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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

Commission File Number: 0-50387

RedEnvelope, Inc.

201 Spear Street, 3rd Floor,

(415) 371-9100

     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 requirement for the past 90 days.     Yes þ          No o

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

      The number of outstanding shares of the registrant’s common stock, $0.01 par value per share, was 8,521,552 as of December 28, 2003.

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REDENVELOPE, INC.

REPORT ON FORM 10-Q

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PART I.

FINANCIAL INFORMATION

REDENVELOPE, INC.

See accompanying notes to these condensed financial statements.

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REDENVELOPE, INC.

CONDENSED STATEMENTS OF OPERATIONS

See accompanying notes to these condensed financial statements.

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REDENVELOPE, INC.

STATEMENTS OF CASH FLOWS

See accompanying notes to these condensed financial statements.

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REDENVELOPE, INC.

1.     Financial Statements — Basis of Presentation

      The accompanying unaudited financial statements include the accounts of RedEnvelope, Inc. (referred to as the “Company”, “we”, “us”, and “our”). The condensed balance sheets as of December 28, 2003 and December 29, 2002, the condensed statements of earnings for the thirteen and thirty-nine week periods ended December 28, 2003 and December 29, 2002, and the condensed statements of cash flows for the thirty-nine week periods ended December 28, 2003 and December 29, 2002 have been prepared by us, without audit. In our opinion, the financial statements include all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position at the balance sheet dates and the results of operations for the thirteen and thirty-nine week periods then ended. The balance sheet at March 30, 2003, presented herein, has been derived from our audited balance sheet included in our Amendment No. 8 of the Registration Statement on Form S-1, declared effective by the Securities and Exchange Commission on September 24, 2003.

      Certain information and disclosures normally included in the notes to the annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted. These financial statements should be read in conjunction with the condensed financial statements and notes thereto included in our Amendment No. 8 of the Registration Statement on Form S-1. Certain reclassifications have been made to the prior period financial statements to conform to the presentation used in the current period.

      The results of operations for the thirteen and thirty-nine weeks ended December 28, 2003 are not necessarily indicative of the operating results of the full year. Further, the preparation of condensed financial statements requires management to make estimates and assumptions that affect the recorded amounts reported therein. A change in facts or circumstances surrounding the estimates could result in a change to the estimates and impact future operating results.

      Our fiscal year ends on the Sunday closest to March 31, resulting in a 52 or 53 week year. Fiscal year 2003 ended on March 30, 2003. Fiscal year 2004 will end on March 28, 2004. Both fiscal year 2003 and fiscal year 2004 are 52 weeks long. We report our interim results on a fiscal quarter basis rather than on a calendar quarter basis. Under the fiscal quarter basis, each of the first three fiscal quarters is thirteen weeks long, ending on the Sunday closest to the calendar quarter end, with the fourth fiscal quarter covering the remaining part of the fiscal year.

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

      Stock Based Compensation — The Company accounts for stock-based employee compensation arrangements in accordance with provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB No. 25”), and complies with the disclosure provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123”) as amended by SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure. Under APB No. 25, compensation cost is recognized based on the difference, if any, between the fair market value of the Company’s stock on the date of grant and the amount an employee must pay to acquire the stock. Equity

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NOTES TO CONDENSED FINANCIAL STATEMENTS — (Continued)

instruments issued to non-employees are accounted for in accordance with the provision of SFAS No. 123 and Emerging Issues Task Force Issue No. 96-18.

      Had compensation cost for the Company’s stock options been determined based on the fair value of the options at the date of grant for options granted in the thirteen and thirty-nine weeks ended December 28, 2003 and December 29, 2002 consistent with the provisions of SFAS No. 123 the Company’s pro forma net income/(loss) would have been as follows:

      Earnings Per Share — For the thirteen weeks ended December 28, 2003 and December 29, 2003, basic net income per share was greater than the diluted net income per share because the effect of stock options, unvested shares and warrants outstanding was dilutive. The number of dilutive stock options, unvested shares, and warrants excluded from the calculation for the thirty-nine weeks ended December 28, 2003 and December 29, 2002, were approximately 1.4 million and 0.9 million, respectively.

      Comprehensive Income/(Loss) — Comprehensive income/ (loss) equals net income/ (loss) for all periods presented.

      New Accounting Pronouncements — In May 2003, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 requires instruments that are mandatorily redeemable, among other financial instruments, which embody an unconditional obligation requiring the issuer to redeem them by transferring its assets at a specified or determinable date or upon an event that is certain to occur, be classified as liabilities. We adopted SFAS No. 150 effective June 30, 2003. The adoption of this statement did not have an impact on the Company’s financial statements.

3.     Initial Public Offering

      On September 30, 2003, we completed our initial public offering, whereby we sold 2.2 million shares of our common stock at $14 per share and received proceeds of approximately $29.0 million (after underwriters’ discounts of $1.8 million). Total related offering expenses were $1.6 million.

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NOTES TO CONDENSED FINANCIAL STATEMENTS — (Continued)

      Immediately prior to the offering, the Company effected a 1 for 11.71 reverse stock split. All shares and per share calculations included in the accompanying unaudited condensed financial statements have been adjusted to reflect this split.

      On September 30, 2003, the Company’s outstanding Preferred Stock was automatically converted into approximately 6.0 million shares of common stock. Each share of Series A and B preferred stock outstanding was converted into common stock on a one-for-one exchange ratio of common for preferred. Each share of Series C, D, E, and F preferred stock outstanding was converted into common stock on an exchange ratio of one share of preferred for approximately 1.58, 1.80, 1.27 and 0.99 shares of common, respectively, as follows:

4.     Benefit Plans

      On September 30, 2003, the Company filed a registration statement on Form S-8 to register shares related to the Directors Stock Option Plan, the Employee Stock Purchase Plan (the “ESPP”), and the 1999 Stock Plan.

      The Directors Stock Option Plan is intended to be a formula award plan providing for the grant of nonstatutory stock options to non-employee members of our Board of Directors. The Company registered 449,615 shares of $0.01 par value common stock for the Directors Stock Option Plan.

      The ESPP allows employees to purchase our common stock at a discount to market price through payroll deductions. The plan is structured through a series of consecutive six-month offering periods. Except for the first offering period, these offering periods generally start on the first trading day on or after May 1st and November 1st of each year and end, respectively, on the last trading day of the next October and April. The Company registered 401,366 shares $0.01 par value common stock for the ESPP.

      The S-8 registered an additional 1,831,855 shares of $0.01 par value common stock related to our 1999 Stock Plan.

5.     Borrowing Arrangements

      The Company’s line of credit is provided by CapitalSource Finance LLC pursuant to the terms of a revolving credit and security agreement dated June 13, 2003. Per the terms of this agreement, CapitalSource Finance LLC has made available to the Company a credit facility under a revolving promissory note with a maximum principal amount of $11.0 million, subject to availability guidelines that specify the amount that can be borrowed under the facility at any given time. Amounts borrowed under this line of credit bear interest at rates equal to the greater of 9.5% or the prime lending rate plus 5.75%, for advances up to a fluctuating base amount, and equal to the greater of 11.5% or the prime lending rate plus 7.75% for advances in excess of that base amount. Amounts borrowed under this line of credit are secured by substantially all of the Company’s assets. The line of credit agreement provides for certain events of default, sets forth a number of affirmative and negative covenants to which the Company must adhere and expires on April 15, 2006, unless extended,

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NOTES TO CONDENSED FINANCIAL STATEMENTS — (Continued)

renewed or terminated pursuant to the terms of the agreement. The Company paid a non-refundable commitment fee of approximately $0.2 million in connection with this line of credit and must pay an unused line fee of up to $0.05 million per year, which is payable monthly, based on the unused portion of the loan commitment. The Company has borrowed funds under this line of credit from time to time and periodically repaid such borrowings with available cash. As of December 28, 2003, the Company did not have an outstanding balance under this line of credit.

      Events of default under this credit agreement include, subject to grace periods and notice periods in certain circumstances, failure to pay any amount owed under the line of credit when due, breach of representations contained in the agreement, failure to perform covenants contained in the agreement, termination of any loan document or security interest created under the agreement, a judgment against the Company in excess of certain amounts, failure to pay certain amounts of indebtedness due under, or another default under, debt or other agreements to which the Company is party, insolvency or petition for bankruptcy or dissolution, certain defined change of control transactions, the termination of the employment of the Company’s Chief Executive Officer or Brand Strategist if not timely replaced by suitable successors, a material adverse effect on the Company’s business or material adverse change in the validity of the credit agreement, the value of the Company’s assets that are pledged as collateral or the Company’s business, operations, prospects, properties, assets, liabilities or condition, the occurrence of an uninsured casualty loss in excess of certain amounts, indictment or conviction of any director or senior officer of a felony or a levy, attachment or garnishment that could lead to forfeiture of collateral under the agreement.

      Under the provisions of this credit agreement, subject to exceptions in limited circumstances, the Company must comply with certain covenants during the term of that agreement including, but not limited to, financial covenants that require the Company to obtain certain levels of minimum earnings before interest, taxes, depreciation and amortization (EBITDA) for the trailing four accounting quarters ending on the last day of the applicable date.

      The credit agreement requires us to pay and deliver all collections to an account over which CapitalSource Finance LLC has sole control. When we borrow under the credit agreement, the borrowings are repaid through the funds in this account. In a situation where we are not borrowing, we must request the funds to be withdrawn from this account and deposited into our bank account.

