Form 10-K
Table of Contents

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark one)
     
þ   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2009
or
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                      to                     
Commission File Number 001-34082
Kona Grill, Inc.
(Exact Name of Registrant as Specified in Its Charter)
     
Delaware
(State or other jurisdiction of incorporation or organization)
  20-0216690
(I.R.S. Employer Identification No.)
7150 East Camelback Road, Suite 220
Scottsdale, Arizona 85251
(480) 922-8100

(Address, including zip code, and telephone number, including area code, of principal executive offices)
Securities registered pursuant to Section 12(b) of the Act:
     
Title of Each Class   Name of Each Exchange on Which Registered
     
Common Stock, par value $0.01 per share   NASDAQ Global Market
Securities registered pursuant to Section 12(g) of the Act:
None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No þ
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section15(d) of the Act. Yes o No þ
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 þ No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) 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. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
             
Large accelerated filer o   Accelerated filer o   Non-accelerated filer þ   Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
The aggregate market value of common stock held by non-affiliates of the registrant as of the last business day of the registrant’s most recently completed second fiscal quarter, June 30, 2009, was $24,432,000, calculated based on the closing price of the registrant’s common stock as reported by the NASDAQ Global Market. For purposes of this computation, all officers, directors, and 10% beneficial owners of the registrant are deemed to be affiliates. Such determination should not be deemed to be an admission that such officers, directors, or 10% beneficial owners are, in fact, affiliates of the registrant.
As of March 1, 2010, there were 9,160,445 shares of the registrant’s common stock outstanding.
Documents Incorporated by Reference
Portions of the registrant’s definitive proxy statement for the 2010 Annual Meeting of Stockholders are incorporated by reference into Part III of this report.
 
 

 

 


 

KONA GRILL, INC.
Annual Report on Form 10-K
For the Year Ended December 31, 2009
TABLE OF CONTENTS
         
PART I
 
       
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PART II
 
       
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PART III
 
       
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PART IV
 
       
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    F-1  
 
       
 Exhibit 4.10
 Exhibit 21
 Exhibit 23
 Exhibit 31.1
 Exhibit 31.2
 Exhibit 32.1
 Exhibit 32.2
Statements Regarding Forward-Looking Statements
The statements contained in this report on Form 10-K that are not purely historical are forward-looking statements within the meaning of applicable securities laws. Forward-looking statements include statements regarding our “expectations,” “anticipation,” “intentions,” “beliefs,” or “strategies” regarding the future. Forward-looking statements relating to our future economic performance, plans and objectives for future operations, and projections of sales and other financial items are based on our beliefs as well as assumptions made by and information currently available to us. Actual results could differ materially from those currently anticipated as a result of a number of factors, including those discussed in Item 1A, “Risk Factors.”

 

 


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PART I
Item 1.  
Business
Overview
Kona Grill, Inc. (referred to herein as the “Company” or “we,” “us,” and “our”) owns and operates 24 upscale casual dining restaurants in 15 states. Kona Grill restaurants offer fresh high quality food, personalized service, and an upscale contemporary ambiance that create an exceptional, yet affordable dining experience that we believe exceeds many traditional casual dining restaurants with whom we compete. Our high-volume upscale casual restaurants feature a diverse selection of flavorful American food, internationally influenced appetizers and entrees and an extensive selection of award-winning sushi. Our menu items also incorporate over 40 signature sauces and dressings that we make from scratch, creating broad based appeal for the lifestyle and taste trends of a diverse group of guests. Our freshly prepared menu offerings are complemented by a full service bar offering a broad assortment of wines, specialty drinks, and beers. Our menu is mostly standardized for all of our restaurants allowing us to deliver consistent, high quality meals.
Our restaurants accommodate a range of approximately 260 to 300 guests and are comprised of multiple dining areas that incorporate modern design elements to create an upscale ambiance that reinforces our high standards of food and service. Our main dining area, full-service bar, outdoor patio, and sushi bar provide a choice of atmospheres and a variety of environments designed to attract new guests and encourage repeat visits from regular guests. We locate our restaurants in high-activity areas such as retail centers, shopping malls, and lifestyle centers that are situated near commercial office space and residential housing to attract guests throughout the day. Our restaurants are designed to satisfy our guests’ dining preferences during lunch, dinner, and non-peak periods such as late afternoon and late night.
We believe that the portability of our concept has been successfully demonstrated in a variety of markets across the United States. Our primary growth objective is to gradually expand the Kona Grill concept in selected markets over the next several years. We intend to continue developing Kona Grill restaurants in high quality, densely populated areas in both new and existing markets. During 2009, we opened four restaurants in Richmond, Virginia; Woodbridge, New Jersey; Eden Prairie, Minnesota; and Tampa, Florida. We plan to open one new restaurant in Baltimore, Maryland during 2010.
We believe that our vast array of menu offerings and generous portions combined with an estimated average check per guest during 2009 of approximately $23.90 offers our guests an attractive price-value proposition. This value proposition, coupled with our multiple daypart model and exceptional service, has created an attractive business model. Furthermore, our restaurant model provides us with considerable growth opportunities to expand the Kona Grill concept. We believe our concept has the potential for over 100 restaurants nationwide.
Our executive offices are located at 7150 East Camelback Road, Suite 220, Scottsdale, Arizona 85251, and our telephone number is (480) 922-8100. Our website is located at www.konagrill.com. Through our website, we make available free of charge our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements, and any amendments to those reports filed or furnished to the Securities and Exchange Commission. These reports are available as soon as reasonably practicable after we electronically file these reports with the SEC. We also post on our website the charters of our Audit, Compensation, and Nominating Committees; Code of Business Conduct and Ethics and Code of Ethics for the CEO and Senior Financial Officers; and any other corporate governance materials contemplated by SEC or NASDAQ regulations. These documents are also available in print to any stockholder requesting a copy from our corporate secretary at our principal executive offices.
Our History
Our predecessor concept was a sushi restaurant that commenced operations during 1994. As our guests frequently requested additional selection and diversity in our menu offerings, we developed a successor restaurant concept offering sushi plus innovative menu selections with mainstream appeal that became Kona Grill. We opened the first Kona Grill restaurant in Scottsdale, Arizona during 1998. We sold the predecessor restaurant during 2002 to focus on growing the Kona Grill concept.

 

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Competitive Strengths
The restaurant business is intensely competitive with respect to food quality, price-value relationships, ambiance, service and location. We believe that the key strengths of our business include the following:
   
Innovative Menu Selections with Mainstream Appeal. We offer a menu of freshly prepared, high quality food that includes a diverse selection of mainstream American selections, a variety of appetizers and entrees with an international influence, and award-winning sushi to appeal to a wide range of tastes, preferences, and price points. We prepare our dishes from scratch using original recipes with generous portions and creative and appealing presentations that adhere to standards that we believe are much closer to fine dining than typical casual dining. Our more than 40 proprietary sauces and dressings create memorable flavor profiles and further differentiate our menu items. With an average check during 2009 of approximately $23.90 per guest ($16.35 per guest, excluding alcoholic beverages) we believe we provide an exceptional price-value proposition that helps create a lasting relationship between Kona Grill and our guests.
   
Distinctive Upscale Casual Dining Experience. Our upscale casual dining concept captures some of the best elements of fine dining including a variety of exceptional food, impeccable service, and an extensive wine and drink list, and combines them with more casual qualities, like a broad menu with attractive price points and a choice of environments to fit any dining occasion, enabling us to attract a broad guest demographic. Our innovative menu, personalized service, and contemporary restaurant design blend together to create our upscale casual dining experience. We design our restaurants with a unique layout and utilize modern, eye-catching design elements such as our signature saltwater aquarium stocked with bright and colorful exotic fish, plants, and coral. Our multiple dining areas provide our guests with a number of distinct dining environments and atmospheres to satisfy a range of occasions or dining preferences. Our open exhibition-style kitchen and sushi bar further emphasize the quality and freshness of our food that are the cornerstones of our unique upscale casual dining concept.
   
Significant Bar and Happy Hour Business. Our high-energy bar and patio offer a distinctive atmosphere where guests can enjoy one of our many alcoholic beverage offerings, while providing a place to be seen and see others. Our patio is a popular place for younger clientele and industry professionals to enjoy our high-value happy hour and reverse happy hour offerings. Our patio, including our enclosed patio in colder climate locations, provides a year-round sales opportunity and is a key driver in generating business during non-traditional periods as sales during these non-peak periods accounted for 24% of our total sales during 2009, which we believe provides us with a competitive advantage.
   
Personalized Guest Service. Our commitment to provide prompt, friendly, and efficient service enhances our food, reinforces our upscale ambiance, and helps distinguish us from other traditional casual dining restaurants. We train our service personnel to be cordial, friendly, and knowledgeable about all aspects of the restaurant, especially the menu, which helps us provide personalized guest service that is designed to ensure a pleasurable dining experience and exceed our guests’ expectations. Our kitchen staff completes extensive training to ensure that our dishes are precisely prepared to provide a consistent quality of taste. We believe our focus on high service standards underscores our guest-centric philosophy.
   
Multiple Daypart Model. Our appetizers, pizzas, entrees, and sushi offerings provide a flexible selection of items that can be ordered individually or shared by our guests, allowing guests to dine with us during traditional lunch and dinner meal periods as well as in between customary dining periods such as in the late afternoon and late night. The lively ambiance of our patio and bar areas provides an energetic social forum that attracts a young professional clientele during these non-peak periods, as well as provides a unique atmosphere for all of our guests to enjoy before or after they dine with us. Our sushi bar provides another dining venue for our guests while offering a wide selection of health conscious menu items. We believe that our ability to attract and satisfy guests throughout the day distinguishes us from many other casual dining chains and helps us maximize sales and leverage our fixed operating costs.
   
Attractive Unit Economics. During 2009, the average unit volume of our comparable base restaurants was $3.9 million, or $547 per square foot. We believe our high average unit volume helps us attract high-quality employees, leverage our fixed costs, and makes us a desirable tenant for landlords. We expect the average cash investment for our new restaurants to be approximately $2.5 million, net of landlord tenant improvement allowances and excluding preopening expenses. Restaurants that are subject to ground leases and do not receive landlord tenant improvement allowances may require a significantly higher cash investment, but typically have lower average rental costs over the duration of the lease.

 

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Growth Strategy
We believe that there are significant opportunities to grow our sales and increase our brand awareness throughout the United States. The following sets forth the key elements of our growth strategy.
Pursue Disciplined Restaurant Growth
We adhere to a disciplined site selection process and intend to continue opening Kona Grill restaurants in both new and existing markets that meet our demographic, real estate, and investment criteria. In 2010, we plan to open one restaurant in Baltimore, Maryland to expand our nationwide footprint and to continue to build awareness of our concept, while further establishing Kona Grill as a national upscale casual brand. Beyond 2011 we expect the rate of new unit expansion to moderately increase as the cost of capital becomes more affordable and quality new restaurant sites become available. Our expansion plans do not involve any franchised restaurant operations.
We believe the location of our restaurants plays a key role in our long-term success and, accordingly, we devote significant time and resources to analyzing each prospective site. We maintain a disciplined and controlled site selection process involving our management team and Board of Directors. Our site selection criteria for new restaurants include locating our restaurants near high activity areas such as retail centers, shopping malls, and lifestyle and entertainment centers. In addition, we focus on areas that have above-average density and income populations, have high customer traffic throughout the day from thriving businesses or retail markets, and are convenient for and appealing to business and leisure travelers.
Our growth strategy for developing new restaurants also includes expansion in existing markets. Operating multiple restaurants in existing markets enables us to leverage our brand equity as well as gain operating efficiencies associated with regional supervision, marketing, purchasing, and hiring. In addition, our ability to hire qualified employees is enhanced in markets where we are well-known and we are able to utilize existing associates in new restaurants.
Grow Existing Restaurant Sales
Our goal for existing restaurants is to improve unit volumes through ongoing local and social marketing efforts designed to generate awareness and trial of our concept and increase the frequency of guest visits. During 2009, restaurant sales for our comparable base restaurants, which include those units open for more than 18 months, declined 9.3% compared to 2008 reflecting lower overall guest traffic and reduction in the average guest check as a result of the challenging macroeconomic environment. We expect same-store sales to improve as the U.S. economy recovers from the current economic downturn.
We continue to implement initiatives designed to increase sales at our restaurants. During 2009, we rolled out our Perfect Pairings lunch offering to drive weekday lunch sales and support our price-value proposition. During 2010, we plan to introduce several marketing and branding initiatives, including the recent launch of our new Konavore loyalty and rewards program that enables us to track guest usage patterns and drive higher guest frequency through unique offerings to specific guests. We have also increased our presence in social marketing and interactive advertising. We also launched an ongoing guest satisfaction survey across the entire brand to provide valuable feedback our management team can respond to immediately. We believe we can generate additional sales through these programs at a reasonable expense per restaurant.

 

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Leverage Depth of Existing Corporate Infrastructure
We believe that successful execution of our growth strategies will enable Kona Grill to be a leading upscale casual dining restaurant operator in the United States. We continue to make strategic investments in our corporate infrastructure including the hiring of senior personnel with significant restaurant experience. We continue to implement information systems and tools to enhance our business while ensuring that strong financial controls are in place to minimize risks associated with our current growth strategy. As we continue to realize the benefits of our growth, we believe that we will be able to leverage our investments in corporate personnel and information systems and realize benefits from the increasing sales volume that our company generates.
Unit Economics
On average, we target a 35% net cash-on-cash return for our restaurants once they reach their mature level of operations. Maturation periods vary from restaurant to restaurant, but generally range from two to four years. We target our restaurants to achieve average annual unit volume of $4.5 million following 24 months of operations. During 2009, the average unit volume of our comparable base restaurants was approximately $3.9 million, or $547 per square foot. Recent trends are lower than our targeted volume due to the current recession. The cash-based performance target for our restaurant operations do not consider field supervision, corporate support expenses or non-cash items such as depreciation and amortization; and do not represent a targeted return on investment in our common stock.
Our investment costs for new restaurants vary significantly depending upon the type of lease entered into, the amount of tenant improvement allowance we receive from landlords, and whether we assume responsibility for the construction of the building. We expect the cash investment cost of our prototype restaurant to be approximately $2.5 million, net of landlord tenant improvement allowances between $0.7 million and $1.2 million, and excluding cash preopening expenses of approximately $0.4 million.
We believe our high average unit volume helps us attract high-quality employees, leverage our fixed costs, and makes us a desirable tenant for landlords. In addition, our ability to generate sales throughout the day is a key strength of our concept. The following table depicts the amount and percentage of contribution for each daypart of overall restaurant sales during 2009.
2009 Sales by Daypart
                 
    Sales     Percent  
    (Dollars in thousands)  
 
               
Lunch (Open to 3 p.m.)
  $ 17,885       22 %
Dinner (5 p.m. to 9 p.m.)
    44,055       54 %
Non-Peak (3 p.m. to 5 p.m. and 9 p.m. to Close)
    19,155       24 %
 
           
Total All Day
  $ 81,095       100 %
 
           
Menu
The Kona Grill menu offers guests a diverse selection of mainstream American dishes as well as a variety of appetizers and entrees with an international influence, including a broad selection of award-winning sushi. This broad menu is an important factor in our differentiation from the other upscale casual dining competitors. We are well-known for our selection of over 40 signature sauces and dressings. Our sauces and dressings distinguish and compliment our dishes, creating delicious flavor profiles and artistic presentations for our guests. All of our menu items are prepared from scratch using fresh high quality ingredients and adhere to food standards that we believe are much closer to fine dining than typical casual dining.
Our menu features a selection of appetizers, soups, salads, pizzas, sandwiches, noodle dishes, seafood, signature entrees, and desserts. We round out our menu with over 60 hand-made award-winning sushi choices. Our appetizers include socially interactive items that can be eaten individually or easily shared amongst guests such as our Chicken Satay, Avocado Egg Rolls and Sweet and Spicy Shrimp. Our signature entrees feature our various sauces and offer guests generous portions that are impressive in presentation and in taste. For example, our most popular entrée is the Macadamia Nut Chicken served with our special shoyu-cream sauce accompanied by wok-tossed vegetables and white cheddar mashed potatoes. Other favorites include our Miso-Sake Marinated Sea Bass served with shrimp and pork fried rice and our Pan-Seared Ahi Tuna served over steamed white rice with a sweet-chili sauce accompanied by sautéed spinach.

 

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We are also known for our broad assortment of sushi that includes traditional favorites as well as distinct specialty items such as our Tuna Carpaccio made with thinly sliced tuna sashimi topped with wasabi mayo and yuzu ponzu served with fresh arugula, or our Salmon Wasabi Sashimi topped with fresh wasabi root and red onions and served with cucumber salad and yuzu ponzu sauce. We have designed our sushi menu with a combination of both straight-forward and unintimidating selections such as our California Roll as well as more sophisticated items such as our Spider Roll made with soft shell crab, avocado, and cucumber wrapped in seaweed and soy paper and served with eel sauce. Our menu, coupled with our sushi selections, offers ample choices for health conscious guests, which the National Restaurant Association expects will continue to be a point of focus for consumers in the future.
Each of our restaurants has a dedicated kitchen staff member, whom we refer to as our saucier, to oversee the preparation of our more than 40 unique sauces and dressings that are made fresh from scratch using only high-quality ingredients and fresh products. Each sauce is designed according to a proprietary recipe for a specific menu item and includes unique flavors and combinations such as our honey cilantro, shoyu-cream, and spicy aioli dipping sauces, and our sesame-soy and honey dijon dressings. We believe that our distinctive sauces and dressings provide a unique flavor profile, which further distinguishes Kona Grill from its competitors. Our flavorful sauces and dressings also enhance our guests’ overall dining experience by allowing them to not only experience new tastes but to also share their favorite sauces with others, helping to create customer loyalty and a socially interactive dining experience.
The versatility of our menu enables us to provide guests with dishes that can be enjoyed outside of the traditional lunch and dinner meal periods as well as to serve guests for a variety of dining occasions, including everyday dining, business lunches, social gatherings and special occasions. Furthermore, each restaurant offers a separate children’s menu with selections appealing to our youngest guests.
Menu prices range from $4.00 to $9.50 for appetizers and soups, $6.50 to $12.50 for salads, $8.25 to $8.75 for our Perfect Pairings menu, $7.75 to $31.50 for sandwiches, pizza, seafood and entrees, and $4.00 to $32.00 for our sushi selections ranging from a single sushi item up to our assorted 18-piece Sashimi Platter. Based upon our innovative high-quality recipes, generous portions, and flexible price points we believe we provide our guests exceptional value that allows us to attract a diverse customer base and increase the frequency of dining visits to our upscale casual restaurants.
In general our menu is consistent from location to location. We have added a local favorites section designed to appeal to the local tastes of each of our restaurants’ guests. We review our menu regularly and consider enhancements to existing items or the introduction of new items based on customer feedback, which helps assure that we are meeting the needs of our guests.
Our restaurants also offer an extensive selection of domestic and imported bottled and draft beers, over 25 selections of wines by the glass or bottle, and a broad selection of liquors and specialty cocktail drinks. During our weekday happy hour (3 p.m. to 7 p.m.), reverse happy hour (9 p.m. to 11 p.m.), and Sunday happy hour we offer discounts on selected food and alcoholic beverage items. Happy hour times may vary by location due to local liquor laws. Alcoholic beverage sales represented approximately 32% of our total restaurant sales during 2009.
Decor and Atmosphere
We have created a uniform restaurant look and feel to adapt to varying real estate opportunities. The layout of our restaurants focuses on joined spaces that create multiple distinct dining areas for our guests while also maintaining an open atmosphere that allows our guests to have a panoramic view of the entire restaurant without negatively impacting the specific ambiance or dining occasion they desire.

 

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Our main dining room area offers a combination of booth seating and central tables of varying sizes. Our full service bar area and covered outdoor patio offer not only a high-energy, socially interactive area for our guests to enjoy appetizers or sushi while they wait to dine with us, but also serves as a destination for many of our frequent guests who visit us during the late afternoon and late night periods. Our bar area is strategically placed to ensure that families and other groups that may prefer a quieter, more intimate dining experience are not disturbed. Our sushi bar provides yet another dining alternative for singles, couples, and larger parties with more sophisticated, health conscious, or adventuresome tastes.
We showcase our signature saltwater aquarium stocked with bright and colorful exotic fish, plants, and coral in each of our restaurants. Our bars are made of granite and compliment our mahogany finishes to enhance our contemporary design. We use a variety of directional lighting to deliver a warm glow throughout our restaurants and we adjust our dining atmosphere throughout the day by adjusting the lighting, music, and the choice of television programming in our bar and patio areas. Our exhibition-style kitchens are brightly lit to display our kitchen staff at work. Our covered outdoor patio areas seat an average of 60 guests. We utilize heaters suspended from our roof structure to allow us to maximize the use of our patios throughout most of the year while avoiding obtrusive heating mechanisms that could detract from our upscale ambiance. We have enclosed the patio areas in certain of our colder climate locations allowing guests to utilize the patio area throughout the year.
The exterior of our restaurants typically employ cultured stone and slate to create a highly visible and attractive restaurant. We landscape our restaurants where appropriate and vary the exterior design to coordinate with the surrounding area. We use accent lighting on trees and directional lighting on our buildings to further increase the visual appeal of our restaurants.
Food Preparation, Quality Control, and Purchasing
We believe that we have some of the highest food quality standards in the industry. Our standards are designed to protect our food products throughout the preparation process. We provide detailed specifications to suppliers for our food ingredients, products, and supplies. We strive to maintain quality and consistency in our restaurants through careful hiring, training and supervision of personnel. Our restaurant general managers and executive chefs generally receive a minimum of nine weeks of training while our other restaurant managers and sous chef receive seven weeks of training. We have an annual recertification training for all employees and each employee receives an operations manual relating to food and beverage preparation and restaurant operations. We also instruct kitchen managers and staff on safety, sanitation, housekeeping, repair and maintenance, product and service specifications, ordering and receiving products, and quality assurance. All of our restaurant managers are compliant with Hazard Analysis and Critical Control Point, or HACCP. We monitor minimum cook temperature requirements and conduct twice-a-day kitchen and food quality inspections to further assure the safety and quality of all of the items we use in our restaurants.
We are committed to purchasing high-quality ingredients for our restaurants while managing costs. We use only the freshest ingredients and, as a result, we maintain only modest inventories. We also have a nonexclusive contract with U.S. Foodservice, a national food distributor, to be the primary supplier of our food. We have arrangements with local produce distributors and specialty food suppliers who provide high-quality ingredients and perishable food products. We believe that competitively priced alternative distribution sources are available should those channels be necessary. We source all of our products and supplies with reputable and high-quality providers that are capable of providing consistent, reliable distribution to all of our stores.
Our goal is to maximize our purchasing efficiencies and obtain the lowest possible prices for our ingredients, products, and supplies, while maintaining the highest quality. Our corporate purchasing manager coordinates our national supply contracts, negotiates prices for food supply throughout all of our restaurants, monitors quality control and consistency of the food supplied to our restaurants, and oversees delivery of food on a nationwide basis. In order to provide the freshest ingredients and products, and to maximize operating efficiencies between purchase and usage, we implemented an automated food cost and inventory system to assist each restaurant’s kitchen manager in determining daily order requirements for food ingredients, products, and supplies. The kitchen manager orders accordingly from approved suppliers, and all deliveries are inspected to assure that the items received meet our quality specifications and negotiated prices.

