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TABLE OF CONTENTS
Index to Consolidated Financial Statements

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

For the fiscal year ended April 1, 2001

OR

For the transition period from                to               

Commission File Number 0-26829

TULLY'S COFFEE CORPORATION
(Exact name of registrant as specified in its charter)

Registrant's telephone number, including area code:
(206) 233-2070

Securities registered pursuant to Section 12(b) of the Act:
None

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, no par value
(Title of each class)

    Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes / /  No /x/

    Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.

    As of October 1, 2001, the aggregate market value of the registrant's Common Stock held by non affiliates of the registrant was $         N.A.

    As of October 1, 2001, the number of shares of the registrant's Common Stock outstanding was 16,377,005.

TABLE OF CONTENTS

Statement About Forward-Looking Statements

    We make forward-looking statements in this document that are subject to risks and uncertainties. These forward-looking statements include information about possible or assumed future results of the Company's financial condition, operations, plans, objectives and performance. Additionally, when we use the words "believe," "expect," "anticipate," "estimate" or similar expressions, we are making forward-looking statements. Many possible events or factors could affect our future financial results and performance. The forward-looking statements are not guarantees of future performance and results or performance may differ materially from those expressed in our forward-looking statements. In addition to the factors discussed elsewhere in this annual report, the following possible events or factors could cause our actual results to differ materially:

•

our growth strategy may not be as successful as we expect if we are unable to achieve market acceptance in new geographic areas or to locate and open stores in suitable locations;



•

competition within the retail specialty coffee market may intensify;



•

adverse changes in the general economic climate, interest rates or other factors affecting discretionary spending by consumers could adversely affect our revenues and growth potential; and



•

natural or political events could either interrupt the supply or increase the price of premium coffee beans, thereby significantly increasing our operating costs.

    In addition, this document contains forward-looking statements attributed to third parties relating to their estimates regarding the specialty coffee business. You should not place undue reliance on these forward-looking statements. Except to the extent required by the federal securities laws, Tully's does not intend to update or revise the forward-looking statements contained in this report.

PART I

ITEM 1. BUSINESS

General

    Tully's Coffee Corporation ("Tully's" or the "Company") sells high quality, premium roasted whole bean coffees, richly brewed coffees, Italian-style espresso and other cold beverages, baked goods and pastries, and coffee-related accessories and equipment. As of October 1, 2001, Tully's operated 106 Company-owned retail stores in the western United States. Tully's is a stockholder (with approximately a 5% equity interest) and has a license and supply agreement with Tully's Coffee Japan, Ltd. ("Tully's Coffee Japan") which, as of October 1, 2001, operated 36 Tully's retail stores in Japan as a licensee of the Company. Tully's has also entered into an exclusive license agreement with UCC Ueshima Coffee Company Ltd. ("Ueshima Coffee Company" or "UCC"), a Japanese company, to operate coffee stores under the Tully's name throughout Asia, excluding Japan. In addition, Tully's has a specialty coffee division that markets its products to wholesale accounts, office coffee services, food service establishments, and supermarket chains. Tully's products also are sold directly to consumers through the Company's website and through mail order.

    The Company's retail store philosophy focuses on providing an upscale atmosphere, with quick, friendly service where customers can relax and enjoy some of the finest coffee and espresso drinks available. It is management's goal to make each location a friendly, neighborhood meeting place, with employees who go out of their way to make customers feel special. The Company believes that developing customer loyalty and brand recognition is of the utmost importance in its business and growth strategy.

Fiscal Periods

    The Company ends its fiscal year on the Sunday closest to March 31. As a result, the Company records its revenue and expenses on a 52-53 week period. The fiscal year ended April 1, 2001 included 52 weeks ("Fiscal 2001"), the fiscal year ended April 2, 2000 included 53 weeks ("Fiscal 2000") and the fiscal year ended March 28, 1999 included 52 weeks ("Fiscal 1999").

Company Background

    Tully's was formed in July 1992 after its founder and Chairman of the Board, Tom T. O'Keefe, concluded that an opportunity to develop, own and operate a chain of specialty coffee stores existed in the greater Puget Sound, Washington area. During the early 1990s, Mr. O'Keefe's real estate company was approached by numerous companies inquiring about locating specialty coffee stores in the properties owned and managed by his company. As a result, Mr. O'Keefe began researching the specialty coffee industry and determined that an opportunity existed for development of a company focused on the sale of high-quality coffee beans, coffee drinks and coffee related products in an upscale atmosphere that emphasized customer service. On September 16, 1992 Tully's opened its first store in Kent, Washington.

    Tully's Coffee Corporation is a Washington corporation and is headquartered at 3100 Airport Way South, Seattle, Washington 98134. The Company's telephone number is (206) 233-2070 or 1-800-96Tully.

Strategy

General

    The Company's objective is to establish Tully's as one of the most respected coffee brands in the world. As a part of this brand building strategy, the Company has made significant investments in

marketing and building its brand. The Company wants each Tully's retail store to provide a warm and inviting atmosphere that will attract customers and encourage those customers to stay and enjoy Tully's coffee, espresso and other beverages and food products. Tully's seeks to employ people who contribute to the "coffee experience" of its customers.

    Tully's strives to develop customer loyalty and brand recognition by providing superior service and offering quality coffee products that are competitively priced. Management believes that the Company's staff is well trained and knowledgeable about the coffee products offered for sale. It is the Company's belief that customer service, along with product freshness, consistency and variety, have become its hallmarks.

    Another important element of the Company's strategy is to become an integral part of the local neighborhood served by each retail store. This is accomplished in a variety of ways, such as becoming involved in local fundraising and charitable organizations, participating in primary and secondary school programs and by providing jobs to area high school students. The Company believes that community involvement not only helps the Company by building goodwill, but also strengthens its market position.

Expansion Strategy

    Tully's principal expansion strategy has been to develop new retail stores in the Company's current and prospective new geographic markets. During Fiscal 2001, the Company opened 37 new Company-owned stores, closed two Company- owned stores, and acquired 14 stores that were re-named as Tully's stores. During Fiscal 2000, the Company opened 10 new Company-owned stores and closed four stores. Tully's Coffee Japan opened 10 licensed stores in Japan during Fiscal 2001 and opened 10 new stores in Fiscal 2000. In light of the Company's current capital constraints and management's focus on achieving operating efficiencies and profitability, the Company anticipates opening only a limited number of new retail stores during the fiscal year ending March 31, 2002 ("Fiscal 2002"). During Fiscal 2002, Tully's intends to focus primarily on expanding the specialty coffee division through wholesale accounts, especially in the supermarket and food service channels. The Company also plans on pursuing domestic and international licensing and joint venture opportunities.

    In September 2000, Tully's acquired the assets and real property leases of four Los Angeles-area stores and one Seattle-area store from Coffee Station, Inc. ("Coffee Station"). In December 2000, the Company entered the Portland, Oregon market by acquiring nine stores from Tri-Brands, Inc., dba Marsee Baking ("Marsee Baking"). During Fiscal 2002, Tully's expects to continue to investigate and evaluate strategic acquisition opportunities that might fit strategically into its future growth plans.

Marketing

Stores

    Tully's focus on consistency and quality in both its products and customer service is the basis for its marketing program as the Company strives for increased exposure in its communities. Stores and kiosks are intended to be billboards themselves as the Company opens new locations. Point of sale signage, custom bags, boxes, cups, gift sets, products and literature with the Company's distinctive name and logo are intended to increase name awareness and to portray the Company's image.

