UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 001-34082

 

Kona Grill, Inc.

Delaware		20-0216690
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

7150 East Camelback Road, Suite 220
Scottsdale, Arizona 85251
(480) 922-8100
(Address, including zip code, and telephone number, including area code, of principal executive offices)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o		Accelerated filer o		Non-accelerated filer þ		Smaller reporting company o
				(Do not check if a smaller reporting company)

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

As of October 31, 2009, there were 9,143,856 shares of the registrant’s common stock outstanding.

 

 

TABLE OF CONTENTS

		Page
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
Consolidated Balance Sheets as of September 30, 2009 (Unaudited) and December 31, 2008			2
Unaudited Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2009 and 2008			3
Unaudited Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2009 and 2008			4
Notes to Unaudited Consolidated Financial Statements			5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			13
Item 3. Quantitative and Qualitative Disclosures about Market Risk			24
Item 4T. Controls and Procedures			24
PART II. OTHER INFORMATION
Item 1. Legal Proceedings			25
Item 1A. Risk Factors			25
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			25
Item 3. Defaults Upon Senior Securities			25
Item 4. Submission of Matters to a Vote of Security Holders			25
Item 5. Other Information			25
Item 6. Exhibits			26
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1
Exhibit 32.2

PART I — FINANCIAL INFORMATION

Item 1.		Consolidated Financial Statements

KONA GRILL, INC.

CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)

		September 30,				December 31,
		2009				2008
		(Unaudited)				(Note 1)
ASSETS
Current assets:
Cash and cash equivalents		$	2,516			$	2,477
Investments			6,268				370
Receivables			501				980
Other current assets			1,107				938
Total current assets			10,392				4,765
Long-term investments			—				6,491
Other assets			702				794
Property and equipment, net			56,591				53,504
Total assets		$	67,685			$	65,554
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	1,761			$	4,335
Accrued expenses			5,830				4,878
Current portion of notes payable			715				717
Line of credit			5,798				2,488
Total current liabilities			14,104				12,418
Notes payable			789				1,320
Deferred rent			15,779				16,218
Total liabilities			30,672				29,956
Commitments and contingencies (Note 11)
Stockholders’ equity:
Preferred stock, $0.01 par value, 2,000,000 shares authorized, none issued			—				—
Common stock, $0.01 par value, 15,000,000 shares authorized, 9,260,056 shares issued and 9,143,856 shares outstanding at September 30, 2009 and 6,628,191 shares issued and 6,511,991 shares outstanding at December 31, 2008			93				66
Additional paid-in capital			57,472				53,739
Treasury stock, at cost, 116,200 shares at September 30, 2009 and December 31, 2008			(1,000	)			(1,000	)
Accumulated deficit			(19,552	)			(17,207	)
Total stockholders’ equity			37,013				35,598
Total liabilities and stockholders’ equity		$	67,685			$	65,554

See accompanying notes to the unaudited consolidated financial statements.

KONA GRILL, INC.

UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)

		Three Months Ended September 30,								Nine Months Ended September 30,
		2009				2008				2009				2008
Restaurant sales		$	20,173			$	19,454			$	61,096			$	57,242
Costs and expenses:
Cost of sales			5,267				5,254				15,825				15,816
Labor			7,117				6,496				21,135				19,003
Occupancy			1,655				1,260				4,711				3,760
Restaurant operating expenses			3,296				2,978				9,568				8,468
General and administrative			1,590				2,079				6,138				5,957
Preopening expense			480				471				1,332				1,190
Depreciation and amortization			1,820				1,656				5,373				4,806
Total costs and expenses			21,225				20,194				64,082				59,000
Loss from operations			(1,052	)			(740	)			(2,986	)			(1,758	)
Nonoperating income (expense):
Interest income and other, net			44				62				169				371
Interest expense			(22	)			—				(153	)			(51	)
Loss from continuing operations before provision for income taxes			(1,030	)			(678	)			(2,970	)			(1,438	)
Provision for income taxes			5				55				65				205
Loss from continuing operations			(1,035	)			(733	)			(3,035	)			(1,643	)
Gain (loss) from discontinued operations, net of tax			—				(3,161	)			690				(3,459	)
Net loss		$	(1,035	)		$	(3,894	)		$	(2,345	)		$	(5,102	)
Net (loss) income per share—basic and diluted (Note 5):
Continuing operations		$	(0.11	)		$	(0.09	)		$	(0.36	)		$	(0.20	)
Discontinued operations			—				(0.40	)			0.08				(0.43	)
Net loss		$	(0.11	)		$	(0.49	)		$	(0.28	)		$	(0.63	)
Weighted average shares used in computation (Note 5):
Basic			9,141				7,998				8,478				8,071
Diluted			9,141				7,998				8,478				8,071

See accompanying notes to the unaudited consolidated financial statements.

KONA GRILL, INC.

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

		Nine Months Ended September 30,
		2009				2008
Operating activities
Net loss		$	(2,345	)		$	(5,102	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization			5,373				5,063
Stock-based compensation expense			392				403
Amortization of debt discount			70				—
Asset impairment charge in discontinued operations			—				2,158
Change in operating assets and liabilities:
Receivables			479				(1,955	)
Other current assets			(169	)			(88	)
Accounts payable			(40	)			667
Accrued expenses			952				264
Deferred rent			(439	)			3,012
Net cash provided by operating activities			4,273				4,422
Investing activities
Purchase of property and equipment			(10,994	)			(12,516	)
Decrease (increase) in other assets			92				(78	)
Net purchases and sales of investments			593				7,221
Net cash used in investing activities			(10,309	)			(5,373	)
Financing activities
Net borrowings on line of credit			3,310				—
Proceeds from bridge loan			1,200				—
Repayment of bridge loan			(1,200	)			—
Repayments of notes payable			(533	)			(493	)
Proceeds from issuance of common stock, net of issuance costs			3,245				—
Proceeds from issuance of common stock under the Employee Stock Purchase Plan and exercise of stock options and warrants			53				66
Purchase of treasury stock			—				(1,000	)
Net cash provided by (used in) financing activities			6,075				(1,427	)
Net increase (decrease) in cash and cash equivalents			39				(2,378	)
Cash and cash equivalents at the beginning of the period			2,477				4,991
Cash and cash equivalents at the end of the period		$	2,516			$	2,613
Supplemental disclosure of cash flow information
Cash paid for interest, net of capitalization		$	83			$	51
Noncash investing activities
(Decrease) increase in accounts payable related to property and equipment additions		$	(2,534	)		$	1,059

See accompanying notes to the unaudited consolidated financial statements.