 

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Expansion Strategy and Site Selection
We believe the location of our restaurants is critical to our long-term success and, accordingly, we devote significant time and resources to analyzing each prospective site. Our restaurant expansion strategy focuses primarily on penetrating new markets in major metropolitan areas throughout the United States, as well as further penetrating existing markets. In general, we prefer to open our restaurants in high-profile sites within specific trade areas with the following considerations:
   
suitable demographic characteristics, including residential and commercial population density and above-average household incomes;
   
visibility;
   
high traffic patterns;
   
general accessibility;
   
availability of suitable parking;
   
proximity of shopping areas and office parks;
   
degree of competition and the revenue level of those competitors within the trade area; and
   
general availability of restaurant-level employees.
These sites generally include high-volume retail centers, regional malls, and lifestyle and entertainment centers.
We thoroughly analyze each prospective site before presenting the site to our Real Estate Committee, currently comprised of members of the Board of Directors, for review. Prior to committing to a restaurant site and signing a lease, at least three members of our senior management team and our Board of Directors visit the prospective site and evaluate the proposed economics of the restaurant based on demographic data and other relevant criteria to assure that the site will meet our return on investment criteria. In addition, we completed a comprehensive custom guest profile study in December 2009 which is a precursor to a real estate site model program to ensure even greater scrutiny when selecting new locations.
We lease all of our restaurant sites under lease terms that vary by restaurant; however, we generally lease space (freestanding or in-line) for 10 to 20 years and negotiate at least two five-year renewal options. Our rent structures vary from lease to lease, but generally provide for the payment of both minimum base rent and contingent rent based on restaurant sales. We are also generally responsible for our proportionate share of common area maintenance, property tax, insurance, and other occupancy-related expenses.
We believe the high sales volumes of our restaurants make us an attractive tenant and provide us with ample opportunities to obtain suitable leasing terms from landlords. As a result of the locations we select, which are often in new retail center or shopping mall developments, our restaurant development timeframes vary according to the landlord’s construction schedule and other factors that are beyond our control. Once the site has been turned over to us, the typical lead-time from commencement of construction to opening is approximately six months.

 

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Restaurant Operations
Executive and Restaurant Management
Our executive management team continually monitors restaurant operations to assure the quality of products and services and the maintenance of facilities. Restaurant management and our Scottsdale Support Center institute procedures to enhance efficiency, reduce costs and provide centralized support systems. Our Senior Vice President of Operations and District Managers have primary responsibility for managing our restaurants and participate in analyzing restaurant-level performance and strategic planning. We employ four district managers who report directly to our Senior Vice President of Operations and who are each responsible for overseeing the restaurants in a specific region. The district managers’ responsibilities include supporting the general managers and helping each general manager achieve the sales and cash flow targets for their restaurant as well as providing insight for decision making in such areas as food and beverage, people development, and systems to enhance the efficiency of our operations. As we expand our operations, we expect to hire additional district managers who will each oversee six to eight restaurants. In addition, our support center team includes an executive chef and sushi chef who help educate, coach, and develop kitchen personnel, implement systems to improve the efficiency of our kitchen operations, and develop new menu offerings.
Our typical restaurant management team consists of a general manager, assistant general manager, two front-of-the-house managers, executive chef, sous chef, and sushi chef. Our restaurants employ on average approximately 75 non-management employees, many of whom work part-time. The general manager is responsible for the day-to-day operations of the restaurant, including the hiring, training, development of personnel, execution of local marketing programs, and operating results. The chefs are responsible for overseeing the preparation of our menu and sushi items, maintaining product quality, and closely monitoring food costs and department labor costs. We also employ a kitchen staff member who is dedicated to the preparation of our signature sauces and dressings.
Training
In order to maintain quality and consistency in each of our restaurants, we carefully train and supervise restaurant personnel and adhere to high standards related to personnel performance, food and beverage preparation, and maintenance of our restaurants. All of our restaurant personnel participate in both initial and ongoing training programs. Each restaurant general manager, assistant general manager, front-of-the-house manager, and kitchen and sushi chef completes a formal training program that is comprised of a mix of classroom and on-the-job instruction. Typical programs for general managers and executive chefs provide at least nine weeks of training that may include a rotation to different restaurants throughout the country. Typical programs for other managers provide seven weeks of training and may involve work in our other restaurants and cross training of various duties. The training covers all aspects of management philosophy and overall restaurant operations, including supervisory skills, operating and performance standards, accounting procedures, and employee selection and training necessary for top-quality restaurant operations. The training programs also involve intensive understanding and testing of our menu, the ingredients of our various menu items, and other key service protocols. In addition, our hourly staff go through a series of in-depth interactive training for their positions.
We implement these programs by hiring dedicated corporate personnel as well as designate high-performing existing restaurant personnel to assist in training. Our training personnel are involved in training for both new employees hired in anticipation of new restaurant openings as well as for ongoing training in existing restaurants. When we open a new restaurant, we provide training to restaurant personnel in every position for several weeks prior to opening to assure the smooth and efficient operation of the restaurant from the first day it opens to the public. Prior to opening a new restaurant, certain of our newly-hired restaurant personnel are staffed in existing restaurants to learn the operational aspects of a Kona Grill and to obtain on the job instruction.
Recruitment and Retention
Our future growth and success is highly dependent upon our ability to attract, develop, and retain qualified individuals who are capable of successfully managing our high-volume, upscale casual restaurants. We believe that our unit volume, the image and atmosphere of the Kona Grill concept, and our career advancement and employee benefit programs enable us to attract high quality management and restaurant personnel. We offer our restaurant management personnel competitive wages and benefits, including medical insurance and participation in our 401(k) plan with a company match. We motivate and prepare our restaurant personnel by providing them with opportunities for increased responsibility and advancement. Furthermore, the management team of each restaurant share in a bonus tied to the sales and overall profitability of their restaurant. We believe that our compensation package for managers and restaurant employees is comparable to those provided by other upscale casual restaurants. We believe our compensation policies help us attract quality personnel.

 

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Information Systems
We believe that our management information systems enable us to increase the speed and accuracy of order-taking and pricing, efficiently schedule labor to better serve guests, monitor labor costs, assist in product purchasing and menu mix management, promptly access financial and operating data, and improve the accuracy and efficiency of store-level information and reporting.
We utilize an integrated information system to manage the flow of information within each of our restaurants and between each restaurant and the corporate office. This system includes an Aloha point-of-sales (POS) local area network that helps facilitate the operations of the restaurant by recording sales transactions and printing orders in the appropriate locations within the restaurant. Additionally, we utilize the POS system to authorize, batch, and transmit credit card transactions, record employee time clock information, and produce a variety of management reports. Our point of sale system is integrated with food cost and labor scheduling software as well as our financial reporting system and incorporates a redundancy and back-up emergency operating plan on a temporary basis if the system experiences downtime.
We transmit electronically to the support center on a daily basis select information that is captured from the POS system. This information system enables senior management to monitor operating results with daily and weekly sales analysis, detailed labor and food cost information, and comparisons between actual and budgeted operating results. We anticipate continually updating both our restaurant information systems and our corporate office information systems to enhance our operations. We believe our information systems are secure and scalable as we continue to build our organization.
Advertising and Marketing
Our ongoing advertising and marketing strategy consists of loyalty and reward programs, social marketing, interactive advertising, selected outdoor and print mediums, various public relations activities, direct mail, and word-of-mouth recommendations. We believe that these mediums are a key component in driving guest trial and usage. During 2009, our marketing and advertising expenditures were $1.1 million, or 1.3% of restaurant sales. We expect to continue to invest in marketing, branding and advertising efforts, primarily in connection with driving comparable restaurant sales and supporting new restaurant openings.
We implement a coordinated public relations effort in conjunction with each new restaurant opening. Approximately 60 days before a scheduled restaurant opening, we collaborate with the local media to publicize our restaurant and generate awareness of our brand. This effort is usually supplemented by targeted direct mail campaigns, social marketing, and other marketing efforts, including hosting a high profile event for a local charity as part of our preopening practice activities that also serves to introduce our concept to the local market. In addition, we use our website, www.konagrill.com, to help increase our brand awareness as well as gift card sales.
Competition
The restaurant industry is highly competitive. Key competitive factors in the industry include the taste, quality, and price of the food products offered, quality and speed of guest service, brand name identification, attractiveness of facilities, restaurant location, and overall dining experience.
We believe we compete favorably with respect to each of these factors, as follows:
   
We offer a diverse selection of fresh high quality mainstream American dishes as well as a variety of appetizers and entrees with an international influence, including an extensive selection of sushi items;
   
We appeal to multiple demographic and psychographic profiles;
   
We strive to maintain quality and consistency in each of our restaurants through the careful training and supervision of restaurant personnel and adherence to high standards related to personnel performance, food and beverage preparation, and maintenance of our restaurants;
   
Our innovative menu with attractive price points, personalized service, and contemporary restaurant design with multiple environments blend together to create our upscale casual dining experience and enables us to attract a broad guest demographic.

 

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Although we believe we compete favorably with respect to each of these factors, there are a substantial number of restaurant operations that compete directly and indirectly with us, many of which have significantly greater financial resources, higher revenue, and greater economies of scale. The restaurant business is often affected by changes in consumer tastes and discretionary spending patterns; national and regional economic and public safety conditions; demographic trends; weather conditions; the cost and availability of raw materials, labor, and energy; purchasing power; governmental regulations; and local competitive factors. Any change in these or other related factors could adversely affect our restaurant operations. Accordingly, we must constantly evolve and refine the critical elements of our restaurant concept over time to protect their longer-term competitiveness. Additionally, there is competition for highly qualified restaurant management employees and for attractive locations suitable for upscale, high volume restaurants.
Trademarks
We have registered the service mark “Kona Grill” and the description “East Meets West. They Party” with the United States Patent and Trademark Office. We believe that our trademarks and other proprietary rights, such as our unique menu offerings and proprietary sauce recipes, have significant value and are important to the marketing of our restaurant concept. We have in the past and expect to continue to protect vigorously our proprietary rights. We cannot predict, however, whether steps taken by us to protect our proprietary rights will be adequate to prevent misappropriation of these rights or the use by others of restaurant features based upon, or otherwise similar to, our concept. It may be difficult for us to prevent others from copying elements of our concept and any litigation to enforce our rights will likely be costly. In addition, other local restaurant companies with names similar to ours may try to prevent us from using our marks in those locales.
Government Regulation
Each of our restaurants is subject to licensing and regulation by state and local departments and bureaus of alcohol control, health, sanitation, zoning, and fire and to periodic review by state and municipal authorities for areas in which the restaurants are located. In addition, we are subject to local land use, zoning, building, planning, and traffic ordinances and regulations in the selection and acquisition of suitable sites for developing new restaurants. Delays in obtaining, or denials of, or revocation or temporary suspension of, necessary licenses or approvals could have a material adverse impact on our development of restaurants.
Alcoholic beverage control regulations require each of our restaurants to apply to a state authority and, in certain locations, county and municipal authorities for a license and permit to sell alcoholic beverages on the premises. Typically, licenses must be renewed annually and may be subject to penalties, temporary suspension or revocation for cause at any time. Alcoholic beverage control regulations impact many aspects of the daily operations of our restaurants, including the minimum age of patrons and employees, hours of operation, inventory control and handling, and storage and dispensing of alcoholic beverages. We have not encountered any material problems relating to alcoholic beverage licenses or permits to date. The failure of a restaurant to obtain or retain its liquor license would adversely affect that restaurant’s operations and profitability.
We are subject to dram shop statutes in most of the states in which we operate. Those statutes generally provide a person who has been injured by an intoxicated person the right to recover damages from an establishment that wrongfully served alcoholic beverages to such person. We carry liquor liability coverage as part of our existing comprehensive general liability insurance which we believe is consistent with coverage carried by other companies in the restaurant industry of similar size and scope of operations. Even though we carry liquor liability insurance, a judgment against us under a dram shop statute in excess of our liability coverage could have a material adverse effect on our operations.
Our operations are also subject to federal and state laws governing such matters as wages, working conditions, citizenship requirements, and overtime. Some states have set minimum wage requirements higher than the current federal level. A significant number of hourly personnel at our restaurants are paid at rates related to state and federal minimum wage laws and, accordingly, state minimum wage increases effective during 2010 and the federal minimum wage increase in July 2009 have increased our labor costs. Increases in the minimum wage rate or the cost of workers’ compensation insurance, changes in tip-credit provisions, employee benefit costs (including costs associated with mandated health insurance coverage), or other costs associated with employees could adversely affect our operating results. To our knowledge, we are in compliance in all material respects with all applicable federal, state, and local laws affecting our business.

 

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Employees
As of February 12, 2010, we employed approximately 1,908 people of whom approximately 1,876 worked in our restaurants and 32 were corporate management and staff personnel. None of our employees are covered by a collective bargaining agreement with us. We have never experienced a major work stoppage, strike, or labor dispute. We consider our relations with our employees to be favorable.
Executive Officers
The following table sets forth certain information regarding our executive officers:
             
Name   Age   Position
 
           
Marc A. Buehler
    40     President, Chief Executive Officer and Director
Mark S. Robinow
    53     Executive Vice President, Chief Financial Officer and Secretary
Larry J. Ryback
    41     Senior Vice President of Operations
Marc A. Buehler joined our company as Chief Executive Officer and President in November 2009 and was also appointed as a member of our Board of Directors. Prior to joining our company, Mr. Buehler was the Chief Executive Officer of LS Management, Inc., the owner and operator of the Lone Star Steakhouse & Saloon/Texas Land and Cattle Steak House restaurant concepts, as well as Lone Star Business solutions, where he served from July 2007 to May 2009. From July 2002 to July 2007, Mr. Buehler worked at Romacorp, which operates and franchises more than 200 Tony Roma’s casual dining locations, as the Vice President of Marketing and was promoted to Chief Executive Officer, President, and Director of Romacorp during July 2006. Prior to that, Mr. Buehler served as Vice President of Marketing at Eateries, Inc. from March 1999 to July 2002 and Marketing Manager at Applebee’s International, Inc. from February 1996 to March 1999. Mr. Buehler also serves as a Board Member of Share Our Strength and is a co-chairperson of the National Restaurant Association’s Marketing Executives Group. In addition he is a member of the Young Presidents’ Organization.
Mark S. Robinow has served as our Executive Vice President, Chief Financial Officer, and Secretary since October 2004. Prior to joining our company, Mr. Robinow served as the Chief Financial Officer of Integrated Decisions and Systems, Inc. (IDeaS) from July 2000 until October 2004. Mr. Robinow served as the Senior Vice President and Chief Financial Officer of Rainforest Cafe, Inc. from November 1995 until January 2000. Mr. Robinow served as the Chief Financial Officer of Edina Realty, Inc. from 1993 until 1995, and as Chief Financial Officer, Secretary, and Treasurer of Ringer Corporation from 1986 until 1993. Mr. Robinow also served as a senior auditor with Deloitte & Touche from 1980 until 1983. Mr. Robinow is a Certified Public Accountant (inactive license holder).
Larry J. Ryback was appointed as Senior Vice President of Operations in February 2010. Mr. Ryback oversees the day-to-day restaurant operations for our brand, culinary operations, training and recruiting. Mr. Ryback brings more than 20 years of restaurant operations experience to our company. Prior to joining our company, Mr. Ryback served as the President and Chief Operating Officer of Redstone American Grill, Inc., a $35 million privately held company with five high-volume, upscale restaurants in four states. Before joining Redstone during 2005, Mr. Ryback spent 10 years with Champps Entertainment in various operations roles including three years as a Regional Vice President of Operations overseeing 26 restaurants that together generated over $130 million in revenue.

 

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Item 1A.  
Risk Factors
Risks Related to Our Business
We have a history of losses and we may never achieve profitability.
We incurred net losses during each of the last five years. We forecast that we will incur net losses for at least the next year, and possibly longer. We expect that our expenses during the next year will increase as we build and open at least one new restaurant. We may find that these efforts are more expensive than we currently anticipate or that our expansion efforts do not result in proportionate increases in our sales, which would further increase our losses. We cannot predict whether we will be able to achieve profitability in the future.
We may require additional capital in the future as a result of changes in our restaurant operations or growth plans, and our inability to raise such capital could harm our operations and restrict our growth.
Changes in our restaurant operations, acceleration of our restaurant expansion plans, lower than anticipated restaurant sales, increased food or labor costs, increased property expenses, or other events, including those described in this report, may cause us to seek additional debt or equity financing on an accelerated basis. Financing may not be available to us on acceptable terms, or at all, and our failure to raise capital when needed could negatively impact our restaurant growth plans as well as our financial condition and results of operations. Additional equity financing, if available, will be dilutive to the holders of our common stock. Debt financing may involve significant cash payment obligations, covenants, and financial ratios that may restrict our ability to operate and grow our business, and would cause us to incur additional interest expense and financing costs.
Unexpected expenses and low market acceptance of our restaurant concept could adversely affect the profitability of restaurants that we open in new markets.
As part of our expansion strategy, we have opened and plan to open restaurants in markets in which we have no prior operating experience and in which our brand may not be well-known. These new markets may have different competitive conditions, consumer tastes, and discretionary spending patterns than restaurants in our existing markets. As a result, we may incur costs related to the opening, operation, and promotion of these new restaurants that are greater than those incurred in markets with longer operating history. As a result of these factors, sales at restaurants opening in new markets may take longer to achieve average unit volumes comparable with our existing restaurants, if at all, which would adversely affect the profitability of those new restaurants.
We are dependent upon high levels of consumer traffic at the sites where our restaurants are located and any adverse change in consumer activity could negatively affect our restaurant sales and may require us to record an impairment charge for restaurants performing below expectations.
Our restaurants are primarily located in high-activity areas such as retail centers, shopping malls, and lifestyle centers. We depend on high consumer traffic rates at these centers to attract guests to our restaurants. In general, such visit frequencies are significantly affected by many factors, including national, regional, or local economic conditions, anchor tenants closing in retail centers or shopping malls in which we operate, changes in consumer preferences or shopping patterns, higher frequency of online shopping, changes in discretionary consumer spending, increasing gasoline prices, or otherwise. If visitor rates to these centers decline, our unit volumes could decline and adversely affect our results of operations, including recording an impairment charge for restaurants that are performing below expectations. During 2009, we recorded $16.9 million in asset impairment charges for six underperforming restaurants. We may be required to record impairment charges in the future if certain restaurants perform below expectations.

 

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We have a limited operating history and a limited number of restaurants upon which to evaluate our company, and you should not rely on our history as an indication of our future results.
We currently operate 24 restaurants, more than half of which have operated for less than four years. Consequently, the results we have achieved to date with a relatively small number of restaurants may not be indicative of those restaurants’ long-term performance or the potential performance of new restaurants. A number of factors historically have affected and are likely to continue to affect our average unit volumes and comparable restaurant sales, including the following:
   
our ability to execute effectively our business strategy;
 
   
our ability to successfully select and secure sites for our Kona Grill concept;
 
   
the operating performance of new and existing restaurants;
 
   
competition in our markets;
 
   
consumer trends; and
 
   
changes in political or economic conditions.
Our average unit volume and same-store sales have declined in recent years. Average unit volumes for two of our restaurants opened within the last four years were significantly below the average unit volume of our comparable restaurant base. In addition, we closed our restaurant in Naples, Florida in September 2008 due to low sales volume. Changes in our average unit volumes and comparable restaurant sales could cause the price of our common stock to fluctuate substantially.
Disruptions in the capital and credit markets may adversely affect our business, including the availability and cost of funding, which could adversely affect our results of operations, cash flows, and financial condition.
Our growth strategy depends upon the capital markets to expand our operations. Recent disruptions in the capital and credit markets could adversely affect our ability to borrow money from banks or other potential lenders. Our access to funds under any potential credit facility will depend on the ability of the banks or other lenders to commit to lend funds to us. In the event we enter into a credit facility with banks or other lenders, those parties may not be able to meet their funding commitments to us if they experience shortages of capital or if they experience excessive volumes of borrowing requests from us and other borrowers within a short period of time.
Longer term disruptions in the capital and credit markets as a result of uncertainty, changing or increased regulation, or failures of significant financial institutions could adversely affect our access to capital. Any long-term disruption could require us to take measures to conserve cash until the markets stabilize or until alternative credit arrangements or other funding for our business can be arranged. Such measures could result in deferring capital expenditures or altering our growth strategy to reduce the opening of new restaurants.
Our future operating results may fluctuate significantly due to our limited number of existing restaurants and the expenses required to open new restaurants.
We currently operate 24 restaurants, four of which opened during 2009, and we expect to open one restaurant during 2010. The capital resources required to develop each new restaurant are significant. We estimate that the cost of opening a new Kona Grill restaurant currently ranges from $3.2 million to $3.7 million, exclusive of landlord tenant improvement allowances and preopening expenses and assuming that we do not purchase the underlying real estate. Actual costs may vary significantly depending upon a variety of factors, including the site and size of the restaurant and conditions in the local real estate and employment markets. The combination of our relatively small number of existing restaurants, the significant investment associated with each new restaurant, and the average unit volumes of our new restaurants may cause our results of operations to fluctuate significantly, and poor operating results at any one restaurant or a delay or cancellation in the planned opening of a restaurant could materially affect our company, making the investment risks related to any one location much larger than those associated with most other restaurant chains.