Specialty Coffee

    Tully's uses its wholesale and office coffee service accounts to provide additional opportunities for coffee consumers to experience the Company's coffee and reinforce Tully's branded logo and name. The Company's products are delivered to its wholesale and coffee service accounts in branded packaging. Tully's also provides logo-bearing coffee cups, banners and point of use signage to these accounts. This type of secondary brand marketing reinforces the Company's brand awareness and

exposes the Company's products to coffee consumers who may not have previously sampled the products in one of its stores.

Community

    Tully's commitment to the local community is another key element of its marketing strategy. Tully's supports local and national organizations focusing on children's educational and health-related issues. Each store supports events within its neighborhood and community. The Company's employees volunteer service and the Company donates product to local non-profit organizations, including schools, sports teams, food banks, charities and service organizations. The Company also provides product and resource donations to national organizations including the Cystic Fibrosis Foundation, the Juvenile Diabetes Foundation, Childhaven, Children's Hospital and the Leukemia Society.

Media

    Tully's seeks to generate awareness of its brand by disseminating press releases to local and national media announcing Tully's events, new product launches, community programs, and promotions. As part of the marketing strategy, Tully's participates in the neighborhoods of its retail stores. This may include local area marketing such as advertising in neighborhood newspapers, supporting community activities, customer appreciation promotions, direct mail and targeted marketing.

    The Company is a sponsor of the Seattle Mariners and is the exclusive coffee provider at Safeco Field pursuant to an agreement which is effective through December 31, 2003. This sponsorship agreement includes prominent signage at several places in the stadium, including the leftfield wall, and allows Tully's to use the Mariners' trademarks in advertising and in certain geographic areas. This relationship is similar to the arrangement that Tully's entered into with the San Francisco Giants and PacBell Stadium that is effective through October 31, 2002. The sponsorship agreement includes prominent signage at several places in the stadium, including the centerfield wall, and allows Tully's to use the San Francisco Giants and PacBell Stadium trademarks in certain geographic areas. The Company does not plan to renew this contract in 2002. In addition, Tully's has a supply partnership with PacWest Racing pursuant to which Tully's coffee and logo cups are available in the pit area and hospitality suites at PacWest Racing events.

International

    Tully's is a stockholder (with approximately a 5% equity interest) and has a license and supply agreement with Tully's Coffee Japan, which, as of October 1, 2001, operated 36 retail stores in Japan as a licensee of the Company and in Tully's Europe B.V., which operated one retail store in Sweden as a licensee of the Company. In Taiwan and Singapore, a licensee of the Company's Spinelli brand operated 12 retail stores. Sales to licensees located outside the United States accounted for approximately 4.0% of Tully's net sales in Fiscal 2001 and approximately 2.0% of Tully's net sales in Fiscal 2000.

    Subsequent to year-end, the Company and the other shareholders of Tully's Europe B.V. decided to sell the store in Sweden and liquidate the business. The Company is engaged in negotiations with the licensee of its Spinelli brand in Singapore and Taiwan to sell the licensee the rights to the name in those markets and to terminate the license agreement.

    On April 11, 2001, the Company entered into an exclusive license agreement (the "License Agreement") with UCC Ueshima Coffee Company, LTD ("UCC"), a Japanese company that is one of Asia's largest coffee purveyors. Under the terms of the License Agreement, Tully's granted UCC an exclusive, perpetual license to use Tully's business names, trademarks, and other intellectual property rights to develop and operate specialty coffee stores throughout Asia, except for Japan. On April 17, 2001, the parties completed the transaction upon payment by UCC to Tully's of a $12,000,000 license

fee. In further consideration of the license, UCC will pay Tully's a royalty and service fee, commencing in April 2009, based on the aggregate net revenues of the stores that UCC operates under the Tully's business name, and all other sales of products or services made under the Tully's business names and trademarks in Asia. UCC has been roasting coffee in Japan for decades and has several state-of-the-art plants in Japan. UCC plans to roast coffee for the licensed stores in Asia. Tully's did not grant UCC rights to use the Tully's business names and trademarks in Japan because of Tully's preexisting license and supply agreements with Tully's Coffee Japan.

    On October 1, 2001, the Company received $4,200,000 and 300 shares of Tully's Coffee Japan stock (with a market value of approximately $1,771,000 at October 1, 2001) from Tully's Coffee Japan in connection with the amendment of Tully's existing license and supply agreements with Tully's Coffee Japan. The amendments will allow Tully's Coffee Japan to be the exclusive wholesaler of Tully's coffee in Japan and to roast Tully's coffee in Japan, which will provide more efficient delivery and a lower cost. Prior to this agreement, and until Tully's Coffee Japan establishes roasting in Japan, Tully's income has been derived from the gross margin on product shipped to Japan and royalties on store locations franchised by Tully's Coffee Japan. When Tully's Coffee Japan commences roasting operations in Japan, Tully's will continue to receive the royalties based on retail and wholesale coffee volume. In July 2001, Tully's Coffee Japan completed an initial public offering of its common stock on the Japan NASDAQ. Tully's owns 1,124 shares of Tully's Japan stock, which, on October 1, 2001 had a market value of approximately $6,635,000.

Competition

    The specialty coffee market is highly fragmented and competitive. A number of Tully's competitors have greater financial and marketing resources and brand name recognition and larger customer bases than Tully's. Tully's competes with a number of specialty coffee retailers including Starbucks Corporation, Coffee Bean and Tea Leaf, Diedrich Coffee, Inc., Seattle's Best Coffee and Peet's Coffee & Tea. Coffee manufacturers including Starbucks Corporation, Kraft Foods, Inc., The Proctor & Gamble Company, and Nestle USA, Inc. distribute premium coffee products nationally in supermarkets and convenience stores. Many of these products may be substitutes for Tully's coffees and coffee drinks. Tully's coffee beverages compete directly against all restaurant and beverage outlets that serve coffee and a growing number of single location specialty coffee outlets (espresso stands, carts, kiosks, drive- throughs, and stores). Tully's whole bean coffees and its coffee beverages compete indirectly against all other coffees available in the market. Tully's believes that its customers choose among specialty coffee brands primarily on the basis of product quality, service, convenience, and, to a lesser extent, on price.

    The development of the specialty coffee industry has shown that there is room for a variety of retailers, all seeking their own niche. The Company acknowledges that there are a large number of single location specialty coffee outlets in the geographic markets in which it operates. Tully's believes that it has developed significant brand identity and customer loyalty, however, which give it a competitive advantage over the numerous single location operators.

    Tully's faces intense competition for suitable new store sites and for qualified personnel to operate both new and existing stores. Tully's may not be able to continue to secure sites at acceptable rent levels or to attract a sufficient number of qualified workers. Tully's specialty coffee division also faces significant competition from established wholesale and mail order suppliers, many of whom have greater financial and marketing resources than Tully's.

Store Operations And Management / Employees

    As of October 1, 2001, Tully's employed 1,200 people, approximately 1,100 of which were employed in retail stores or regional operations. The balance of the employees work in the Company's administrative, wholesale, roasting and warehouse operations. All employees are non-union and

management anticipates this will continue to be the case. Approximately 925 of the Company's employees work 20 hours or more per week and are considered full-time employees.