      In addition, the credit agreement requires, subject to exceptions in certain limited circumstances, maintaining certain inventory ratios, which are determined by dividing 115% of the cost of the Company’s inventory at a given date by the Company’s projected net sales for the subsequent three month period subject to certain maximums, maintaining excess availability of a certain amount of capital at certain specified times, covenants limiting the Company’s capital expenditures, a covenant which among other things restricts the Company’s ability to engage in certain acquisition and investment transactions, and other covenants which restrict or place limitations on the Company’s ability to incur indebtedness, issue securities, create or allow to exist any liens on the Company’s assets, transfer the Company’s assets, or declare or pay dividends.

      As of December 28, 2003, the Company was not in compliance with the EBITDA ratio covenant. On January 22, 2004, we received a waiver from CapitalSource Finance LLC for our non-compliance with such covenant. Additionally, we were not in compliance with the inventory ratio covenant for the months of October 2003 and November 2003, but received a waiver of such non-compliance from CapitalSource Finance LLC on November 11, 2003 and December 23, 2003, respectively. As of February 5, 2004, the Company was not in compliance with the inventory ratio covenant for January. We received a waiver of such non-compliance from CapitalSource Finance LLC on February 5, 2004.

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NOTES TO CONDENSED FINANCIAL STATEMENTS — (Continued)

6.     Marketable Securities

     Cash Equivalents and Investments

      For purposes of the statements of cash flows, the Company considers all highly liquid debt instruments purchased with an original maturity of three months or less at the date of purchase to be cash equivalents. Cash and cash equivalents consist of demand accounts, government securities, and money market funds. Short-term investments consist of government securities and corporate bonds both with original maturities beyond three months. Long term investments consist of corporate bonds with original maturities of one year or longer.

      All of the Company’s cash equivalents and investments are considered available-for-sale. Such securities are carried at fair market value, which is equal to cost at December 28, 2003. Fair value is based on market quotes. Unrealized gains and losses, net of tax, on securities in this category are reported as a separate component of stockholders’ equity. There were no unrealized gains or losses for the quarter ended December 28, 2003. The cost of securities sold is based on the specific identification method. Interest earned on securities is included in interest income.

      Available-for-sale investments at December 28, 2003 were as follows:

      There were no gross realized gains or losses for quarter ending December 28, 2003 and the gross realized gains or losses for the quarter ended December 29, 2002 were immaterial.

      The amortized cost, which equals the estimated fair value of investments in debt securities at December 28, 2003, by contractual maturity were as follows:

7.     Contingencies

      From time to time, the Company is subject to legal proceedings and claims in the ordinary course of business, including claims of alleged infringement of trademarks and other intellectual property rights. The Company is not currently aware of such legal proceedings or claims that it believes will have, individually or in the aggregate, a material adverse effect on its financial position or results of operations.

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      The following discussion should be read in conjunction with the unaudited condensed financial statements and the notes thereto included in Item 1 of this Quarterly Report on Form 10-Q.

Forward-Looking Statements

      This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended. Such statements are based upon current expectations and involve risks and uncertainties. Any statements contained in this report that are not purely statements of historical fact may be deemed to be forward-looking statements. Such forward-looking statements may include but are not limited to statements regarding our future operations and enhancements, product offerings, business, financial condition, results of operations and prospects. Additionally, statements concerning possible changes in applicable rules or legislation are forward-looking statements. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates”, “may,” “should,” “could” and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this report. All forward-looking statements in this report are based upon information available to us as of the date hereof, and we assume no obligation to revise or update any such forward-looking statements in order to reflect any event or circumstance that may arise after the date of this report. Actual results and the timing of certain events could differ materially from our current expectations. Factors that could cause or contribute to such differences include, but are not limited to, those set forth under “Factors That May Affect Future Operating Results” below in this report, and elsewhere in this report, the section entitled Risk Factors contained in our Prospectus dated September 24, 2003 as filed with the Securities and Exchange Commission and those contained from time to time in our other filings with the SEC. We caution investors that our business and financial performance are subject to substantial risks and uncertainties.

Overview

      We are an online retailer of upscale gifts. Our fourteen product categories provide customers with a wide assortment of choices for all gift-giving occasions. Product revenues consist of sales made to individual consumers and businesses. We market our products through our website and our catalogs. Customers place orders with us through our website or the telephone. Telephone orders are taken at our customer service center. At the time an order is taken, we obtain the customer’s credit card information. When the order is shipped, the customer’s credit card is charged. We recognize revenue on the date on which we estimate that the product has been received by the customer. Product sales are recorded net of discounts and estimated returns.

      Historically, revenues have been seasonal. Revenues have been higher in our third fiscal quarter, reflecting higher consumer holiday spending. Our strategy includes offering a product assortment for all gift occasions throughout the year, and thereby increasing the percentage of revenues in the first, second and fourth fiscal quarters. For example, in the first and second quarters of fiscal 2004, we introduced two new catalogs. In the first quarter of fiscal 2004, we introduced a catalog dedicated solely to jewelry products. In the second quarter of fiscal 2004, we introduced a new catalog that featured non-seasonal gifts for all occasions. While we are focused on reducing the seasonality of the third fiscal quarter, we anticipate higher revenues in our third fiscal quarter than in our other three fiscal quarters to continue in the foreseeable future. As a result, promptly obtaining sufficient volumes and an appropriate mix of product inventory is especially important in our third fiscal quarter. In the third fiscal quarter of fiscal 2004, conservative inventory purchasing, operational difficulties in our distribution center and sourcing problems with respect to some of our products led to our inability to satisfy customer demand. Achieving operational effectiveness at times of peak demand and the appropriate mix and amount of inventory will continue to be critical areas of management focus.

      We believe our gift assortment provides an opportunity for corporate gift giving, and we will look at opportunities to grow our corporate sales channel. For example, some corporations are implementing policies which do not allow for the acceptance of gifts valued at more than one hundred dollars. We believe our

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      On September 30, 2003, we completed our initial public offering whereby we sold 2.2 million shares of our common stock at $14 per share and received proceeds of approximately $29.0 million (after underwriters’ discounts of $1.8 million). Total related offering expenses were $1.6 million.

      Our revenues are comprised of product sales, shipping revenue and gift-wrap revenue. Our shipping revenue represents the amounts we charge our customers for delivering the product. From the second quarter of fiscal year 2003 until August 25, 2003, the delivery charge to our customers was based on the order value and the method of delivery. As the order value increased, the delivery charge increased as well. However, after August 25, 2003, we changed the delivery charge for standard ground delivery to a flat rate regardless of the order value. For expedited delivery methods, we charge a flat fee over the standard delivery charge. We believe the flat rate delivery charge allows us to better compete with other online retailers. We want our customers to focus on the product rather than the cost of delivery. The change to flat rate shipping and shipping discount promotions did not result in an increase in order volume to offset the reduction in shipping revenues. Our gift wrap revenue consists of amounts we charge our customers for our signature red gift boxes. The customer has the option to purchase gift wrap if the product is offered with our special gift wrapping. The gift wrapping process occurs as part of order fulfillment at the distribution center. No single customer accounts for more than 1% of our net revenues. To date, we have achieved our growth from internal operations rather than through acquisitions.

      Our merchandising strategy is based on providing unique and innovative products. Historically, approximately 50% of our products can be characterized as proprietary. For the third quarter of fiscal year 2004, 61% of the products in our holiday catalog were exclusive to RedEnvelope and our proprietary products were some of our strongest performing products. We currently intend to increase the percentage of exclusive products to approximately 80% over the next several years. We believe that by continually offering innovative, proprietary products, we can better differentiate us from our competitors and can provide a more satisfactory gift-purchasing experience for our customers. In order to provide these levels of proprietary products, our merchandising group works directly with domestic manufacturers, importers and overseas agents to design and manufacture our products. During our fiscal year 2003, we sourced approximately 25% of our products from overseas. In an effort to increase our proprietary product offering, we will be increasing our overseas product sourcing. We believe working directly with overseas agents and manufacturers will allow us to effectively manage product development and quality. Due to the complexities of overseas sourcing, we plan on creating an international sourcing group. In addition, since we do not have long-term arrangements with any vendor or distributor that guarantees the availability of products, we do not have a predictable or guaranteed supply of these products in the near future. In addition, while our product development process includes sampling products for quality, there remains the possibility that final production runs will include products that do not meet our quality standards. Due to the lead times of overseas production, we may not be able to receive adequate levels of product that meet our quality standards. If we are unable to provide our customers with continued access to adequate levels of proprietary products that meet our quality standards, our operating results would be harmed. While products sourced overseas typically have lower costs, our product margins may be slightly offset by an increase in inbound freight costs. As security measures around shipping ports increase, these additional costs may result in higher inbound freight costs. Furthermore, in recent years, U.S. companies were subject to port strikes which delayed the delivery of goods. As we increase our overseas sourcing, we face the risk of these delays which could harm our business.

      We terminated our relationship with our third-party fulfillment service provider and assumed control of our fulfillment services in August 2003. In the third quarter of fiscal 2004, we experienced delays and errors in the fulfillment process at our distribution center, which prevented us from fulfilling demand for our products. In addition, the anticipated efficiencies from managing the distribution center ourselves did not materialize. Improvements in managing our distribution center will be a key objective in the ensuing months. Our current plans include revising certain materials handling processes, implementing new warehouse management

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      We rely primarily on Internet-based online programs and catalog advertising. Revenues to our customers attributable to online Internet-based channels, specifically portals, search, and affiliate derived sales, increased by 42% over the third quarter of the prior fiscal year, which was less than we expected. Additionally, the catalog business generated similar levels of revenue for the quarter ended December 28, 2003 compared to the same period last year, even though we mailed 2.0 million fewer catalogs this year.