KONA GRILL, INC.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation

Kona Grill, Inc. (referred to herein as the “Company” or “we,” “us,” and “our”) owns and operates upscale casual dining restaurants under the name “Kona Grill.” Our restaurants feature a diverse selection of mainstream American dishes and award-winning sushi that are prepared fresh daily. We currently own and operate 23 restaurants in 15 states throughout the United States.

The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In our opinion, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine month periods ended September 30, 2009 are not necessarily indicative of the results that may be expected for the year ending December 31, 2009.

The consolidated balance sheet at December 31, 2008 has been derived from the audited consolidated financial statements at that date, but does not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. Accordingly, these financial statements should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2008.

Recent Accounting Pronouncements

In April 2009, the FASB issued additional application guidance and enhanced disclosures regarding fair value measurements and impairment of securities. The guidance includes how to determine the fair value of assets and liabilities when the volume and level of activity for the asset or liability has significantly decreased. Enhanced disclosure requirements include the following: 1) interim disclosures regarding the fair values of financial instruments that are not currently reflected on the balance sheet at fair value; and 2) disclosure on the methods and significant assumptions used to estimate the fair value of financial instruments on an interim basis as well as changes of the methods and significant assumptions from prior periods. We adopted the additional guidance and disclosure requirements as of our second quarter ended June 30, 2009. The adoption did not have a material effect on our financial condition or results of operations.

In May 2009, the FASB issued its pronouncement regarding subsequent events which provides guidance to establish general standards of accounting for, and disclosures of, events that occur after the balance sheet date but before financial statements are issued or are available to be issued. In connection with preparation of the consolidated financial statements, we evaluated subsequent events after the balance sheet date of September 30, 2009 through November 3, 2009, the date the financial statements were issued.

In June 2009, the FASB approved the FASB Accounting Standards Codification (“the Codification”) as the single source of authoritative nongovernmental GAAP. All existing accounting standard documents, such as the FASB, American Institute of Certified Public Accountants, Emerging Issues Task Force and other related literature, excluding guidance from the SEC, have been superseded by the Codification. All non-grandfathered, non-SEC accounting literature not included in the Codification has become non-authoritative. The Codification does not change GAAP, but instead introduces a new structure that combines all authoritative standards into a comprehensive, topically organized online database. The Codification is effective for our September 30, 2009 financial statements and impacts financial statement disclosures as all references to authoritative accounting literature are referenced in accordance with the Codification.

2. Discontinued Operations

Discontinued operations include results attributable to our Naples, Florida restaurant that was closed during the third quarter of 2008. Gain (loss) from discontinued operations includes both the historical results of operations as well as exit costs. During the second quarter of 2009, we entered into a settlement agreement for the termination of the lease for $700,000. As the settlement amount was less than the lease termination accrual previously recorded during 2008, we recorded a gain of $690,000, after deducting fees and other expenses, for the nine months ended September 30, 2009. Gain (loss) from discontinued operations, net of tax is comprised of the following (in thousands):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2009				2008				2009				2008
Restaurant sales		$	—			$	340			$	—			$	1,531
Gain (loss) from discontinued operations before income tax benefit		$	—			$	(3,186	)		$	690			$	(3,534	)
Income tax benefit			—				25				—				75
Gain (loss) from discontinued operations, net of tax		$	—			$	(3,161	)		$	690			$	(3,459	)

Activity associated with the lease termination accrual is summarized below (in thousands):

Balance at December 31, 2008		$	1,417
Cash payments			(456	)
Non-cash activity			(690	)
Balance at September 30, 2009		$	271

Non-cash activity reflects the updated estimate of lease termination costs based upon the settlement agreement discussed above. The lease settlement requires an initial payment of $350,000 that was paid during July 2009 and the remaining amount, including interest at a 6% annual rate, is payable in 12 equal monthly installments beginning in August 2009. Settlement fees of $271,000 are included in accrued expenses on the accompanying consolidated balance sheet as of September 30, 2009.

3. Investments

The following is a summary of our investments (in thousands):

						Gross
		Adjusted				Unrealized				Estimated
		Cost				Losses				Fair Value
September 30, 2009
Short-term investments:
Certificates of deposit		$	171			$	—			$	171
Money market securities			314				—				314
Auction rate securities			5,386				—				5,386
Put option on auction rate securities			397				—				397
Total investments		$	6,268			$	—			$	6,268
December 31, 2008
Short-term investments:
Certificates of deposit		$	370			$	—			$	370
Long-term investments:
Auction rate securities			5,858				—				5,858
Put option on auction rate securities			633				—				633
			6,491				—				6,491
Total investments		$	6,861			$	—			$	6,861

As of September 30, 2009, our investment portfolio included auction rate securities with a par value of $5,800,000. These securities are AAA rated long term debt obligations secured by student loans, substantially all of which are guaranteed by the federal government under the Federal Family Education Loan Program. While the maturity dates of our auction rate securities range from 2029 to 2046, liquidity for these securities has historically been provided by an auction process that resets the applicable interest rate at pre-determined calendar intervals, generally every 28 days. Since February 2008, events in the credit markets have adversely affected the auction market for these types of securities and auctions for our securities have failed to settle on their respective settlement dates. During August 2009, we were able to sell $800,000 of these securities at par value. The proceeds from the sale were used to pay down a portion of the outstanding balance under the line of credit.

Our auction rate securities are classified as trading securities as they are subject to an agreement we entered into with UBS during October 2008 pursuant to which UBS issued to us Series C-2 Auction Rate Securities Rights. The agreement allows us the right to sell our auction rate securities to UBS at full par value between June 30, 2010 and July 2, 2012. In conjunction with this agreement, we elected to apply the provisions of fair value accounting to this put option because the put option does not provide for net settlement, and the auction rate securities themselves are not readily convertible to cash. The put option does not meet the definition of a derivative, and thus, would not be marked to fair value. We therefore elected to apply fair value accounting to our put option as the put option acts as an economic hedge against any further price movement in the auction rate securities and enables us to recognize future changes in the fair value of the put option as those changes occur to offset fair value movements in the auction rate securities. Also as part of this agreement, UBS agreed to provide a line of credit through June 30, 2010 that is secured by the auction rate securities held with UBS. Both the put option and the auction rate securities are marked to market value through the consolidated statements of operations each period (see Note 4 for discussion of how fair value measurements are determined). At September 30, 2009, the fair value of the put option was $397,000 and the fair value of the auction rate securities was $5,386,000. We recorded a net gain of $31,000 and $92,000 for the three and nine months ended September 30, 2009, respectively, for the fair value measurement of both the auction rate securities and the put option that is included in interest income and other, net. As of June 30, 2009, we reclassified our auction rate securities and put option from long-term to short-term investments on our consolidated balance sheet due to the expected timing of when these securities will be redeemed at par value by UBS. We continue to earn interest on our auction rate securities at the maximum contractual rate. Interest earned on the auction rate securities is used to reduce the outstanding balance under the line of credit.