 

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Our future expansion in existing markets may cause sales in some of our existing restaurants to decline.
Our future growth strategy may include opening new restaurants in our existing markets. We may be unable to attract enough guests to our new restaurants for them to operate profitably. In addition, guests to our new restaurants may be former guests of one of our existing restaurants in that market, which may reduce guest visits and sales at those existing restaurants, adversely affecting our results of operations.
Our ability to open new restaurants may be adversely affected by delays or problems associated with securing suitable restaurant locations and leases and by other factors, some of which are beyond our control and the timing of which is difficult to forecast accurately.
Due in part to the unique nature of each proposed restaurant location, we cannot predict the timing or ultimate success of our site selection process. Our ability to open new restaurants depends upon a number of factors, many of which are beyond our control, including the following:
   
the availability and cost of suitable restaurant locations for development and our ability to compete successfully for those locations;
   
the availability of adequate financing;
   
cash flow generated by our existing restaurants;
   
the timing of delivery of leased premises from our landlords so we can commence our build-out construction activities;
   
construction and development costs;
   
labor shortages or disputes experienced by our landlords or outside contractors;
   
unforeseen engineering or environmental problems with the leased premises;
   
our ability to secure governmental approvals and permits, including liquor licenses, construction permits, and occupancy permits;
   
weather conditions or natural disasters; and
   
general economic conditions.
Our growth may strain our infrastructure and resources, which could slow our development of new restaurants and adversely affect our ability to manage our existing restaurants.
Over the last two years, we have opened seven restaurants or 29% of our total restaurant base. This expansion and any future growth has increased demands on our management team, restaurant management systems and resources, financial controls, and information systems. These increased demands may adversely affect our ability to manage our existing restaurants. If we fail to continue to improve our infrastructure or to manage other factors necessary for us to meet our expansion objectives, our operating results could be adversely affected.
Our restaurants are subject to natural disasters and other events which are beyond our control and for which we may not be able to obtain insurance at reasonable rates.
We endeavor to insure our restaurants against wind, flood, and other disasters, but we may not be able to obtain insurance for these types of events for all of our restaurants at reasonable rates. A devastating natural disaster or other event in the vicinity of one of our restaurants could result in substantial losses and have a material adverse affect on our results of operations.

 

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If our distributors or suppliers do not provide food and beverages to us in a timely fashion, we may experience short-term supply shortages and increased food and beverage costs.
We currently depend on U.S. Foodservice, a national food distribution service company, and other regional distributors to provide food and beverage products to all of our restaurants. If U.S. Foodservice or other distributors or suppliers cease doing business with us, we could experience short-term supply shortages in some or all of our restaurants and could be required to purchase food and beverage products at higher prices until we are able to secure an alternative supply source. In addition, any delay in replacing our suppliers or distributors on acceptable terms could, in extreme cases, require us to remove temporarily items from the menus of one or more of our restaurants, which also could adversely affect our business.
Our failure to protect our trademarks, service marks, or trade secrets could negatively affect our competitive position and the value of the Kona Grill brand.
Our business prospects depend in part on our ability to develop favorable consumer recognition of the Kona Grill name. Although Kona Grill is a federally registered trademark, our trademarks and service marks could be imitated in ways that we cannot prevent. Alternatively, third parties may attempt to cause us to change our name or not operate in a certain geographic region if our name is confusingly similar to their name. In addition, we rely on trade secrets, proprietary know-how, concepts, and recipes. Our methods of protecting this information may not be adequate. Moreover, we may face claims of misappropriation or infringement of third parties’ rights that could interfere with our use of this information. Defending these claims may be costly and, if unsuccessful, may prevent us from continuing to use this proprietary information in the future, and may result in a judgment or monetary damages. We do not maintain confidentiality and non-competition agreements with all of our executives, key personnel, or suppliers. If competitors independently develop or otherwise obtain access to our trade secrets, proprietary know-how, or recipes, the appeal of our restaurants could be reduced and our business could be harmed.
Risks Related to the Restaurant Industry
Negative publicity surrounding our restaurants or the consumption of beef, seafood, poultry, or produce generally, or shifts in consumer tastes, could negatively impact the popularity of our restaurants, our sales, and our results of operations.
The popularity of our restaurants in general, and our menu offerings in particular, are key factors to the success of our operations. Negative publicity resulting from poor food quality, illness, injury, or other health concerns, whether related to one of our restaurants or to the beef, seafood, poultry, or produce industries in general (such as negative publicity concerning salmonella, e-coli, Hepatitis A, mercury poisoning and other food-borne illnesses), or operating problems related to one or more of our restaurants, could make our brand and menu offerings less appealing to consumers. In addition, other shifts in consumer preferences away from the kinds of food we offer, whether because of dietary or other health concerns or otherwise, would make our restaurants less appealing and adversely affect our sales and results of operations. If our restaurants are unable to compete successfully with other restaurants in new and existing markets, our results of operations will be harmed and we will not achieve profitability.
Increases in the prices of, or reductions in the availability of, seafood, poultry, beef, or produce could reduce our operating margins and adversely affect our operating results.
Our profitability depends, in part, on our ability to anticipate and react to changes in seafood, poultry, beef, or produce costs. The supply and price of these items is more volatile than other types of food. The type, variety, quality, and price of seafood, poultry, beef, and produce is subject to factors beyond our control, including adverse weather conditions, transportation costs, governmental regulation, availability, and seasonality, each of which may affect our food costs or cause a disruption in our supply. We currently do not purchase seafood, poultry, beef, or produce pursuant to long-term contracts or use financial management strategies to reduce our exposure to price fluctuations. Changes in the price or availability of certain types of seafood, poultry, beef, or produce could affect our ability to offer a broad menu and price offering to our guests and could reduce our operating margins and adversely affect our results of operations.

 

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Regulations affecting the operation of our restaurants could increase operating costs, restrict our growth, or require us to suspend operations.
Each of our restaurants must obtain licenses from regulatory authorities allowing it to sell liquor, beer, and wine, and each restaurant must obtain a food service license from local health authorities. Each restaurant’s liquor license must be renewed annually and may be revoked or suspended at any time for cause, including violation by us or our employees of any laws and regulations relating to the minimum drinking age, over serving, advertising, wholesale purchasing, and inventory control. Each restaurant is also subject to local health inspections. Failure to pass one or multiple inspections may result in temporary or permanent suspension of operations and could significantly impact our reputation. In certain states, including states where we have existing restaurants or where we plan to open restaurants in the near term, the number of liquor licenses available is limited and licenses are traded at market prices. Liquor, beer, and wine sales comprise a significant portion of our sales, representing approximately 32% of our sales during 2009. Therefore, if we are unable to maintain our existing licenses, or if we choose to open a restaurant in those states, the cost of a new license could be significant. Obtaining and maintaining licenses is an important component of each of our restaurant’s operations, and the failure to obtain or maintain food and liquor licenses and other required licenses, permits, and approvals would adversely impact our restaurants and our growth strategy.
In addition, the Federal Americans with Disabilities Act prohibits discrimination on the basis of disability in public accommodations and employment. Although our restaurants are designed to be accessible to the disabled, we could be required to reconfigure our restaurants to provide service to, or make reasonable accommodations for, disabled persons. Non-compliance with this law and related laws enacted at the state or local level could result in the imposition of fines or an award of damages in litigation.
Litigation concerning our food quality, our employment practices, liquor liability, and other issues could result in significant expenses to us and could divert resources from our operations.
Like other restaurants, we may receive complaints or litigation from, and potential liability to, our guests involving food-borne illness or injury or other operational issues. We may also be subject to complaints or allegations from, and potential liability to, our former, existing, or prospective employees involving our restaurant employment practices and procedures. In addition, we are subject to state “dram shop” laws and regulations, which generally provide that a person injured by an intoxicated person may seek to recover damages from an establishment that wrongfully served alcoholic beverages to such person. Recent litigation against restaurant chains has resulted in significant judgments, including punitive damages, under “dram shop” statutes. While we carry liquor liability coverage as part of our existing comprehensive general liability insurance, we may still be subject to a judgment in excess of our insurance coverage and we may not be able to obtain or continue to maintain such insurance coverage at reasonable costs, if at all. Regardless of whether any claims against us are valid or whether we are liable, our sales may be adversely affected by publicity resulting from such claims. Such claims may also be expensive to defend and may divert time and money away from our operations and adversely affect our business.
Labor shortages or increases in labor costs could slow our growth or adversely affect our business.
Our success depends in part on our ability to attract, motivate, and retain a sufficient number of qualified employees, including restaurant general managers and kitchen managers, necessary to continue our operations and keep pace with our growth. This ability is especially critical to our company because of our relatively small number of existing restaurants and our current development plans. If we are unable to recruit and retain a sufficient number of qualified employees, our business and growth strategy could be adversely affected.
Competition for qualified restaurant employees in our current or prospective markets could require us to pay higher wages and benefits, which could result in higher labor costs. In addition, we have a substantial number of hourly employees who are paid rates based upon the federal or state minimum wage and who rely on tips for a significant portion of their income. Government-mandated increases in minimum wages, overtime pay, health benefits, or increased tax reporting and tax payment requirements for employees who receive gratuities, or a reduction in the number of states that allow tips to be credited toward minimum wage requirements, could increase our labor costs. We may be unable to increase our prices proportionately in order to pass these increased costs on to our guests, in which case our operating margins would be adversely affected.

 

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Risks Related to Ownership of Our Common Stock
The market price for our common stock may be volatile.
Many factors could cause the market price of our common stock to rise and fall, including but not limited to the following:
   
actual or anticipated variations in comparable restaurant sales or operating results; whether in our operations or those of our competitors;
   
changes in the consumer spending environment or general economic conditions;
   
changes in the market valuations of other companies in the restaurant industry;
   
recruitment or departure of key restaurant operations or management personnel;
   
changes in the estimates of our operating performance or changes in recommendations by any research analysts that follow our stock; and
   
announcements of investigations or regulatory scrutiny of our restaurant operations or lawsuits filed against us.
Due to the volatility of our stock price, we also may become the target of securities litigation. Securities litigation could result in substantial costs and divert our management’s attention and resources from our business as well as depress the price of our common stock.
Our current principal stockholders own a large percentage of our voting stock, which allows them to control substantially all matters requiring stockholder approval.
Six entities or persons together own approximately 59% of our outstanding common stock, including two of our directors. As a result, these investors may have significant influence over a decision to enter into any corporate transaction and may have the ability to prevent any transaction that requires the approval of stockholders, regardless of whether or not our other stockholders believe that such transaction is in their own best interests. Such concentration of voting power could have the effect of delaying, deterring, or preventing a change of control or other business combination, which could in turn have an adverse effect on the market price of our common stock or prevent our stockholders from realizing a premium over the then-prevailing market price for their shares of common stock.
The large number of shares eligible for public sale and registered for resale could depress the market price of our common stock.
The market price for our common stock could decline as a result of sales of a large number of shares of our common stock in the market, and the perception that these sales could occur may depress the market price. As of December 31, 2009, we had outstanding 9,146,695 shares of common stock, all of which shares are either freely tradable or otherwise eligible for sale under Rule 144 under the Securities Act of 1933. In addition, we have 1,875,000 shares reserved for issuance under our stock award and employee stock purchase plans, of which approximately 300,000 shares have been issued. We have filed registration statements under the securities laws to register the common stock to be issued under these plans. As a result, shares issued under these plans will be freely tradable without restriction unless acquired by affiliates of our company, who will be subject to the volume and other limitations of Rule 144.

 

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We have also filed a registration statement covering the resale of 950,000 shares held by investors in our private placement transaction during November 2007 and one other stockholder. We have agreed to keep this registration effective for a period of time following the private transaction. As a result, the existence of the registration statement may have a depressive effect on the market price of our common stock.
Provisions in our certificate of incorporation, our bylaws, and Delaware law could make it more difficult for a third party to acquire us, discourage a takeover, and adversely affect existing stockholders.
Our certificate of incorporation, our bylaws, and the Delaware General Corporation Law contain provisions that may have the effect of making more difficult, delaying, or deterring attempts by others to obtain control of our company, even when these attempts may be in the best interests of stockholders. These include provisions on our maintaining a classified Board of Directors and limiting the stockholders’ powers to remove directors or take action by written consent instead of at a stockholders’ meeting. Our certificate of incorporation also authorizes our Board of Directors, without stockholder approval, to issue one or more series of preferred stock, which could have voting and conversion rights that adversely affect or dilute the voting power of the holders of common stock. Delaware law also imposes conditions on the voting of “control shares” and on certain business combination transactions with “interested stockholders.”
These provisions and others that could be adopted in the future could deter unsolicited takeovers or delay or prevent changes in our control or management, including transactions in which stockholders might otherwise receive a premium for their shares over then current market prices. These provisions may also limit the ability of stockholders to approve transactions that they may deem to be in their best interests.
Failure to maintain effective internal controls in accordance with Section 404 of the Sarbanes-Oxley Act could have a material adverse effect on our ability to produce accurate financial statements and on our stock price.
Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we have furnished a report by our management on internal control over financial reporting as of December 31, 2009. To achieve compliance with Section 404, we engaged in a process to document and evaluate our internal control over financial reporting which was both challenging and time-consuming.
Subject to proposed changes by the SEC, our independent auditors will be required to issue a report on the effectiveness of our internal control over financial reporting for the year ended December 31, 2010. Despite our efforts, we can provide no assurance as to our, or our independent auditors’, conclusions with respect to the effectiveness of our internal control over financial reporting under Section 404 in the future. There is a risk that neither we nor our independent auditors will be able to conclude within the prescribed timeframe that our internal controls over financial reporting are effective as required by Section 404. This could result in an adverse reaction in the financial markets due to a loss of confidence in the reliability of our financial statements.
Since we do not expect to pay any dividends for the foreseeable future, holders of our common stock may be forced to sell their stock in order to obtain a return on their investment.
We do not anticipate that we will pay any dividends to holders of our common stock in the foreseeable future. Instead, we plan to reinvest any earnings to finance our restaurant operations and growth plans. Accordingly, stockholders must rely on sales of their common stock after price appreciation, which may never occur, as the only way to realize any return on their investment. As a result, investors seeking cash dividends should not purchase our common stock.
Item 1B.  
Unresolved Staff Comments
Not applicable.

 

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Item 2.  
Properties
We currently operate 24 restaurants in 15 states. Each of our restaurants and our corporate offices are located in a leased facility. As of December 31, 2009, our restaurant leases had expiration dates ranging from 2013 to 2029, typically with options to renew for at least a five-year period. We do not anticipate any difficulties renewing existing leases as they expire. The following table sets forth our current restaurant locations.
                             
            Year   Square     Number of  
State   City   Location   Opened   Footage     Seats (1)  
Arizona
  Scottsdale   Scottsdale Fashion Square   1998     5,964       274  
Arizona
  Chandler   Chandler Fashion Center   2001     7,389       326  
Missouri
  Kansas City   Country Club Plaza   2002     7,455       222  
Nevada
  Las Vegas   Boca Park Fashion Village   2003     7,380       295  
Colorado
  Denver   Cherry Creek Mall   2004     5,920       243  
Nebraska
  Omaha   Village Pointe   2004     7,415       304  
Indiana
  Carmel   Clay Terrace   2004     7,433       295  
Texas
  Sugar Land   First Colony Mall   2005     7,127       285  
Texas
  San Antonio   The Shops at La Cantera   2005     7,200       256  
Texas
  Dallas   North Park Mall   2006     6,872       299  
Illinois
  Lincolnshire   Lincolnshire Commons   2006     7,020       305  
Texas
  Houston   Houston Galleria   2006     7,459       315  
Illinois
  Oak Brook   Oak Brook Promenade   2006     6,999       298  
Texas
  Austin   The Domain   2007     6,890       298  
Michigan
  Troy   Big Beaver Road   2007     7,000       280  
Connecticut
  Stamford   Stamford Town Center   2007     7,654       305  
Louisiana
  Baton Rouge   Perkins Rowe   2007     6,900       260  
Arizona
  Gilbert   San Tan Village   2008     6,770       259  
Florida
  West Palm Beach   CityPlace   2008     6,750       243  
Arizona
  Phoenix   CityNorth   2008     7,510       368  
Virginia
  Richmond   West Broad Village   2009     7,000       282  
New Jersey
  Woodbridge   Woodbridge Conference Center   2009     7,000       280  
Minnesota
  Eden Prairie   Windsor Plaza   2009     7,000       310  
Florida
  Tampa   MetWest International   2009     7,500       338  
 
     
(1)  
Number of seats includes dining room, patio seating, sushi bar, bar, and private dining room (where applicable).
Item 3.  
Legal Proceedings
We are involved in various legal proceedings arising out of our operations in the ordinary course of business. We do not believe that such proceedings, even if determined adversely, will have a material adverse effect on our business, financial condition, or results of operations. See discussion of Legal Proceedings in Note 14 to the consolidated financial statements.
Item 4.  
Reserved

 

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PART II
Item 5.  
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information
Our common stock has traded on the NASDAQ Global Market under the symbol KONA since our initial public offering on August 16, 2005. The following table sets forth high and low sale prices of our common stock for each calendar quarter indicated as reported on the NASDAQ Global Market.
                 
    High     Low  
2009
               
First quarter
  $ 3.25     $ 1.42  
Second quarter
  $ 4.34     $ 1.17  
Third quarter
  $ 4.15     $ 3.16  
Fourth quarter
  $ 3.59     $ 2.32  
2008
               
First quarter
  $ 14.77     $ 8.38  
Second quarter
  $ 9.70     $ 6.15  
Third quarter
  $ 8.37     $ 5.45  
Fourth quarter
  $ 5.97     $ 1.10  
On March 1, 2010, the closing sale price of our common stock was $3.25 per share. On March 1, 2010, there were approximately 31 holders of record of our common stock.
Dividend Policy
We have not paid any dividends to holders of our common stock since our initial public offering and do not anticipate that we will pay any dividends to holders of our common stock in the foreseeable future, but instead we currently plan to retain any earnings to finance our restaurant operations and the growth of our business. Payments of any cash dividends in the future, however, is within the discretion of our Board of Directors and will depend on our financial condition, results of operations, and capital and legal requirements as well as other factors deemed relevant by our Board of Directors.

 

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PERFORMANCE GRAPH
The following line graph compares cumulative total stockholder returns for the period from August 16, 2005 through December 31, 2009 for (1) our common stock; (2) the NASDAQ Composite (U.S.) Index; and (3) a restaurant peer group. We do not believe that an index exists with companies comparable to those of our company. We have therefore elected to include a peer group consisting of P.F. Chang’s China Bistro, Inc.; The Cheesecake Factory Incorporated; McCormick & Schmick’s Seafood Restaurants, Inc.; Benihana, Inc.; BJ’s Restaurants, Inc.; Granite City Food & Brewery Ltd.; and J. Alexander’s Corporation. The graph assumes an investment of $100 on August 16, 2005, which was the first day on which our stock was listed on the NASDAQ Global Market. The calculations of cumulative stockholder return for the NASDAQ Composite (U.S.) Index and the restaurant peer group include reinvestment of dividends, but the calculation of cumulative stockholder return on our common stock does not include reinvestment of dividends because we did not pay any dividends during the measurement period. The performance shown is not necessarily indicative of future performance.
The performance graph shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or the Exchange Act, or otherwise subject to the liability of that section. The performance graph will not be deemed incorporated by reference into any filing of our company under the Exchange Act or the Securities Act of 1933, as amended.
(PERFORMANCE GRAPH)

 

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Item 6.  
Selected Financial Data
The following selected consolidated financial data has been derived from audited financial statements and should be read in conjunction with the consolidated financial statements and notes thereto and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
                                         
    Year Ended December 31,  
    2009     2008     2007     2006     2005  
    (In thousands, except per share data)  
Consolidated Statement of Operations Data:
                                       
Restaurant sales
  $ 81,095     $ 75,815     $ 69,521     $ 50,322     $ 36,828  
Costs and expenses:
                                       
Cost of sales
    21,058       20,730       19,600       14,320       10,550  
Labor
    28,517       25,396       21,554       15,555       11,123  
Occupancy
    6,457       5,157       4,465       3,363       2,466  
Restaurant operating expenses
    13,156       11,314       9,479       6,875       4,698  
General and administrative
    8,200       8,416       7,294       7,155       4,783  
Preopening expense
    1,685       2,073       1,962       1,971       634  
Depreciation and amortization
    7,314       6,547       5,428       3,906       2,333  
Asset impairment charge
    16,915       3,219                    
 
                             
Total costs and expenses
    103,302       82,852       69,782       53,145       36,587  
 
                             
(Loss) income from operations
    (22,207 )     (7,037 )     (261 )     (2,823 )     241  
Nonoperating expenses:
                                       
Interest income and other, net
    204       296       617       936       300  
Interest expense
    (174 )     (51 )     (85 )     (294 )     (841 )
 
                             
(Loss) income from continuing operations before provision for income taxes
    (22,177 )     (6,792 )     271       (2,181 )     (300 )
Provision for income taxes
    65       205       406       60       83  
 
                             
Loss from continuing operations
    (22,242 )     (6,997 )     (135 )     (2,241 )     (383 )
Gain (loss) from discontinued operations (1)
    690       (3,504 )     (534 )     (503 )      
 
                             
Net loss
  $ (21,552 )   $ (10,501 )   $ (669 )   $ (2,744 )   $ (383 )
 
                             
Net (loss) income per share — Basic and Diluted:
                                       
Continuing operations
  $ (2.57 )   $ (0.87 )   $ (0.02 )   $ (0.31 )   $ (0.10 )
Discontinued operations
    0.08       (0.43 )     (0.07 )     (0.07 )      
 
                             
Net loss
  $ (2.49 )   $ (1.30 )   $ (0.09 )   $ (0.38 )   $ (0.10 )
 
                             
Weighted average shares used in computation:
                                       
Basic
    8,645       8,054       7,364       7,128       3,747  
 
                             
Diluted
    8,645       8,054       7,364       7,128       3,747  
 
                             
 
                                       
Balance Sheet Data (end of period):
                                       
Cash and cash equivalents
  $ 2,404     $ 2,477     $ 4,991     $ 1,934     $ 4,466  
Investments
    6,282       6,861       14,188       14,249       24,200  
Working (deficit) capital
    (5,054 )     (7,653 )     13,656       9,142       24,672  
Total assets
    49,963       65,554       69,474       58,796       52,418  
Total debt
    7,120       4,525       2,700       3,313       4,042  
 
                                       
Total stockholders’ equity
    17,983       35,598       46,431       35,822       37,311  
 
     
(1)  
As a result of our decision to close our Naples, Florida restaurant during September 2008, the results of this restaurant (including related asset impairment, lease obligation, and restaurant-level closing costs) are classified as discontinued operations for all periods presented as discussed further in Note 2 to our consolidated financial statements.