      Currently, we believe the increase in commerce over the Internet will continue for the foreseeable future. However, if consumers are unwilling to use the Internet to purchase retail products, our business will be harmed. In addition, if competitors increase the utilization of online marketing campaigns, the cost of online marketing programs may increase. Moreover, software programs that block certain email marketing campaigns have gained in popularity with individuals. The federal government and certain states have enacted legislation specifically prohibiting or placing significant restrictions on email marketing campaigns. These trends could negatively impact our ability to market to customers through email campaigns.

      We currently intend to use our catalog programs to market our products and brand. However, increases in the cost of catalogs may limit our ability to advertise and market our business without reducing profitability. We plan on exploring other ways to market our products and brand. For example, in the third fiscal quarter of 2004, we launched a series of television advertisements. We are currently considering running additional television advertisements as well as radio and print advertisements. These marketing programs may result in an increase in our marketing costs.

      We are planning on implementing new software programs for our financial, warehouse management, and order entry functions in fiscal year 2005. These projects will result in uses of cash and will result in additional depreciation expense. In addition, the reporting and regulatory requirements associated with being a publicly-traded company will likely increase our accounting and legal expenses.

Critical Accounting Policies

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

      Revenue recognition. We derive our revenues from merchandise sales made to consumers and businesses. We generally require payment by credit card prior to shipment. We recognize revenue on the date on which we estimate that the product has been received by the customer and any payments received prior to the estimated date of receipt of the goods by the customer are deferred. We use our third-party freight carrier information to estimate when delivery has occurred. Revenues are recorded net of estimated returns, coupons redeemed by customers, and other discounts. Significant management judgments and estimates must be made and used in connection with determining revenue recognized in any accounting period. Our management must make estimates of potential future product returns related to current period revenue. We analyze historical returns, current economic trends and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns and other allowances in any accounting period. Actual returns may differ materially from our estimated reserve. As a result, our operating results and financial condition could be affected adversely. The reserve for returns was $1.4 million as of December 28, 2003.

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      Shipping and Handling Costs. Shipping costs, which include inbound and outbound freight and the cost of gift wrap, are included in cost of sales. Handling costs, which include fees paid to our former third-party fulfillment service provider and distribution center expenses, are included in operating expenses — fulfillment. Handling costs included in operating expenses — fulfillment for the thirteen weeks ended December 28, 2003 and December 29, 2002 were $2.4 million and $1.8 million, respectively. Our gross profit may not be comparable to other entities, which may allocate all shipping and handling costs to either cost of sales, resulting in lower gross profit, or operating expenses, resulting in higher gross profit.

      Inventory. We write down inventory for estimated obsolescence or damage equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions or demand for our products are less favorable than projected by management, additional inventory write-downs may be required. For the quarters ended December 28, 2003 and December 29, 2002, we wrote down inventory of approximately $0.8 million and $0.7 million, respectively.

      Accounting for income taxes. Significant management judgment is required in determining our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. As of March 30, 2003, we had recorded a valuation allowance of $25.9 million against our net deferred tax asset balance due to uncertainties related to our deferred tax assets as a result of our history of operating losses. The valuation allowance is based on our estimates of taxable income by jurisdiction in which we operate and the period over which our deferred tax assets will be recoverable. In the event that actual results differ from these estimates or we adjust these estimates in future periods, we may need to change the valuation allowance, which could materially impact our financial position and results of operations.

      Catalog Amortization. Prepaid catalog costs consist of third-party costs including paper, printing, postage and mailing costs for all of our direct response catalogs. Such costs are capitalized as prepaid catalog costs and are amortized over their expected period of future benefit. Such amortization is based upon the ratio of actual revenues to the total of actual and estimated future revenues on an individual catalog basis. Prepaid catalog costs are evaluated for realizability at each reporting period by comparing the carrying amount associated with each catalog to the estimated probable remaining future net benefit of the catalog (defined as net revenues less merchandise cost of goods sold, selling expenses and catalog completion costs) associated with that catalog. If the carrying amount is in excess of the estimated probable remaining future net benefit of the catalog, the excess is expensed in the reporting period.

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

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Results of Operations

      The following table sets forth our statements of operations data for the thirteen weeks and thirty-nine weeks ended December 28, 2003 and December 29, 2002, respectively, expressed as a percentage of net revenues.

      Net revenues were $35.9 million and $34.3 million for the thirteen weeks ended December 28, 2003 and December 29, 2002, respectively, representing a 4.8% increase. The number of orders increased by approximately 7.1% over the third quarter of fiscal 2003. The increase in both revenues and number of orders was primarily due to increased demand for our products resulting from additional marketing efforts through our online marketing campaigns. Online revenues, through search, portals, and affiliates, grew 42% over the same quarter in the prior year. Although there was an increase in online sales, it fell short of management expectations for such period. While we reduced our catalog circulation by 21.7%, we generated similar levels of revenues from customers who receive our catalogs as the same quarter in the prior year.

      Net revenues per order decreased by approximately 2.2% over the third quarter of fiscal 2003. This was primarily attributable to shipping revenues for the third quarter of fiscal 2004 that were 18.9% lower than shipping revenue from the third quarter of fiscal 2003. In August of 2003, we changed the delivery charge for standard ground delivery to a flat rate regardless of order value, and for expedited delivery methods, we charge a flat fee over the standard delivery charge. Periodically, we offer shipping discount promotions intended to increase order volume. The change to flat rate shipping and shipping discount promotions did not result in an increase in order volume to offset the reduction in shipping revenues. In addition, we experienced unexpectedly high demand for some new proprietary products, which we bought conservatively. The resulting inventory deficiencies caused missed revenue opportunities. We also ran into limitations in our ability to fulfill in a timely manner personalized items in our assortment. Rather than disappoint customers with late deliveries, in some cases we let customers know that items would not arrive on time, and this led to order cancellations. With additional and timely training of the core staff, management changes at the warehouse, process changes, and the implementation of new warehouse, financial and order entry software, we believe that we will improve the operating efficiency of the warehouse, although there can be no assurance that we will be successful in this endeavor. If we are unable to appropriately manage our inventory levels of certain items, our customers may become dissatisfied and look to our competitors for their gift items. Furthermore, if we are unable to improve the performance of the fulfillment process at our distribution center, this may result in unsatisfied customers and order cancellations, which would adversely affect our business.

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      Net revenues were $62.0 million and $54.9 million for the thirty-nine weeks ended December 28, 2003 and December 29, 2002, respectively, representing a 12.8% increase. The increase was primarily due to increased demand for our products resulting from additional marketing efforts through our online and catalog campaigns. During the first thirty-nine weeks of fiscal year 2004, we increased our online marketing programs compared to the same period in the prior year. Online revenues, through search, portals, and affiliates, grew 57% over the same period in the prior year. Revenues from customers who receive our catalogs, grew 8% over the same period in the prior year. In the first quarter of fiscal 2004, we introduced a catalog dedicated solely to jewelry products. Also, in the second quarter of fiscal 2004, we introduced a new catalog that featured non-seasonal gifts for all occasions. For the third quarter of fiscal 2004, our Holiday catalog circulation decreased by approximately 2.0 million catalogs, or 21.7%. The number of orders increased approximately 15.0% over the thirty-nine weeks of fiscal 2003. Net revenues per order decreased by approximately 2.0% over the thirty-nine weeks of fiscal 2003. This was primarily attributable to lower shipping revenues for the third quarter of fiscal 2004 in comparison to the third quarter of fiscal 2003. As of December 28, 2003, we had approximately 1.7 million customers which was an increase of 0.5 million customers over the third quarter of fiscal 2003.

      Cost of sales consists of the cost of the product sold, inbound and outbound freight and gift-wrap expense. Shipping costs, which include inbound and outbound freight, and the cost of gift wrap are included in cost of sales. Handling costs, which include fees paid to our former third-party fulfillment service provider and distribution center expenses, are included in operating expenses — fulfillment.

      Cost of sales were $18.1 million and $17.3 million for the thirteen weeks ended December 28, 2003 and December 29, 2002, respectively, representing 50.5% of net revenues for both periods. For the thirteen weeks ended December 28, 2003 and December 29, 2002, the increase in dollars was mainly attributable to the 4.8% increase in net revenues as well as additional shipping costs. During December 2003, we expedited delivery of certain orders due to delays in the fulfillment process at our distribution center. The expedited delivery methods resulted in additional shipping costs above our expectations. As a percentage of net revenues, we accomplished higher product margins resulting from an increase in product sourcing overseas, which typically have lower product costs. This was offset, however, by higher shipping costs as a result of expedited delivery methods.

      Cost of sales were $31.5 million and $28.5 million for the thirty-nine weeks ended December 28, 2003 and December 29, 2002, respectively, representing 50.8% and 51.9% of net revenues, respectively. The increase in cost of sales was mainly attributable to the 12.8% increase in net revenues as well as additional shipping costs incurred during December 2003. If we are unable to improve the performance of the fulfillment process at our distribution center, we may be required to expedite delivery of products which will result in additional shipping costs that would increase our cost of sales.

      Fulfillment. Fulfillment expenses consist of wages and benefits for employees and seasonal hires working in our distribution center and customer service facility, fees incurred to process credit card transactions and certain fixed costs, such as rent and utilities, incurred by our distribution center and customer service facility. Prior to August 2003, fulfillment expenses also included fees paid to our former third-party fulfillment service provider. Services performed by our former third-party fulfillment service provider included receiving, picking, packing, shipping and other warehousing activities.

      Fulfillment expenses were $5.2 million and $4.5 million for the thirteen weeks ended December 28, 2003 and December 29, 2002, respectively, representing 14.5% and 13.1% of net revenues, respectively. The increase in dollars and percentage of net revenues was primarily attributable to the 7.1% increase in the number of orders, specifically labor costs incurred at our distribution center. Due to delays in the fulfillment process at our distribution center, we utilized more seasonal employees and incurred more overtime hours than anticipated.