    Tully's knows that its employees are an integral part of its business, and has structured its benefit programs accordingly. Full time employees are eligible for vacation, holidays, medical and dental insurance, maternity leave and sick leave. To promote product loyalty and enhance expertise, all employees receive discounts on beverages and resale items. Tully's believes that its current relations with employees are excellent.

    To maintain Tully's high standards of quality products and customer service, all employees complete a 2-day training course prior to commencing work in our stores, plus 6 hours of on-site training while working in a store. Training hours are devoted to orientation, which includes Company history and philosophy, as well as cash register and paperwork procedures, store equipment use, cash handling, retail product knowledge, sales techniques, customer service and thorough familiarization with Tully's Employee Handbook. Training also includes an intensive course that examines coffee history, roasting, decaffeinating processes, and tasting, or "cuppings", of Tully's proprietary blends. Barista testing concludes the training program, with extensive hands-on beverage preparation.

    Tully's is committed to attracting and retaining the best people in the coffee business. It has developed a sense of business partnership with its employees through its corporate culture, employee ownership and quality employee benefits. In addition to the benefits described above, Tully's offers a Stock Option Plan and, a 401k savings plan.

Suppliers And Equipment Vendors

Coffee Markets

    The Company purchases unroasted, or "green" coffee beans. There are many varieties of green coffee beans and a range of quality grades within each variety. Tully's purchases only premium grade arabica coffee beans and believes these beans are the best available from each producing region. Tully's seeks to purchase the finest qualities and varieties of coffee beans by identifying the unique characteristics and flavors of the varieties available from each region of the world.

    Coffee is the world's second largest agricultural product and is grown commercially in over fifty countries in tropical regions of the world. The price and supply of coffee are subject to significant volatility. While most coffee trades in the commodity market, coffee beans of the quality sought by the Company tends to trade on a negotiated basis at a substantial premium above commodity coffee bean prices, depending upon the supply and demand at the time of purchase. Supply and price can be affected by multiple factors in the producing countries including weather, political and economic conditions. In addition, green coffee bean prices have been affected in the past, and may be affected in the future, by the actions of certain organizations and associations that have historically attempted to influence commodity prices of green coffee beans through agreements establishing export quotas or restricting coffee supplies worldwide. The Company's ability to raise sales prices in response to rising coffee bean prices may be limited, and the Company's future profitability could be adversely affected if coffee bean prices were to rise substantially.

    During the buying season, Tully's may enter into forward commitments for the purchase of green coffee beans that may only be available in small quantities. Rotating our coffee bean selection enables us to provide our customers with a wider variety of coffees, as well as certain coffees that are available only on a seasonal basis. Tully's enters into contracts for future delivery of green coffee beans to help ensure adequacy of supply. As of October 1, 2001, the Company had approximately $418,000 in fixed-price purchase commitments through March 2002 which, together with existing inventory, is expected to provide an adequate supply (except for certain varietals that will need to be replenished of green coffee

beans) through Fiscal 2002. Tully's believes, based on relationships established with its suppliers, that the risk of non-delivery on such purchase commitments is remote.

Roasting

    Tully's procures and roasts green coffee beans to its exacting specifications at its roasting plant in Seattle. Tully's employs a roasting process that varies based upon the variety, quality, origin and physical characteristics of the coffee beans being roasted. Each batch is craft roasted to maximize the flavor characteristics.

    As a result of the new licensing agreement with UCC, Tully's coffee will be roasted in Japan for sale in the stores UCC licenses or owns throughout Asia. In addition, the amended supply agreement with Tully's Coffee Japan provides that it can roast in Japan as well. The agreements require that both companies roast to Tully's specifications, recipes and quality standards, which will be periodically audited by Tully's. The amended supply agreement with Tully's Coffee Japan provides for UCC to be the preferred contract coffee roaster.

Freshness

    The Company is able to roast coffee to order for its retail stores and specialty coffee division. All of the Company's retail stores and wholesale customers receive fresh roasted coffee shipped promptly after roasting.

Equipment and Store Supplies

    Tully's purchases the equipment, fixtures and supplies for its retail store locations from a number of different vendors. The materials are purchased through purchase orders on an as needed basis. In the past Tully's has used different vendors for the same type of equipment and supplies as the Company searched for the best sources and best vendors to meet its requirements. As Tully's expands, it is standardizing its purchasing systems and has begun to use vendors and suppliers for particular products on a more regular basis. Tully's believes that its relationships with vendors will develop into reliable, long-term relationships that will benefit the Company. However, if for some reason a particular supplier or vendor is unable to meet its needs, begins to deliver unsatisfactory materials or is not price competitive, Tully's believes that there are a number of alternative sources to meet all of its equipment, store supplies and other materials needs.

Patents and Trademarks

    Tully's does not hold any patents. The Company owns several trademarks that are registered with the United States Patent and Trademark Office, including Swirkle-Registered Trademark and Tullini-Registered Trademark. In addition, we have applied for federal trademark registration in the United States and for trademark registration in several foreign countries for Tully's™.

    Since Tully's filed its application for federal trademark registration for Tully's™ two other companies have claimed rights to the trademark. Tully's believes that one of these claims is not likely to impact Tully's because the claimant filed its application after Tully's and apparently cannot demonstrate use of the trademark prior to Tully's.

    The other claimant also filed its federal trademark registration application after the Company and has filed an opposition to the issuance of a trademark to the Company. It is claiming use of a Tully's trademark prior to the Company. If it can successfully support its claim, it may be able to exclude the Company's use of the Tully's name in certain markets. That applicant currently operates a chain of four restaurants in the greater Syracuse, New York area. On January 31, 2001, the Trademark Trial and Appeal Board of the U.S. Patent and Trademark Office issued its opinion sustaining the applicant's

opposition to Tully's trademark registration applications and refusing registration thereof. In response, Tully's filed a complaint against the applicant in the U.S. District Court for the Northern District of New York on April 2, 2001. The Company intends to pursue this case vigorously or, if appropriate, to seek an out-of-court settlement.

    Tully's also has a federal lawsuit presently pending in the United States District Court for the Western District of Washington in Seattle. This litigation is a trademark infringement, trademark dilution, and unfair competition dispute against a company that used a commercial designation that the Company believes is confusingly similar to Tully's trademark and trade name. The Company currently is engaged in settlement discussions to resolve this dispute.

    In addition to registered and pending trademarks, Tully's considers the overall design and visual language of its trade dress to be a valuable asset to the Company's brand. The design of its stores, including but not limited to the use of materials, furniture, signage, layout and overall aesthetic, developed in conjunction with packaged goods and marketing collateral, create a distinctive "look and feel" as well as a unique visual language. This "look and feel" and visual language continues to build its brand exposure and deliver "The Tully's Experience" through all channels of its business. Although Tully's considers store design, packaging and marketing collateral to be essential to brand identity, Tully's has not applied to register these trademarks and trade dress, and thus cannot rely on the legal protections afforded by trademark registration.

    The ability to differentiate the Tully's brand from its competitors depends, in part, on the strength and enforcement of its trademarks. If a competitor infringes on Tully's trademark rights, the Company may have to litigate to protect its rights, in which case Tully's may incur significant expenses and management's attention may be diverted from the Company's business operations.