4. Fair Value Measurements

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or a liability. As a basis for considering such assumptions, a three-tier value hierarchy has been established, which prioritizes the inputs used in the valuation methodologies in measuring fair value.

Level 1:		Fair values determined by quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access.
Level 2:		Fair values utilize inputs other than quoted prices that are observable for the asset or liability, and may include quoted prices for similar assets and liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability.
Level 3:		Fair values determined by unobservable inputs that are not corroborated by market data and may reflect the reporting entity’s own assumptions market participants would use in pricing the asset or liability.

Our short-term investments in fixed income and money market securities represent available-for-sale securities that are valued primarily using quoted market prices or alternative pricing sources and models utilizing market observable inputs. Money market securities represent collateral for a letter of credit required under certain lease obligations.

Our investment in auction rate securities are classified within Level 3 because they are valued using a discounted cash flow model. We estimate the fair value of auction rate securities using valuation models provided by third parties and internal analyses. The valuation models require numerous assumptions and assessments, including the following: (i) collateralization underlying each security; (ii) present value of future principal and interest payments discounted at rates considered to reflect current market conditions; (iii) creditworthiness of the counterparty; and (iv) current illiquidity of the investments.

The fair value of the put option is determined through comparison of the fair value of each auction rate security to its par value and then discounted by a rate reflective of the risk of default by UBS between the valuation date and the expected exercise date of the put option. A discounted cash flow approach is used to value the difference between the par value and fair value of each security using a discount rate that considers the credit risk associated with UBS and the expected timing of when the put option will be exercised. The put option is adjusted on each balance sheet date based on its then fair value. The fair value of the put option is based on unobservable inputs and is therefore classified within Level 3 in the hierarchy. The following table presents information about our assets measured at fair value on a recurring basis at September 30, 2009, and indicates the fair value hierarchy of the valuation techniques utilized to determine such fair value (in thousands):

		Fair Value Measurements at Reporting Date Using
		Quoted Prices in				Significant
		Active Markets				Other				Significant
		for Identical				Observable				Unobservable
		Assets				Inputs				Inputs				September 30,
Description		(Level 1)				(Level 2)				(Level 3)				2009
Certificates of deposit		$	171			$	—			$	—			$	171
Money market securities			314				—				—				314
Auction rate securities			—				—				5,386				5,386
Put option on auction rate securities			—				—				397				397
		$	485			$	—			$	5,783			$	6,268

The following table summarizes the changes in fair value of our Level 3 assets (in thousands):

						Put option on
		Auction rate				auction rate
		securities				securities
Balance at December 31, 2008		$	5,858			$	633
Transfer to Level 3			—				—
Total gains or losses (realized and unrealized)
Included in earnings			328				(236	)
Included in other comprehensive loss			—				—
Net settlements			(800	)			—
Balance at September 30, 2009		$	5,386			$	397

5. Net Loss Per Share

Basic net loss is computed by dividing net loss by the weighted average number of common shares outstanding during the period. Diluted net loss per share excludes the dilutive effect of potential stock option and warrant exercises, which are calculated using the treasury stock method.

The following table sets forth the computation of basic and diluted net loss per share:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2009				2008				2009				2008
		(In thousands, except per share data)
Numerator:
Loss from continuing operations		$	(1,035	)		$	(733	)		$	(3,035	)		$	(1,643	)
Gain (loss) from discontinued operations			—				(3,161	)			690				(3,459	)
Net loss		$	(1,035	)		$	(3,894	)		$	(2,345	)		$	(5,102	)
Denominator:
Weighted average shares — Basic			9,141				7,998				8,478				8,071
Effect of dilutive stock options and warrants			—				—				—				—
Weighted average shares — Diluted			9,141				7,998				8,478				8,071
Basic and diluted net (loss) income per share:
Loss from continuing operations		$	(0.11	)		$	(0.09	)		$	(0.36	)		$	(0.20	)
Gain (loss) from discontinued operations			—				(0.40	)			0.08				(0.43	)
Net loss		$	(0.11	)		$	(0.49	)		$	(0.28	)		$	(0.63	)

On June 9, 2009, we completed our rights offering for which each holder of common stock as of the April 17, 2009 record date received one non-transferrable subscription right for every 2.5 shares of common stock. Each subscription right entitled our stockholders to purchase one share of common stock at a purchase price of $1.35 per share. The market price of our common stock was $3.93 per share on June 5, 2009, which was the expiration date of the rights offering. Since the $1.35 per share subscription price of common stock issued under the rights offering was lower than the $3.93 per share market price on June 5, 2009, the rights offering contained a bonus element. As a result, we retroactively increased the weighted average common shares outstanding used to compute basic earnings (loss) per share by an adjustment factor of 1.2309 for all periods presented prior to the completion of the rights offering.

For the three and nine months ended September 30, 2009, there were 795,000 stock options and warrants outstanding, that were not included in the dilutive earnings per share calculation because the effect would have been anti-dilutive. For the three and nine months ended September 30, 2008, there were 1,025,000 stock options and warrants outstanding that were excluded from the dilutive earnings per share calculation for the same reason.

6. Accrued Expenses

Accrued expenses consisted of the following (in thousands):

		September 30,				December 31,
		2009				2008
Accrued payroll		$	2,313			$	1,846
Business and income taxes			680				663
Sales taxes			568				643
Gift cards			545				654
Lease termination accrual			271				—
Accrued occupancy			122				255
Other			1,331				817
		$	5,830			$	4,878

7. Debt and Credit Agreements

Credit Facility

During October 2008, as part of the settlement agreement with UBS, our broker from which we purchased auction rate security instruments, we entered into a line of credit that is secured by the auction rate security instruments held with UBS. Available borrowings under the line of credit are based upon terms specified in the agreement and are subject to adjustment by UBS after consideration of various factors. At September 30, 2009, $5,798,000 was outstanding under the line of credit. Borrowings under the line of credit are callable by UBS at any time. The line of credit is classified as short-term in the accompanying consolidated balance sheets as the loan expires on June 30, 2010. The cost of the line of credit effectively offsets the interest earned on the auction rate securities. See Note 3 for further information on the auction rate securities and the settlement agreement.