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      Fulfillment expenses were $9.4 million and $8.3 million for the thirty-nine weeks ended December 28, 2003 and December 29, 2002, respectively, representing 15.2% and 15.1% of net revenues, respectively. The increase in dollars and percentage of net revenues was primarily attributable to the 15.0% increase in the number of orders, specifically labor costs incurred at our distribution center. Our current plans include revising certain materials handling processes, implementing new warehouse management software, and effecting management changes. We believe that these changes will allow us to better manage our fulfillment operations and scale our business. If we are unable to improve the performance of the fulfillment process at our distribution center or if our planned modifications cost more than we anticipate, our operating results could be materially harmed.

      Marketing. Marketing expenses consist primarily of online and catalog programs as well as advertising, public relations, and other promotional expenditures.

      Marketing expenses were $7.4 million and $7.6 million for the thirteen weeks ended December 28, 2003 and December 29, 2002, respectively, representing 20.7% and 22.1% of net revenues, respectively. The decrease in dollars and percentage of net revenues was primarily due to approximately 2.0 million fewer catalogs circulated compared to the third quarter of fiscal 2003. This resulted in a decrease in our catalog expenses by approximately $1.6 million compared to the third quarter of fiscal 2003. This decrease was offset by increases in our online marketing spend. In addition, we introduced television advertising during the holiday season, which led to additional interest in our products and catalogs. Currently, we plan on increasing the circulation of our Valentine’s Day and Spring catalogs. This increased circulation will increase marketing expenses by approximately $0.6 million from the original projection.

      Marketing expenses were $12.9 million and $12.1 million for the thirty-nine weeks ended December 28, 2003 and December 29, 2002, respectively, representing 20.8% and 22.0% of net revenues, respectively. The decrease in dollars and percentage of net revenues was primarily due to approximately 1.3 million fewer catalogs circulated compared to the thirty-nine weeks of fiscal 2003. This resulted in a decrease in our catalog expenses by approximately $1.2 million compared to the thirty-nine weeks ended December 29, 2002, which was partially offset by increases in our online marketing campaigns. Currently, we plan to further consider marketing opportunities through television, radio, and print advertising to further enhance our brand. If we are unsuccessful in generating revenues through these marketing vehicles, our operating results could be adversely affected.

      General and Administrative. General and administrative expenses consist of wages and benefits for our administrative employees, located primarily at our corporate office. These expenses also include costs incurred for computer and communications technology, rent and utilities for our headquarters, travel, depreciation, and other general corporate expenditures.

      General and administrative expenses were $3.9 million and $3.8 million for the thirteen weeks ended December 28, 2003 and December 29, 2002, respectively, representing 10.9% and 11.1% of net revenues, respectively. General and administrative expenses were $10.8 million and $10.7 million for the thirty-nine weeks ended December 28, 2003 and December 29, 2002, respectively, representing 17.3% and 19.4% of net revenues, respectively. As a percentage of net revenues, the decrease was primarily due to similar costs allocated over a larger revenue base. As of December 28, 2003, we had a total of approximately $0.6 million in deferred compensation expense as a result of stock options issued in fiscal year 2000 and the first and second quarter of fiscal year 2004 at exercise prices that were less than the fair market value of our common stock at the time of grant. The amounts to be amortized are expected to be approximately $0.2 million in each of the fiscal years 2004-2007, less any cancellations or forfeitures of stock options subject to the deferred compensation. The planned implementation of new software systems in fiscal year 2005 will result in additional depreciation expense. In addition, the reporting and regulatory requirements associated with being a publicly-traded company will likely increase our accounting and legal expenses.

      Interest Income. Interest income was $0.06 million and $0.02 million in the thirteen weeks ended December 28, 2003 and December 29, 2002, respectively. The increase is primarily due to higher average cash

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      Interest Expense. Interest expense was $0.1 million and $0.2 million in the thirteen weeks ended December 28, 2003 and December 29, 2002, respectively. Interest expense was $0.4 million and $0.6 million for the thirty-nine weeks ended December 28, 2003 and December 29, 2002, respectively. The decreases for both the thirteen and thirty-nine week periods were attributable to lower amounts of debt outstanding.

      Income Taxes. We have not recorded a provision for federal and state income taxes since inception. As of March 30, 2003, we had $96.3 million of net operating loss carryforwards, which may be impaired or limited in certain circumstances. These net operating loss carryforwards will begin to expire in 2007. We have provided a valuation allowance on our deferred tax assets, consisting primarily of net operating loss carryforwards, because of the uncertainty regarding their realizability.

      We have funded our operations through December 28, 2003 primarily through private sales of equity securities, borrowings, and the completion of our initial public offering which resulted in net offering proceeds of approximately $29.0 million.

      Net cash flows provided by operating activities was $8.8 million and $1.9 million for the thirty-nine weeks ended December 28, 2003 and December 29, 2002, respectively. Net cash provided by operating activities resulted from changes in working capital that was slightly offset by net losses. Specifically, the increase in our accounts payable and accrued expenses contributed to our ability to generate cash flows from operations. The increase was due primarily to higher inventory, marketing and shipping related costs from our holiday sales.

      Net cash flows used in investing activities was $5.1 million and $1.5 million for the thirty-nine weeks ended December 28, 2003 and December 29, 2002, respectively. Uses of cash flow for investing activities were for purchases of investments as well as capital expenditures for property and equipment. Currently, we are planning capital expenditures for software systems to support our financial, warehouse management, and order management functions. We believe the implementation of these software systems will support the needs of our business and customers. Software implementation projects entail significant technical and business risks. If we are unsuccessful in implementing these systems, it may hinder our ability to process and fulfill customer orders as well as complete critical financial processing transactions. These capital expenditures will result in an increase in our depreciation expense. We currently estimate spending between $1.2 million and $1.5 million over the next twelve months on the financial and warehouse management systems. In addition, we are considering projects for an order management system and other warehouse upgrades which we estimate may range between $1.5 to $2.0 million.

      Net cash flows provided by financing activities was $26.0 million and $8.8 million for the thirty-nine weeks ended December 28, 2003 and December 29, 2002, respectively. For the thirty-nine weeks ended December 28, 2003, net cash provided by financing activities consisted of the net initial public offering proceeds (after underwriter’s discount of $1.8 million) of approximately $29.0 million slightly offset by payments on an existing line of credit as well as a $1.1 million repayment of a loan. For the thirty-nine weeks ended December 29, 2002, net cash provided by financing activities consisted primarily of approximately $13.7 million of net proceeds from the issuance of Series F convertible preferred stock slightly offset by a $4.8 million repayment of a loan.

      On September 30, 2003, we completed our initial public offering, whereby we sold 2.2 million shares of our common stock at $14 per share and received proceeds of approximately $29.0 million (after underwriters’ discounts of $1.8 million). Total related offering expenses were $1.6 million.

      The Company also has available up to $11 million pursuant to its revolving credit facility with CapitalSource Finance LLC, which is described more fully in Note 5 to the financial statements contained in this report. The Company’s ability to borrow under this credit facility is subject to compliance with its terms. As of December 28, 2003, the Company was not in compliance with the EBITDA covenant contained in the credit agreement and such breach constituted an event of default under the credit agreement. On January 21,

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      Based on our current revenue projections, we may not be in compliance with certain EBITDA and inventory covenants. If we are not in compliance, we will seek waivers from our lender. Because we have zero borrowing outstanding and have no current plans to borrow, we believe that we can obtain waivers. If we are unable to obtain waivers, we believe the credit facility could be terminated without a material adverse impact on our ability to meet our currently projected capital needs.

      Management believes that the cash currently on hand will be sufficient to continue operations through at least the next twelve months. Management’s assessment is based on historical working capital needs, operating loss trends, and current business outlook. Beyond the next twelve months, management intends to utilize the cash generated from operations to fund operations and capital expenditures. Additionally, equity and or debt financing may need to be obtained to support our long-term obligations and needs. However, there can be no assurance that if additional financing is necessary it will be available, or if available, that such financing can be obtained on satisfactory terms. Failure to generate sufficient revenues or raise additional capital could have a material adverse effect on our ability to continue as a going concern and to achieve our intended business objectives

Factors That May Affect Future Operating Results

      You should consider carefully the risks and uncertainties described below. Additional risks and uncertainties not currently known to us or that we currently do not deem material may also become important factors that may harm our business. The trading price of our common stock could decline due to any of these risks and uncertainties.

Our limited operating history makes evaluation of our business difficult.

      We were originally incorporated in 1997 and began selling products in September 1997. As a result, we have limited historical financial data upon which to base planned operating expenses or forecast accurately our future operating results. Further, our limited operating history will make it difficult for investors and securities analysts to evaluate our business and prospects. You must consider our business and prospects in light of the risks and difficulties we may face as an early stage company with limited operating history. These risks and difficulties include challenges in accurate financial planning as a result of limited historical data and the uncertainties resulting from having had a relatively limited time period in which to implement and evaluate our business strategies as compared to older companies with longer operating histories. Our failure to successfully address these risks and difficulties would seriously harm our business.

We have a history of significant losses. If we do not achieve or sustain profitability, our financial condition and stock price could suffer.