Seasonality

    The Company's business is subject to seasonal fluctuations. Significant portions of Tully's net sales and profits are realized during the third quarter of Tully's fiscal year, which includes the December holiday season. In addition, quarterly results are affected by the timing of the opening of new stores, and Tully's rapid growth may conceal the impact of other seasonal influences. Because of the seasonality of Tully's business, results for any quarter are not necessarily indicative of the results that may be achieved for the full fiscal year.

Risk Factors

    In this section "Risk Factors," the terms "we," "us," and "our" refer to Tully's Coffee Corporation. The following factors may affect our future results and financial condition and should be considered in evaluating our business, operations and prospects.

Company Risks

Our history of losses may continue in the future and this could have an adverse affect on our ability to grow.

    To date, we have not made a profit from operations. We expect to continue to incur losses in Fiscal 2002 and cannot assure you that we will ever become or remain profitable.

Our rapid growth may make it difficult to effectively allocate our resources and manage our business.

    We have experienced significant growth and cannot assure you that we will be able to manage any future growth effectively. Continued growth could strain our management, production, financial and other resources. To manage our growth effectively, we must:

•

add production capacity while maintaining high levels of quality and efficiency,

•

continue to enhance our operational, financial and management systems, and



•

successfully attract, train, manage and retain our employees.

    Any failure to manage our growth effectively could have an adverse effect on our business, financial condition and results of operations.

If we are unable to successfully integrate future acquisitions, our business could be negatively impacted.

    We may consider future strategic acquisitions similar to our acquisitions of the Coffee Station and Marsee Baking stores in Fiscal 2001. Integrating newly-acquired businesses is expensive and time-consuming. If we acquire a business, we may not manage these integration efforts successfully, and our business and results of operations could suffer.

Tom T. O'Keefe has significant influence over matters subject to shareholder vote and may support corporate actions that conflict with other shareholders' interests.

    As of October 1, 2001, Mr. O'Keefe beneficially owned 23% of our outstanding common stock. This ownership position gives him the ability to significantly influence the election of our directors and other matters brought before the shareholders for a vote, including any potential sale or merger of our Company or a sale of substantially all of our assets. This voting power could prevent or significantly delay another company from acquiring or merging with us, even if the acquisition or merger was in your best interests.

We may not be able to obtain additional capital when needed.

    To date, we have not generated sufficient cash to fully fund operations. We historically have financed this cash shortfall through the issuance of debt and equity securities and through borrowings under our credit facilities. We expect that we may need to raise additional capital in the future to fund operations and planned growth. Any equity or debt financing may not be available on favorable terms, if at all. If financing is unavailable to us or is available only on a limited basis, we may be unable to take advantage of business opportunities or respond to competitive pressures which could have an adverse effect on our business, operating results, and financial condition.

Industry Risks

We cannot be certain that the specialty coffee industry will be accepted in new markets. Failure to achieve market acceptance will adversely affect our revenues.

    Although the specialty coffee industry has gained substantial market acceptance throughout the United States over the last several years through the operation of a variety of specialty coffee shops, there is a risk that our brand or products may not be accepted in new markets. Consumer tastes and brand loyalties vary from one location or region of the country to another. Consumers in areas other than the Pacific Northwest, San Francisco and Los Angeles areas may not embrace specialty coffee or the Tully's brand if Tully's were to expand its operations into new geographic areas.

We compete with a number of companies for customers. The success of these companies could have an adverse effect us.

    We operate in highly competitive markets in the Pacific Northwest, San Francisco and Los Angeles. Our specialty coffees compete directly against all restaurant and beverage outlets that serve coffee and a growing number of espresso stands, carts and stores. Companies that compete directly with us include, among others, Starbucks Corporation, Coffee Bean and Tea Leaf, Diedrich Coffee, Inc., Peet's Coffee and Tea, and Seattle's Best Coffee. We must spend significant resources to differentiate our product from the products offered by these companies, but our competitors still may be successful in attracting customers away from our stores. Our failure to compete successfully against

current or future competitors would have an adverse effect on our business, including loss of customers, declining revenues and loss of market share.

Our whole bean coffee sales must compete with supermarkets and warehouse clubs.

    Supermarkets and warehouse clubs pose a competitive challenge in the whole bean coffee market. A number of global coffee suppliers, such as Starbucks Corporation, Kraft Foods, Inc., The Procter & Gamble Company, and Nestle USA, Inc., distribute premium coffee products in supermarkets and warehouse clubs that may serve as substitutes for our whole bean coffees.

Competition for store locations and qualified workers could adversely affect our growth plans.

    We face intense competition from both restaurants and other specialty retailers for suitable sites for new stores and for qualified personnel to operate both new and existing stores. We may not be able to continue to secure adequate sites at acceptable rent levels or attract a sufficient number of qualified workers. These factors could impact our plans for expansion and our ability to operate existing stores.

A shortage in the supply or an increase in price of coffee beans could adversely affect our revenues.

    Our future success depends to a large extent upon the availability of premium quality unroasted, or green, coffee beans at reasonable prices. The world coffee bean market is largely a commodity market, although purchases of premium Arabica coffee beans are typically negotiated on a per sale basis with growers. Natural or political events could interrupt the supply of these premium beans. In addition, green coffee bean prices have been affected in the past, and could be affected in the future, by the actions of organizations such as the International Coffee Organization and the Association of Coffee Producing Countries, which have attempted to influence commodity prices of green coffee beans through agreements establishing export quotas or restricting coffee supplies worldwide. Price increases for whole bean coffee result in increases in the costs of coffee beverages served in our stores. These cost increases may force us to increase the retail and wholesale prices for our coffee products, which could adversely affect our revenues.

Changes in economic climates could adversely affect our revenues.

    Our business is not diversified. Our revenues are derived predominantly from the sale of coffee, coffee beverages, baked goods and pastries and coffee-related accessoriesand equipment. Given that many of these items are discretionary items in our customers' budgets, our business depends upon a healthy economic climate for the coffee industry as well as the economy generally.

Investment Risks

We may need additional capital, which if raised, could dilute your interest in our Company.

    If we raise additional funds through the issuance of equity, convertible debt or other securities, current shareholders may experience dilution and the securities issued to the new investors may have rights or preferences senior to those of common stock. In addition, prior to October 1999, holders of our capital stock were entitled to preemptive rights pursuant to our Articles of Incorporation and the Washington Business Corporation Act. Some of our shareholders may be entitled to purchase additional shares of our common stock pursuant to these preemptive rights. We intend to either satisfy or seek waivers of these rights from such shareholders. If we were not able to obtain waivers from all the necessary shareholders, non-waiving shareholders may be entitled to purchase additional shares of our capital stock at the price or prices at which those shares were historically offered. Any such issuances could further dilute current shareholders.

The lack of a public market for Tully's common stock and restrictions on transfer substantially limit the liquidity of an investment in our common stock.

    There is currently no public market for our common stock, and consequently liquidity of an investment in our common stock currently is limited.

ITEM 2. PROPERTIES

    As of October 1, 2001, Tully's had 106 Company-owned retail stores in the United States. The Company is currently developing one additional retail store location in Berkeley, California. The Company also entered into leases for 18 additional retail store locations, but has not developed these sites. Through October 1, 2001, eight of the 18 leases have been terminated. The Company is evaluating several stores for possible closure and is seeking lease terminations or to sublease such locations

    The Company leases approximately 220,000 square feet in a building located in Seattle, Washington, which currently houses roasting, warehousing, administrative and executive offices. The lease has a ten-year term with two five-year options to renew. Annual rent payments under the lease are approximately $792,000 for fiscal years 2002 through 2005, $911,000 for fiscal years 2006 through 2010 and $114,000 for fiscal year 2011. In February 2001, the Company received $1,000,000 from its landlord as reimbursement for company-paid tenant improvements, which is being repaid to the landlord in the form of increased rents over the remaining life of the lease.

