the closing specified in the underwriting agreement, certificates in such denominations and registered in such names as required by the underwriters to permit prompt delivery to each purchaser. Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Securities Act and will be governed by the final adjudication of such issue. The undersigned registrant hereby undertakes that: (i) for purposes of determining any liability under the Securities Act, the information omitted from the form of prospectus filed as part of this registration statement in reliance upon Rule 430A and contained in a form of prospectus filed by the registrant pursuant to Rule 424(b)(1) or (4) or 497(h) under the Securities Act shall be deemed to be part of this registration statement as of the time it was declared effective. (ii) for purposes of determining any liability under the Securities Act, each post-effective amendment that contains a form of prospectus shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. II-4 SIGNATURES Pursuant to the requirements of the Securities Act of 1933, the registrant has duly caused this registration statement to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Jackson, State of Tennessee, on the 22nd day of April, 2002. KIRKLAND'S, INC. By: /s/ ROBERT E. ALDERSON ------------------------------------ Robert E. Alderson Chief Executive Officer POWER OF ATTORNEY Pursuant to the requirements of the Securities Act of 1933, this registration statement has been signed below by the following persons in the capacities and on the dates indicated. Each person whose signature appears below hereby constitutes and appoints Robert E. Alderson and Reynolds C. Faulkner his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution for him in any and all capacities, to sign any and all amendments (including post-effective amendments) to this registration statement, or any registration statement for the same offering that is to be effective upon filing pursuant to Rule 462(b) under the Securities Act of 1933, and to file the same, with exhibits thereto and other documents in connection therewith or in connection with the registration of the common stock offered hereby under the Securities Exchange Act of 1934, with the Securities and Exchange Commission, granting unto such attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary in connection with such matters and hereby ratifying and confirming all that such attorney-in-fact and agent or his substitutes may do or cause to be done by virtue hereof. <Table> <Caption> SIGNATURE TITLE DATE --------- ----- ---- /s/ ROBERT E. ALDERSON President, Chief Executive Officer April 22, 2002 - --------------------------------------------- and Director (Principal Executive Robert E. Alderson Officer) /s/ REYNOLDS C. FAULKNER Executive Vice President, Chief April 22, 2002 - --------------------------------------------- Financial Officer and Director Reynolds C. Faulkner (Principal Financial Officer) /s/ CONNIE L. SCOGGINS Vice President of Finance and April 22, 2002 - --------------------------------------------- Treasurer/Controller (Principal Connie L. Scoggins Accounting Officer) /s/ CARL KIRKLAND Chairman of the Board April 22, 2002 - --------------------------------------------- Carl Kirkland /s/ ALEXANDER S. MCGRATH Director April 22, 2002 - --------------------------------------------- Alexander S. McGrath /s/ DAVID M. MUSSAFER Director April 22, 2002 - --------------------------------------------- David M. Mussafer </Table> II-5 <Table> <Caption> SIGNATURE TITLE DATE --------- ----- ---- /s/ R. WILSON ORR, III Director April 22, 2002 - --------------------------------------------- R. Wilson Orr, III /s/ JOHN P. OSWALD Director April 22, 2002 - --------------------------------------------- John P. Oswald /s/ MURRAY SPAIN Director April 22, 2002 - --------------------------------------------- Murray Spain </Table> II-6 EXHIBIT INDEX <Table> <Caption> EXHIBIT NO. DESCRIPTION - ------- ----------- 3.1 Amended and Restated Charter of Kirkland's, Inc. 3.2 Form of Amended and Restated Charter of Kirkland's, Inc. (to become effective immediately prior to completion of this offering) 3.3 Bylaws of Kirkland's, Inc. 3.4 Form of Amended and Restated Bylaws of Kirkland's, Inc. (to become effective immediately prior to completion of this offering) 10.1 Amended and Restated Credit Agreement dated as of June 19, 2001, among Kirkland's Holdings, L.L.C., the entities listed on Schedule 1.1A thereto, the several banks and other financial institutions or entities from time to time parties to the agreement, the First National Bank of Boston, and Lehman Commercial Paper Inc. 10.3 Form of Amended and Restated Registration Rights Agreement dated as of April 15, 2002, by and among Kirkland Holdings L.L.C., Kirkland's, Inc., SSM Venture Partners, L.P., Joseph R. Hyde III, Johnston C. Adams, Jr., John H. Pontius, CT/Kirkland Equity Partners, L.P., R-H Capital Partners, L.P., TCW/Kirkland Equity Partners, L.P., Capital Resource Lenders II, L.P., Allied Capital Corporation, The Marlborough Capital Investment Fund, L.P., Capital Trust Investments, Ltd., Global Private Equity II Limited Partnership, Advent Direct Investment Program Limited Partnership, Advent Partners Limited Partnership, Carl Kirkland, Robert Kirkland, Robert E. Alderson, The Amy Katherine Alderson Trust, The Allison Leigh Alderson Trust, The Carl T. Kirkland Grantor Retained Annuity Trust 2001-1 and Steven Collins 10.5 Employment Agreement by and between Kirkland's and Carl Kirkland dated June 12, 1996, as amended 10.6 Employment Agreement by and between Kirkland's and Robert E. Alderson dated June 12, 1996, as amended 10.7 Employment Agreement by and between Kirkland's and Reynolds C. Faulkner dated as of February 2, 1998, as amended 10.8 Employment Agreement by and between Kirkland's and H.R. Harvey dated June 18, 2001 10.9 Employment Agreement by and between Kirkland's and C. Edmond Wise, Jr. dated December 4, 2000 10.10 1996 Executive Incentive and Non-Qualified Stock Option Plan, as amended through April 17, 2002 10.11 2002 Incentive Plan 10.12 Employee Stock Purchase Plan 10.13 Form of Amended and Restated Shareholders Agreement dated as of April 15, 2002, by and among Kirkland Holdings L.L.C., Kirkland's, Inc., SSM Venture Partners, L.P., Joseph R. Hyde III, Johnston C. Adams, Jr., John H. Pontius, CT/Kirkland Equity Partners, L.P., R-H Capital Partners, L.P., TCW/Kirkland Equity Partners, L.P., Capital Resource Lenders II, L.P., Allied Capital Corporation, The Marlborough Capital Investment Fund, L.P., Capital Trust Investments, Ltd., Global Private Equity II Limited Partnership, Advent Direct Investment Program Limited Partnership, Advent Partners Limited Partnership, Carl Kirkland, Robert Kirkland, Robert E. Alderson, The Amy Katherine Alderson Trust, The Allison Leigh Alderson Trust, The Carl T. Kirkland Grantor Retained Annuity Trust 2001-1 and Steven Collins 10.14 Stock Option Agreement by and between Kirkland's and Carl Kirkland dated June 11, 1996, as amended through April 17, 2002 10.16 Sublease Agreement by and between Southwind Properties and Kirkland's dated March 5, 2001 21 Subsidiaries of Kirkland's 23.1 Consent of PricewaterhouseCoopers LLP 24.1 Power of Attorney (included on signature pages) </Table>