      We have a history of losses and we may continue to incur losses for the foreseeable future, although we incurred net income of $1.2 million and $0.9 million for the thirteen weeks ended December 28, 2003 and December 29, 2002, respectively. As of December 28, 2003, our accumulated deficit was $76.4 million. We have not achieved profitability for a full fiscal year. If our revenues grow more slowly than we anticipate, or if our operating expenses exceed our expectations, we may not be able to achieve profitability in the near future or at all. Even if we do achieve profitability, we may not be able to sustain or increase profitability on an annual basis in the future. If we are unable to achieve profitability within a short period of time, or at all, or if we are unable to sustain profitability at satisfactory levels, our financial condition and stock price could be adversely affected.

Because we experience seasonal fluctuations in our net sales, our quarterly results will fluctuate and our annual performance will depend largely on results from one quarter.

      Our business is highly seasonal, reflecting the general pattern of peak sales for the retail industry during the holiday shopping season. Typically, a substantial portion of our net revenues occur during our third fiscal

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Our operating results are volatile and difficult to predict and may adversely affect our stock price.

      Our annual and quarterly operating results have fluctuated in the past and may fluctuate significantly in the future due to a variety of factors, many of which are outside of our control. Further, because our business is seasonal, our operating results may vary significantly from one quarter to the next as part of our normal business cycle. As a result, we believe that quarterly comparisons of our operating results are not necessarily meaningful and that you should not rely on the results of one quarter as an indication of our future performance. It is likely that in some future quarter our operating results may fall below the expectations of securities analysts and investors. In this event, the trading price of our common stock could decline significantly.

      Factors that could cause our operating results to fluctuate include the following:

	•	The seasonality of our business
	•	Decreases in the number of visitors to our website or our inability to convert those visitors into customers
	•	Technical difficulties, including system or Internet failures
	•	Fluctuations in the demand for our products
	•	The number of prior customers that make repeat purchases
	•	Overstocking or understocking of our merchandise
	•	Offering of new or enhanced services or products by our competitors
	•	Fluctuations in the level of our product returns
	•	Termination of existing marketing relationships or failure to develop successful new marketing relationships
	•	Fluctuations in shipping costs, particularly during the holiday season
	•	Fluctuations in advertising, marketing or catalog production and distribution costs
	•	The amount and timing of operating costs and capital expenditures relating to expansion of our operations
	•	Changes in government regulations and taxation related to use of the Internet or otherwise applicable to our business
	•	Economic conditions generally or economic conditions specific to the Internet, online commerce, the retail industry, the mail order industry or the gift industry
	•	Changes in the mix of products that we sell
	•	Fluctuations in levels of inventory theft, damage or obsolescence

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

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

If we fail to offer a broad selection of innovative merchandise that consumers find attractive, our revenues could decline or fail to reach anticipated levels and our stock price could be harmed.

      In order to meet our strategic goals, we must successfully offer, on a continuous basis, a broad selection of appealing products. These products must satisfy the diverse tastes of our customers and potential customers for a variety of gift-giving occasions. To be successful, our product offerings must be affordable, well made, innovative and attractive to a wide range of consumers whose preferences may change regularly. We cannot predict with certainty that we will be successful in offering products that meet these requirements. If our products become less popular with consumers, our revenues may decline or fail to meet expected levels or we may decide to offer our products at lower prices. If consumers do not find our products attractive or if we are required to reduce our prices, our revenues and earnings may decline or fail to meet expected levels and our stock price could be affected adversely.

Failure to successfully manage or expand our fulfillment and distribution operation would have a material adverse effect on us.

      Our fulfillment and distribution operation is located in leased facilities in Lockbourne, Ohio. Our agreement with the fulfillment services company that previously managed the fulfillment and distribution operations at the Lockbourne, Ohio facility expired in August 2003, at which point we assumed direct control of fulfillment and distribution operations. We have no prior experience managing fulfillment and distribution operations and we cannot assure you that we will be successful in this endeavor. We experienced significant difficulties managing the fulfillment and distribution operations during the 2003 holiday season. If we are unable to successfully manage our fulfillment and distribution operations or if we experience any significant disruptions in connection with the transition from our prior service provider, our operations and financial condition could be seriously harmed. Any failure in managing our fulfillment and distribution operations would require us to find one or more parties to provide these services for us. If we are required to engage one or more service providers, we could incur higher fulfillment expenses than anticipated or incur additional costs for balancing merchandise inventories among multiple distribution facilities. Further, we may need to expand our distribution operations in the future to accommodate increases in customer orders. If we fail to successfully manage or expand our fulfillment and distribution operations it would have a material adverse effect on our business.

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

      We must maintain sufficient inventory levels to operate our business successfully. Rapidly changing trends in consumer tastes for gift items expose us to significant inventory risks, particularly during our third fiscal quarter when inventory levels are highest due to the holiday shopping season. Consumer preferences can change between the time we order a product and the time it is available for sale. We base our product selection

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Because we do not have long-term vendor contracts, we may not have continued access to popular products.

      More than half of our products are unique designs manufactured by third-party suppliers. We enter into exclusive supply agreements for these products to maintain a competitive advantage. However, since we do not have long-term arrangements with any vendor or distributor that would guarantee the availability of products from year to year, we do not have a predictable or guaranteed supply of these products in the future. If we are unable to provide our customers with continued access to popular, exclusive products, our operating results could be harmed.

Our facilities and systems are vulnerable to natural disasters or other catastrophic events.

      Our headquarters, customer service center and the majority of our infrastructure, including computer servers, are located in California, an area that is susceptible to earthquakes and other natural disasters. Our distribution facility, located in Lockbourne, Ohio, houses substantially all of our product inventory and is the location from which substantially all of our sales are shipped. A natural disaster or other catastrophic event, such as an earthquake, fire, flood, severe storm, break-in, terrorist attack or other comparable problems could cause interruptions or delays in our business and loss of data or render us unable to accept and fulfill customer orders in a timely manner, or at all. Further, California has in the recent past experienced power outages as a result of limited electrical power supplies. These outages may recur in the future and we cannot determine the effect, if any, that such outages would have on the operation of our business. In addition, as our inventory and distribution facility is located in an area that is susceptible to harsh weather, a major storm, heavy snowfall or other similar event could prevent us from delivering products in a timely manner. Also, areas in and around San Diego, California, the site of our customer service facility, have experienced severe wildfires. Such wildfires could destroy, render inoperable or cause the evacuation of our customer service facility, which could significantly disrupt our ability to provide satisfactory customer service. We have no formal disaster recovery plan and our business interruption insurance may not adequately compensate us for losses that may occur from any of the foregoing. In the event that an earthquake, natural disaster or other catastrophic event were to destroy any part of our facilities or interrupt our operations for any extended period of time, or if harsh weather conditions prevent us from delivering products in a timely manner, our business, financial condition and operating results would be seriously harmed.

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

      We have rapidly and significantly expanded our operations, and anticipate that further significant expansion, including the possible acquisition of third-party assets, technologies or businesses, will be required to address potential growth in our customer base and market opportunities. This expansion has placed, and is expected to continue to place, a significant strain on our management, operational and financial resources. Some of our officers or senior management personnel have no prior senior management experience at public companies. Our new employees include key officers as well as a number of key managerial, technical and operations personnel who have not yet been fully integrated into our operations. Additionally, we need to

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We experience intense competition in the rapidly-changing retail gift market.

      We operate in a highly competitive environment. We principally compete with a variety of department stores, Internet retailers, specialty retailers and other catalog merchandisers that offer products similar to or the same as our products. Increased competition is likely to result in price reductions, reduced gross margins and loss of market share, any of which could seriously harm our net revenues and results of operations. We expect competition to intensify in the future because current and new competitors can enter our market with little difficulty and can launch new websites at a relatively low cost. We currently or potentially compete with a variety of other companies, including:

	•	other online retailers, such as Amazon.com
	•	major department stores, such as Macy’s and Bloomingdale’s
	•	physical and online stores and catalog retailers that sell popular gift items such as Pottery Barn, Brookstone, The Sharper Image, Tiffany’s, Harry & David, J Crew, and 1-800-Flowers
	•	Internet portals and online service providers that feature shopping services, such as AOL, Yahoo! and Lycos

      Many of our traditional store-based, catalog-based and online competitors have longer operating histories, larger customer or user bases, greater brand recognition and significantly greater resources, particularly financial and marketing resources. Many of these competitors can devote substantially more resources to website development and catalog retailing than we can. In addition, large, well-established and well-financed entities may join with online competitors in the future. Our competitors may be able to secure products from vendors on more favorable terms, provide popular products to which we do not have access, fulfill customer orders more efficiently and adopt more aggressive pricing or inventory availability policies than we can.

      The U.S. retail industry, the specialty retail industry in particular, and the online commerce sector are highly competitive, dynamic in nature and have undergone significant changes over the past several years and will likely continue to undergo significant changes. Our ability to anticipate and respond successfully to these changes is critical to our long-term growth and we cannot assure you that we will anticipate and respond successfully to changes in the retail industry and online commerce sectors. If we are unable to maintain or increase our market share or compete effectively in the retail gift market, our business, financial condition and operating results would be adversely affected.

If we do not successfully expand our website and order processing systems or respond to rapid technological changes, we could lose customers and our net revenues could decline.

      If we fail to upgrade our website in a timely manner to accommodate higher volumes of traffic, our website performance could suffer and we may lose customers. In addition, if we fail to expand the computer systems that we use to process and ship customer orders and process customer payments, we may not be able to fulfill customer orders successfully. As a result, we could lose customers and our net revenues could be reduced. Further, to remain competitive, we must continue to enhance and improve the functionality and features of our online store. The Internet and the online commerce industry are subject to rapid technological change. If competitors introduce new features and website enhancements embodying new technologies, or if new industry standards and practices emerge, our existing website and systems may become obsolete or

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      We are currently in the process of implementing certain system enhancements and upgrades, including a new warehouse management system, an order-entry system, and an updated financial software package. Also, we are in the process of modifying certain internal processes for the purpose of improving our productivity and making our operations more cost efficient. However, we cannot assure you that we will be successful in these efforts or that we will achieve the desired results. Possible cost overruns in these implementation efforts may result in higher than anticipated capital expenditures. If we do not successfully implement one or more of these intended upgrades or modified processes or if we do not achieve desired efficiencies or cost savings as a result of these changes, our business and operating results could be harmed.