ITEM 3. LEGAL PROCEEDINGS

    The Company is a party to various legal proceedings arising in the ordinary course of its business, including the trademark-related proceedings described at "Patents and Trademarks" on page 8, but is not currently a party to any legal proceeding which the Company believes will have a material adverse effect on the financial position or results of operations of the Company.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

    No matters were submitted for a vote of shareholders of the Company during the fourth quarter of Fiscal 2001.

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Market Information and Dividends

    Currently there is no public market for Tully's common stock. As of October 1, 2001, there were 5,207 holders of Tully's common stock.

    The Company has not paid dividends in the past and Tully's presently does not plan to pay dividends in the foreseeable future. The Company intends to retain and use earnings to finance the growth of its business for an indefinite period. Any determination to pay cash dividends will be at the discretion of the Board of Directors and will be dependent upon the Company's financial condition, results of operations, capital requirements and such other factors as the Board of Directors deems relevant.

Recent Sales of Unregistered Securities

    The Company issued and sold securities in the transactions described below during Fiscal 2001. The offer and sale of these securities were made in reliance on the exemptions from registration

provided by Section 4(2) of the Securities Act of 1933, as amended, as offers and sales not involving a public offering, or Rule 506 of Regulation D promulgated thereunder.

    During Fiscal 2001, the Company granted options to purchase an aggregate of 222,849 shares of its common stock to 92 employees pursuant to the Company's Amended and Restated 1994 Stock Option Plan at exercise prices between $0.01 and $2.50 per share in consideration for services rendered.

    During Fiscal 2001, Tully's granted options to purchase an aggregate of 287,676 shares of its common stock to its Chairman of the Board and to a director in consideration for their personal guarantees of the Company's bank line of credit.

    During Fiscal 2001, the Company issued 59,737 shares of its common stock to four vendors for goods and services provided to the Company.

    During 2001, the Company issued 28,297 shares of its common stock to 21 employees upon exercise of their options.

    During 2001, the Company issued 6,044 shares of its common stock to an employee for a bonus.

    During Fiscal 2001, the Company issued 525,625 shares of its common stock to 74 purchasers upon exercise of warrants for aggregate consideration of approximately $160,000.

    In December 2000, the Company issued a convertible promissory note (the "Note") in the principal amount of $3,000,000 to a company owned by a director of the Company. At any time prior to the earlier of January 2, 2005, or repayment of the Note, the Note is convertible into the Company's Series A Preferred Stock or, in the event that all shares of Series A Preferred Stock have been converted prior to such date, then into the Company's common stock. The conversion rate is the lesser of $2.50 per share or the price per share of the most recent offering price, public or private, of the Company's common stock. On each January 1^st until the Note is repaid, the Company will issue, in lieu of interest thereon, warrants to purchase 8,000 shares or common stock for each $100,000 of principal outstanding under the Note. The warrants have an exercise price of $0.01 and are exercisable for ten years from the issuance dates thereof. In January 2001, the Company granted warrants to purchase 240,000 shares of common stock in accordance with the terms of the Note.

    During Fiscal 2001, the Company issued and sold 4,990,709 shares of its Series B Convertible Preferred Stock to accredited investors. The Company received gross proceeds of $12,477,000 in the offering and paid placement agent commissions and offering costs of approximately $1,411,000. The Series B Convertible Preferred Stock is initially convertible into an equivalent number of shares of common stock, and is subject to customary anti-dilution adjustments.

ITEM 6.  SELECTED FINANCIAL DATA

    The following selected financial data have been derived from the consolidated financial statements of the Company. The data set forth below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Company's consolidated financial statements and notes thereto appearing elsewhere in this Form 10-K.

(1)

The additional week during the 53 weeks ended April 2, 2000 accounted for $503,000 in net sales.

(2)

Fourth quarter adjustments during Fiscal 2001 were as follows:

(3)

Subsequent to the year-end of Fiscal 2001 through October 5, 2001, the Company received a $12,000,000 license fee from UCC and $1,000,000 from the issuance of notes payable to three directors of the Company. In addition, the Company received $4,200,000 and 300 shares of Tully's Coffee Japan stock (with a market value of approximately $1,771,000 at October 1, 2001) in connection with the amendment of its license and supply agreements with Tully's Coffee Japan. Tully's Coffee Japan completed an initial public offering of its common stock on the Japan NASDAQ in July 2001. Tully's owns 1,124 shares of Tully's Japan stock, which, on October 1, 2001 had a market value of approximately $6,635,000.

ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

    The following discussion and analysis provides information that Tully's believes is relevant to an assessment and understanding of its results of operations and financial condition for the fiscal years ended April 1, 2001, April 2, 2000 and March 28, 1999. The following discussion should be read in conjunction with the consolidated financial statements and related notes appearing elsewhere in this report. The Company believes that certain statements herein, including statements concerning anticipated store openings, planned capital expenditures, and trends in or expectations regarding Tully's operations, constitute "forward-looking statements" within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. Such statements are based on currently available operating, financial and competitive information, and are subject to risks and uncertainties. Actual future results and trends may differ materially depending on a variety of factors, including, but not limited to, coffee and other raw materials prices and availability, successful execution of internal performance and expansion plans, the impact of competition, the effect of legal proceedings, and other risks summarized at "Item 1—Business—Risk Factors."

Overview

    Tully's derives its revenues from sales from its Company-owned retail stores and from its specialty sales, which consist of product sales to wholesale customers, office coffee service, direct mail order sales, and international licensees and royalty and licensing fees from licensed stores. For Fiscal 2001, Tully's derived approximately 85% of net sales from its Company-owned retail stores.

    The Company's cash flow from operations has not been sufficient to cover operating expenses and the Company has not made a profit from operations in any year since inception. These losses are primarily due to costs associated with the Company's significant growth, especially opening new stores in new markets, and its significant investment in building the Tully's brand. During Fiscal 2002, the Company intends to focus primarily on expanding its specialty coffee sales and international licensee opportunities, opening a limited number of new stores and managing its costs more effectively. The Company has historically funded its cash flow shortfalls through the issuance of debt and equity securities and through borrowings. During Fiscal 2001, Tully's raised approximately $11,066,000, net of offering costs, in equity capital from a private placement of Series B Preferred Stock and warrants to purchase common stock. The proceeds from this offering have been used for capital expenditures on new and acquired stores, to repay debt and for working capital. Additionally, the Company received $3,000,000 from the issuance of a convertible promissory note. Tully's ended Fiscal 2001 with $408,000 in total cash and a working capital deficit of $12,348,000. However, subsequent to the end of Fiscal 2001, the Company received a $12,000,000 license fee from UCC, $1,000,000 from the issuance of notes payable to three directors of the Company and $4,200,000 in cash and 300 shares of Tully's Coffee Japan stock received in connection with the amendment of the Company's license and supply agreements with Tully's Coffee Japan. At October 1, 2001, the market value of the 1,124 shares of Tully's Coffee Japan owned by Tully's was approximately $6,635,000. There are currently no restrictions on the sale of these shares and the Company may sell all or a portion of these shares as needed to fund liquidity needs or for expansion.