 

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Item 7.  
Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes contained elsewhere in this report. This discussion contains forward-looking statements that involve risks, uncertainties, and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of a variety of factors, including those set forth under Item 1A, “Risk Factors” and elsewhere in this report.
Overview
We currently own and operate 24 restaurants located in 15 states. We offer freshly prepared food, personalized service, and a contemporary ambiance that create a satisfying yet affordable dining experience that we believe exceeds many traditional casual dining restaurants with whom we compete. Our high-volume upscale casual restaurants feature a diverse selection of mainstream American favorites as well as a variety of appetizers and entrees with an international influence, including an extensive selection of sushi items. Our menu items are freshly prepared and incorporate over 40 signature sauces and dressings that we make from scratch, creating broad-based appeal for the lifestyle and taste trends of a diverse group of guests. Our menu is mostly standardized for all of our restaurants, allowing us to deliver consistent quality meals. We believe that our vast menu and generous portions, combined with an average check of approximately $23.90, offers our guests an attractive price-value proposition.
Over the last four years, we have funded development of new restaurants primarily from the proceeds of our initial public offering, a private offering of common stock completed during November 2007, the rights offering completed during June 2009, and cash flows from operations. We opened four restaurants during 2009 in Richmond, Virginia; Woodbridge, New Jersey; Eden Prairie, Minnesota; and Tampa, Florida. We plan to open one restaurant in Baltimore, Maryland during 2010. We target our restaurants to achieve an average annual unit volume of $4.5 million following 24 months of operations. Recent openings are trending lower than our targeted volume during the current recession. We continue to believe that in a stable economic environment our typical new restaurants experience gradually increasing unit volumes as guests begin to discover our concept and we begin to generate market awareness. Our restaurants are also subject to seasonal fluctuations. Sales in most of our restaurants typically are higher during the spring and summer months and winter holiday season.
During 2009, we recorded non-cash asset impairment charges for six underperforming restaurants. The asset impairment charges resulted from an evaluation of the long-term prospects of each of these restaurants that have not been meeting sales, profitability, and cash flow targets. We have no plans to close any of these restaurants; however, we will continue to evaluate each of these restaurants to determine whether operating performance can be improved.
We experience various trends in our operating cost structure. Cost of sales, labor, occupancy, and other operating expenses for our restaurants open at least 12 months generally trend consistent with restaurant sales, and we analyze those costs as a percentage of restaurant sales. We anticipate that our new restaurants will take approximately six months to achieve operating efficiencies as a result of challenges typically associated with opening new restaurants, including lack of market recognition and the need to hire and sufficiently train employees, as well as other factors. We expect cost of sales and labor expenses as a percentage of restaurant sales to be higher when we open a new restaurant, but decrease as a percentage of restaurant sales as the restaurant matures and as the restaurant management and employees become more efficient operating that unit. As a result, the volume and timing of newly opened restaurants has had, and is expected to continue to have, an impact on costs of sales, labor, occupancy, restaurant operating expenses, and preopening expenses. The majority of our general and administrative costs are fixed costs. We expect our general and administrative spending to decrease as a percentage of restaurant sales as we leverage these investments and realize the benefits of higher sales volumes.

 

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Key Measures We Use to Evaluate Our Company
Key measures we use to evaluate and assess our business include the following:
Number of Restaurant Openings. Number of restaurant openings reflects the number of restaurants opened during a particular reporting period.
Same-Store Sales Percentage Change. Same-store sales percentage change reflects the periodic change in restaurant sales for the comparable restaurant base. In calculating the percentage change in same-store sales, we include a restaurant in the comparable restaurant base after it has been in operation for more than 18 months. Same-store sales growth can be generated by an increase in guest traffic counts or by increases in the per person average check amount. Menu price changes and the mix of menu items sold can affect the per person average check amount.
Average Weekly Sales. Average weekly sales represents the average of restaurant sales measured over consecutive Monday through Sunday time periods.
Average Unit Volume. Average unit volume represents the average restaurant sales for all of our restaurants open for at least 12 months before the beginning of the period measured.
Sales Per Square Foot. Sales per square foot represents the restaurant sales for our restaurants open for at least 12 months, divided by the total leasable square feet for such restaurants.
Restaurant Operating Profit. Restaurant operating profit is defined as restaurant sales minus cost of sales, labor, occupancy, and restaurant operating expenses. Restaurant operating profit does not include general and administrative expenses, depreciation and amortization, preopening expenses, or asset impairment charges. We believe restaurant operating profit is an important component of financial results because it is a widely used metric within the restaurant industry to evaluate restaurant-level productivity, efficiency, and performance prior to application of corporate overhead. We use restaurant operating profit as a percentage of restaurant sales as a key metric to evaluate our restaurants’ financial performance compared with our competitors. This measure provides useful information regarding our financial condition and results of operations and allows investors to more easily determine future financial results driven by growth and allows investors to more easily compare restaurant level profitability.
Key Financial Definitions
Restaurant Sales. Restaurant sales include gross food and beverage sales, net of promotions and discounts.
Cost of Sales. Cost of sales consists of food and beverage costs.
Labor. Labor includes all direct and indirect labor costs incurred in operations.
Occupancy. Occupancy includes all rent payments associated with the leasing of real estate, including base, percentage and straight-line rent, property taxes, and common area maintenance expense. We record tenant improvement allowances as a reduction of occupancy expense over the initial term of the lease.
Restaurant Operating Expenses. Restaurant operating expenses consist of all other restaurant-level operating costs, the major components of which are utilities, credit card fees, advertising, supplies, marketing, repair and maintenance, and other expenses. Other operating expenses contain both variable and fixed components.
General and Administrative. General and administrative includes all corporate and administrative functions that support operations and provide infrastructure to facilitate our future growth. Components of this category include management and staff salaries, bonuses, stock-based compensation and related employee benefits, travel, information systems, human resources, training, corporate rent, professional and consulting fees, and corporate insurance costs.

 

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Preopening Expense. Preopening expense consists of costs incurred prior to opening a new restaurant and is comprised principally of manager salaries and relocation, payroll and related training costs for new employees, including food and beverage costs associated with practice and rehearsal of service activities, and rent expense incurred from the date we obtain possession of the property until opening. We expense restaurant preopening expenses as incurred, and we expect preopening expenses to be similar for each new restaurant opening, which typically commence six to eight months prior to a restaurant opening. Our preopening costs will fluctuate from period to period depending upon the number of restaurants opened, the timing of new restaurant openings, the location of the restaurants, and the complexity of the staff hiring and training process.
Depreciation and Amortization. Depreciation and amortization expense consists of the depreciation of property and equipment and gains and losses on disposal of assets.
Asset Impairment Charge. Asset impairment charge results from an assessment of a restaurant’s historical operating performance combined with its projected cash flows over the remaining lease term. An impairment charge is recorded if the asset’s fair value is deemed to be less than its carrying value.
Interest Income and Other, Net. Interest income and other, net consists of interest earned on our cash and investments and any gains or losses on our investments.
Interest Expense. Interest expense includes the cost of servicing our debt obligations, net of capitalized interest.
Financial Performance Overview
The following table sets forth certain information regarding our financial performance for 2009, 2008, and 2007.
                         
    Year Ended December 31,  
    2009     2008     2007  
Restaurant sales growth
    7.0 %     9.1 %     38.2 %
Same-store sales percentage change(1)
    (9.3 )%     (7.2 )%     2.7 %
Average unit volume (in thousands)(2)
  $ 3,815     $ 4,279     $ 4,808  
Sales per square foot (2)
  $ 541     $ 608     $ 684  
Restaurant operating profit (in thousands) (3)
  $ 11,907     $ 13,218     $ 14,423  
Restaurant operating profit as a percentage of sales (3)
    14.7 %     17.4 %     20.7 %
     
(1)  
Same-store sales percentage change reflects the periodic change in restaurant sales for the comparable restaurant base. In calculating the percentage change in same-store sales, we include a restaurant in the comparable restaurant base after it has been in operation for more than 18 months.
 
(2)  
Includes only those restaurants open for at least 12 months.

 

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(3)  
Restaurant operating profit is not a financial measurement determined in accordance with generally accepted accounting principles and should not be considered in isolation or as an alternative to loss from operations. Restaurant operating profit may not be comparable to the same or similarly titled measures computed by other companies. The table below sets forth our calculation of restaurant operating profit and reconciliation to loss from operations, the most comparable GAAP measure.
                         
    Year Ended December 31,  
    2009     2008     2007  
    (In thousands)  
Restaurant sales
  $ 81,095     $ 75,815     $ 69,521  
Costs and expenses:
                       
Cost of sales
    21,058       20,730       19,600  
Labor
    28,517       25,396       21,554  
Occupancy
    6,457       5,157       4,465  
Restaurant operating expenses
    13,156       11,314       9,479  
 
                 
Restaurant operating profit
    11,907       13,218       14,423  
 
                 
Deduct — other costs and expenses
                       
General and administrative
    8,200       8,416       7,294  
Preopening expense
    1,685       2,073       1,962  
Depreciation and amortization
    7,314       6,547       5,428  
Asset impairment charge
    16,915       3,219        
 
                 
Loss from operations
  $ (22,207 )   $ (7,037 )   $ (261 )
 
                 
                         
    Percentage of Restaurant Sales  
    Year Ended December 31,  
    2009     2008     2007  
Restaurant sales
    100.0 %     100.0 %     100.0 %
Costs and expenses:
                       
Cost of sales
    26.0       27.3       28.2  
Labor
    35.2       33.5       31.0  
Occupancy
    8.0       6.8       6.4  
Restaurant operating expenses
    16.2       14.9       13.6  
 
                 
Restaurant operating profit
    14.7       17.4       20.7  
 
                 
Deduct — other costs and expenses
                       
General and administrative
    10.1       11.1       10.5  
Preopening expense
    2.1       2.7       2.8  
Depreciation and amortization
    9.0       8.6       7.8  
Asset impairment charge
    20.9       4.2        
 
                 
Loss from operations
    (27.4 )%     (9.3 )%     (0.4 )%
 
                 
Certain percentage amounts may not sum to total due to rounding.
                         
    Year Ended December 31,  
    2009     2008     2007  
Store Growth Activity
                       
Beginning Restaurants
    20       18       14  
Openings
    4       3       4  
Closings
          (1 )      
 
                 
Total
    24       20       18  
 
                 

 

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Results of Operations
The following table sets forth, for the years indicated, our Consolidated Statements of Operations expressed as a percentage of restaurant sales.
                         
    Year Ended December 31,  
    2009     2008     2007  
Restaurant sales
    100.0 %     100.0 %     100.0 %
Costs and expenses:
                       
Cost of sales
    26.0       27.3       28.2  
Labor
    35.2       33.5       31.0  
Occupancy
    8.0       6.8       6.4  
Restaurant operating expenses
    16.2       14.9       13.6  
General and administrative
    10.1       11.1       10.5  
Preopening expense
    2.1       2.7       2.8  
Depreciation and amortization
    9.0       8.6       7.8  
Asset impairment charge
    20.9       4.2        
 
                 
Total costs and expenses
    127.4       109.3       100.4  
 
                 
Loss from operations
    (27.4 )     (9.3 )     (0.4 )
Nonoperating expenses:
                       
Interest income and other, net
    0.3       0.4       0.9  
Interest expense
    (0.2 )     (0.1 )     (0.1 )
 
                 
(Loss) income from continuing operations before provision for income taxes
    (27.3 )     (9.0 )     0.4  
Provision for income taxes
    0.1       0.3       0.6  
 
                 
Loss from continuing operations
    (27.4 )     (9.3 )     (0.2 )
Gain (loss) from discontinued operations, net of tax
    0.8       (4.6 )     (0.8 )
 
                 
Net loss
    (26.6 )%     (13.9 )%     (1.0 )%
 
                 
Certain percentage amounts may not sum to total due to rounding.
Year Ended December 31, 2009 Compared with Year Ended December 31, 2008
Restaurant Sales. Restaurant sales increased $5.3 million, or 7.0% to $81.1 million during 2009 from $75.8 million during 2008. The increase in sales is primarily attributable to restaurant sales generated from the opening of seven new restaurants since June 2008, partially offset by overall traffic declines at our comparable restaurant sales base resulting from the weak U.S. economy, high unemployment rates, and reduced consumer spending. Higher menu pricing of approximately 2.0% was more than offset by reduced guest traffic and a decline in the average guest check as comparable restaurant sales declined 9.3% during 2009.
Cost of Sales. Cost of sales increased $0.3 million, or 1.6% to $21.0 million during 2009 from $20.7 million during 2008. Cost of sales as a percentage of restaurant sales decreased 1.3% to 26.0% during 2009 from 27.3% during the prior year period. Cost of sales during 2009 was positively affected by favorable year-over-year pricing on certain proteins and produce products and operating efficiencies attributed to the rollout of an automated food cost and inventory management system that was completed during July 2008.
Labor. Labor costs for our restaurants increased $3.1 million, or 12.3% to $28.5 million during 2009 from $25.4 million during the prior year period. The increase was primarily due to the opening of seven new restaurants since June 2008. As a percentage of restaurant sales, labor costs increased 1.7% to 35.2% during 2009 from 33.5% during 2008. The increase in labor costs as a percentage of restaurant sales was primarily due to reduced leverage of fixed labor costs and hourly labor expense resulting from lower average weekly sales. In addition, high labor costs from restaurants opened during the year also contributed to the increase in labor expense as labor expenses are typically higher than normal during the first several months of operations. Federal and state minimum wage increases, implemented during the second half of 2008 and during 2009, also contributed to increased labor costs as a percentage of sales.

 

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Occupancy. Occupancy expense increased by $1.3 million, or 25.2% to $6.5 million during 2009 from $5.2 million during the prior year period. Occupancy expenses as a percentage of restaurant sales increased 1.2% to 8.0% during 2009 from 6.8% during 2008. The increase reflects increased common area maintenance allocations at many locations, reduction in deferred rent credits at several locations with rent concessions, and decreased leverage of fixed rental costs from lower average sales volume, partially offset by reduced percentage rent.
Restaurant Operating Expenses. Restaurant operating expenses increased by $1.8 million, or 16.3% to $13.1 million during 2009 from $11.3 million during the prior year period. Restaurant operating expenses as a percentage of restaurant sales increased 1.3% to 16.2% during 2009 from 14.9% during the prior year period. During 2009, higher repair and maintenance, utilities, and property taxes combined with reduced leverage of fixed operating costs resulting from lower average sales volume contributed to the increase in restaurant operating expenses as a percentage of sales.
General and Administrative. General and administrative expenses decreased $0.2 million, or 2.6% to $8.2 million during 2009 compared to $8.4 million during 2008. The decrease is primarily attributable to lower salary and benefit costs resulting from the January 2009 downsizing and realignment of certain corporate office staff and lower expenditures attributable to cost containment efforts, partially offset by $1.6 million in special charges including $0.8 million in severance and related benefits associated with the resignation of two executive officers, $0.6 million in legal and professional fees associated with stockholder activities, including financial advisory fees to evaluate an unsolicited offer to purchase our company, and $0.2 million write-off for architectural drawings and permit costs associated with amending the lease for our Baltimore, Maryland restaurant expected to open in 2010. General and administrative expenses as a percentage of restaurant sales decreased 1.0% to 10.1% of restaurant sales during 2009 compared to 11.1% of restaurant sales during the prior year period.
Preopening Expense. Preopening expense decreased $0.4 million, or 18.7% to $1.7 million during 2009 compared to $2.1 million during 2008. The decrease in preopening expense is attributable to the timing of new restaurant openings. During 2009, there were four restaurant openings compared to three new restaurants during 2008; however $0.5 million of expenses were incurred during 2008 for the four restaurants opened during 2009.
Depreciation and Amortization. Depreciation and amortization expense increased $0.8 million, or 11.7% to $7.3 million during 2009 from $6.5 million during the prior year period. The increase was primarily attributable to seven restaurants opened since June 2008, partially offset by a reduction of $0.5 million due to the fourth quarter of 2008 impairment of long-lived assets at our Lincolnshire, Illinois restaurant. Depreciation and amortization expense as a percentage of restaurant sales increased 0.4% to 9.0% during 2009 from 8.6% during 2008 reflecting decreased leverage from lower average weekly sales.
Asset Impairment Charge. During 2009, we recorded non-cash asset impairment charges of $16.9 million related to the write-down of the carrying value of long-lived assets associated with six underperforming restaurants that have not been meeting sales, profitability, and cash flow targets. The asset impairment charges were based upon an assessment of each restaurant’s historical operating performance combined with expected cash flows for these restaurants over the respective remaining lease term. During 2008, we recorded non-cash asset impairment charges of $3.2 million for one restaurant. We have no plans to close any of these restaurants; however, we will continue to evaluate each of these restaurants to determine whether operating performance can be improved.
Interest Income and Other, Net. Interest income and other, net decreased $0.1 million during 2009 compared to the prior year period due to lower interest rates received and lower investment balances. Please refer to Note 3 to the consolidated financial statements for discussion of our investment in auction rate securities.
Interest Expense. Interest expense increased $0.1 million due to interest costs associated with the $1.2 million bridge loan issued during March 2009 and subsequently repaid during June 2009. Interest expense for 2009 includes $70,000 for amortization of the debt discount associated with warrants issued to the noteholders that was charged to interest expense.

 

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Provision for Income Taxes. During 2009, we recorded income taxes of $65,000 primarily for states in which income taxes are not calculated based upon net income compared to $205,000 during 2008.
Gain from Discontinued Operations. During the second quarter of 2009, we reached a settlement agreement regarding the lease for our closed Naples, Florida restaurant. We recorded a gain of approximately $0.7 million as the settlement amount was less than the lease termination costs originally recorded during 2008 when the restaurant was closed. During 2008, we recorded a loss of $3.5 million for asset impairment and lease obligations, along with the sales, costs and expenses attributable to this restaurant.
Year Ended December 31, 2008 Compared with Year Ended December 31, 2007
Restaurant Sales. Restaurant sales increased by $6.3 million, or 9.1%, to $75.8 million during 2008 from $69.5 million during the prior year primarily attributed to restaurant sales generated from the opening of five new restaurants since November 2007, partially offset by overall traffic declines at our existing restaurants resulting from the slowing U.S. economy which has negatively impacted overall consumer traffic in the restaurant industry. Higher menu pricing of approximately 3.8% was more than offset by reduced guest traffic as comparable restaurant sales declined 7.2% during 2008.
Cost of Sales. Cost of sales increased by $1.1 million, or 5.8%, to $20.7 million during 2008 from $19.6 million during 2007. Cost of sales as a percentage of restaurant sales decreased 0.9% to 27.3% during 2008 from 28.2% during the prior year. Cost of sales during 2008 was positively affected by increased purchasing efficiency and reduced waste attributed to the rollout of an automated food cost and inventory management system that was completed during July 2008.
Labor. Labor costs for our restaurants increased $3.8 million, or 17.8%, to $25.4 million during 2008 from $21.6 million during 2007. The increase was primarily due to the opening of five new restaurants since November 2007. As a percentage of restaurant sales, labor costs increased 2.5% to 33.5% during 2008 from 31.0% during 2007. The increase in labor costs as a percentage of restaurant sales was primarily due to reduced leverage of fixed labor costs resulting from lower average weekly sales during 2008. In addition, higher average salaries to attract and retain qualified restaurant managers and federal and state minimum wage increases implemented during 2008 contributed to increased labor costs as a percentage of sales.
Occupancy. Occupancy expense increased by $0.7 million, or 15.5%, to $5.2 million during 2008 from $4.5 million during 2007. Occupancy expenses as a percentage of restaurant sales increased 0.4% to 6.8% during 2008 from 6.4% during 2007. The increase reflects decreased leverage of the fixed portion of these costs from lower average weekly sales, partially offset by reduced percentage rent.
Restaurant Operating Expenses. Restaurant operating expenses increased by $1.8 million, or 19.4%, to $11.3 million during 2008 from $9.5 million during 2007. Restaurant operating expenses as a percentage of restaurant sales increased 1.3% to 14.9% during 2008 from 13.6% during the prior year period. During 2008, we incurred higher repair and maintenance costs to refurbish our mature units in addition to higher utilities and increased training costs. Furthermore, reduced leverage of fixed operating costs resulting from lower average weekly sales contributed to the increase in restaurant operating expenses as a percentage of sales.
General and Administrative. General and administrative expenses increased by $1.1 million, or 15.4%, to $8.4 million during 2008 from $7.3 million during 2007. The increase is primarily attributable to planned investments in corporate personnel to support our growth, costs associated with our stockholder rights plan adopted in May 2008, separation costs related to the resignation of our chief operating officer, and higher professional fees. General and administrative expenses as a percentage of restaurant sales increased 0.6% to 11.1% of restaurant sales during 2008 compared to 10.5% of restaurant sales during 2007. During January 2009, we downsized and realigned certain staff at the corporate office which we estimate will result in approximately $0.8 million of savings during 2009.
Preopening Expense. Preopening expense increased by $0.1 million, or 5.6%, to $2.1 million during 2008 compared to $2.0 million during 2007. Preopening expense for 2008 primarily relates to expenses associated with three restaurants opened during 2008, one restaurant opened during January 2009, and other restaurants scheduled to open during 2009. During 2007, preopening expense reflected costs associated with opening four restaurants during 2007.