Bridge Loan

On March 6, 2009, and as amended on April 7, 2009, we entered into a Note and Warrant Purchase Agreement (the “Agreement”) with certain accredited investors whereby we sold $1,200,000 aggregate principal amount of 10% unsecured subordinated notes (“Notes”) and warrants to purchase shares of our common stock. The principal and accrued interest outstanding under the Notes were due and payable upon the closing of any offering of equity securities by us generating gross proceeds to us of at least $2,500,000. As described in Note 8 below, we completed a rights offering during June 2009 and used a portion of the proceeds to repay amounts owed on the Notes.

For each $100,000 issued in Notes, we issued to the noteholder three-year warrants to purchase 10,000 shares of our common stock at an aggregate exercise price per share of $2.29, which was equal to 120% of the five-day average of the closing price of our common stock during the five trading days prior to the date of issuance. In connection with the issuance of the warrants, we recorded a discount to the bridge loan and a corresponding increase in stockholders’ equity of $70,000 due to the warrants. The value of the warrants was derived through application of the Black-Scholes option pricing model. We amortized the debt discount to interest expense in the amount of $0 and $70,000 for the three and nine months ended September 30, 2009, respectively.

8. Rights Offering

As part of the Agreement, we filed with the SEC a registration statement on Form S-3 to conduct a subscription rights offering with targeted gross proceeds to the Company of $3,520,000 (the “Rights Offering”) pursuant to which each stockholder of the Company received one non-transferrable subscription right for every 2.5 shares of common stock owned on April 17, 2009. Each subscription right entitled the holder to purchase one share of common stock at a price of $1.35 per share. The terms of the Agreement provided that any shares of common stock that were not subscribed for in the Rights Offering by existing stockholders were offered to the holders of the Notes on a pro rata basis based on the aggregate principal amount of Notes outstanding and at the same subscription price as offered to the holders of subscription rights granted under the Rights Offering. We sold 2,608,045 shares of common stock pursuant to the Rights Offering, including the exercise of over-subscription rights by the holders of the Notes for the purchase of 482,178 shares or 18.5% of the total shares sold. We received net proceeds of $3,245,000 after deducting $276,000 in expenses. A portion of the net proceeds was used to repay amounts owed on the Notes, and the remaining proceeds are being utilized to fund capital expenditure requirements.

9. Stock-Based Compensation

We maintain stock award plans which provide for discretionary grants of incentive and nonstatutory stock options, restricted stock, and other types of awards to our employees and non-employee directors. Stock options issued under these plans are granted with an exercise price at or above the fair market value of the underlying common stock on the date of grant and generally expire five or ten years from the date of grant. Employee stock options generally vest 25 percent each year over a four-year period, while annual recurring awards for non-employee director options vest 25 percent each quarter over a one-year period.

The fair value of stock options granted during the nine months ended September 30, 2009 and 2008 was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:

		Nine Months Ended
		September 30,
		2009				2008
Expected volatility			55.0	%			36.0	%
Risk-free interest rate			1.6	%			2.5	%
Expected option life (in years)			3.8				3.7
Dividend yield			0.0	%			0.0	%
Weighted average fair value per option granted		$	0.86			$	3.42

The following table summarizes activity under our stock award plans for the nine months ended September 30, 2009:

		Shares				Weighted				Weighted Average
		Under				Average				Remaining				Aggregate
		Option				Exercise Price				Contractual Term				Intrinsic Value
Outstanding options at December 31, 2008			824,056			$	12.34
Granted			197,100				2.03
Forfeited			(336,100	)			12.91
Exercised			—				—
Outstanding options at September 30, 2009			685,056			$	9.08			3.6 years				$	213,000
Exercisable at September 30, 2009			409,706			$	9.68			3.4 years				$	32,000

We recognized stock-based compensation expense of $85,000 and $138,000 during the three months ended September 30, 2009 and 2008, respectively and $392,000 and $403,000 during the nine months ended September 30, 2009 and 2008, respectively. As of September 30, 2009, there was approximately $535,000 of unrecognized stock-based compensation expense related to unvested stock-based compensation arrangements, which is expected to be recognized over a weighted average period of 2.1 years.

10. Comprehensive Loss

Comprehensive loss is defined as the aggregate change in stockholders’ equity, excluding changes in ownership interests. It is the sum of net loss and changes in unrealized losses on available-for-sale securities. The components of comprehensive loss for the three and nine months ended September 30, 2009 and 2008 are as follows (in thousands):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2009				2008				2009				2008
Net loss		$	(1,035	)		$	(3,894	)		$	(2,345	)		$	(5,102	)
Net unrealized loss on available-for-sale securities			—				(171	)			—				(629	)
Total comprehensive loss		$	(1,035	)		$	(4,065	)		$	(2,345	)		$	(5,731	)

11. Commitments and Contingencies

We are engaged in various legal actions, which arise in the ordinary course of our business. Although there can be no assurance as to the ultimate disposition of these matters, we believe, based upon the information available at this time, that the expected outcome of these matters, individually or in the aggregate, will not have a material adverse effect on our results of operations or financial condition.

On April 1, 2009, Samuel Beren, as trustee for the Samuel Beren Trust, filed a stockholder derivative suit in the Court of Chancery of the State of Delaware. The suit was brought on behalf of us against our directors and the purchasers of our promissory notes issued on March 5, 2009, and named us as a nominal defendant. The complaint alleged that our directors breached their fiduciary duties of loyalty, good faith, and due care to us, and that the noteholders aided and abetted such breach, in connection with certain of our fundraising efforts. The suit originally sought unspecified damages, interest, reasonable attorneys’ fees, expert witness fees, and other costs, and any further relief the court deems just and proper.

During June 2009, the plaintiffs filed an amended complaint that, among other things, eliminated the allegation that the noteholders aided and abetted the alleged breaches of fiduciary duty; seeks to include in the litigation as a class all owners of our common stock; and sought to enjoin us from effecting the subscription rights offering, or, if the subscription rights offering was consummated, to rescind and set aside the subscription rights offering.

On June 16, 2009, we filed a motion to dismiss the claim. On August 28, 2009, we filed an opening brief in support of the motion to dismiss this claim. On October 26, 2009, the plaintiffs filed a demand pursuant to Section 220 of the Delaware General Corporation Law that we make certain books, records, and documents available for inspection. We believe that the allegations in the complaint, including the amended complaint, are without merit and we intend to defend vigorously this action.