    The Company's fiscal year ends on the Sunday closest to March 31. Fiscal 2001, ending on April 1, 2001, included 52 weeks while Fiscal 2000 included 53 weeks and Fiscal 1999 included 52 weeks.

Results of Operations

    The following table sets forth, for the periods indicated, selected statements of operations data expressed as a percentage of sales.

Fiscal Year Ended April 1, 2001 Compared To Fiscal Year Ended April 2, 2000

Net Sales

    Net sales for Fiscal 2001 increased $14,404,000 or 52.0% to $42,102,000 from $27,698,000 for Fiscal 2000. During the same period, retail sales increased $11,697,000 or 48.6% to $35,759,000 from $24,062,000. The $11,697,000 increase in retail sales resulted from: a) the opening of 37 new Company-owned retail stores which contributed $8,523,000, b) the acquisition of 14 retail stores from Coffee Station. and Marsee Baking which contributed $2,413,000 and c) comparable store sales growth of 3.5% which contributed the remaining $761,000 of the increase. Comparable store sales are defined as sales generated in stores open for at least 12 months in each of the periods. At fiscal year end, there were 114 Company-owned stores in North America.

    Specialty coffee sales, which consist of domestic and international wholesale, office coffee service and mail order sales, increased $2,707,000 or 74.5% to $6,343,000 for Fiscal 2001 from $3,636,000 for Fiscal 2000. The increase was due to new wholesale and office coffee service customer accounts. International sales and licensing fees accounted for $1,119,000 of the increase.

Operating Expenses

    Cost of goods sold and related occupancy costs increased $8,546,000 or 61.2% to $22,505,000 in Fiscal 2001 from $13,959,000 in Fiscal 2000. This increase was the result of higher sales volumes. As a percentage of net sales, cost of goods sold and related occupancy costs increased to 53.5% for Fiscal 2001 compared with 50.4% for Fiscal 2000, primarily as a result of increased rents for the Company's new stores, increased costs of paper product and drink supplies and promotional costs associated with the roll-out of a new sandwich program.

    Store operating expenses increased $5,550,000 or 57.3% to $15,236,000 in Fiscal 2001 from $9,686,000 in Fiscal 2000. Labor and other expenses from newly opened and acquired stores in Fiscal 2001 generated $4,233,000 of the increase. Approximately $169,000 of the increase resulted from monthly rents for 18 unopened store locations. The remaining cost increases resulted from increased rents on existing stores. As a percentage of net sales, store operating expenses increased to 36.2% for Fiscal 2001 from 35.0% for Fiscal 2000.

    Other operating expenses (expenses associated with all operations other than Company-owned retail stores) increased $1,849,000 or 159.1% to $3,011,000 in Fiscal 2001 from $1,162,000 in Fiscal 2000. The expense increase resulted from: a) the write-down of the Company's investment in Tully's Europe B.V. and related trade receivables totaling approximately $1,036,000, and 2) increased sales and distribution costs required to support the growth of domestic specialty coffee sales.

    Marketing, general and administrative costs (excluding non-cash stock option compensation expense) increased $5,494,000 or 80.2% to $12,346,000 in Fiscal 2001 from $6,852,000 in Fiscal 2000. The $5,494,000 increase resulted from: a) an increase of $1,203,000 in marketing expenditures primarily due to the new PacBell stadium sponsorship, b) an increase of $846,000 in professional fees for legal, accounting and auditing services related to ongoing litigation, regulatory and trademark filings, c) an increase of $777,000 in payroll expenditures to support business growth, d) incremental occupancy expenses associated with the new roasting and corporate headquarters of $513,000, and e) an increase of $606,000 in charitable giving and corporate sponsorships. As a percentage of net sales, marketing, general and administrative costs increased to 29.3% in Fiscal 2001 from 24.7% in Fiscal 2000.

    Non-cash stock option compensation expense decreased $426,000 or (35.3)% to $782,000 in Fiscal 2001 from $1,208,000 in Fiscal 2000. As a percentage of net sales, stock option expense decreased to 1.9% for Fiscal 2001 from 4.4% for Fiscal 2000. Non-cash stock compensation expense is a non-cash charge representing the difference between the exercise price and fair market value of the stock at the date of grant.

    Depreciation and amortization expense increased $1,845,000 or 72.4% to $4,393,000 in Fiscal 2001 from $2,548,000 in Fiscal 2000. This increase was due to the opening of 37 new Company-owned stores, the acquisition of five Coffee Station stores in September 2000 and nine Marsee Baking stores in December 2000. As a percentage of net sales, depreciation and amortization expense increased to 10.4% for Fiscal 2001 from 9.2% for Fiscal 2000. As a result of the reduced carrying value of the impaired assets described below, depreciation and amortization expense for Fiscal 2002 are expected to be reduced by approximately $308,000.

Impairment of Long-Lived Assets

    A non-cash charge of $5,006,000 for the impairment of long-lived assets was recognized during Fiscal 2001 under the application of Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of" ("SFAS 121"). See "Item 8—Financial Statements and Supplementary Data—Note 9 to the Consolidated Financial Statements." The charge consists of a non-cash write-off of the goodwill, leasehold improvements and other long term assets determined to be impaired under the application of SFAS 121.

Store Closure and Lease Termination Costs

    Store closure and lease termination costs of $2,620,000 for Fiscal 2001 reflect the Company's estimate of write-offs to be made and costs to be incurred in connection with the closure of four Company-owned retail stores and termination of 18 leases. As of April 1, 2001, the Company had 18 retail store locations for which leases had been signed. In March 2001, the Company determined that it would not build these 18 retail stores due to capital constraints and because current financial projections for these locations did not meet management's financial criteria. Estimated lease

termination costs were determined using management's best estimate, which includes rent and broker fees. The Company anticipates a net cash outlay of approximately $1,426,000 to terminate the leases. See "Item 8—Financial Statements and Supplementary Data—Note 17 to the Consolidated Financial Statements."

Interest and Other Expenses (Income)

    Interest expense increased $427,000 or 121.7% to $778,000 in Fiscal 2001 compared to $351,000 for Fiscal 2000 due to higher average borrowings on the Company's bank line of credit in Fiscal 2001 compared with Fiscal 2000 and due to the interest from the beneficial conversion feature of the convertible promissory note in Fiscal 2001. See "Item 8—Financial Statements and Supplementary Data—Note 14 to the Consolidated Financial Statements."

    Miscellaneous income decreased $241,000 or 56.1% to $189,000 for Fiscal 2001 from $430,000 for Fiscal 2000. The decrease reflects less interest income due to lower average cash balances in Fiscal 2001.

    Loan guarantee fee expense increased $243,000 or 56.8% to $671,000 in Fiscal 2001 from $428,000 for Fiscal 2000. This non-cash expense is for options to purchase common stock of the Company, granted to the Company's Chairman of the Board and to a director in consideration of their guarantees of the Company's bank line of credit, with the number of options based on the amount outstanding on the line of credit. This increase of $243,000 is due to higher average borrowings on the bank line of credit.