 

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Depreciation and Amortization. Depreciation and amortization expense increased $1.1 million, or 20.6%, to $6.5 million during 2008 from $5.4 million during 2007. The increase was primarily the result of additional depreciation and amortization from five restaurants opened since November 2007. Depreciation and amortization expense as a percentage of restaurant sales increased 0.8% to 8.6% during 2008 from 7.8% during 2007 reflecting decreased leverage from lower average weekly sales.
Asset Impairment Charge. Asset impairment charge of $3.2 million during 2008, or 4.2% of restaurant sales resulted from the evaluation of restaurants that have not been meeting sales, profitability, and cash flow targets. This evaluation resulted in long-lived asset impairment charges of $3.2 million for our Lincolnshire, Illinois restaurant. We intend to continue operating this restaurant and believe that the operating performance of this restaurant can be improved.
Interest Income and Other, Net. Interest income and other, net decreased $0.3 million, or 52.0%, to $0.3 million during 2008 from $0.6 million during 2007. This decrease is primarily due to lower average investment balances, coupled with lower average interest rates, as compared to the same period last year. In addition, we recognized a loss of approximately $0.1 million on our investments as the fair value of the put option on our auction rate securities was determined to be less than the impairment recorded on our auction rate securities. Please refer to Note 3 to the consolidated financial statements for discussion of our investment in auction rate securities.
Interest Expense. Interest expense decreased slightly due to lower average debt balances during 2008 as compared to 2007.
Provision for Income Taxes. During 2008, we recorded income taxes of $0.2 million primarily for states in which income taxes are not calculated based upon net income. During 2007, we incurred $0.4 million of federal and state tax expense, including a non-cash charge of $0.2 million related to stock options exercised during 2007 which required the recording of additional tax expense under accounting rules for stock-based compensation.
Loss from Discontinued Operations, Net of Tax. During September 2008, we closed our Naples, Florida restaurant to focus our attention on our profitable restaurants. As a result of the closure, we determined that the closure met the criteria for classification as a discontinued operation during 2008. Accordingly, all impairment charges and exit costs, along with the sales, costs and expenses and income taxes attributable to this restaurant are included in discontinued operations for all periods presented. See Note 2 to the consolidated financial statements for additional discussion.
Potential Fluctuations in Quarterly Results and Seasonality
Our quarterly operating results may fluctuate significantly as a result of a variety of factors, including the following:
   
timing of new restaurant openings and related expenses;
 
   
restaurant operating costs and preopening costs for our newly-opened restaurants, which are often materially greater during the first several months of operation than thereafter;
 
   
labor availability and costs for hourly and management personnel;
 
   
profitability of our restaurants, especially in new markets;
 
   
increases and decreases in comparable restaurant sales;
 
   
impairment of long-lived assets and any loss on restaurant closures;
 
   
changes in borrowings and interest rates;
 
   
general economic conditions;
 
   
weather conditions or natural disasters;
 
   
timing of certain holidays;
 
   
changes in government regulations;

 

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outside shareholder activities;
 
   
settlements, damages and legal costs associated with litigation;
 
   
new or revised regulatory requirements and accounting pronouncements;
 
   
changes in consumer preferences and competitive conditions; and
 
   
fluctuations in commodity prices.
Quarterly Results of Operations
The following table presents unaudited consolidated statement of operations data for each of the eight quarters in the period ended December 31, 2009. We believe that all necessary adjustments have been included to present fairly the quarterly information when read in conjunction with our annual financial statements and related notes. The operating results for any quarter are not necessarily indicative of the results for any subsequent quarter.
                                                                 
    Quarter Ended  
    2009     2008  
    March 31     June 30     Sept. 30     Dec. 31     March 31     June 30     Sept. 30     Dec. 31  
    (In thousands, except per share data)  
Consolidated Statement of Operations Data:
                                                               
Restaurant sales
  $ 19,455     $ 21,468     $ 20,173     $ 19,999     $ 18,103     $ 19,685     $ 19,454     $ 18,573  
Costs and expenses:
                                                               
Cost of sales
    5,097       5,461       5,267       5,233       5,193       5,369       5,254       4,914  
Labor
    6,749       7,269       7,117       7,382       6,127       6,380       6,496       6,393  
Occupancy
    1,520       1,536       1,655       1,746       1,256       1,244       1,260       1,397  
Restaurant operating expenses
    3,030       3,242       3,296       3,588       2,588       2,902       2,978       2,846  
General and administrative
    1,887       2,661       1,590       2,062       1,852       2,026       2,079       2,459  
Preopening expense
    500       352       480       353       178       541       471       883  
Depreciation and amortization
    1,741       1,812       1,820       1,941       1,566       1,584       1,656       1,741  
Asset impairment charge
                      16,915                         3,219  
 
                                               
Total costs and expenses
    20,524       22,333       21,225       39,220       18,760       20,046       20,194       23,852  
 
                                               
Loss from operations
    (1,069 )     (865 )     (1,052 )     (19,221 )     (657 )     (361 )     (740 )     (5,279 )
Nonoperating expenses:
                                                               
Interest income and other, net
    48       77       44       35       204       105       62       (75 )
Interest expense
    (32 )     (99 )     (22 )     (21 )     (34 )     (17 )            
 
                                               
Loss from continuing operations before provision for income taxes
    (1,053 )     (887 )     (1,030 )     (19,207 )     (487 )     (273 )     (678 )     (5,354 )
Provision for income taxes
    30       30       5             75       75       55        
 
                                               
Loss from continuing operations
    (1,083 )     (917 )     (1,035 )     (19,207 )     (562 )     (348 )     (733 )     (5,354 )
(Loss) gain from discontinued operations
    (13 )     703                   (111 )     (187 )     (3,161 )     (45 )
 
                                               
Net loss
  $ (1,096 )   $ (214 )   $ (1,035 )   $ (19,207 )   $ (673 )   $ (535 )   $ (3,894 )   $ (5,399 )
 
                                               
 
                                                               
Net (loss) income per share — Basic and diluted:
                                                               
Continuing operations
  $ (0.14 )   $ (0.11 )   $ (0.11 )   $ (2.10 )   $ (0.07 )   $ (0.04 )   $ (0.09 )   $ (0.67 )
Discontinued operations
          0.08                   (0.01 )     (0.03 )     (0.40 )      
 
                                               
Net loss
  $ (0.14 )   $ (0.03 )   $ (0.11 )   $ (2.10 )   $ (0.08 )   $ (0.07 )   $ (0.49 )   $ (0.67 )
 
                                               
 
                                                               
Weighted average shares used in computation:
                                                               
Basic and diluted
    8,016       8,278       9,141       9,144       8,134       8,081       7,998       8,003  
 
                                               

 

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Liquidity and Capital Resources
Our primary capital requirements are for new restaurant development. Subject to availability of capital on terms acceptable to us, we will pursue additional leases based on significant economic opportunity. Similar to many restaurant chains, we utilize operating lease arrangements for all of our restaurant locations. We believe that our operating lease arrangements provide appropriate leverage for our capital structure in a financially efficient manner. We are typically required to expend cash to perform site-related work and to construct and equip each restaurant. The average investment cost for our restaurants depends upon the type of lease entered into, the amount of tenant improvement allowance we receive from landlords, and whether we assume responsibility for the construction of the building. We expect the cash investment cost of our typical restaurant to be approximately $2.5 million, net of landlord tenant improvement allowances between $0.7 million and $1.2 million, and excluding cash preopening expenses of approximately $0.4 million. We expect these costs will vary from one market to another based on real estate values, zoning regulations, permitting requirements, labor markets and other variables. Restaurants that are subject to ground leases and do not receive landlord tenant improvement allowances typically require a significantly higher cash investment. We also require capital resources to maintain our existing base of restaurants and to further expand and strengthen the capabilities of our corporate and information technology infrastructures.
The following tables set forth, for the periods indicated, a summary of our key liquidity measurements (amounts in thousands):
                 
    December 31,     December 31,  
    2009     2008  
Cash and short-term investments(1)
  $ 2,890     $ 2,847  
Net working capital (deficit)(2)
    (5,054 )     (7,653 )
     
(1)  
At December 31, 2009 and 2008, cash and short-term investments exclude $5.8 million and $6.5 million, respectively, in auction rate securities that are used as collateral for the line of credit. Proceeds from the sale of auction rate securities are used to reduce the outstanding balance on the line of credit.
 
(2)  
The working capital deficit at December 31, 2009, is primarily attributable to accruals for payroll, legal fees, and severance. The working capital deficit at December 31, 2008 is principally due to $6.5 million of investments in auction rate securities which were classified as non-current assets.
                 
    2009     2008  
Cash provided by operating activities
  $ 5,341     $ 6,693  
Capital expenditures
    12,021       17,146  
Future Capital Requirements
Our capital requirements, including development costs related to the opening of new restaurants, have historically been significant. Over the last several years, we funded development of new restaurants primarily from the proceeds of equity financing, debt financing, and cash flows from operations. Our future cash requirements and the adequacy of available funds will depend on many factors, including the operating performance of our restaurants, the pace of expansion, real estate markets, site locations, the nature of the arrangements negotiated with landlords and the credit market environment.
Our current operations generate sufficient cash flow to fund operations and general and administrative costs. We believe existing cash and short-term investments of $2.9 million in addition to cash flow from operations is sufficient to fund development costs required for our Baltimore restaurant. Any reduction of our cash flow from operations may cause a delay or cancellation of planned future restaurant development. As of December 31, 2009, we had a working capital deficit of $5.1 million. We plan to reduce this deficit through cost containment efforts and cash flow from operations. Financing to construct new restaurants may not be available on acceptable terms, or at all, and our failure to raise capital when needed could impact our growth plans, financial condition, and results of operations. Additional equity financing may result in dilution to current shareholders and debt financing, if available, may involve significant cash payment obligations or financial covenants and ratios that may restrict our ability to operate our business.

 

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Bridge Loan
On March 6, 2009, and as amended on April 7, 2009, we entered into a Note and Warrant Purchase Agreement with certain accredited investors whereby we sold $1.2 million aggregate principal amount of 10% unsecured subordinated notes and warrants to purchase shares of our common stock. The principal and accrued interest outstanding under the notes were due and payable upon the closing of any offering of equity securities by our company generating gross proceeds to us of at least $2.5 million. For each $100,000 issued in notes, we issued to the noteholder three-year warrants to purchase 10,000 shares of our common stock at an aggregate exercise price per share of $2.29, which was equal to 120% of the five-day average of the closing price of our common stock during the five trading days prior to the date of issuance. The bridge loan, including accrued interest, was repaid during June 2009 upon completion of the rights offering described below. The holders of the notes exercised over-subscription rights granted in the agreement and purchased 482,178 shares or 18.5% of the total shares sold in the rights offering.
Rights Offering
As part of the Note and Warrant Purchase Agreement, we filed with the SEC a registration statement on Form S-3 to conduct a rights offering with targeted gross proceeds to us of $3,520,000 pursuant to which each of our stockholders received one non-transferrable subscription right for every 2.5 shares of common stock owned on April 17, 2009. Each subscription right entitled the holder to purchase one share of common stock at a price of $1.35 per share. The terms of the agreement provided that any shares of common stock that were not subscribed for in the rights offering by existing stockholders were offered to the holders of the notes on a pro rata basis based on the aggregate principal amount of notes outstanding and at the same subscription price as offered to the holders of subscription rights granted under the rights offering. We sold 2,608,045 shares of common stock pursuant to the rights offering and received net proceeds of $3,245,000 after deducting $275,000 in expenses. A portion of the net proceeds was used to repay amounts owed on the notes, and the remaining proceeds are being utilized to fund capital expenditure requirements.
Equipment Loans
As of December 31, 2009, we had five equipment term loans with a lender, each collateralized by restaurant equipment. The outstanding principal balance under these loans aggregated $1.3 million. The loans bear interest at rates ranging from 7.0% to 8.5% and require monthly principal and interest payments aggregating approximately $71,000. The loans mature between June 2010 and June 2012. The loans also require us to maintain certain financial covenants, including a Fixed Charge Coverage Ratio of 1.25:1.00 calculated at the end of each calendar year, and we were in compliance with all such financial covenants as of December 31, 2009.
Credit Facility
During October 2008, as part of the settlement agreement with UBS, our broker from which we purchased auction rate security instruments, we entered into a line of credit that is secured by the auction rate security instruments held with UBS. Available borrowings under the line of credit are based upon terms specified in the agreement and subject to adjustment by UBS after consideration of various factors. At December 31, 2009, $5,800,000 was outstanding under the line of credit. Borrowings under the line of credit are callable by UBS at any time. The line of credit is classified as short-term in the accompanying consolidated balance sheets as the loan expires on June 30, 2010. The cost of the line of credit effectively offsets the interest earned on the auction rate securities. See Note 3 to the consolidated financial statements for further information on the auction rate securities and the settlement agreement.

 

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Cash Flows
The following table summarizes our primary sources and uses of cash during the periods presented.
                         
    Year Ended December 31,  
    2009     2008     2007  
    (In thousands)  
Net cash provided by (used in):
                       
Operating activities
  $ 5,341     $ 6,693     $ 5,701  
Investing activities
    (11,316 )     (10,118 )     (12,781 )
Financing activities
    5,902       911       10,137  
 
                 
Net (decrease) increase in cash and cash equivalents
  $ (73 )   $ (2,514 )   $ 3,057  
 
                 
Operating Activities. During 2009, net cash provided by operating activities was $5.3 million and exceeded our net loss by $26.9 million due principally to non-cash asset impairment charges, depreciation and amortization, and the timing of payment for accrued expenses. During 2008, net cash provided by operating activities was $6.7 million and exceeded our net loss by $17.2 million primarily due to depreciation and amortization, non-cash asset impairment charges, and an increase in the deferred rent liability, partially offset by our net loss of $10.5 million. During 2007, net cash provided by operating activities was $5.7 million and exceeded our net loss by $6.4 million due principally to the effect of depreciation and amortization and an increase in the deferred rent liability.
Investing activities. We fund the development and construction of new restaurants primarily with cash and investments. Net cash used in investing activities during 2009 was $11.3 million primarily reflecting $12.0 million to fund construction of four restaurants opened during the year. Net cash used in investing activities was $10.1 million during 2008 reflecting $17.1 million to fund construction at three restaurants opened during 2008 and one restaurant opened during January 2009, as well as capital expenditures for existing restaurants and other restaurants scheduled to open during 2009. This increase was partially offset by $7.3 million in proceeds from the sale of investments to fund this construction. Net cash used in investing activities was $12.8 million during 2007 which consisted primarily of $12.8 million in expenditures for leasehold improvements and restaurant equipment principally to construct new restaurants.
Financing Activities. Net cash provided by financing activities was $5.9 million during 2009 reflecting $3.3 million in net borrowings under our line of credit and $3.2 million in net proceeds from the subscription rights offering completed during June 2009, partially offset by $0.7 million in principal payments on equipment loans. Net cash provided by financing activities was $0.9 million during 2008 principally consisting of $2.5 million in net borrowings under our line of credit offset by the purchase of 116,200 shares of common stock under our stock repurchase program at a total cost of $1.0 million, and $0.7 million in principal payments on equipment notes. Net cash provided by financing activities was approximately $10.1 million during 2007 consisting primarily of $10.0 million in net proceeds from the sale of common stock in a private placement transaction, $0.6 million in proceeds primarily from the issuance of common stock as a result of the exercise of stock options and warrants, partially offset by $0.6 million of principal payments on equipment loans.

 

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Aggregate Contractual Obligations
The following table sets forth our contractual commitments as of December 31, 2009 (in thousands).
                                         
    Payments Due by Period  
            Less than                     More than  
Contractual Obligations   Total     1 year     1-3 years     3-5 years     5 years  
Long-term notes payable, including current portion
  $ 1,320     $ 684     $ 636     $     $  
Interest on notes payable
    116       81       35              
Line of credit(1)
    5,800       5,800                    
Operating leases
    61,972       6,699       14,150       13,490       27,633  
 
                             
Total
  $ 69,208     $ 13,264     $ 14,821     $ 13,490     $ 27,633  
 
                             
 
     
(1)  
The line of credit expires on June 30, 2010, but is callable upon demand. See Note 8 to the consolidated financial statements for further information.
The table above does not include obligations related to lease renewal option periods even if it is reasonably assured that we will exercise the related option. In addition, the table above does not reflect unrecognized tax benefits of $140,000, the timing of which is uncertain. Refer to Note 9 of the Consolidated Financial Statements for additional discussion on unrecognized tax benefits. We have evaluated and determined that we do not have any purchase obligations as defined in the SEC Final Rule No. 67, Disclosure in Management’s Discussion and Analysis about Off-Balance Sheet Arrangements and Aggregate Contractual Obligations.
Off-Balance Sheet Arrangements
We had no off-balance sheet guarantees or off-balance sheet arrangements as of December 31, 2009.
Critical Accounting Policies
Critical accounting policies are those that we believe are most important to the portrayal of our financial condition and results of operations and also require our most difficult, subjective, or complex judgments. Judgments or uncertainties regarding the application of these policies may result in materially different amounts being reported under various conditions or using different assumptions. We consider the following policies to be the most critical in understanding the judgment that is involved in preparing our consolidated financial statements.
Fair Value Measurements
Our investment portfolio includes auction rate securities that are reflected at estimated fair value in the consolidated balance sheets. We held auction rate securities with a par value of $5.8 million which are classified as trading securities at December 31, 2009. Historically, due to the auction process that reset interest rates at pre-determined calendar intervals, quoted market prices were readily available, which would have qualified as Level 1 under the fair value hierarchy. Since February 2008, events in the credit markets have adversely affected the auction market and auctions for these securities have failed, and, therefore, we were required to determine the fair value of our auction rate securities using valuation models obtained from third parties. We also elected to apply fair value accounting to the put option received from our broker as the put option acts as an economic hedge against any further price movement in the auction rate securities and enables us to recognize future changes in the fair value of the put option as those changes occur to offset fair value movements in the auction rate securities.
As we rely on unobservable (Level 3) inputs, which are highly subjective, in determining the fair value of our auction rate security instruments and related put option, the valuations could vary significantly based on our assumptions. We use a discounted cash flow model to value our auction rate security instruments. The valuation models require numerous assumptions and assessments, including the following: (i) collateralization underlying each security; (ii) the present value of future principal and interest payments discounted at rates considered to reflect current market conditions; (iii) the creditworthiness of the counterparty; and (iv) the current illiquidity of the investments. We determine the fair value of our put option through comparison of the fair value of each auction rate security instrument to its par value and then discount this amount by a rate reflective of the risk of default by the issuer between the valuation date and the expected exercise date of the put option. These assumptions, assessments and the interpretations of relevant market data are subject to uncertainties, are difficult to predict and require significant judgment. The use of different assumptions, applying different judgment to inherently subjective matters and changes in future market conditions could result in significantly different estimates of fair value. The fair value of our auction rate securities could change significantly based on market conditions and continued uncertainties in the credit markets.

 

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Property and Equipment
We record property and equipment at cost less accumulated depreciation and we select useful lives that reflect the actual economic lives of the underlying assets. We amortize leasehold improvements over the shorter of the useful life of the asset or the related lease term. We calculate depreciation using the straight-line method for financial statement purposes. We capitalize improvements and expense repairs and maintenance costs as incurred. We are often required to exercise judgment in our decision whether to capitalize an asset or expense an expenditure that is for maintenance and repairs. Our judgments may produce materially different amounts of repair and maintenance or depreciation expense if different assumptions were used.
We evaluate property and equipment for impairment whenever events or changes in restaurant operating results indicate that the carrying value of those assets may not be recoverable. Factors considered include, but are not limited to, significant underperformance relative to expected historical or projected future operating results; significant negative industry or economic trends; and significant changes in legal factors or in the business climate. The assessment of impairment is performed on a restaurant-by-restaurant basis. The recoverability is assessed by comparing the carrying value of the asset to the undiscounted cash flows expected to be generated by the asset. This assessment process requires the use of estimates and assumptions regarding future cash flows and estimated useful lives, which are subject to a significant degree of judgment. If indicators of impairment are present and if we determine that the carrying value of the asset exceeds the fair value of the restaurant assets, an impairment charge is recorded to reduce the carrying value of the asset to its fair value. Calculation of fair value requires significant estimates and judgments which could vary significantly based on our assumptions.
During 2009 and 2008, we recorded non-cash asset impairment charges for underperforming restaurants. We continue to monitor the operating performance of each individual restaurant. We may be required to record impairment charges in the future if certain restaurants perform below expectations.
Leasing Activities
We lease all of our restaurant properties. At the inception of the lease, we evaluate each property and classify the lease as an operating or capital lease in accordance with applicable accounting standards. We exercise significant judgment in determining the estimated fair value of the restaurant as well as the discount rate used to discount the future minimum lease payments. The term used for this evaluation includes renewal option periods only in instances in which the exercise of the renewal option can reasonably be assured and failure to exercise such option would result in an economic penalty. All of our restaurant leases are classified as operating leases.
Our lease term used for straight-line rent expense is calculated from the date we take possession of the leased premises through the lease termination date. There is potential for variability in our “rent holiday” period which typically begins on the possession date and ends on the store open date. Factors that may affect the length of the rent holiday period generally include construction related delays. Extension of the rent holiday period due to delays in restaurant opening will result in greater rent expensed during the rent holiday period.
We record contingent rent expense based on a percentage of restaurant sales, which exceeds minimum base rent, over the periods the liability is incurred. Contingent rent expense is recorded prior to achievement of specified sales levels if achievement of such amounts is considered probable and estimable.