12. Subsequent Event

Effective November 2, 2009, our Board of Directors appointed Marc A. Buehler to serve as Chief Executive Officer and President of Kona Grill, Inc. Mr. Buehler was also appointed as a member of our Board of Directors. Prior to joining our company, Mr. Buehler was the Chief Executive Officer of LS Management, Inc., the owner and operator of the Lone Star Steakhouse & Saloon/Texas Land and Cattle Steak House restaurant concepts, as well as Lone Star Business Solutions, where he served from July 2007 to May 2009. From July 2002 to July 2007, Mr. Buehler worked at Romacorp, which operates and franchises more than 200 Tony Roma’s casual dining locations, as the Vice President of Marketing and was promoted to Chief Executive Officer, President, and Director during July 2006.

Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations

This information should be read in conjunction with the unaudited consolidated financial statements and notes thereto included in Item 1 of Part I of this Quarterly Report and the audited consolidated financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations for the year ended December 31, 2008 contained in our 2008 Annual Report on Form 10-K. The following discussion contains certain forward-looking statements that involve known and unknown risks and uncertainties, such as statements relating to our future economic performance, plans and objectives for future operations, and projections of restaurant sales and other financial items that are based on our beliefs as well as assumptions made by and information currently available to us. Factors that might cause actual events or results to differ materially from those indicated by these forward-looking statements may include the matters under Item 1A, “Risk Factors” in this report, our Annual Report on Form 10-K for the year ended December 31, 2008 and other reports filed from time to time with the SEC.

Overview

We currently own and operate 23 restaurants located in 15 states. We offer freshly prepared food, personalized service, and a contemporary ambiance that create a satisfying yet affordable dining experience that we believe exceeds many traditional casual dining restaurants with whom we compete. Our high-volume upscale casual restaurants feature a diverse selection of mainstream American favorites as well as a variety of appetizers and entrees with an international influence, including an extensive selection of sushi items. Our menu items are freshly prepared and incorporate over 40 signature sauces and dressings that we make from scratch, creating broad-based appeal for the lifestyle and taste trends of a diverse group of guests. Our menu is mostly standardized for all of our restaurants, allowing us to deliver consistent quality meals. We believe that our vast menu and generous portions, combined with an average check of approximately $23 per guest, offers our guests an attractive price-value proposition.

We continue to follow a disciplined growth plan focused largely on expanding our presence in new markets. Over the last four years, we have funded development of new restaurants primarily from the proceeds of our initial public offering, our private offering of common stock completed during November 2007, our rights offering completed during June 2009, and cash flows from operations. We plan to open four restaurants during 2009, including our Richmond, Virginia restaurant which opened on January 22, 2009, our Woodbridge, New Jersey restaurant which opened on April 28, 2009, our Eden Prairie, Minnesota restaurant which opened on September 29, 2009, and a restaurant in Tampa, Florida which is expected to open in November 2009. We target our restaurants to achieve an average annual unit volume of $4.5 million following 24 months of operations. Recent openings are trending lower than our targeted volume during the current recession. We continue to believe that in a stable economic environment our typical new restaurants experience gradually increasing unit volumes as guests begin to discover our concept and we begin to generate market awareness. Our restaurants are also subject to seasonal fluctuations. Sales in most of our restaurants typically are higher during the spring and summer months and winter holiday season.

On September 13, 2008, we closed our restaurant in Naples, Florida to focus more on our profitable locations. As a result, we classified the Naples’ restaurant operations and related closure costs as discontinued operations in our consolidated financial statements.

We experience various trends in our operating cost structure. Cost of sales, labor, occupancy, and other operating expenses for our restaurants open at least 12 months generally trend consistent with restaurant sales, and we analyze those costs as a percentage of restaurant sales. We anticipate that our new restaurants will take approximately six months to achieve operating efficiencies as a result of challenges typically associated with opening new restaurants, including lack of market recognition and the need to hire and sufficiently train employees, as well as other factors. We expect cost of sales and labor expenses as a percentage of restaurant sales to be higher when we open a new restaurant, but decrease as a percentage of restaurant sales as the restaurant matures and as the restaurant management and employees become more efficient operating that unit. As a result, the volume and timing of newly opened restaurants has had, and is expected to continue to have, an impact on costs of sales, labor, occupancy, restaurant operating expenses, and preopening expenses. The majority of our general and administrative costs are fixed costs. We expect our general and administrative spending to decrease as a percentage of restaurant sales as we leverage these investments and realize the benefits of higher sales volumes.

Key Measures We Use to Evaluate Our Company

Key measures we use to evaluate and assess our business include the following:

Number of Restaurant Openings. Number of restaurant openings reflects the number of restaurants opened during a particular reporting period.

Same-Store Sales Percentage Change. Same-store sales percentage change reflects the periodic change in restaurant sales for the comparable restaurant base. In calculating the percentage change in same-store sales, we include a restaurant in the comparable restaurant base after it has been in operation for more than 18 months. Same-store sales growth can be generated by an increase in guest traffic counts or by increases in the per person average check amount. Menu price changes and the mix of menu items sold can affect the per person average check amount.

Average Weekly Sales. Average weekly sales represents the average of restaurant sales measured over consecutive Monday through Sunday time periods.

Average Unit Volume. Average unit volume represents the average restaurant sales for all of our restaurants open for at least 12 months before the beginning of the period measured.

Sales Per Square Foot. Sales per square foot represents the restaurant sales for our restaurants open for at least 12 months, divided by the total leasable square feet for such restaurants.

Restaurant Operating Profit. Restaurant operating profit is defined as restaurant sales minus cost of sales, labor, occupancy, and restaurant operating expenses. Restaurant operating profit does not include general and administrative expenses, depreciation and amortization, or preopening expenses. We believe restaurant operating profit is an important component of financial results because it is a widely used metric within the restaurant industry to evaluate restaurant-level productivity, efficiency, and performance. We use restaurant operating profit as a percentage of restaurant sales as a key metric to evaluate our restaurants’ financial performance compared with our competitors.

Key Financial Definitions

Restaurant Sales. Restaurant sales include gross food and beverage sales, net of promotions and discounts.

Cost of Sales. Cost of sales consists of food and beverage costs.

Labor. Labor includes all direct and indirect labor costs incurred in operations.

Occupancy. Occupancy includes all rent payments associated with the leasing of real estate, including base, percentage and straight-line rent, property taxes, and common area maintenance expense. We record tenant improvement allowances as a reduction of occupancy expense over the initial term of the lease.

Restaurant Operating Expenses. Restaurant operating expenses consist of all other restaurant-level operating costs, the major components of which are utilities, credit card fees, advertising, supplies, marketing, repair and maintenance, and other expenses. Restaurant operating expenses contain both variable and fixed components.

General and Administrative. General and administrative includes all corporate and administrative functions that support operations and provide infrastructure to facilitate our future growth. Components of this category include management and staff salaries, bonuses, stock-based compensation and related employee benefits, travel, information systems, human resources, training, corporate rent, professional and consulting fees, and corporate insurance costs.