Net Loss

    Net operating loss increased $16,991,000 or 210.6% to $25,057,000 in Fiscal 2001 from $8,066,000 for Fiscal 2000. As a percentage of sales, gross margins decreased by 3.1%. The addition of 51 new and acquired Company-owned retail stores resulted in higher store operating expenses, marketing, general and administrative costs, and depreciation and amortization. Fiscal 2001 also included the write-down for the impairment of long-lived assets under FAS 121 and store closure and lease termination costs. Net loss applicable to common shareholders increased $8,197,000 or 48.6% to $25,057,000 from $16,860,000 for Fiscal 2000. There was no preferred stock dividend/accretion in Fiscal 2001. Net loss applicable to common shareholders per share increased by $0.44 or 38.3% to $1.59 per share in Fiscal 2001 from $1.15 per share in Fiscal 2000.

Fiscal Year Ended April 2, 2000 Compared To Fiscal Year Ended March 28, 1999

Net Sales

    Net sales increased $7,491,000 or 37.1% to $27,698,000 in Fiscal 2000 from $20,207,000 in Fiscal 1999. Retail sales increased $6,525,000 or 37.2% to $24,062,000 in Fiscal 2000 from $17,537,000 in Fiscal 1999, due primarily to the addition of ten new Company-owned stores and, to a lesser extent, to an increase in comparable store sales of 12.0% and sales for the 53rd week of the year. Comparable store sales have been calculated excluding the 53rd week. During Fiscal 2000, the Company opened 10 new Company-owned stores. At April 2, 2000, there were 65 Company-owned retail stores in North America.

    Specialty sales, which consist of domestic and international wholesale, office coffee service and mail order sales, increased $966,000 or 36.2% to $3,636,000 for Fiscal 2000 compared with $2,670,000 for Fiscal 1999. The increase was due to new customer accounts.

Operating Expenses

    Cost of goods sold and related occupancy costs increased $3,254,000 or 30.4% to $13,959,000 in Fiscal 2000 from $10,705,000 in Fiscal 1999. This increase was the result of higher sales volumes. As a percent of net sales, cost of goods sold and related occupancy costs decreased to 50.4% for Fiscal 2000 compared with 53.0% for Fiscal 1999 primarily as a result of improved coffee purchasing. Lower store occupancy costs and increases in same store sales relative to rental expense accounted for the remainder of the decrease.

    Store operating expenses increased $2,511,000 or 35.0% to $9,686,000 in Fiscal 2000 from $7,175,000 in Fiscal 1999. Labor and other expenses from stores newly opened and acquired in Fiscal 2000 generated $1,279,000 of the increase. The remaining cost increases resulted from increased rents on existing stores. As a percentage of net sales, store operating expenses decreased to 35.0% for Fiscal 2000 from 35.5% for Fiscal 1999. Improved store labor utilization generated this improvement.

    Other operating expenses (expenses associated with all operations other than Company-owned retail stores) increased $492,000 or 73.4% to $1,162,000 in Fiscal 2000 from $670,000 in Fiscal 1999. The increase was primarily due to the additional sales and distribution labor costs required to support growth of domestic specialty coffee sales.

    Marketing, general and administrative costs (excluding non-cash stock option compensation expense) increased $2,609,000 or 61.5% to $6,852,000 in Fiscal 2000 from $4,243,000 in Fiscal 1999. The $2,609,000 increase was due to: a) an increase of $1,235,000 in payroll expenditures required to support business growth, b) an increase of $235,000 in advertising and marketing expenditures, c) an increase of $434,000 in professional fees for legal, accounting and auditing and consulting services and d) insurance, utilities, supplies and business travel expenses required to support ongoing business growth. As a percentage of net sales, marketing, general and administrative costs increased to 24.7% in Fiscal 2000 from 21.0% in Fiscal 1999.

    Non-cash stock option compensation expense increased $375,000 or 45.0% to $1,208,000 in Fiscal 2000 from $833,000 in Fiscal 1999 as the number of employees increased due to growth in the number of Company-owned retail stores. As a percentage of net sales, stock option expense increased to 4.4% for Fiscal 2000 from 4.1% for Fiscal 1999. The expense is a non-cash charge representing the difference between the exercise price and fair market value of the stock at the date of grant. Stock option expense is composed primarily of options to purchase common stock granted to officers and key employees.

    Depreciation and amortization expense increased $879,000 or 52.7% to $2,548,000 in Fiscal 2000 from $1,669,000 in Fiscal 1999. This increase was primarily due to the opening of 10 new Company-owned retail stores, the impact of the costs associated with the Company's June 1998 acquisition of Spinelli Coffee Company for a full year in Fiscal 2000 compared with 9 months in Fiscal 1999 and the 53^rd week in the fiscal year. As a percentage of net sales, depreciation and amortization expense increased to 9.2% for Fiscal 2000 from 8.3% for Fiscal 1999

Interest and Other Expenses (Income)

    Interest expense decreased $483,000 or 57.9% to $351,000 in Fiscal 2000 from $834,000 for Fiscal 1999. The decrease was due to lower average borrowings on the Company's bank line of credit in Fiscal 2000 compared with Fiscal 1999.

    Miscellaneous income increased $360,000 or 514.3% to $430,000 in Fiscal 2000 from $70,000 for Fiscal 1999. The increase is due to higher average cash balances in Fiscal 2000.

    Loan guarantee fee expense decreased $301,000 or 41.3% to $428,000 in Fiscal 2000 from $729,000 for Fiscal 1999. This non-cash expense is for options to purchase common stock of the Company,

granted to the Company's Chairman of the Board and to a director in consideration of their guarantees of the Company's bank line of credit.

Net Loss

    Net operating loss increased $1,485,000 or 22.6% to $8,066,000 in Fiscal 2000 from $6,581,000 in Fiscal 1999. As a percentage of sales, gross margins improved by 2.6%, and other net expenses improved 6.1%. These improvements were partially offset by higher store operating expenses, other operating expenses, marketing, general and administrative costs and depreciation and amortization and stock option expense. These changes decreased the net loss as a percentage of sales by 3.5%. Net loss applicable to common shareholders increased $4,311,000 or 34.4% to $16,860,000 in Fiscal 2000 from $12,549,000 for Fiscal 1999 due to the preferred stock dividend/accretion attributed to the issuance by the Company of Series A Preferred Stock with non-detachable warrants. Net loss applicable to common shareholders per share increased $0.27 or 30.7% to $1.15 per share in Fiscal 2000 compared to $0.88 per share in Fiscal 1999.

    In connection with the issuance of Series A Preferred Stock in Fiscal 2000, the Company issued 4,580,392 warrants to purchase common stock at an exercise price of $0.33 per share. The exercise price of the warrant at the date of issuance was below management's estimation of the fair market value of the common stock and is therefore considered an "in the money" or beneficial conversion feature. Accounting for the issuance of convertible preferred stock with a nondetachable beneficial conversion feature at the date of issue requires that the conversion feature be recognized and measured in the financial statements by allocating a portion of the preferred stock offering proceeds to additional paid in capital. The discount resulting from the allocation of the proceeds to the beneficial conversion feature is conceptually similar to a dividend and is recognized as a return to preferred shareholders from the date of issuance through the date the warrants are exercisable. As a result of this accounting, the Company allocated $8,794,000 of the preferred stock proceeds to additional paid in capital. As a result, net loss applicable to common shareholders decreased to 60.9% of sales in Fiscal 2000 from 62.1% of sales in Fiscal 1999.