 

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Income Taxes
We provide for income taxes based on our estimate of federal and state tax liabilities. These estimates consider, among other items, effective rates for state and local income taxes, allowable tax credits for items such as taxes paid on reported tip income, estimates related to depreciation and amortization expense allowable for tax purposes, and the tax deductibility of certain other items. Our estimates are based on information available to us at the time we prepare the income tax provision. We generally file our annual income tax returns several months after our fiscal year end. Income tax returns are subject to audit by federal, state, and local governments, generally years after the returns are filed. These returns could be subject to material adjustments or differing interpretations of the tax laws.
Deferred income tax assets and liabilities are recognized for the expected future income tax consequences of carryforwards and temporary differences between the book and tax basis of assets and liabilities. Valuation allowances are established for deferred tax assets that are deemed more likely than not to be realized in the near term. We must assess the likelihood that we will be able to recover our deferred tax assets. If recovery is not likely, we establish valuation allowances to offset any deferred tax asset recorded. The valuation allowance is based on our estimates of future taxable income in each jurisdiction in which we operate, tax planning strategies, and the period over which our deferred tax assets will be recoverable. In the event that actual results differ from these estimates, we may be unable to implement certain tax planning strategies or adjust these estimates in future periods. As we update our estimates, we may need to establish an additional valuation allowance which could have a material negative impact on our results of operations or financial position, or we could reduce our valuation allowances which would have a favorable impact on our results of operations and financial position.
Stock-Based Compensation
We apply the Black-Scholes valuation model in determining the fair value of stock option awards, which requires the use of a number of highly complex and subjective variables. These variables include, but are not limited to the actual and projected employee and director stock option exercise behavior, expected volatility, risk-free interest rate, expected dividends, and expected term. Expected volatility is based on the historical volatility of a peer group of companies over the expected life of the option as we do not have enough history trading as a public company to calculate our own stock price volatility. We utilize historical data to estimate option exercise and employee termination behavior within the valuation model. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant for the expected term of the option. We also estimate forfeitures at the time of grant and revise these estimates, if necessary, in subsequent periods if actual forfeitures differ from those estimates. We estimate forfeitures based on our expectation of future experience while considering our historical experience. Changes in the subjective assumptions can materially affect the estimate of fair value of stock-based compensation and consequently, the related amount recognized in the consolidated statement of operations. We are also required to establish deferred tax assets for expense relating to options that would be expected to generate a tax deduction under their original terms. The recoverability of such assets are dependent upon the actual deduction that may be available at exercise and can further be impaired by either the expiration of the option or an overall valuation reserve on deferred tax assets.
We believe the estimates and assumptions related to these critical accounting policies are appropriate under the circumstances; however, should future events result in unanticipated consequences, there could be a material impact on our future financial condition or results of operations.
Recent Accounting Pronouncements
See the Recent Accounting Pronouncements section of Note 1 to our consolidated financial statements for a summary of new accounting standards.

 

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Item 7A.  
Quantitative and Qualitative Disclosures About Market Risk
Interest Rates
We are exposed to market risk primarily from fluctuations in interest rates on our investments. We held approximately $6.3 million in investments, including $5.8 million of auction rate securities, as of December 31, 2009. Changes in interest rates affect the investment income we earn on our investments and, therefore, impact our cash flows and results of operations. For 2009, the average interest rate earned on our investments was approximately 1.4%. A hypothetical 100 basis point decline in the interest rate earned on our investments would decrease our interest income by approximately $50,000.
Primary Market Risk Exposures
Our primary market risk exposures are in the areas of commodity costs. Many of the food products purchased by us can be subject to volatility due to changes in weather, production, availability, seasonality, and other factors outside our control. Substantially all of our food and supplies are available from several sources, which helps to diversify our overall commodity cost risk. We also believe that we have the ability to increase certain menu prices in response to food commodity price increases.
Item 8.  
Financial Statements and Supplementary Data
Reference is made to the consolidated financial statements, the notes thereto, and the report thereon, commencing on page F-1 of this report, which financial statements, notes, and report are incorporated herein by reference.
Item 9.  
Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
Not applicable.
Item 9A(T).  
Controls and Procedures
Evaluation of Disclosure Controls and Procedures
We have evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of December 31, 2009. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have each concluded that our disclosure controls and procedures are effective to ensure that we record, process, summarize, and report information required to be disclosed by us in our reports filed under the Exchange Act within the time periods specified by the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
Management’s Report on Internal Control Over Financial Reporting
We are responsible for establishing and maintaining adequate internal control over financial reporting. As defined in the securities laws, internal control over financial reporting is a process designed by, or under the supervision of, our principal executive and principal financial officer and effected by our Board of Directors, management, and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.

 

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Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we carried out an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2009 based on the criteria in “Internal Control — Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based upon this evaluation, we concluded that our internal control over financial reporting was effective as of December 31, 2009.
This annual report does not include an attestation report of our independent registered public accounting firm regarding internal control over financial reporting pursuant to temporary rules of the SEC that permit us to provide only management’s report in this annual report on Form 10-K for the year ended December 31, 2009.
Changes in Internal Control Over Financial Reporting
There has not been any change in our internal control over financial reporting during our fourth fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.  
Other Information
Not applicable.
PART III
Item 10.  
Directors, Executive Officers and Corporate Governance
The information required by this Item relating to our directors is incorporated herein by reference to the definitive Proxy Statement to be filed pursuant to Regulation 14A of the Exchange Act for our 2010 Annual Meeting of Stockholders. The information required by this Item relating to our executive officers is included in Part I, Item 1 “Business — Executive Officers.”
Item 11.  
Executive Compensation
The information required by this Item is incorporated herein by reference to the information contained in the definitive Proxy Statement to be filed pursuant to Regulation 14A of the Exchange Act for our 2010 Annual Meeting of Stockholders.
Item 12.  
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by this Item is incorporated herein by reference to the information contained in the definitive Proxy Statement to be filed pursuant to Regulation 14A of the Exchange Act for our 2010 Annual Meeting of Stockholders.
Item 13.  
Certain Relationships and Related Transactions, and Director Independence
The information required by this Item is incorporated herein by reference to the information contained in the definitive Proxy Statement to be filed pursuant to Regulation 14A of the Exchange Act for our 2010 Annual Meeting of Stockholders.
Item 14.  
Principal Accountant Fees and Services
The information required by this Item is incorporated herein by reference to the information contained in the definitive Proxy Statement to be filed pursuant to Regulation 14A of the Exchange Act for our 2010 Annual Meeting of Stockholders.

 

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PART IV
Item 15.  
Exhibits and Financial Statement Schedules
(a) The following documents are filed as a part of the report:
  (1)  
Financial Statements
 
     
Financial Statements are listed in the Index to Consolidated Financial Statements on page F-1 of this report.
 
  (2)  
Financial Statement Schedules
 
     
No financial statement schedules are included because such schedules are not applicable, are not required, or because required information is included in the consolidated financial statements or notes thereto.
 
  (3)  
Exhibits
         
Exhibit    
Number   Exhibit
       
 
  3.1    
Amended and Restated Certificate of Incorporation of the Registrant (2)
  3.3    
Amended and Restated Bylaws of Kona Grill, Inc., as of October 30, 2007 (6)
  3.4    
Certificate of Designations, Preferences, and Rights of Series A Junior Participating Preferred Stock of Kona Grill, Inc. (8)
  4.1    
Form of Common Stock Certificate (3)
  4.2    
Kona Grill, Inc. Stockholders’ Agreement, dated August 29, 2003 (3)
  4.3    
Kona Grill, Inc. Series A Investor Rights Agreement, dated August 29, 2003 (3)
  4.4    
Amendment No. 1 to Kona Grill, Inc. Series A Investor Rights Agreement, dated May 31, 2005 (3)
  4.9    
Form of First Amended and Restated Promissory Note, dated April 7, 2009, among Kona Grill, Inc. and the investor parties thereto (10)
  4.10    
Form of Warrant
  10.6 (a)  
Loan Agreement, dated May 19, 2003, between GE Capital Franchise Finance Corporation and Kona Grill Kansas City, Inc. (1)
  10.6 (b)  
Promissory Note, dated May 19, 2003, issued by Kona Grill Kansas City, Inc. in favor of GE Capital Franchise Finance Corporation (1)
  10.7 (a)  
Loan Agreement, dated April 30, 2004, between GE Capital Franchise Finance Corporation and Kona Grill Las Vegas, Inc. (1)
  10.7 (b)  
Promissory Note, dated April 30, 2004, issued by Kona Grill Las Vegas, Inc. in favor of GE Capital Franchise Finance Corporation (1)
  10.8 (a)  
Form of Equipment Loan and Security Agreement (i) dated as of September 2, 2004, between Kona Grill Denver, Inc. and GE Capital Franchise Finance Corporation; (ii) dated as of December 31, 2004, between Kona Grill Omaha, Inc. and GE Capital Franchise Finance Corporation; and (iii) dated January 21, 2005 between Kona Grill Indiana, Inc. and GE Capital Franchise Finance Corporation (1)
  10.8 (b)  
Form of Equipment Promissory Note, each in favor of GE Capital Franchise Finance Corporation (i) dated as of April 22, 2005, issued by Kona Grill Omaha, Inc.; and (ii) dated as of May 20, 2005, issued by Kona Grill Indiana, Inc. (1)
  10.8 (c)  
Equipment Promissory Note, dated September 17, 2004, issued by Kona Grill Denver, Inc. in favor of GE Capital Franchise Finance Corporation (1)
  10.10 *  
Kona Grill, Inc. 2002 Stock Plan (as of November 13, 2002) (1)
  10.11 *  
Kona Grill, Inc. 2005 Stock Award Plan (2)
  10.12 *  
Kona Grill, Inc. 2005 Employee Stock Purchase Plan (amended as of August 15, 2005) (4)
  10.15 *  
Form of Stock Option Agreement (2005 Stock Award Plan) (5)
  10.17    
Securities Purchase Agreement, dated November 1, 2007, among Kona Grill, Inc. and the investor parties thereto (7)
  10.21    
Note and Warrant Purchase Agreement, dated March 6, 2009, among Kona Grill, Inc. and the investor parties thereto (9)

 

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Exhibit    
Number   Exhibit
  10.22 *  
Employment Agreement, dated as of May 11, 2009, between the Company and Marcus E. Jundt (11)
  10.23 *  
Employment Agreement, dated as of May 11, 2009, between the Company and Mark L. Bartholomay (11)
  10.24 *  
Employment Agreement, dated as of May 11, 2009, between the Company and Mark S. Robinow (11)
  10.25 *  
Separation Agreement, dated as of August 6, 2009, between the Company and Marcus E. Jundt (12)
  10.26 *  
Employment Agreement, dated as of November 2, 2009, between the Company and Marc A. Buehler (13)
  10.27 *  
Separation Agreement, dated as of November 24, 2009, between the Company and Mark L. Bartholomay (14)
  21    
List of Subsidiaries
  23    
Consent of Independent Registered Public Accounting Firm
  31.1    
Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.
  31.2    
Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.
  32.1    
Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
  32.2    
Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
     
*  
Management contract or compensatory plan or arrangement in which directors or executive officers are eligible to participate.
 
(1)  
Incorporated by reference to the Registrant’s Registration Statement on Form S-1 (Registration No. 333-125506), as filed with the Commission on June 3, 2005.
 
(2)  
Incorporated by reference to Amendment No. 1 to the Registrant’s Registration Statement on Form S-1 (Registration No. 333-125506), as filed on July 8, 2005.
 
(3)  
Incorporated by reference to Amendment No. 2 to the Registrant’s Registration Statement on Form S-1 (Registration No. 333-125506), as filed on July 21, 2005.
 
(4)  
Incorporated by reference to the Registrant’s Registration Statement on Form S-8 (Registration No. 333-127593), as filed with the Commission on August 16, 2005.
 
(5)  
Incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2006, as filed with the Commission on May 8, 2006.
 
(6)  
Incorporated by reference to the Registrant’s Form 8-K filed on November 5, 2007.
 
(7)  
Incorporated by reference to the Registrant’s Form 8-K filed on November 6, 2007.
 
(8)  
Incorporated by reference to the Registrant’s Form 8-K filed on May 28, 2008.
 
(9)  
Incorporated by reference to the Registrant’s Form 8-K filed on March 9, 2009.
 
(10)  
Incorporated by reference to the Registrant’s Form 8-K filed on April 10, 2009.
 
(11)  
Incorporated by reference to the Registrant’s Form 8-K filed on May 14, 2009.
 
(12)  
Incorporated by reference to the Registrant’s Form 8-K filed on August 12, 2009.
 
(13)  
Incorporated by reference to the Registrant’s Form 8-K filed on November 3, 2009.
 
(14)  
Incorporated by reference to the Registrant’s Form 8-K filed on November 27, 2009.

 

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Signatures
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
         
  Kona Grill, Inc.
 
 
  /s/ Marc A. Buehler    
  Marc A. Buehler   
  President and Chief Executive Officer   
 
Date: March 4, 2010
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacity and on the dates indicated.
         
Signature   Capacity   Date
 
       
/s/ Marc A. Buehler
 
Marc A. Buehler
  President, Chief Executive Officer and Director
(Principal Executive Officer) 
  March 4, 2010
 
       
/s/ Mark S. Robinow
 
Mark S. Robinow
  Executive Vice President, Chief Financial
Officer, and Secretary
(Principal Accounting and Financial Officer) 
  March 4, 2010
 
       
/s/ Richard J. Hauser
 
Richard J. Hauser
  Director    March 4, 2010
 
       
/s/ Douglas G. Hipskind
 
Douglas G. Hipskind
  Director    March 4, 2010
 
       
/s/ Berke Bakay
 
Berke Bakay
  Director    March 4, 2010
 
       
/s/ Anthony L. Winczewski
 
Anthony L. Winczewski
  Director    March 4, 2010
 
       
/s/ Mark A. Zesbaugh
 
Mark Zesbaugh
  Director    March 4, 2010

 

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KONA GRILL, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
         
    Page  
    F-2  
 
       
    F-3  
 
       
    F-4  
 
       
    F-5  
 
       
    F-6  
 
       
    F-7  

 

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Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders of Kona Grill, Inc.
We have audited the accompanying consolidated balance sheets of Kona Grill, Inc. as of December 31, 2009 and 2008, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2009. 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 in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, 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.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Kona Grill, Inc. at December 31, 2009 and 2008, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles.
/s/ Ernst & Young LLP
Phoenix, Arizona
March 4, 2010

 

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KONA GRILL, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
                 
    December 31,  
    2009     2008  
ASSETS
               
Current assets:
               
Cash and cash equivalents
  $ 2,404     $ 2,477  
Investments
    6,282       370  
Receivables
    308       980  
Other current assets
    1,111       938  
 
           
Total current assets
    10,105       4,765  
Long-term investments
          6,491  
Other assets
    668       794  
Property and equipment, net
    39,190       53,504  
 
           
Total assets
  $ 49,963     $ 65,554  
 
           
 
               
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current liabilities:
               
Accounts payable
  $ 2,922     $ 4,335  
Accrued expenses
    5,753       4,878  
Current portion of notes payable
    684       717  
Line of credit
    5,800       2,488  
 
           
Total current liabilities
    15,159       12,418  
Notes payable
    636       1,320  
Deferred rent
    16,185       16,218  
 
           
Total liabilities
    31,980       29,956  
 
           
 
               
Commitments and contingencies (Note 13)
               
 
               
Stockholders’ equity:
               
Preferred stock, $0.01 par value, 2,000,000 shares authorized; none issued
           
Common stock, $0.01 par value, 15,000,000 shares authorized, 9,262,895 shares issued and 9,146,695 shares outstanding at December 31, 2009 and 6,628,191 shares issued and 6,511,991 shares outstanding at December 31, 2008
    93       66  
Additional paid-in capital
    57,649       53,739  
Accumulated deficit
    (38,759 )     (17,207 )
Treasury stock, at cost, 116,200 shares at December 31, 2009 and 2008
    (1,000 )     (1,000 )
 
           
Total stockholders’ equity
    17,983       35,598  
 
           
Total liabilities and stockholders’ equity
  $ 49,963     $ 65,554  
 
           
See accompanying notes to the consolidated financial statements.

 

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KONA GRILL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
                         
    Year Ended December 31,  
    2009     2008     2007  
 
                       
Restaurant sales
  $ 81,095     $ 75,815     $ 69,521  
Costs and expenses:
                       
Cost of sales
    21,058       20,730       19,600  
Labor
    28,517       25,396       21,554  
Occupancy
    6,457       5,157       4,465  
Restaurant operating expenses
    13,156       11,314       9,479  
General and administrative
    8,200       8,416       7,294  
Preopening expense
    1,685       2,073       1,962  
Depreciation and amortization
    7,314       6,547       5,428  
Asset impairment charge
    16,915       3,219        
 
                 
Total costs and expenses
    103,302       82,852       69,782  
 
                 
Loss from operations
    (22,207 )     (7,037 )     (261 )
Nonoperating expenses:
                       
Interest income and other, net
    204       296       617  
Interest expense
    (174 )     (51 )     (85 )
 
                 
(Loss) income from continuing operations before provision for income taxes
    (22,177 )     (6,792 )     271  
Provision for income taxes
    65       205       406  
 
                 
Loss from continuing operations
    (22,242 )     (6,997 )     (135 )
Gain (loss) from discontinued operations, net of tax
    690       (3,504 )     (534 )
 
                 
Net loss
  $ (21,552 )   $ (10,501 )   $ (669 )
 
                 
 
                       
Net loss per share – Basic and Diluted (Note 1):
                       
Continuing operations
  $ (2.57 )   $ (0.87 )   $ (0.02 )
Discontinued operations
    0.08       (0.43 )     (0.07 )
 
                 
Net loss
  $ (2.49 )   $ (1.30 )   $ (0.09 )
 
                 
 
                       
Weighted average shares used in computation (Note 1):
                       
Basic
    8,645       8,054       7,364  
 
                 
Diluted
    8,645       8,054       7,364  
 
                 
See accompanying notes to the consolidated financial statements.

 

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KONA GRILL, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(In thousands)
                                                         
                                            Accumulated        
                    Additional                     Other        
    Common Stock     Paid-in     Accumulated     Treasury     Comprehensive        
    Shares     Amount     Capital     Deficit     Stock     Income/(Loss)     Total  
Balances at December 31, 2006
    5,848     $ 58     $ 41,722     $ (5,957 )   $     $ (1 )   $ 35,822  
Cumulative effect adjustment upon adoption of FIN 48
                15       (80 )                 (65 )
Tax benefit from stock option exercises
                145                         145  
Stock-based compensation expense
                607                         607  
Issuance of common stock, net of $594 of offering expenses
    650       7       9,962                         9,969  
Issuance of common stock under the Employee Stock Purchase Plan and exercise of stock options and warrants
    110       1       620                         621  
Net loss
                      (669 )                 (669 )
Unrealized holding gain (loss), net
                                  1       1  
 
                                                     
Comprehensive loss
                                                    (668 )
 
                                         
Balances at December 31, 2007
    6,608       66       53,071       (6,706 )                 46,431  
Stock-based compensation expense
                582                         582  
Purchase of treasury stock
    (116 )                       (1,000 )           (1,000 )
Issuance of common stock under the Employee Stock Purchase Plan and exercise of stock options and warrants
    20             86                         86  
Net loss
                      (10,501 )                 (10,501 )
Unrealized holding gain (loss), net
                                         
 
                                                     
Comprehensive loss
                                                    (10,501 )
 
                                         
Balances at December 31, 2008
    6,512       66       53,739       (17,207 )     (1,000 )           35,598  
Stock-based compensation expense
                560                         560  
Issuance of common stock, net of $275 of offering expenses
    2,608       26       3,219                         3,245  
Issuance of common stock under the Employee Stock Purchase Plan and exercise of stock options and warrants
    27       1       61                         62  
Warrants issued with bridge loan
                70                         70  
Net loss
                      (21,552 )                 (21,552 )
Unrealized holding gain (loss), net
                                         
 
                                                     
Comprehensive loss
                                                    (21,552 )
 
                                         
Balances at December 31, 2009
    9,147     $ 93     $ 57,649     $ (38,759 )   $ (1,000 )   $     $ 17,983  
 
                                         
See accompanying notes to the consolidated financial statements.

 

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KONA GRILL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
                         
    Year Ended December 31,  
    2009     2008     2007  
Operating activities
                       
Net loss
  $ (21,552 )   $ (10,501 )   $ (669 )
Adjustments to reconcile net loss to net cash provided by operating activities:
                       
Depreciation and amortization
    7,314       6,805       5,791  
Stock-based compensation
    560       582       607  
Asset impairment
    16,915       5,377        
Amortization of debt discount
    70              
Excess tax benefit related to stock option exercises
                (160 )
Change in operating assets and liabilities:
                       
Receivables
    672       116       (147 )
Other current assets
    (173 )     455       (652 )
Accounts payable
    693       (218 )     (1,123 )
Accrued expenses
    875       853       603  
Deferred rent
    (33 )     3,224       1,451  
 
                 
Net cash provided by operating activities
    5,341       6,693       5,701  
Investing activities
                       
Purchase of property and equipment
    (12,021 )     (17,146 )     (12,755 )
Decrease (increase) in other assets
    126       (299 )     (88 )
Net purchases and sales of investments
    579       7,327       62  
 
                 
Net cash used in investing activities
    (11,316 )     (10,118 )     (12,781 )
 
                       
Financing activities
                       
Net borrowings on line of credit
    3,312       2,488        
Repayments of notes payable
    (717 )     (663 )     (613 )
Proceeds from bridge loan
    1,200              
Repayment of bridge loan
    (1,200 )            
Proceeds from issuance of common stock, net of issuance costs
    3,245             9,969  
Proceeds from issuance of common stock under the Employee Stock Purchase Plan and exercise of stock options and warrants
    62       86       621  
Purchase of treasury stock
          (1,000 )      
Excess tax benefit related to stock option exercises
                160  
 
                 
Net cash provided by financing activities
    5,902       911       10,137  
 
                 
Net (decrease) increase in cash and cash equivalents
    (73 )     (2,514 )     3,057  
Cash and cash equivalents at the beginning of the year
    2,477       4,991       1,934  
 
                 
Cash and cash equivalents at the end of the year
  $ 2,404     $ 2,477     $ 4,991  
 
                 
 
                       
Supplemental disclosures of cash flow information
                       
Cash paid for interest (net of capitalized interest)
  $ 104     $ 51     $ 85  
Cash paid for income taxes, net of refunds
  $ 74     $ 110     $  
Noncash investing activities
                       
(Decrease) increase in accounts payable related to property and equipment additions
  $ (2,106 )   $ 1,229     $ (169 )
See accompanying notes to the consolidated financial statements.