Delivery of our merchandise could be delayed or disrupted by factors beyond our control, and we could lose customers as a result.

      As timely gift delivery is essential to our customer’s satisfaction, any delay or disruption in order, fulfillment and shipping, particularly during the holiday shopping season, could cause us to lose customers and negatively affect our business. In addition, we rely upon third-party carriers for timely delivery of our product shipments. As a result, we are subject to carrier disruptions and increased costs due to factors that are beyond our control, including employee strikes, inclement weather and increased fuel costs. Any failure to deliver products to our customers in a timely and accurate manner would damage our reputation and brand and could cause us to lose customers.

      We also depend on temporary employees to adequately staff our distribution facility during busy periods such as the holiday shopping season. We cannot assure you that we will continue to receive adequate assistance from our temporary employees, or that we will continue to have access to sufficient numbers of competent temporary employees on a cost-effective basis, particularly during the holiday shopping season, which season is critical to our business. If we are unable to adequately staff our distribution and fulfillment facility during the holiday shopping season, our operations and sales during such period could suffer, and our reputation could be harmed.

Increased merchandise returns and a failure to accurately predict merchandise returns could harm our business.

      As part of our customer service commitment, we maintain a merchandise return policy that allows recipients to return most merchandise items received from us if they are dissatisfied with those items. We make allowances for merchandise returns in our financial statements based on historical return rates. We cannot assure you that actual merchandise returns will not significantly exceed our allowances for returns. In addition, because our allowances are based on historical return rates, we cannot assure you that the introduction of new merchandise in our catalogs, the introduction of new catalogs, increased sales over the Internet, changes in our merchandise mix, changes in the habits of our gift item recipients, or other factors will not cause actual returns to exceed return allowances, perhaps significantly. Any increase in merchandise returns that exceed our allowances would affect our business adversely.

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If we are unable to successfully manage the costs of our catalog operations or our catalogs fail to produce sales at satisfactory levels it could adversely affect our business.

      Our catalog has been an important tool for the acquisition and retention of customers. We believe that the success of our catalog as a cost-effective marketing tool depends on the following factors:

	•	effective management of costs associated with the production and distribution of our catalog
	•	achievement of adequate response rates to our mailings
	•	displaying a mix of merchandise in our catalog that is attractive to our customers
	•	cost-effective production of appealing catalogs
	•	timely delivery of catalog mailings to our customers

      Catalog production and mailings entail substantial paper, printing, postage and human labor costs. Increases in the costs of producing and distributing the RedEnvelope catalog, including increases in postage rates or paper, photography, or printing costs, may reduce the margin on sales derived from our catalog. The U.S. Postal Service is likely to increase its postage rates in the future and other delivery and overnight courier services that we utilize to deliver our products also will likely raise their rates in the future, which could significantly increase the aggregate cost of mailing our catalogs. As we incur nearly all of the costs associated with our catalogs prior to mailing, we are unable to adjust the costs being incurred in connection with a particular mailing to reflect the actual performance of the catalog. In addition, response rates to our mailings and, as a result, revenues generated by each mailing are affected by factors such as consumer preferences, economic conditions, the timing and mix of catalog mailings, the timely delivery by the postal system of our catalog mailings, and changes in our merchandise mix, several or all of which may be outside of our control. If we were to experience an increase in the costs associated with producing or distributing our catalogs or our catalogs fail to produce sales at satisfactory levels, our operating results would be adversely affected.

We are dependent on the success of our advertising and marketing efforts which are costly and may not achieve desired results.

      Our revenues depend on our ability to advertise and market our products effectively through the RedEnvelope catalog and our other advertising and marketing efforts. Increases in the cost of advertising and marketing, including paper and postage costs and the costs of complying with applicable regulations, may limit our ability to advertise and market our business without reducing our profitability. If we decrease our advertising or marketing activities due to increased costs, restrictions enacted by regulatory agencies or for any other reason, our future operating results could be significantly harmed. We expect to increase spending on advertising and marketing in the future, and if such efforts do not produce a sufficient level of sales to cover their costs, it would harm our operating results.

Recent changes to our shipping rate policy could cause our revenues to decline.

      In August 2003, we changed our shipping rate policy from a graduated rate schedule, based on the cost of the item(s) purchased by a customer, to a consistent flat rate per shipment. This change will have the effect of lowering our average per-shipment shipping fee, thereby reducing our shipping revenues per order. While we believe that this change to our shipping rate policy will be conducive to an increase in our order volume, we cannot assure you that our order volume will be increased or that any increase in shipments will offset the reduction in shipping revenues resulting from our shipping rate policy change. If our aggregate shipping revenues decrease as a result of the change in our shipping rate policy without a commensurate rise in product revenue, our business, financial condition and results of operations could be harmed.

If we are unable to provide satisfactory customer service, we could lose customers.

      Our ability to provide satisfactory levels of customer service depends, to a large degree, on the efficient and uninterrupted operation of our call center. Any material disruption or slowdown in our order processing systems resulting from labor disputes, telephone or Internet failures, power or service outages, natural disasters

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The loss of our senior management or other key personnel could harm our current and future operations and prospects.

      Our performance is substantially dependent on the continued services and on the performance of our senior management and other key personnel, particularly Alison L. May, our President and Chief Executive Officer, and Hilary Billings, our Brand Strategist. Our performance also depends on our ability to retain and motivate other officers and key employees. We do not have long-term employment agreements with any of our key personnel. The loss of the services of Ms. May, Ms. Billings, any of our executive officers or other key employees for any reason could harm our business, financial condition and operating result. Our future success also depends on our ability to identify, attract, hire, train, retain and motivate other highly-skilled technical, managerial, editorial, merchandising, marketing and customer service personnel. Competition for such personnel is intense, particularly in the San Francisco Bay Area, and we cannot assure you that we will be able to successfully attract, assimilate or retain sufficiently qualified personnel. Our failure to attract and retain the necessary technical, managerial, editorial, merchandising, marketing and customer service personnel would harm our business, financial condition and results of operations.

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

      We regard our copyrights, service marks, trademarks, trade dress, trade secrets and similar intellectual property as critical to our success. We rely on trademark and copyright law, trade secret protection and confidentiality agreements with our employees, consultants, partners, suppliers, and others to protect our proprietary rights. Nevertheless, the steps we take to protect our proprietary rights may be inadequate. Further, effective trademark, service mark, copyright and trade secret protection may not be available in every country in which we will sell our products and offer our services. Currently, we are involved in a trademark dispute with a company based in the United Kingdom regarding trademark rights in the United Kingdom and European Community. For more information on this dispute, see “Part II. Other Information — Legal Proceedings” below. In addition, the relationship between regulations governing domain names and laws protecting trademarks and similar proprietary rights is unclear. Therefore, we may be unable to prevent third parties from acquiring domain names that are similar to, infringe upon or otherwise decrease the value of our trademarks and other proprietary rights. If we are unable to protect or preserve the value of our trademarks, copyrights, trade secrets or other proprietary rights for any reason, our business would be harmed.

      We also rely on technologies that we license from third parties. These licenses may not continue to be available to us on commercially reasonable terms, or at all, in the future. As a result, we may be required to

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

      Other parties may assert infringement or unfair competition claims against us. In the past, we have received notices from third parties alleging that our trademarks or product offerings infringe proprietary rights held by them. We have also received claims alleging that our Internet marketing program and website operations infringe patents held by third parties. We are currently a defendant in a lawsuit alleging infringement by us of patents held by a third-party. For additional information on this lawsuit, see “Part II. Other Information — Legal Proceedings” below. We may receive other similar notices from, or have lawsuits filed against us by, third parties in the future. We cannot predict whether third parties will assert claims of infringement against us, or whether any past, present or future claims will prevent us from offering popular products or operating our business as planned. If we are forced to defend against thirty-party infringement claims, whether they are with or without merit or are determined in our favor, we could face expensive and time-consuming litigation, which could distract technical and management personnel, or result in product shipment delays. If an infringement claim is determined against us, we may be required to pay monetary damages or ongoing royalties. Further, as a result of infringement claims either against us or against those who license technology to us, we may be required to develop non-infringing intellectual property or enter into costly royalty or licensing agreements. Such royalty or licensing agreements, if required, may be unavailable on terms that are acceptable to us, or at all. If a third-party successfully asserts an infringement claim against us and we are required to pay monetary damages or royalties or we are unable to develop suitable non-infringing alternatives or license the infringed or similar intellectual property on reasonable terms on a timely basis, it could significantly harm our business.

We face the risk of inventory shrinkage.

      We are subject to the risk of inventory loss and theft. Although we believe that the levels of inventory shrinkage that we have suffered in the past are within an acceptable range, we cannot assure you that incidences of inventory loss and theft will not increase in the future or that the security measures we have taken in the past will effectively address the problem of inventory theft. If we were to suffer higher rates of inventory shrinkage or incur increased security costs to combat inventory theft, our financial condition could be affected adversely.

Poor economic conditions may constrain discretionary consumer spending on retail products such as ours.