Liquidity and Capital Resources

    Tully's ended Fiscal 2001 with $408,000 in cash and cash equivalents and a working capital deficit of $12,348,000 compared to $5,058,000 in cash and cash equivalents and a working capital deficit of $47,000 at the end of Fiscal 2000. The decrease in cash and cash equivalents and increase in working capital deficit was due to cash used to fund operating activities and the construction costs associated with the 37 new Company-owned retail stores and the acquisition of the five Coffee Station and nine Marsee Baking stores.

    Cash used in operating activities increased $629,000 or 10.5% to $6,611,000 in Fiscal 2001, from $5,982,000 in Fiscal 2000. The cash used in operating activities primarily resulted from a net loss before non-cash charges of $11,713,000, coupled with increased levels of trade accounts receivable of $898,000 and inventory of $1,241,000. Trade accounts receivable resulted from increased specialty coffee sales while additional green bean inventory was purchased to support future business growth. These increases were partially offset by a reduction of prepaid expenses related to the timing of marketing payments and increased trade accounts payable resulting from extended vendor payment terms.

    Cash used by investing activities in Fiscal 2001 totaled approximately $13,948,000. This included capital additions to property, plant and equipment of $9,325,000 related to opening 37 new Company-owned retail stores, new store construction, the Company's new roasting plant, and remodeling certain existing stores. Costs associated with roasting plant and computer hardware and software at the Company headquarters totaled approximately $1,695,000 during Fiscal 2001. Property and equipment acquired as part of the Coffee Station acquisition was approximately $342,000 and approximately

$1,334,000 for the Marsee Baking stores. Goodwill and other intangibles acquired in connection with the purchase of the Coffee Station stores totaled approximately $464,000 and Marsee Baking stores accounted for approximately $605,000.

    Cash provided from financing activities for Fiscal 2001 totaled $15,909,000 and included cash generated from the Series B Preferred Stock financing. Aggregate proceeds from this offering, before offering expenses, were approximately $12,477,000. Additionally, the Company had net borrowings under its line of credit of $2,500,000, received $3,000,000 from a convertible promissory note issued to an affiliate of a director of the Company, and issued notes payable in the principal amounts of approximately $250,000 and $100,000, respectively, to one director and one shareholder of the Company. These proceeds were offset by payments on capital leases, notes payable and the decrease in checks drawn in excess of bank balances. Subsequent to the end of Fiscal 2001, the Company paid off the $100,000 shareholder note payable and issued notes payable to three directors of the Company in the aggregate principal amount of $1,000,000. These notes are secured by all present and future accounts receivable and all tangible and intangible personal property, including, without limitation future inventory, goods and equipment. These notes payable originally matured on May 7, 2001, but were subsequently extended to May 2002. Interest is payable monthly at prime plus ¹/2 percent. (8.5% at April 1, 2001).

    As of October 1, 2001, the Company had fixed price inventory purchase commitments for green coffee totaling approximately $418,000. The Company believes, based on relationships established with its suppliers, that the risk of loss on nondelivery on such purchase commitments is remote. Such commitments are short-term in nature.

    The lease of the Company's administrative and executive offices in Seattle, Washington has a ten-year term with two five-year options to renew. Annual rent payments under the lease are approximately $792,000 for fiscal years 2002 through 2005, $911,000 for fiscal years 2006 through 2010 and $114,000 for fiscal year 2011. In February 2001, the Company received $1,000,000 from its landlord as reimbursement for company-paid tenant improvements, which is being repaid in the form of increased rents over the remaining life of the lease.

    The Company has sponsorship agreements with PacBell Stadium in San Francisco and Safeco Field in Seattle expiring on October 31, 2002 and December 31, 2003, respectively, that provide for certain advertising and marketing rights in exchange for annual fees. The annual fees under the PacBell Stadium agreement are $850,000 and $950,000 due on March 1, 2001, and March 1, 2002, respectively. The Company does not plan to renew this contact in 2002. The annual fees under the Safeco Field agreement are approximately $450,000 due in 2001, 2002 and 2003. These fees are due at the beginning of the major league baseball season.

    Cash requirements for Fiscal 2002, other than normal operating expenses and the commitments described above, are expected to consist primarily of capital expenditures related to the remodeling and addition of a limited number of new Company-owned retail stores. Management believes that the Company will have sufficient capital remaining from the $12,000,000 UCC licensing fee received in April 2001, the $1,000,000 received from issuance of notes payable to three directors of the Company and the $4,200,000 received from Tully's Coffee Japan on October 1, 2001 in connection with the amendment of the Company's license and supply agreements with Tully's Coffee Japan to fund the Company's operations during the next twelve months. In addition, the Company may sell all or a portion of its shares in Tully's Coffee Japan, which had a market value of approximately $6,635,000 as of October 1, 2001. There is no assurance that such funds would still be available at such time. The Company has historically funded its capital requirements principally through the issuance of equity and debt securities and through borrowings, but there is no assurance that such financing, if needed, would be available on satisfactory terms or at all. In the event that current funds are depleted and other funding sources are not available, the Company would need to further modify or discontinue its growth

plans and new store construction and reduce marketing, general and administrative costs related to its growth plans.

Financing

    The Company had a bank line of credit totaling $6,000,000 of which $5,500,000 was outstanding at April 1, 2001. The interest rate on this line was prime plus ¹/2 percent and was at 8.5% at April 1, 2001. This line was secured by the assets of the Company, and was guaranteed by the Company's Chairman of the Board and by a director. These guarantees assisted the Company in obtaining more favorable terms on its bank line than would have otherwise been the case given that the Company's cash from operations is not sufficient to fund its operations currently. At April 1, 2001 the line was due on July 1, 2001. Subsequent to year-end, the maturity date of the line of credit was extended to October 1, 2001 subject to the pay down of the principal balance to $2,500,000. The interest rate was increased to prime plus 1 percent with all other terms remaining substantially the same. The line of credit agreement contains certain covenants and restrictions requiring, among other things, limitations on capital expenditures. The Company was in compliance with these provisions at April 1, 2001.

New Accounting Standards

    In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS 133, Accounting for Derivative Instruments and Hedging Activities. This pronouncement will require the Company to recognize certain derivatives on its balance sheet at fair value. Changes in the fair values of derivatives that qualify as cash flow hedges will be recognized in comprehensive income until the hedged item is recognized in earnings. Tully's expects that this new standard will not have a significant effect on its results of operations. SFAS 133 was amended by SFAS 137, "Accounting for Derivative Instruments and Hedging Activities—Deferral of the Effective Date of FASB Statement No. 133," deferring the effective date to fiscal years beginning after June 15, 2001. In June 2000, the FASB issued Statement of Financial Accounting Standards Board No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities," ("SFAS 138"), which amends provision of SFAS 133. SFAS 138 will be implemented concurrently with SFAS 133. The Company does not anticipate that the adoption of these standards will have a material impact on its financial condition or the results of its operations.

    In December 1999, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 101 ("SAB 101"), "Revenue Recognition," which provides guidance on the recognition, presentation and disclosure of revenue in financial statements filed with the SEC. SAB No. 101 outlines the basic criteria that must be met to recognize revenue and provides guidance for disclosures related to revenue recognition policies. The Company has recognized revenue and made disclosures in accordance with SAB No. 101. The adoption of SAB No. 101 did not have a material impact on the Company's financial position or results of operations.

    In April 2000, the Financial Accounting Standards Board issued Interpretation FIN 44, "Accounting for Certain Transactions Involving Stock Compensation—an Interpretation of APB 25." (