 

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KONA GRILL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009
1. The Company and Summary of Significant Accounting Policies
Description of Business
Kona Grill, Inc. (referred to herein as the “Company” or “we,” “us,” and “our”) owns and operates upscale casual dining restaurants under the name “Kona Grill.” Our restaurants feature a diverse selection of mainstream American dishes and award-winning sushi that are prepared fresh daily. We currently own and operate 24 restaurants in 15 states across the United States.
Basis of Presentation
The accompanying consolidated financial statements include the accounts and operations of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
In connection with preparation of the consolidated financial statements, we evaluated subsequent events after the balance sheet date of December 31, 2009 through March 4, 2010, the date the financial statements were issued.
Use of Estimates
The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
Cash and Cash Equivalents
Cash and cash equivalents consist of cash, money market funds, and highly liquid short-term fixed income securities with a maturity of 90 days or less when purchased. Amounts receivable from credit card processors are also considered cash equivalents because they are both short-term and highly liquid in nature and are typically converted to cash within one business day of the sales transaction.
Investments
Investments consist primarily of auction rate securities, certificates of deposit, and money market securities that are generally highly liquid in nature and represent the investment of cash that is available for current operations. We generally invest in high quality securities that are rated “AAA.” We classify our investments based on the intended holding period. Available-for-sale securities are carried at estimated fair value, based on available market information, with unrealized gains and losses, if any, reported as a separate component of stockholders’ equity. Trading securities are carried at fair value with gains and losses reported in the consolidated statements of operations.
Inventories
Inventories consist of food and beverage products and are stated at the lower of cost or market using the first-in, first-out method. Inventories are included in other current assets in the accompanying consolidated balance sheets.
Fair Value of Financial Instruments
The carrying amount of cash and cash equivalents, certificates of deposit, money market securities, receivables, accounts payable, and accrued expenses approximates fair value because of the immediate or short-term maturity of these financial instruments. Investments in auction rate securities are recorded at fair value based on valuation models and methodologies using “Level 3” inputs as defined by accounting guidance for fair value measurements. The fair value of long-term debt is determined using current applicable rates for similar instruments and approximates the carrying value of such obligations.

 

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KONA GRILL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
Concentration of Credit Risk
Financial instruments that potentially subject us to a concentration of credit risk principally consist of cash and cash equivalents, investments and accounts receivable. Concentration of credit risk is limited by diversifying cash deposits among a variety of high credit-quality issuers. At times, cash and cash equivalent balances may be in excess of the FDIC insurance limit. Concentration of credit risk for our investments is limited by diversifying investments among a variety of high credit-quality issuers. We consider our concentration of credit risk with respect to receivables to be limited as the balance is primarily comprised of tenant improvement allowances from landlords.
Property and Equipment
Property and equipment are stated at cost less accumulated depreciation. We capitalize all direct costs on the construction of leasehold improvements and capitalize interest during the construction and development period. Leasehold improvements are amortized over the shorter of the useful life of the asset or the related lease term that includes reasonably assured lease renewals as determined on the date of acquisition of the leasehold improvement. Improvements that materially extend the life of an asset are capitalized while repair and maintenance costs are expensed as incurred.
Depreciation and amortization are recorded on a straight-line basis over the following estimated useful lives:
         
Furniture and fixtures
  5-7 years
Equipment
  7 years
Computer software and electronic equipment
  3 years
Leasehold improvements
  Shorter of the useful life or the lease term
We evaluate property and equipment for impairment whenever events or changes in restaurant operating results indicate that the carrying value of those assets may not be recoverable. Factors considered include, but are not limited to, significant underperformance relative to expected historical or projected future operating results; significant negative industry or economic trends; and significant changes in legal factors or in the business climate. The assessment of impairment is performed on a restaurant-by-restaurant basis. The recoverability is assessed by comparing the carrying value of the asset to the undiscounted cash flows expected to be generated by the asset. This assessment process requires the use of estimates and assumptions regarding future cash flows and estimated useful lives, which are subject to a significant degree of judgment. If indicators of impairment are present and if we determine that the carrying value of the asset exceeds the fair value of the restaurant assets, an impairment charge is recorded to reduce the carrying value of the asset to its fair value. See Note 2 for discussion of asset impairment charges recorded during 2008 and 2009.
Leases
We lease our restaurant locations under operating lease agreements with initial terms of approximately 10 to 20 years. Most of these agreements require minimum annual rent payments plus contingent rent payments based on a percentage of restaurant sales which exceed the minimum base rent. Contingent rent payments, to the extent they exceed minimum payments, are accrued over the periods in which the liability is incurred. Rent expense associated with these contingent payments is recorded prior to the achievement of specified sales levels if exceeding such amount is considered probable and is estimable. The lease agreements typically also require scheduled increases to minimum annual rent payments. For leases that contain rent escalations, we record the total rent payable over the initial lease term, starting on the date we gain possession of the property (including the construction period), on a straight-line basis. Any difference between minimum rent and straight-line rent is recorded as deferred rent. Deferred rent also includes tenant improvement allowances which are amortized as a reduction of rent expense on a straight-line basis over the initial term of the lease.

 

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KONA GRILL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
Revenue Recognition
Revenues from food, beverage, and alcohol sales are recognized when payment is tendered at the point of sale. Restaurant sales are recorded net of promotions and discounts. Revenues from gift card sales are recognized upon redemption. Prior to redemption, the outstanding balances of all gift cards are included in accrued expenses in the accompanying consolidated balance sheets.
Sales Taxes
Revenues are presented net of sales taxes. The obligation is included in accrued expenses until the taxes are remitted to the appropriate taxing authorities.
Advertising Costs
Advertising costs are expensed as incurred. Advertising expense for 2009, 2008, and 2007 was $1,063,000, $934,000, and $1,192,000, respectively, and is included in restaurant operating expenses in the accompanying consolidated statements of operations. Costs associated with the redemption of a promotion in the form of a coupon for a free or discounted product are recorded in cost of sales as the intent of the coupon is to generate additional restaurant sales through driving guest traffic. Costs associated with promotional giveaways of food and beverages to local businesses and sponsorship of events are viewed as advertising in nature and recorded in restaurant operating expenses in the accompanying consolidated statements of operations.
Preopening Expense
Costs directly related to the opening of new restaurants, including employee relocation, travel, employee payroll and related training costs, and rent expense subsequent to the date we take possession of the property through the restaurant opening, are expensed as incurred.
Stock-Based Compensation
We have two stock option plans under which we may issue incentive stock options, non-qualified stock options, restricted stock, and other types of awards to employees, directors, and consultants. Upon effectiveness of the 2005 Stock Award Plan, the 2002 Stock Award Plan was closed for purposes of new grants. During the last three years, we have only granted non-qualified stock options. Stock options issued under these plans are granted with an exercise price at or above the fair market value of the underlying common stock on the date of grant and generally expire five years from the date of grant. Employee stock options generally vest 25% each year over a four-year period, while annual recurring awards for non-employee director options vest 25% each quarter over a one-year period. Certain executive officer stock options may vest earlier in the event of a change of control or termination, as defined in the executive officer’s employment agreement.
We apply the Black-Scholes valuation model in determining the fair value of stock option grants. We recognize compensation cost for our stock awards using a graded vesting schedule on a straight line basis over the requisite service period.
Income Taxes
We utilize the liability method of accounting for income taxes. Under the liability method, deferred tax assets and liabilities are computed at each balance sheet date for temporary differences between the consolidated financial statements and tax basis of assets and liabilities that will result in taxable or deductible amounts in the future based on tax rates in effect in the years in which the temporary differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts that will more likely than not be realized.

 

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KONA GRILL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
We recognize the impact of a tax position in our financial statements if that position is more likely than not of being sustained on audit, based on the technical merits of the position. We recognize accrued interest and penalties related to uncertain tax positions as income tax expense.
Net Loss Per Share
Basic net loss per share is computed by dividing net loss by the weighted average number of common shares outstanding during the year. Diluted net loss per share excludes the dilutive effect of potential stock option and warrant exercises, which are calculated using the treasury stock method, as these shares are anti-dilutive.
The following table sets forth the computation of basic and diluted net loss per share:
                         
    Year Ended December 31,  
    2009     2008     2007  
    (In thousands, except per share data)  
Numerator:
                       
Loss from continuing operations
  $ (22,242 )   $ (6,997 )   $ (135 )
Gain (loss) from discontinued operations
    690       (3,504 )     (534 )
 
                 
Net loss
  $ (21,552 )   $ (10,501 )   $ (669 )
 
                 
Denominator:
                       
Weighted average shares — basic
    8,645       8,054       7,364  
Effect of dilutive stock options and warrants
                 
 
                 
Weighted average shares — diluted
    8,645       8,054       7,364  
 
                 
                         
Net loss per share — Basic and Diluted:
                       
Continuing operations
  $ (2.57 )   $ (0.87 )   $ (0.02 )
Discontinued operations
    0.08       (0.43 )     (0.07 )
 
                 
Net loss
  $ (2.49 )   $ (1.30 )   $ (0.09 )
 
                 
On June 9, 2009, we completed our rights offering for which each holder of common stock as of the April 17, 2009 record date received one non-transferrable subscription right for every 2.5 shares of common stock. Each subscription right entitled our stockholders to purchase one share of common stock at a purchase price of $1.35 per share. The market price of our common stock was $3.93 per share on June 5, 2009, which was the expiration date of the rights offering. Since the $1.35 per share subscription price of common stock issued under the rights offering was lower than the $3.93 per share market price on June 5, 2009, the rights offering contained a bonus element. As a result, we retroactively increased the weighted average common shares outstanding used to compute basic and diluted earnings (loss) per share by an adjustment factor of 1.2309 for all periods presented prior to the completion of the rights offering.
For 2009, 2008, and 2007, there were approximately 965,000, 1,033,000, and 855,000, stock options and warrants outstanding, respectively, that were not included in the dilutive earnings per share calculation because the effect would have been anti-dilutive.
Comprehensive Loss
Comprehensive loss is defined as the aggregate change in stockholders’ equity, excluding changes in ownership interests. Comprehensive loss reported in the accompanying consolidated statements of stockholders’ equity consists of net loss and unrealized gains or losses on available-for-sale securities.

 

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KONA GRILL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
Recent Accounting Pronouncements
In April 2009, the Financial Accounting Standards Board issued additional application guidance and enhanced disclosures regarding fair value measurements and impairment of securities. The guidance includes how to determine the fair value of assets and liabilities when the volume and level of activity for the asset or liability has significantly decreased. Enhanced disclosure requirements include the following: 1) interim disclosures regarding the fair values of financial instruments that are not currently reflected on the balance sheet at fair value; and 2) disclosure on the methods and significant assumptions used to estimate the fair value of financial instruments on an interim basis as well as changes of the methods and significant assumptions from prior periods. We adopted the additional guidance and disclosure requirements as of our second quarter ended June 30, 2009. The adoption did not have a material effect on our financial condition or results of operations.
2. Asset Impairment Charges and Discontinued Operations
Asset Impairment Charges
We review the carrying value of our long-lived assets on a restaurant-by-restaurant basis. During 2009, we recorded non-cash asset impairment charges of $16,915,000 for six underperforming restaurants based upon an assessment of each restaurant’s historical operating performance combined with expected cash flows for these restaurants over the respective remaining lease term. We reduced the carrying value of these assets to their estimated fair value which was determined using a discounted cash flow model or the market value of each restaurant’s assets. The six restaurants that comprise the asset impairment charge are located in the following cities: 1) Phoenix, Arizona; 2) Stamford, Connecticut; 3)West Palm Beach, Florida; 4) Oak Brook, Illinois; 5) Baton Rouge, Louisiana and 6) Sugar Land, Texas. We do not intend to close any of these restaurants at this time, but will continue to evaluate each of these restaurants on a case-by-case basis.
Additionally during 2008, we recorded non-cash charges of $3,219,000 for the impairment of long-lived assets at our Lincolnshire, Illinois restaurant based upon the restaurant’s past and present operating performance combined with our assessment of expected cash flows from this location over the remainder of the original lease term. We intend to continue operating this restaurant and believe that the operating performance of this restaurant can be improved. No asset impairment charges were recorded during 2007.
Discontinued Operations
On September 13, 2008, we closed our Naples, Florida restaurant to focus our attention on the profitable locations and position our concept to generate profit from operations. As a result of the closure, we recorded non-cash asset impairment charges of $2,158,000 as well as ongoing contractual lease obligations, restaurant-level closing costs, and employee termination benefits, net of deferred costs, of approximately $800,000 during 2008.
Gain (loss) from discontinued operations includes both the historical results of operations as well as exit costs attributed to the Naples, Florida restaurant. During the second quarter of 2009, we entered into a settlement agreement for the termination of the lease for $700,000. As the settlement amount was less than the lease termination accrual previously recorded during 2008, we recorded a gain of $690,000, after deducting fees and other expenses, for 2009. Gain (loss) from discontinued operations, net of tax is comprised of the following (in thousands):
                         
    Year Ended December 31,  
    2009     2008     2007  
Restaurant sales
  $     $ 1,531     $ 2,737  
 
                       
Gain (loss) from discontinued operations before income tax benefit
  $ 690     $ (3,579 )   $ (590 )
Income tax benefit
          75       56  
 
                 
Gain (loss) from discontinued operations, net of tax
  $ 690     $ (3,504 )   $ (534 )
 
                 

 

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KONA GRILL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
Activity associated with the lease termination accrual is summarized below (in thousands):
         
Balance at December 31, 2008
  $ 1,417  
Cash payments
    (546 )
Non-cash activity
    (690 )
 
     
Balance at December 31, 2009
  $ 181  
 
     
Non-cash activity reflects the revised estimate of lease termination costs based upon the settlement agreement discussed above. The lease settlement required an initial payment of $350,000 that was paid during July 2009 and the remaining amount, including interest at a 6% annual rate, is payable in 12 equal monthly installments beginning in August 2009. Settlement fees of $181,000 are included in accrued expenses on the accompanying consolidated balance sheet as of December 31, 2009.
3. Investments
The following is a summary of our investments (in thousands):
                         
            Gross        
    Adjusted     Unrealized     Estimated  
    Cost     Losses     Fair Value  
December 31, 2009
                       
Short-term investments:
                       
Certificates of deposit
  $ 172     $     $ 172  
Money market securities
    314             314  
Auction rate securities
    5,433             5,433  
Put option on auction rate securities
    363             363  
 
                 
Total investments
  $ 6,282     $     $ 6,282  
 
                 
 
                       
December 31, 2008
                       
Short-term investments:
                       
Certificates of deposit
  $ 370     $     $ 370  
 
                 
Long-term investments:
                       
Auction rate securities
    5,858             5,858  
Put option on auction rate securities
    633             633  
 
                 
 
    6,491             6,491  
 
                 
Total investments
  $ 6,861     $     $ 6,861  
 
                 
As of December 31, 2009, our investment portfolio included six auction rate securities with a par value of $5,800,000. These securities are AAA rated long term debt obligations secured by student loans, substantially all of which are guaranteed by the federal government under the Federal Family Education Loan Program. While the maturity dates of our auction rate securities range from 2029 to 2046, liquidity for these securities has historically been provided by an auction process that resets the applicable interest rate at pre-determined calendar intervals, generally every 28 days. Since February 2008, events in the credit markets have adversely affected the auction market for these types of securities and auctions for our securities have failed to settle on their respective settlement dates. During August 2009, we were able to sell $800,000 of these securities at par value. The proceeds from the sale were used to pay down a portion of the outstanding balance under the line of credit.

 

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KONA GRILL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
Our auction rate securities are classified as trading securities as they are subject to an agreement we entered into with UBS during October 2008 pursuant to which UBS issued to us Series C-2 Auction Rate Securities Rights. The agreement allows us the right to sell our auction rate securities to UBS at full par value between June 30, 2010 and July 2, 2012. In conjunction with this agreement, we elected to apply the provisions of fair value accounting to this put option because the put option does not provide for net settlement, and the auction rate securities themselves are not readily convertible to cash. The put option does not meet the definition of a derivative, and thus, would not be marked to fair value. We therefore elected to apply fair value accounting to our put option as the put option acts as an economic hedge against any further price movement in the auction rate securities and enables us to recognize future changes in the fair value of the put option as those changes occur to offset fair value movements in the auction rate securities. Also as part of this agreement, UBS agreed to provide a line of credit through June 30, 2010 that is secured by the auction rate securities held with UBS. Both the put option and the auction rate securities are marked to market value through the consolidated statements of operations each period (see Note 4 for discussion of how fair value measurements are determined). At December 31, 2009, the fair value of the put option was $363,000 and the fair value of the auction rate securities was $5,433,000. We recorded a net gain of $105,000 during 2009 and a net loss of $109,000 during 2008 for the fair value measurement of both the auction rate securities and the put option that is included in interest income and other, net. As of June 30, 2009, we reclassified our auction rate securities and put option from long-term to short-term investments on our consolidated balance sheet due to the expected timing of when these securities will be redeemed at par value by UBS. We continue to earn interest on our auction rate securities at the maximum contractual rate. Interest earned on the auction rate securities is used to reduce the outstanding balance under the line of credit.
4. Fair Value Measurements
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or a liability. As a basis for considering such assumptions, a three-tier value hierarchy has been established, which prioritizes the inputs used in the valuation methodologies in measuring fair value.
Level 1:  
Fair values determined by quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access.
Level 2:  
Fair values utilize inputs other than quoted prices that are observable for the asset or liability, and may include quoted prices for similar assets and liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability.
Level 3:  
Fair values determined by unobservable inputs that are not corroborated by market data and may reflect the reporting entity’s own assumptions market participants would use in pricing the asset or liability.
Our short-term investments in certificates of deposit and money market securities represent available-for-sale securities that are valued primarily using quoted market prices or alternative pricing sources and models utilizing market observable inputs. Money market securities represent collateral for a letter of credit required under certain lease obligations.
Our investment in auction rate securities are classified within Level 3 because they are valued using a discounted cash flow model. We estimate the fair value of auction rate securities using valuation models provided by third parties and internal analyses. The valuation models require numerous assumptions and assessments, including the following: (i) collateralization underlying each security; (ii) present value of future principal and interest payments discounted at rates considered to reflect current market conditions; (iii) creditworthiness of the counterparty; and (iv) current illiquidity of the investments.

 

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KONA GRILL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
The fair value of the put option is determined through comparison of the fair value of each auction rate security to its par value and then discounted by a rate reflective of the risk of default by UBS between the valuation date and the expected exercise date of the put option. A discounted cash flow approach is used to value the difference between the par value and fair value of each security using a discount rate that considers the credit risk associated with UBS and the expected timing of when the put option will be exercised. The put option is adjusted at each balance sheet date based on its then fair value. The fair value of the put option is based on unobservable inputs and is therefore classified within Level 3 in the hierarchy. The following table presents information about our assets measured at fair value on a recurring basis at December 31, 2009, and indicates the fair value hierarchy of the valuation techniques utilized to determine such fair value (in thousands):
                                 
    Fair Value Measurements at Reporting Date Using  
    Quoted Prices in     Significant              
    Active Markets     Other     Significant        
    for Identical     Observable     Unobservable        
    Assets     Inputs     Inputs     December 31,  
Description   (Level 1)     (Level 2)     (Level 3)     2009  
Certificates of deposit
  $ 172     $     $     $ 172  
Money market securities
    314                   314  
Auction rate securities
                5,433       5,433  
Put option on auction rate securities
                363       363  
 
                       
 
  $ 486     $     $ 5,796     $ 6,282  
 
                       
The following table summarizes the changes in fair value of our Level 3 assets (in thousands):
                 
            Put option on  
    Auction rate     auction rate  
    securities     securities  
Balance at December 31, 2008
  $ 5,858     $ 633  
Transfer to Level 3
           
Total gains or losses (realized and unrealized)
               
Included in earnings
    375       (270 )
Included in other comprehensive loss
           
Net settlements
    (800 )      
 
           
Balance at December 31, 2009
  $ 5,433     $ 363  
 
           
As discussed in Note 2, we recorded asset impairment charges for long-lived assets associated with six of our restaurants. These long-lived assets had a carrying amount of $17,444,000 and were written down to their estimated fair value of $529,000. The fair value of each restaurant’s long-lived assets was determined using either a discounted cash flow model or the market value of each restaurant’s long-lived assets. The market value was determined based upon market prices for similar assets in active markets and are classified within Level 2. Valuations using discounted cash flows are classified within Level 3 as these valuations were determined by projecting future cash flows of each restaurant and discounting those cash flows at a rate reflective of current market conditions and factors specific to our company. The following table presents information about our assets measured at fair value on a non-recurring basis at December 31, 2009, and indicates the fair value hierarchy of the valuation techniques utilized to determine such fair value (in thousands):
                                 
    Fair Value Measurements at Reporting Date Using        
    Quoted Prices in     Significant              
    Active Markets     Other     Significant        
    for Identical     Observable     Unobservable        
    Assets     Inputs     Inputs        
Description   (Level 1)     (Level 2)     (Level 3)     Total Losses  
Property and equipment
  $     $ 427     $ 102     $ (16,915 )
5. Receivables
Receivables consisted of the following (in thousands):
                 
    December 31,  
    2009     2008  
Landlord tenant improvement allowances
  $ 300     $ 970  
Other
    8       10  
 
           
Total receivables
  $ 308     $ 980  
 
           
No allowance for doubtful accounts has been recorded as collection of tenant improvement allowances and other receivables is considered probable.