Preopening Expense. Preopening expense consists of costs incurred prior to opening a new restaurant and is comprised principally of manager salaries and relocation, payroll and related training costs for new employees, including practice and rehearsal of service activities, and rent expense incurred from the date we obtain possession of the property until opening. We expense restaurant preopening expenses as incurred, and we expect preopening expenses to be similar for each new restaurant opening, which typically commence six to eight months prior to a restaurant opening.

Depreciation and Amortization. Depreciation and amortization expense consists of the depreciation of property and equipment and gains and losses on disposal of assets.

Interest Income and Other, Net. Interest income and other, net consists of interest earned on our cash and investments and any gains or losses on our investments.

Interest Expense. Interest expense includes the cost of servicing our debt obligations, net of capitalized interest.

Financial Performance Overview

The following table sets forth certain information regarding our financial performance for the three and nine months ended September 30, 2009 and 2008.

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2009				2008				2009				2008
Restaurant sales growth			3.7	%			4.3	%			6.7	%			9.9	%
Same-store sales percentage change (1)			(9.9	)%			(10.3	)%			(9.7	)%			(6.4	)%
Average weekly sales — comparable restaurant base (2)		$	74,934			$	83,212			$	75,876			$	84,026
Average weekly sales — non-comparable restaurant base (3)		$	56,138			$	78,933			$	64,218			$	75,331
Average unit volume (in thousands) (4)		$	969			$	1,095			$	2,919			$	3,287
Sales per square foot (4)		$	138			$	156			$	414			$	467
Restaurant operating profit (in thousands) (5)		$	2,838			$	3,466			$	9,857			$	10,195
Restaurant operating profit as a percentage of sales (5)			14.1	%			17.8	%			16.1	%			17.8	%

The following tables set forth our calculation of restaurant operating profit and reconciliation to loss from operations, the most comparable GAAP measure.

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2009				2008				2009				2008
		(In thousands)
Restaurant sales		$	20,173			$	19,454			$	61,096			$	57,242
Costs and expenses:
Cost of sales			5,267				5,254				15,825				15,816
Labor			7,117				6,496				21,135				19,003
Occupancy			1,655				1,260				4,711				3,760
Restaurant operating expenses			3,296				2,978				9,568				8,468
Restaurant operating profit			2,838				3,466				9,857				10,195
Deduct — other costs and expenses
General and administrative			1,590				2,079				6,138				5,957
Preopening expense			480				471				1,332				1,190
Depreciation and amortization			1,820				1,656				5,373				4,806
Loss from operations		$	(1,052	)		$	(740	)		$	(2,986	)		$	(1,758	)

		Percentage of								Percentage of
		Restaurant Sales								Restaurant Sales
		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2009				2008				2009				2008
Restaurant sales			100.0	%			100.0	%			100.0	%			100.0	%
Costs and expenses:
Cost of sales			26.1				27.0				25.9				27.6
Labor			35.3				33.4				34.6				33.2
Occupancy			8.2				6.5				7.7				6.6
Restaurant operating expenses			16.3				15.3				15.7				14.8
Restaurant operating profit			14.1				17.8				16.1				17.8
Deduct — other costs and expenses
General and administrative			7.9				10.7				10.0				10.4
Preopening expense			2.4				2.4				2.2				2.1
Depreciation and amortization			9.0				8.5				8.8				8.4
Loss from operations			(5.2	)%			(3.8	)%			(4.9	)%			(3.1	)%

The following table sets forth changes in the number of restaurants opened for the periods indicated:

		Nine Months Ended				Year Ended
		September 30, 2009				December 31, 2008
Beginning of period			20				18
Openings			3				3
Closings			—				(1	)
End of period			23				20

Results of Operations

The following table sets forth, for the periods indicated, the percentage of restaurant sales of certain items in our financial statements.

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2009				2008				2009				2008
Restaurant sales			100.0	%			100.0	%			100.0	%			100.0	%
Costs and expenses:
Cost of sales			26.1				27.0				25.9				27.6
Labor			35.3				33.4				34.6				33.2
Occupancy			8.2				6.5				7.7				6.6
Restaurant operating expenses			16.3				15.3				15.7				14.8
General and administrative			7.9				10.7				10.0				10.4
Preopening expense			2.4				2.4				2.2				2.1
Depreciation and amortization			9.0				8.5				8.8				8.4
Total costs and expenses			105.2				103.8				104.9				103.1
Loss from operations			(5.2	)			(3.8	)			(4.9	)			(3.1	)
Nonoperating income (expense):
Interest income and other, net			0.2				0.3				0.3				0.6
Interest expense			(0.1	)			—				(0.3	)			(0.1	)
Loss from continuing operations before provision for income taxes			(5.1	)			(3.5	)			(4.9	)			(2.5	)
Provision for income taxes			—				0.3				0.1				0.4
Loss from continuing operations			(5.1	)			(3.8	)			(5.0	)			(2.9	)
Gain (loss) from discontinued operations, net of tax			—				(16.2	)			1.1				(6.0	)
Net loss			(5.1	)%			(20.0	)%			(3.9	)%			(8.9	)%

Certain percentage amounts do not sum to total due to rounding.

Three Months Ended September 30, 2009 Compared with Three Months Ended September 30, 2008

Restaurant Sales. Restaurant sales increased by $0.7 million, or 3.7% to $20.2 million during the third quarter of 2009 from $19.5 million during the prior year period. The sales increase was primarily the result of restaurant sales associated with the opening of five new restaurants since November 2008, partially offset by an overall reduction in guest traffic and a decline in the average guest check. Lower guest traffic attributable to the slowdown in the U.S. economy, high unemployment rates and reduced consumer spending resulted in a comparable restaurant sales base decline of 9.9% during the third quarter of 2009, inclusive of an effective menu price increase of approximately 1.0%.

Cost of Sales. Cost of sales was essentially flat at $5.3 million during both the third quarter of 2009 and 2008. Cost of sales as a percentage of restaurant sales decreased 0.9% to 26.1% during the third quarter of 2009 from 27.0% during the prior year period. Cost of sales during the third quarter of 2009 benefited from favorable year-over-year pricing for certain proteins, dairy and wheat products in addition to ongoing operational initiatives.