      Consumer spending patterns, particularly discretionary spending for products such as ours, are affected by, among other things, prevailing economic conditions, stock market volatility, wars, threats of war, acts of terrorism, wage rates, interest rates, inflation, taxation, and consumer confidence. General economic, political and market conditions, such as recessions, may adversely affect our business results and the market price of our common stock. The terrorist attacks of September 11, 2001 and the wars in Afghanistan and Iraq had a negative effect on an already slowing economy and on consumer confidence. Our business and revenues have been, and could continue to be, negatively affected by poor economic conditions and any related decline in consumer demand for discretionary items such as our products. We face uncertainty in the degree to which poor performance in the retail industry, decreased consumer confidence or any economic slowdown will negatively affect demand for our products. We may not be able to accurately anticipate the magnitude of these effects on future quarterly results, which could seriously harm our financial condition. As we do not have large cash reserves, we may not be able to survive an extended recession or sluggish economy.

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

      We anticipate that we may need to raise additional capital in the future to facilitate long-term expansion, to respond to competitive pressures or to respond to unanticipated financial requirements. We cannot be certain that we will be able to obtain additional financing on commercially reasonable terms or at all. If we raise additional funds through the issuance of equity, equity-related or debt securities, such securities may have rights, preferences or privileges senior to those of the rights of our common stock and our stockholders will experience dilution of their ownership interests. Further, under the terms of our credit agreement with CapitalSource Finance LLC, we are subject to certain contractual limitations with respect to raising additional capital during the term of that agreement. A failure to obtain additional financing or an inability to obtain financing on acceptable terms could require us to incur indebtedness that has high rates of interest or substantial restrictive covenants, issue equity securities that will dilute the ownership interests of existing stockholders, or scale back, or fail to address opportunities for expansion or enhancement of, our operations. Since our inception, we have experienced negative cash flow from operations on a fiscal year basis and may experience negative cash flow from operations on a fiscal year basis for the foreseeable future.

If we default on any secured loan, all or a portion of our assets could be subject to forfeiture.

      We are currently party to a credit agreement that is secured by substantially all of our tangible and intangible assets, and we may enter into secured credit or loan agreements in the future. If we default on our current or any future secured loan for any reason and are unable to cure the default pursuant to the terms of the relevant agreement, our lenders could take possession of any or all assets in which they hold a security interest, including intellectual property, and dispose of those assets to the extent necessary to pay off our debts, which could materially harm our business.

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

      If any of the products that we sell causes harm to any of our customers, we could be vulnerable to product liability lawsuits. If we are found liable under product liability claims, we could be required to pay substantial monetary damages. Further, even if we successfully defend ourselves against this type of claim, we could be forced to spend a substantial amount of money in litigation expenses, our management could be required to spend valuable time in the defense against these claims and our reputation could suffer, any of which could harm our business.

We may face difficulty expanding into international markets.

      We may expand our operations to sell our products internationally, but we have relatively little experience in purchasing, marketing and distributing products or services for international markets. It will be costly to establish international facilities and operations, promote our brand internationally, and develop localized websites, catalogs and other systems. Governments in other countries may regulate Internet or other online services in such areas as content, privacy, network security, encryption or distribution, which could significantly affect our ability to conduct business in those countries. If we are unsuccessful in our attempts to expand our operations into other countries, our operating results could be harmed.

We may incur significant costs or experience delays in product availability due to regulations applicable to the sale of food products, which may hurt our business.

      We currently offer select food items for sale to our customers. Applicable federal, state or local regulations may cause us to incur substantial compliance costs or delay the availability of those consumables. In addition, any inquiry or investigation from a food regulatory authority could have a negative impact on our reputation. The occurrence of any of these events could adversely affect our financial condition.

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If we fail to comply with the laws regulating the sale of tobacco products it may have a negative impact on our reputation and make us vulnerable to liability claims.

      We are required to verify the age of purchasers of our tobacco products. If we fail to request or are unable to properly identify the age of our purchasers, we could face substantial penalties and legal liability for sales of tobacco products to underage persons. Any inquiry or investigation from a regulatory authority could have a negative impact on our reputation and any liability claims could subject us to fines, mandatory damages or require us to spend significant time and money in litigation.

Our charter documents, Delaware law and third-party contractual restrictions may make an acquisition of us more difficult, even if an acquisition would be beneficial to our stockholders.

      We are a Delaware corporation and the Delaware General Corporation Law contains certain provisions that may make a change in control of our company or the removal of incumbent directors more difficult. In addition, our Amended and Restated Certificate of Incorporation and Bylaws, contain provisions that may have the same effect, including the elimination of the ability of stockholders to call special meetings or vote by written consent, the elimination of cumulative voting for directors, and procedures requiring advance notification for stockholder proposals. The elimination of cumulative voting substantially reduces the ability of minority stockholders to obtain representation on the Board of Directors. These provisions may discourage potential acquirers from making a bid for our company, or make an acquisition of us or a tender offer to our stockholders more difficult, even if such acquisition or tender offer would be beneficial to our stockholders, and may reduce any premiums paid to stockholders for their common stock.

      Additionally, under the terms of our credit agreement with CapitalSource Finance LLC, we are subject to covenants that could restrict or place limitations on our ability to be acquired by another company during the term of the credit agreement, even if such acquisition would be beneficial to our stockholders.

Our success is tied in large part to the continued use of the Internet by a large number of consumers.

      Our future revenues and profits, if any, substantially depend upon the continued widespread use of the Internet as an effective medium of business and communication. Factors which could reduce the widespread use of the Internet include:

	•	actual or perceived lack of privacy protection
	•	actual or perceived lack of security of credit card information
	•	possible disruptions or other damage to the Internet or telecommunications infrastructure
	•	increased governmental regulation and taxation
	•	decreased use of personal computers

      Any decrease or less than anticipated growth in Internet usage could significantly harm our business.

Customers may be unwilling to purchase goods on the Internet.

      Approximately 70% of our products currently are purchased through our website. Our long-term prospects therefore depend upon the general public’s increasing willingness to use the Internet as a means to purchase goods. The failure of the Internet to continue to develop into an effective and reliable tool for consumer purchases would seriously damage our future operations. Online commerce is a relatively new concept, and online purchases may decline or fail to increase as projected. The future of online commerce is highly uncertain, many online commerce companies have ceased operations in recent years and most existing online commerce companies have a relatively short operating history. If consumers are unwilling to use the Internet to purchase retail products, our business will be harmed.

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

      In order for the online commerce market to develop successfully, we and other market participants must be able to transmit confidential information, including credit card information, securely over public networks. Third parties may have the technology or know-how to breach the security of customer transaction data. Any breach could cause consumers to lose confidence in the security of our website and choose not to purchase from us. Although we take the security of our systems very seriously, we cannot guarantee that our security measures will effectively prohibit others from obtaining improper access to our information. If a person is able to circumvent our security measures, he or she could destroy or steal valuable information or disrupt our operations. Any security breach could expose us to risks of data loss, litigation and liability and could seriously disrupt our operations and harm our reputation.

      We do not carry insurance against the risk of credit card fraud, so the failure to prevent fraudulent credit card transactions could reduce our net revenues and gross margin. In addition, we may in the future suffer losses as a result of orders placed with fraudulent credit card data even though the associated financial institution approved payment of the orders. Under current credit card practices, we may be liable for fraudulent credit card transactions because we do not obtain a cardholder’s signature. If we are unable to detect or control credit card fraud, our liability for these transactions could harm our business, operating results or financial condition.

If one or more states successfully assert that we should collect sales or other taxes on the sale of merchandise purchased from our website, our business could be harmed.

      We do not currently collect sales or other similar taxes for physical shipments of goods into states other than California and Ohio. In the future, one or more local, state or foreign jurisdictions may seek to impose sales tax collection obligations on us. If sales tax obligations are successfully imposed upon us by a state or other jurisdiction, we may suffer decreased sales into such state or jurisdiction as the effective cost of purchasing goods from us increases for those residing in such states or jurisdictions. We may also be subject to value added and other taxes if we sell merchandise to customers located in the European Union and we may incur significant financial and organizational burdens in order to set up the infrastructure required to comply with applicable tax regulations. If additional states or any other jurisdictions successfully assert that we should collect sales or other taxes on the sale of our merchandise into these jurisdictions our business could be affected adversely.

Existing or future government regulation could harm our business.

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

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      Tax authorities in a number of states, as well as a Congressional advisory commission, are currently reviewing the appropriate tax treatment of companies engaged in online commerce, and new state tax regulations may subject us to additional state sales and income taxes, which could have an adverse effect on our cash flows and results of operations. Further, there is a possibility that we could be subject to significant fines or other payments for any past failures to comply with these requirements. In its most recent session, Congress refused to extend the U.S. Internet tax moratorium. Consequently, states are free to impose new taxes on Internet access, which could slow the growth of Internet use and of electronic commerce transactions over the Internet.

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

      Further, recently-enacted federal and state laws place restrictions on email marketing that could make it more difficult for us to acquire new customers, or to obtain repeat purchases from prior customers through inexpensive electronic marketing methods. The CAN-SPAM Act, for example, requires every commercial e-mail message to include an “opt-out” mechanism and requires all senders to comply with their recipients “opt out” requests. It also requires senders to label all commercial e-mail message as advertisements or solicitations. These requirements may reduce the effectiveness of our e-mail marketing activities. If any current or future law requires us to eliminate or curtail our email marketing efforts, our ability to obtain new customer and increase revenues could be adversely affected or we could incur greater marketing costs, either of which could harm our business. While we intend to comply with applicable law regarding email marketing, there is no assurance that we will not incur fines or other liability as a result of an inadvertent violation of such a law.