 

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KONA GRILL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
6. Property and Equipment
Property and equipment consisted of the following (in thousands):
                 
    December 31,  
    2009     2008  
Leasehold improvements
  $ 44,878     $ 49,299  
Equipment
    12,491       13,406  
Furniture and fixtures
    3,208       3,548  
 
           
 
    60,577       66,253  
Less accumulated depreciation and amortization
    (21,525 )     (20,004 )
 
           
 
    39,052       46,249  
Construction in progress
    138       7,255  
 
           
Total property and equipment, net
  $ 39,190     $ 53,504  
 
           
7. Accrued Expenses
Accrued expenses consisted of the following (in thousands):
                 
    December 31,  
    2009     2008  
Accrued payroll
  $ 1,875     $ 1,846  
Gift cards
    859       654  
Business and income taxes
    739       663  
Sales taxes
    686       643  
Accrued occupancy
    192       255  
Lease termination accrual
    181        
Other
    1,221       817  
 
           
Total accrued expenses
  $ 5,753     $ 4,878  
 
           
8. Debt and Credit Agreements
Line of Credit
During October 2008, as part of the settlement agreement with UBS, our broker from which we purchased auction rate security instruments, we entered into a line of credit that is secured by the auction rate security instruments held with UBS. Available borrowings under the line of credit are based upon terms specified in the agreement and are subject to adjustment by UBS after consideration of various factors. At December 31, 2009, $5,800,000 was outstanding under the line of credit. Borrowings under the line of credit are callable by UBS at any time. The line of credit is classified as short-term in the accompanying consolidated balance sheets as the loan expires on June 30, 2010. The cost of the line of credit effectively offsets the interest earned on the auction rate securities. See Note 3 for further information on the auction rate securities and the settlement agreement.
Bridge Loan
On March 6, 2009, and as amended on April 7, 2009, we entered into a Note and Warrant Purchase Agreement with certain accredited investors whereby we sold $1,200,000 aggregate principal amount of 10% unsecured subordinated notes and warrants to purchase shares of our common stock. The principal and accrued interest outstanding under the notes were due and payable upon the closing of any offering of equity securities generating gross proceeds to us of at least $2,500,000. As described in Note 10 below, we completed a rights offering during June 2009 and used a portion of the proceeds to repay amounts owed on the notes.

 

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KONA GRILL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
For each $100,000 issued in notes, we issued to the noteholder three-year warrants to purchase 10,000 shares of our common stock at an aggregate exercise price per share of $2.29, which was equal to 120% of the five-day average of the closing price of our common stock during the five trading days prior to the date of issuance. In connection with the issuance of the warrants, we recorded a discount to the bridge loan and a corresponding increase in stockholders’ equity of $70,000 due to the warrants. The value of the warrants was derived through application of the Black-Scholes option pricing model. We amortized the debt discount to interest expense in the amount of $70,000 for 2009.
Notes Payable
Notes payable consisted of the following:
                 
    December 31,  
    2009     2008  
    (In thousands)  
$1,000,000 equipment loan, collateralized by certain restaurant assets of the Company, payable in monthly installments of $15,521 including interest at 7.87%, until October 2011, at which time all remaining principal and interest is due and payable
  $ 317     $ 472  
$1,000,000 equipment loan, collateralized by certain restaurant assets of the Company, payable in monthly installments of $15,526 including interest at 7.88%, until May 2011, at which time all remaining principal and interest is due and payable
    249       409  
$993,544 equipment loan, collateralized by certain restaurant assets of the Company, payable in monthly installments of $15,015 including interest at 7.04%, until June 2010, at which time all remaining principal and interest is due and payable
    88       256  
$600,000 equipment loan, collateralized by certain restaurant assets of the Company, payable in monthly installments of $9,508 including interest at 8.52%, until May 2012, at which time all remaining principal and interest is due and payable
    248       337  
$995,000 equipment loan, collateralized by certain restaurant assets of the Company, payable in monthly installments of $15,687 including interest at 8.36%, until June 2012, at which time all remaining principal and interest is due and payable
    418       563  
 
           
Total notes payable
    1,320       2,037  
Less current portion
    (684 )     (717 )
 
           
Total notes payable, net of current portion
  $ 636     $ 1,320  
 
           
Future maturities of notes payable at December 31, 2009 are as follows (in thousands):
         
2010
  $ 684  
2011
    504  
2012
    132  
 
     
Total notes payable
  $ 1,320  
 
     
The equipment loans require us to maintain a corporate fixed charge coverage ratio of at least 1.25:1.00 determined on the last day of each fiscal year. We were in compliance with the required coverage ratio as of December 31, 2009. Each equipment loan is collateralized by certain of our restaurant assets. During 2009, 2008, and 2007, we incurred gross interest expense of $312,000, $199,000, and $242,000, respectively. We capitalized $138,000, $148,000, and $157,000 of interest costs during 2009, 2008, and 2007, respectively.

 

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KONA GRILL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
9. Income Taxes
Income tax expense from continuing operations consisted of the following (in thousands):
                         
    Year Ended December 31,  
    2009     2008     2007  
Current:
                       
Federal(1)
  $     $ 15     $ 190  
State(1)
    65       190       216  
 
                 
 
    65       205       406  
 
                       
Deferred:
                       
Federal
                 
State
                 
 
                 
 
                 
 
                 
Total
  $ 65     $ 205     $ 406  
 
                 
 
     
(1)  
Excludes federal and state tax benefits resulting from the exercise of stock options, which were credited directly to “Additional paid-in capital.”
Income tax expense differed from amounts computed by applying the federal statutory rate to (loss) income from continuing operations before provision for income taxes as follows (in thousands):
                         
    Year Ended December 31,  
    2009     2008     2007  
Income tax (benefit) expense at federal statutory rate
  $ (7,540 )   $ (2,309 )   $ 96  
State income taxes, net of federal benefit
    (839 )     125       88  
Nondeductible expenses
    362       373       305  
Business tax credit
    (910 )     (1,028 )     (831 )
Other
    (3 )     (63 )     70  
Discontinued operations
    235       (1,353 )     (175 )
Change in valuation reserve
    8,760       4,460       853  
 
                 
Total
  $ 65     $ 205     $ 406  
 
                 
The temporary differences that give rise to significant portions of deferred tax assets and liabilities were as follows (in thousands):
                 
    December 31,  
    2009     2008  
Deferred tax assets (liabilities):
               
Net operating loss carryforward
  $ 2,533     $ 845  
Deferred rent
    5,971       5,474  
Business tax credits
    3,779       2,869  
Organizational and preopening costs
    162       216  
Impairment of assets
    7,487       1,200  
Stock-based compensation
    905       708  
Accrued expenses
    125       643  
Property and equipment
    (4,784 )     (4,601 )
Accelerated tax depreciation
    792       850  
Other
    128       134  
 
           
Net deferred tax assets
    17,098       8,338  
Valuation allowance
    (17,098 )     (8,338 )
 
           
Total
  $     $  
 
           

 

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KONA GRILL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
The valuation allowance increased by approximately $8,760,000 and $4,460,000 at December 31, 2009 and 2008, respectively. In assessing the realization of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. We consider the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based on historical operating losses, we have elected to maintain a full valuation allowance until realization of deferred tax assets is more likely than not.
At December 31, 2009, we have approximately $6,205,000 and $11,656,000 in federal and state net operating loss carryforwards, respectively, which begin expiring in 2028 for federal income tax purposes and 2011 for state income tax purposes. We also have federal business tax credit carryforwards of approximately $3,780,000 which begin expiring in 2021. These credits are also potentially subject to annual limitations due to ownership change rules under the Internal Revenue Code.
As of December 31, 2009, we had $140,000 of unrecognized tax benefits. Future changes in the unrecognized tax benefits are not expected to have a material impact on the effective tax rate, nor do we expect that the amount of unrecognized tax benefits will significantly change in the next 12 months. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows (in thousands):
                         
    Year Ended December 31,  
    2009     2008     2007  
 
                       
Beginning balance
  $ 158     $ 167     $ 80  
Additions related to current year tax positions
                35  
Additions related to tax positions taken during the prior period
          1       52  
Reductions related to settlements with taxing authorities
                 
Reductions due to lapse of statute of limitations
    (18 )     (10 )      
 
                 
Ending balance
  $ 140     $ 158     $ 167  
 
                 
We recognize interest and penalties related to uncertain tax positions in income tax expense. For the years ended December 31, 2009, 2008, and 2007 provision for income taxes includes $12,000, $12,000, and $14,000, respectively, in interest and penalties on unrecognized tax benefits. We had $36,000 and $30,000 accrued for the payment of interest and penalties at December 31, 2009 and 2008, respectively.
We are subject to U.S. federal income tax as well as income tax of multiple state jurisdictions. The earliest tax year still subject to examination by a significant taxing jurisdiction is 2005.
10. Stockholders’ Equity
Preferred Stock
We are authorized to issue 2,000,000 shares of preferred stock with a par value of $0.01. There were no shares of preferred stock that were issued or outstanding at December 31, 2009 or 2008.
Common Stock
Private Placement
On November 6, 2007, we sold 650,000 shares of common stock at a purchase price of $16.25 per share in a private placement to accredited institutional investors. We received net proceeds of $9,969,000 (net of $594,000 in related fees and expenses). These proceeds were utilized to fund new restaurant development and for general corporate purposes.

 

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KONA GRILL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
Rights Offering
As part of the Note and Warrant Purchase Agreement discussed in Note 8, we filed with the SEC a registration statement on Form S-3 to conduct a subscription rights offering with targeted gross proceeds to us of $3,520,000 pursuant to which each of our stockholders received one non-transferrable subscription right for every 2.5 shares of common stock owned on April 17, 2009. Each subscription right entitled the holder to purchase one share of common stock at a price of $1.35 per share. The terms of the agreement provided that any shares of common stock that were not subscribed for in the rights offering by existing stockholders were offered to the holders of the notes on a pro rata basis based on the aggregate principal amount of notes outstanding and at the same subscription price as offered to the holders of subscription rights granted under the rights offering. We sold 2,608,045 shares of common stock pursuant to the rights offering, including the exercise of over-subscription rights by the holders of the notes for the purchase of 482,178 shares or 18.5% of the total shares sold. We received net proceeds of $3,245,000 after deducting $275,000 in expenses. A portion of the net proceeds was used to repay amounts owed on the notes, and the remaining proceeds are being utilized to fund capital expenditure requirements.
Stock Repurchase Program
During April 2008, our Board of Directors approved a stock repurchase program under which we are authorized to repurchase up to 600,000 shares of our common stock. We repurchased 116,200 shares at a total cost of $1,000,000 during 2008 under a section 10b5-1 purchase program. The authorization does not have an expiration date and it does not require us to purchase a specific number of shares. This authorization may be modified, suspended or terminated at any time. The timing and number of shares repurchased pursuant to the share repurchase authorization are subject to a number of factors, including current market conditions, legal constraints and available cash or other sources of funding.
11. Stock-Based Compensation
Stock Options
We maintain stock award plans which provide for discretionary grants of incentive and nonstatutory stock options, restricted stock, and other types of awards to our employees, consultants, and non-employee directors. A total of 1,450,000 shares of common stock have been reserved for issuance under our plans of which 362,821 shares were available for grant as of December 31, 2009.
The fair value of each option award is estimated on the date of grant using the Black-Scholes option pricing model and is affected by assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the actual and projected employee stock option exercise behavior, expected volatility, risk-free interest rate, expected dividends, and expected term. Expected volatility is based on the historical volatility of a peer group of companies over the expected life of the option as we do not have enough history trading as a public company to calculate our own stock price volatility. The expected term of the options represents the estimated period of time until exercise and is based on historical experience of similar awards, giving consideration to the contractual terms, vesting schedules and expectations of future employee behavior. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant for the expected term of the option. We have not paid dividends in the past and do not plan to pay any dividends in the near future. Compensation expense is recognized only for those options expected to vest, with forfeitures estimated based on our historical experience and future expectations. The fair value of stock options granted was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:
                         
    2009     2008     2007  
Expected volatility
    57.6 %     36.0 %     33.8 %
Risk-free interest rate
    1.8 %     2.5 %     4.8 %
Dividend yield
    0.0 %     0.0 %     0.0 %
Expected life (in years)
    3.9       3.7       3.8  
Weighted average fair value per option granted
  $ 1.19     $ 3.42     $ 6.19  

 

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KONA GRILL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
Activity during 2009, 2008, and 2007 under our stock award plans was as follows:
                                 
    Shares     Weighted     Weighted Average        
    Under     Average     Remaining     Aggregate  
    Option     Exercise Price     Contractual Term     Intrinsic Value  
Outstanding options at December 31, 2006
    631,589     $ 10.65                  
Granted
    146,750       18.79                  
Forfeited
    (43,553 )     15.82                  
Exercised
    (79,347 )     6.84                  
 
                             
Outstanding options at December 31, 2007
    655,439       12.59                  
Granted
    185,417       11.24                  
Forfeited
    (14,800 )     10.29                  
Exercised
    (2,000 )     6.00                  
 
                             
Outstanding options at December 31, 2008
    824,056       12.34                  
Granted
    407,100       2.64                  
Forfeited
    (376,300 )     12.42                  
Exercised
                           
 
                             
Outstanding options at December 31, 2009
    854,856     $ 7.67     3.15 years     $ 130,000  
 
                       
 
                               
Exercisable at December 31, 2009
    453,393     $ 9.70     2.22 years     $ 32,000  
 
                       
Stock-based compensation totaled $560,000, $582,000, and $607,000 during 2009, 2008, and 2007, respectively. The intrinsic value of options exercised during 2008 and 2007 was approximately $6,000 and $764,000, respectively. The total fair value of shares vested during 2009, 2008, and 2007 was approximately $390,000, $489,000, and $629,000, respectively. As of December 31, 2009, there was approximately $587,000 of total unrecognized stock-based compensation expense related to unvested share-based compensation arrangements, which is expected to be recognized over a weighted average period of 1.92 years.
Information regarding options outstanding and exercisable at December 31, 2009 is as follows:
                                         
    Options Outstanding     Options Exercisable  
            Weighted Average     Weighted                
            Remaining     Average             Weighted  
Range of           Contractual     Exercise           Average  
Exercise Prices   Shares     Life (years)     Price     Shares     Exercise Price  
$1.92 – $3.21     351,650       4.43     $ 2.72       48,750     $ 2.39  
$5.00 – $8.35     233,289       2.43     $ 6.31       229,539     $ 6.27  
$10.00 – $12.64     134,417       2.63     $ 11.33       65,104     $ 11.96  
$18.08 – $19.49     135,500       1.57     $ 18.81       110,000     $ 18.72  
 
                                   
 
    854,856       3.15     $ 7.67       453,393     $ 9.70  
Warrants
As discussed in Note 8, we issued to the noteholders of the bridge loan three-year warrants to purchase 120,000 shares of our common stock at an aggregate exercise price per share of $2.29, which was equal to 120% of the five-day average of the closing price of our common stock during the five trading days prior to the date of issuance. These warrants are exercisable through March 6, 2012 and 10,000 warrants were exercised during 2009 resulting in 110,000 warrants outstanding at December 31, 2009. We recorded the value of the warrant at $70,000 and amortized this amount to interest expense during 2009.

 

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KONA GRILL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
12. Employee Benefit Plans
Defined Contribution Plan
We maintain a voluntary defined contribution plan covering eligible employees as defined in the plan documents. Participating employees may elect to defer the receipt of a portion of their compensation, subject to applicable laws, and contribute such amount to one or more investment options. We currently match in cash a certain percentage of the employee contributions to the plan and also pay for related administrative expenses. Matching contributions made during 2009, 2008, and 2007 were $142,000, $126,000, and $107,000, respectively.
Employee Stock Purchase Plan
During 2005, our Board of Directors and stockholders approved the 2005 Employee Stock Purchase Plan, or ESPP and reserved 425,000 shares of common stock for issuance thereunder. The ESPP permits eligible employees to purchase common stock at a discount through payroll deductions up to 15% of employees’ eligible earnings during the offering period. The purchase price per share at which shares of common stock are sold in an offering under the ESPP is equal to 95% of the fair market value of common stock on the last day of the applicable offering period. During 2009, 2008, and 2007, 16,659 shares, 18,113 shares and 5,183 shares, respectively, were purchased under the ESPP.
13. Commitments and Contingencies
We lease restaurant and office facilities and certain real property under operating leases having terms expiring from 2011 to 2029. The restaurant leases primarily have renewal clauses of five years exercisable at the option of our company and rent escalation clauses stipulating specific rent increases. We record deferred rent to recognize rent evenly over the initial lease term. Certain of these leases require the payment of contingent rentals based on a percentage of gross revenues above specified minimum amounts as defined in the respective lease agreement. The leases typically require us to pay our proportionate share of common area maintenance, property tax, insurance, and other occupancy-related costs.
Rent expense on all operating leases was as follows (in thousands):
                         
    Year Ended December 31,  
    2009     2008     2007  
Straight-line minimum base rent
  $ 6,018     $ 4,900     $ 4,127  
Contingent rent
    24       123       376  
 
                 
Total rent
  $ 6,042     $ 5,023     $ 4,503  
 
                 
At December 31, 2009, we had entered into a lease agreement for one restaurant scheduled to be constructed during 2010. The following table does not include obligations related to renewal option periods even if it is reasonably assured that we will exercise the related option. Future minimum lease payments under operating leases at December 31, 2009, were as follows (in thousands):
         
2010
  $ 6,699  
2011
    7,104  
2012
    7,046  
2013
    7,061  
2014
    6,429  
Thereafter
    27,633  
 
     
Total minimum lease payments
  $ 61,972  
 
     

 

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KONA GRILL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
14. Legal Proceedings
We are engaged in various legal actions, which arise in the ordinary course of our business. Although there can be no assurance as to the ultimate disposition of these matters, it is the opinion of our management, based upon the information available at this time, that the expected outcome of these matters, individually or in the aggregate, will not have a material adverse effect on the results of operations or financial condition of our company.
On April 1, 2009, Samuel Beren, as trustee for the Samuel Beren Trust, filed a stockholder derivative suit in the Court of Chancery of the State of Delaware. The suit was brought on behalf of us against our directors and the purchasers of our promissory notes issued on March 5, 2009, and named us as a nominal defendant. The complaint alleged that our directors breached their fiduciary duties of loyalty, good faith, and due care to us, and that the noteholders aided and abetted such breach, in connection with certain of our fundraising efforts. The suit originally sought unspecified damages, interest, reasonable attorneys’ fees, expert witness fees, and other costs, and any further relief the court deems just and proper.
On June 16, 2009, the director defendants filed a motion to dismiss the lawsuit. On August 28, 2009, the director defendants filed an opening brief in support of the motion to dismiss. Separately, on October 26, 2009, the plaintiff served a demand on us pursuant to Section 220 of Delaware’s General Corporation Law requesting that we make certain books and records available for inspection. On November 11, 2009, the plaintiff moved to suspend the briefing schedule on the motion to dismiss the derivative lawsuit until the parties resolved the October 26, 2009 books and records demand. The director defendants opposed the motion to modify the briefing schedule. On January 19, 2010, the Court order that the plaintiff must either amend his complaint, or file an answering brief in response to the motion to dismiss by January 26, 2010.
On January 20, 2010, we produced books and records in response to the October 26, 2009 demand. Two days later, on January 22, 2010, the plaintiff commenced a separate lawsuit against us seeking the production of the books and records requested in the plaintiff’s February 6, 2009 and October 26, 2009 demand letters. The books and records complaint was served on our registered agent in Delaware on February 16, 2010.
On January 25, 2010, the plaintiff filed a letter with the Court informing the Court of the newly filed lawsuit and requested a stay of the lawsuit until the newly filed books and records lawsuit is resolved. After receiving the director defendants’ opposition to the request for a stay, the Court instructed the plaintiff to file a formal motion to stay, as opposed to a letter request, if it is seeking a stay of the derivative lawsuit. The Court also asked the plaintiff to advise the Court as to “why no action has been taken in conformity with [the] Court’s January 19, 2010 letter decision.” We continue to believe that the allegations in the derivative complaint, including the amended complaint, are without merit and we intend to defend vigorously such lawsuit. In addition, we and our legal counsel currently are reviewing the complaint filed in the books and records lawsuit to determine the appropriate response.

 

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Table of Contents

KONA GRILL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (CONTINUED)
15. Selected Quarterly Financial Data (Unaudited)
Summarized unaudited financial data for 2009 and 2008 is as follows (in thousands, except per share data):
                                 
    March 31,     June 30,     September 30,     December 31,  
Quarter ended   2009     2009     2009     2009  
Restaurant sales
  $ 19,455     $ 21,468     $ 20,173     $ 19,999  
Loss from continuing operations
    (1,083 )     (917 )     (1,035 )     (19,207 )(2)
(Loss) gain from discontinued operations
    (13 )     703              
Net loss
    (1,096 )     (214 )     (1,035 )     (19,207 )
 
                               
Diluted net (loss) income per share:
                               
Continuing operations
  $ (0.14 )   $ (0.11 )   $ (0.11 )   $ (2.10 )
Discontinued operations
          0.08              
 
                       
Net loss (1)
  $ (0.14 )   $ (0.03 )   $ (0.11 )   $ (2.10 )
 
                       
                                 
    March 31,     June 30,     September 30,     December 31,  
Quarter ended   2008     2008     2008     2008  
Restaurant sales
  $ 18,103     $ 19,685     $ 19,454     $ 18,573  
Loss from continuing operations
    (562 )     (348 )     (733 )     (5,354 )(3)
Loss from discontinued operations
    (111 )     (187 )     (3,161 )     (45 )
Net loss
    (673 )     (535 )     (3,894 )     (5,399 )
 
                               
Diluted net loss per share:
                               
Continuing operations
  $ (0.07 )   $ (0.04 )   $ (0.09 )   $ (0.67 )
Discontinued operations
    (0.01 )     (0.03 )     (0.40 )      
 
                       
Net loss (1)
  $ (0.08 )   $ (0.07 )   $ (0.49 )   $ (0.67 )
 
                       
     
(1)  
Net loss per share calculations for each quarter are based on the weighted average diluted shares outstanding for that quarter and may not total to the full year amount.
 
(2)  
Includes asset impairment charges of $16.9 million for six underperforming restaurants.
 
(3)  
Includes asset impairment charges of $3.2 million for one underperforming restaurant.

 

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