Labor. Labor costs for our restaurants increased $0.6 million, or 9.6% to $7.1 million during the third quarter of 2009 from $6.5 million during the prior year period. This increase was primarily due to the opening of five new restaurants since November 2008. Labor expenses as a percentage of restaurant sales increased 1.9% to 35.3% during the third quarter of 2009 from 33.4% during the third quarter of 2008. This increase was primarily the result of reduced leverage of fixed labor costs resulting from lower average weekly sales and a higher percentage of restaurant weeks for new restaurants during the third quarter of 2009 compared to the prior year quarter. For new restaurants, our labor expenses will typically be higher than normal during the first several months of operations as restaurant management teams become more accustomed to optimally predicting, managing, and servicing the sales volumes expected at our new restaurants.

Occupancy. Occupancy expense increased by $0.4 million, or 31.3% to $1.7 million during the third quarter of 2009 from $1.3 million during the prior year period. Occupancy expenses as a percentage of restaurant sales increased 1.7% to 8.2% during the third quarter of 2009 from 6.5% during the third quarter of 2008. The increase as a percentage of sales reflects increased common area maintenance allocations at many locations, reduction in deferred rent credits at several locations with rent concessions, and decreased leverage of the fixed portion of these costs from lower average weekly sales, partially offset by reduced percentage rent.

Restaurant Operating Expenses. Restaurant operating expenses increased by $0.3 million, or 10.7% to $3.3 million during the third quarter of 2009 from $3.0 million during the third quarter of 2008. Restaurant operating expenses as a percentage of restaurant sales increased 1.0% to 16.3% during the third quarter of 2009 from 15.3% during the prior year period. During the third quarter of 2009, higher advertising costs combined with reduced leverage of fixed operating costs from lower average weekly sales, resulted in an increase in restaurant operating expenses as a percentage of sales.

General and Administrative. General and administrative expenses decreased by $0.5 million, or 23.5% to $1.6 million during the third quarter of 2009 compared to $2.1 million during the third quarter of 2008. The third quarter of 2009 reflects lower costs for salaries, benefits, incentive compensation, and travel resulting from the January 2009 downsizing and realignment of certain corporate office staff and lower expenditures attributed to cost containment measures offset by approximately $0.1 million in legal fees associated with stockholder activities and litigation. General and administrative expenses as a percentage of restaurant sales decreased 2.8% to 7.9% of restaurant sales during the third quarter of 2009 compared to 10.7% of restaurant sales during the prior year period.

Preopening Expense. Preopening expense was essentially flat at $0.5 million during both the third quarters of 2009 and 2008. Preopening expense varies each quarter based upon the timing of new restaurant openings as the majority of preopening expense is incurred during the two months preceding an opening. During the third quarter of 2009, we opened our Eden Prairie, Minnesota restaurant and began to incur preopening expenses for our Tampa, Florida restaurant scheduled to open during November 2009. Preopening expense in the third quarter of 2008 includes preopening costs for two restaurants that opened during November 2008.

Depreciation and Amortization. Depreciation and amortization expense increased $0.2 million, or 9.9% to $1.8 million during the third quarter of 2009 from $1.6 million during the prior year period. The increase is attributable to five restaurants that opened since November 2008, partially offset by a reduction of $0.1 million due to the fourth quarter of 2008 impairment of long-lived assets at our Lincolnshire, Illinois restaurant. Depreciation and amortization expense as a percentage of restaurant sales increased 0.5% to 9.0% during the third quarter of 2009 from 8.5% during the third quarter of 2008, reflecting reduced leverage of these fixed costs from lower average weekly sales.

Interest Income and Other, Net. Interest income and other, net decreased during the third quarter of 2009 due to lower interest rates received and lower investment balances compared to the prior year period. Please refer to Note 3 to the unaudited consolidated financial statements for discussion of our investment in auction rate securities.

Interest Expense. Interest expense increased to $22,000 from $0 during the third quarter of 2008 due to the capitalization of all interest expense during the third quarter of 2008.

Provision for Income Taxes. During the third quarter of 2009, we recorded income taxes of $5,000 compared to $55,000 during the third quarter of 2008. The decrease in the provision is attributable to lower average weekly sales for restaurants in states where income tax expense has been recorded. The provision for income taxes for both periods primarily reflects taxes due for states in which taxes are not calculated based upon net income.

Gain/(loss) from Discontinued Operations. During the third quarter of 2008, we recorded a loss of $3.2 million for asset impairment, lease obligations, and other costs associated with the closure of our Naples, Florida restaurant.

Nine Months Ended September 30, 2009 Compared with Nine Months Ended September 30, 2008

Restaurant Sales. Restaurant sales increased by $3.9 million, or 6.7% to $61.1 million during the first nine months of 2009 from $57.2 million during the prior year period. The increase in sales is primarily attributable to restaurant sales generated from the opening of six new restaurants since June 2008, partially offset by overall traffic declines at our comparable restaurant sales base resulting from the weak U.S. economy, high unemployment rates, and reduced consumer spending. Higher menu pricing of approximately 2.0% was more than offset by reduced guest traffic and a decline in the average guest check as comparable restaurant sales declined 9.7% during the first nine months of 2009.

Cost of Sales. Cost of sales was essentially flat at $15.8 million during both the first nine months of 2009 and 2008. Cost of sales as a percentage of restaurant sales decreased 1.7% to 25.9% during the first nine months of 2009 from 27.6% during the prior year period. Cost of sales during the first nine months of 2009 was positively affected by favorable year-over-year pricing on certain proteins, produce, and dairy products and operating efficiencies attributed to the rollout of an automated food cost and inventory management system that was completed during July 2008.

Labor. Labor costs for our restaurants increased $2.1 million, or 11.2% to $21.1 million during the first nine months of 2009 from $19.0 million during the prior year period. The increase was primarily due to the opening of six new restaurants since June 2008. As a percentage of restaurant sales, labor costs increased 1.4% to 34.6% during the first nine months of 2009 from 33.2% during the first nine months of 2008. The increase in labor costs as a percentage of restaurant sales was primarily due to reduced leverage of fixed labor costs resulting from lower average weekly sales. In addition, federal and state minimum wage increases, implemented during the second half of 2008 and during 2009, contributed to increased labor costs as a percentage of sales.

Occupancy. Occupancy expense increased by $0.9 million, or 25.3% to $4.7 million during the first nine months of 2009 from $3.8 million during the prior year period. Occupancy expenses as a percentage of restaurant sales increased 1.1% to 7.7% during the first nine months of 2009 from 6.6% during the first nine months of 2008. The increase reflects increased common area maintenance allocations at many locations, reduction in deferred rent credits at several locations with rent concessions, and decreased leverage of fixed rental costs from lower average sales volume, partially offset by reduced percentage rent.