      In addition, because our website is accessible over the Internet in multiple states and other countries, we may be subject to their laws and regulations or may be required to qualify to do business in those locations. We are qualified to do business only in California and Ohio at present. Our failure to qualify in a state or country where we are required to do so could subject us to taxes and penalties and we could be subject to legal actions and liability in those jurisdictions. The restrictions or penalties imposed by, and costs of complying with, these

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

      We are subject to increasing regulation relating to privacy and the use of personal user information. For example, we are subject to various telemarketing laws that regulate the manner in which we may solicit future suppliers and customers. Such regulations, along with increased governmental or private enforcement, may increase the cost of growing our business. California recently enacted a law, currently scheduled to take effect on July 1, 2004, that will require all commercial website operators that collect personal information about California residents to adopt and post a privacy policy that meets certain specified criteria. Any failure to comply with this new law could subject us to civil penalties, injunctions, and/or lawsuits. In addition, several states have proposed legislation that would limit the uses of personal user information gathered online or require online services to establish privacy policies. The Federal Trade Commission has adopted regulations regarding the collection and use of personal identifying information obtained from children under 13 years of age. Bills proposed in Congress would extend online privacy protections to adults. Moreover, proposed legislation in the United States and existing laws in other countries require companies to establish procedures to notify users of privacy and security policies, obtain consent from users for collection and use of personal information, and/or provide users with the ability to access, correct and delete personal information stored by companies. These data protection regulations and enforcement efforts may restrict our ability to collect demographic and personal information from users, which could be costly or harm our marketing efforts. Further, any violation of privacy or data protection laws and regulations may subject us to fines, penalties and damages and may otherwise have a material adverse effect on our business, results of operations and financial condition.

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

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

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

      Our directors, executive officers and current beneficial holders of 5% or more of our outstanding common stock own a substantial portion of our stock. These stockholders, acting together, are able to influence significantly all matters requiring stockholder approval, including the election of directors and significant corporate transactions such as mergers or other business combinations. This control may delay, deter or prevent a third-party from acquiring or merging with us.

The large number of shares eligible for future public sale could cause our stock price to fall.

      A large portion of the shares of our common stock is currently subject to lock-up agreements that will expire in the near future. The lock-up agreements restrict holders’ ability to transfer their stock until March 23, 2004. Of our outstanding shares, 2,200,000 are freely tradable as of the date of this report, an

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      We currently maintain a portfolio of fixed and variable investments consisting of cash equivalents, short-term marketable securities and long-term marketable securities, which can be affected by changes in market interest rates. According to our investment policy, we may invest in taxable and tax exempt instruments. In addition, the policy establishes limits on credit quality, maturity, issuer and type of instrument. Marketable securities are classified as “available for sale”. Marketable securities are comprised of government securities and corporate bonds. We do not use derivative financial instruments in our investment portfolio.

      All highly liquid investments with a maturity of three months or less at the date of purchase are considered to be cash equivalents. The remaining investments are considered short-term marketable securities if maturities range between four and twelve months or long term marketable securities if maturities are over twelve months.

      The following table lists our cash equivalents, short-term marketable securities and long-term marketable securities at December 28, 2003:

      If interest rates rose by 100 basis points, our results from operations and cash flows would not be materially affected.

      The Company evaluated the design and operation of its disclosure controls and procedures to determine whether they are effective in ensuring that the disclosure of required information is timely and made in accordance with the Exchange Act and the rules and forms of the Securities and Exchange Commission. This evaluation was made under the supervision and with the participation of management, including the Company’s principal executive officer and principal financial officer as of the end of the period being reported on in this Quarterly Report on Form 10-Q. The Company continues to implement minor changes primarily to formalize and document procedures already in place. The Company also has established a Disclosure Committee, which consists of certain members of the Company’s senior management. Based on this evaluation, our chief executive officer and our chief financial officer have concluded that our disclosure controls and procedures, as defined at Exchange Act Rules 13a-15(e) and 15d-15(e), are effective to ensure that information required to be disclosed by the Company in reports that it files under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. Since the date of the evaluation of internal controls, no significant changes have been made that could significantly affect these controls.

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PART II.

OTHER INFORMATION

      By its letter dated March 9, 2000, Red Letter Days Plc, a United Kingdom company (Red Letter Days), asserted trademark rights in the United Kingdom in the marks RED LETTER, RED LETTER DAYS and the image of a red envelope. Red Letter Days offers experiential gifts in the United Kingdom. The letter claimed that if we were to use our name and the REDENVELOPE service mark in the United Kingdom in connection with retail sales of gifts, it would infringe Red Letter Days’ trademark rights. We have made a number of attempts to reach an amicable resolution of this dispute, but Red Letter Days has declined, to date, to enter into settlement negotiations. Red Letter Days has opposed our applications to register the REDENVELOPE and RedEnvelope stylized logo marks in the United Kingdom and the European Community. Red Letter Days’ oppositions to our United Kingdom and European Community trademark applications are pending. Evidentiary submissions are being made by the parties in connection with those opposition proceedings and a decision is not expected for several months. The sole issue to be decided in the opposition proceedings is whether the REDENVELOPE mark is entitled to registration in the stated jurisdictions. Even if an opposition is successful in preventing the subject trademark from being registered, that decision by the registration authorities does not prevent the applicant from using the mark in that jurisdiction. In order to prevent us from using the RedEnvelope mark in the United Kingdom or European Community or to obtain any other equitable relief or monetary relief, Red Letter Days would need to bring a lawsuit against us in the appropriate jurisdiction. To the best of our knowledge, no such lawsuit has been filed. We opposed Red Letter Days application to register the RED LETTER mark in the United Kingdom, based on the descriptiveness of the RED LETTER mark as applied to the services of Red Letter Days. The United Kingdom trademark office has denied our opposition and has approved the registration of the Red Letter Days mark in the United Kingdom. This decision did not address a comparison of the REDENVELOPE and RED LETTER marks.

      In a letter dated May 23, 2003, counsel for Activ8Now, LLC offered us a license to U.S. Patents 6,557,006 and 6,535,889 and certain patent applications. In a letter dated July 10, 2003, Activ8Now asserted that we were using the patented technology of Activ8Now. In a letter dated September 3, 2003 and in response to an inquiry from our counsel, counsel for Activ8Now reasserted that certain of Activ8Now’s patents covered certain aspects of our website operations and provided their analysis of how such Activ8Now patented technologies apply to our website operations, and again offered to license such patents to us. On September 5, 2003, our counsel discovered that Activ8Now had filed suit against RedEnvelope in the United States District Court for the Northern District of Georgia on September 3, 2003 alleging infringement of the two patents referenced above arising out of certain aspects of our website operations, and seeking the following relief: actual damages for the alleged infringement (including interest) in an unspecified amount, but no less than a reasonable royalty amount; permanent injunctive relief from further alleged acts of infringement; costs and reasonable attorney’s fees related to the lawsuit; and triple damages in the event that Activ8Now can show infringement that was willful and intentional. On October 17, 2003, RedEnvelope was served with the complaint. Counsel for RedEnvelope is in the process of evaluating the merits of this claim and we intend to pursue any and all available defenses to these allegations vigorously. We currently believe that this lawsuit will not have a material adverse effect on us. However, because this litigation matter is in its early stages, we do not have sufficient information to assess whether the allegations could lead to liability on the part of RedEnvelope or the amount of potential damages. We cannot guarantee that this lawsuit will not result in costly settlement arrangements, royalty payments, statutory damages, significant attorney’s fees and/or require us to modify our website or our methods of conducting business.

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      (c) During the quarterly period ended December 29, 2003, we issued the following securities that were not registered under the Securities Act of 1933.

      On September 29, 2003, we granted options to purchase an aggregate of 426 shares of common stock with an exercise price of $14.04 per share to a number of our employees for an aggregate exercise price of $5,981.04. These transactions were exempt from registration under the Securities Act pursuant to Rule 701 promulgated under Section 3(b) thereof on the basis that the transactions were pursuant to a compensation benefit plan and contracts relating to employment or pursuant to Section 4(2) thereof on the basis that the transactions did not involve a public offering.

      The recipients of securities in the transactions listed above represented their intentions to acquire the securities for investment only and not with a view to or for sale in connection with any distribution thereof. All recipients had adequate access to information about RedEnvelope through their relationships with RedEnvelope. None of the foregoing transactions involved any underwriters, underwriting discounts or commissions, or any public offerings.

      (d) The Securities and Exchange Commission declared our registration statement, which we filed on Form S-1 (Registration No. 333-106120) under the Securities Act of 1933 in connection with the initial public offering of our common stock, effective on September 24, 2003. Under this registration statement, we registered 2,200,000 shares of our common stock, and another 330,000 shares subject to the underwriter’s over-allotment option. The shares of common stock registered under the registration statement, not including the 330,000 shares of common stock covered by the over-allotment option which expired on October 24, 2003 and was not exercised, were sold at a price to the public of $14.00 per share. All of the shares of common stock were sold by us and there were no selling stockholders in the offering. The offering closed on September 30, 2003. The underwriters were WR Hambrecht+Co, LLC and Pacific Crest Securities, Inc.

      The aggregate proceeds to us from the offering were approximately $29.0 million (after underwriters’ discounts of $1.8 million). We will use approximately $1.6 million for fees related to the offering (excluding banker fees) and approximately $3.9 million to fund operations. We invested approximately $23.5 million of the remaining net proceeds in short and long term investments and the balance in cash and cash equivalents.

      (a) Exhibits

      (b) Reports on Form 8-K

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SIGNATURES

      Pursuant to the requirements 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.

	REDENVELOPE, INC.

	By:	/s/ ERIC C. WONG

	Eric C. Wong
	Chief Financial Officer

Date: February 11, 2004

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EXHIBIT INDEX