Restaurant Operating Expenses. Restaurant operating expenses increased by $1.1 million, or 13.0% to $9.6 million during the first nine months of 2009 from $8.5 million during the prior year period. Restaurant operating expenses as a percentage of restaurant sales increased 0.9% to 15.7% during the first nine months of 2009 from 14.8% during the prior year period. During the first nine months of 2009, higher repair and maintenance, utilities, and property taxes combined with reduced leverage of fixed operating costs resulting from lower average sales volume contributed to the increase in restaurant operating expenses as a percentage of sales.

General and Administrative. General and administrative expenses increased $0.2 million, or 3.0% to $6.1 million during the first nine months of 2009 compared to $5.9 million during the first nine months of 2008. The increase is primarily attributable to approximately $1.1 million in unusual charges including $0.4 million in severance and related benefits associated with the May 2009 resignation of our former CEO, $0.5 million in legal and professional fees associated with stockholder activities, including financial advisory fees to evaluate an unsolicited offer to purchase the Company, and $0.2 million write-off for architectural drawings and permit costs associated with amending the lease for our Baltimore, Maryland restaurant expected to open in 2010. This increase in expenses was partially offset by lower salary and benefit costs resulting from the January 2009 downsizing and realignment of certain corporate office staff and lower expenditures attributable to cost containment efforts. General and administrative expenses as a percentage of restaurant sales decreased 0.4% to 10.0% of restaurant sales during the first nine months of 2009 compared to 10.4% of restaurant sales during the prior year period.

Preopening Expense. Preopening expense increased $0.1 million, or 11.9% to $1.3 million during the first nine months of 2009 compared to $1.2 million during the first nine months of 2008. The increase in preopening expense is attributable to three restaurant openings during the first nine months of 2009 compared to the first nine months of 2008 when costs were incurred for one restaurant opening and the preparation for opening two restaurants during the fourth quarter of 2008.

Depreciation and Amortization. Depreciation and amortization expense increased $0.6 million, or 11.8% to $5.4 million during the first nine months of 2009 from $4.8 million during the prior year period. The increase was primarily attributable to six restaurants opened since June 2008, partially offset by a reduction of $0.4 million due to the fourth quarter of 2008 impairment of long-lived assets at our Lincolnshire, Illinois restaurant. Depreciation and amortization expense as a percentage of restaurant sales increased 0.4% to 8.8% during the first nine months of 2009 from 8.4% during the first nine months of 2008 reflecting decreased leverage from lower average weekly sales.

Interest Income and Other, Net. Interest income and other, net decreased $0.2 million during the first nine months of 2009 compared to the prior year period due to lower interest rates received and lower investment balances. Please refer to Note 3 to the unaudited consolidated financial statements for discussion of our investment in auction rate securities.

Interest Expense. Interest expense increased $0.1 million due to interest costs associated with the $1.2 million bridge loan issued during March 2009 and subsequently repaid during June 2009. Interest expense for the first nine months of 2009 includes $70,000 for amortization of the debt discount associated with warrants issued to the noteholders that was charged to interest expense.

Provision for Income Taxes. During the first nine months of 2009, we recorded income taxes of $65,000 primarily for states in which income taxes are not calculated based upon net income compared to $205,000 during the first nine months of 2008.

Gain from Discontinued Operations. During the second quarter of 2009, we reached a settlement agreement regarding the lease for our closed Naples, Florida restaurant. We recorded a gain of approximately $0.7 million as the settlement amount was less than the lease termination costs originally recorded during 2008 when the restaurant was closed. During the first nine months of 2008, we recorded a loss of $3.5 million for asset impairment and lease obligations, along with the sales, costs and expenses attributable to this restaurant.

Potential Fluctuations in Quarterly Results and Seasonality

Our quarterly operating results may fluctuate significantly as a result of a variety of factors, including the following:

•

timing of new restaurant openings and related expenses;

•

restaurant operating costs and preopening costs for our newly-opened restaurants, which are often materially greater during the first several months of operation than thereafter;

•

labor availability and costs for hourly and management personnel;

•

profitability of our restaurants, especially in new markets;

•

increases and decreases in comparable restaurant sales;

	•		impairment of long-lived assets and any loss on restaurant closures;
	•		changes in borrowings and interest rates;

•

general economic conditions;

•

weather conditions or natural disasters;

•

timing of certain holidays;

•

changes in government regulations;

•

outside shareholder activities;

•

settlements, damages and legal costs associated with litigation;

•

new or revised regulatory requirements and accounting pronouncements;

•

changes in consumer preferences and competitive conditions; and

•

fluctuations in commodity prices.

Our business is also subject to seasonal fluctuations. Historically, sales in most of our restaurants have been higher during the spring and summer months and winter holiday season. Consequently, our quarterly and annual operating results and comparable restaurant sales may fluctuate significantly as a result of seasonality and the factors discussed above. Accordingly, results for any one quarter are not necessarily indicative of results to be expected for any other quarter or for any year and comparable restaurant sales for any particular future period may decrease. In the future, operating results may fall below the expectations of our investors. In that event, the price of our common stock would likely decrease.

Liquidity and Capital Resources

The following tables set forth, for the periods indicated, a summary of our key liquidity measurements (amounts in thousands):

		September 30,				December 31,
		2009				2008
Cash and short-term investments(1)		$	3,001			$	2,847
Net working capital (deficit)(2)			(3,712	)			(7,653	)

		Nine Months Ended
		September 30,
		2009				2008
Cash provided by operating activities		$	4,273			$	4,422
Capital expenditures			10,994				12,516

Our primary capital requirements are for new restaurant development. Subject to availability of capital on terms acceptable to us, we intend to continue developing new restaurants in markets where we believe our concept will have broad appeal and attractive restaurant-level economics. Similar to many restaurant chains, we utilize operating lease arrangements for all of our restaurant locations. We believe that our operating lease arrangements provide appropriate leverage for our capital structure in a financially efficient manner. We are typically required to expend cash to perform site-related work and to construct and equip our restaurants. The average investment cost for our restaurants depends upon the type of lease entered into, the amount of tenant improvement allowance we receive from landlords, and whether we assume responsibility for the construction of the building. We expect the cash investment cost of our typical restaurant to be approximately $2.5 million, net of landlord tenant improvement allowances between $0.7 million and $1.2 million, and excluding cash preopening expenses of approximately $0.4 million. We expect these costs will vary from one market to another based on real estate values, zoning regulations, permitting requirements, labor markets and other variables. Restaurants that are subject to ground leases and do not receive landlord tenant improvement allowances typically require a significantly higher cash investment. We also require capital resources to maintain our existing base of restaurants and to further expand and strengthen the capabilities of our corporate and information technology infrastructures.

Future Capital Requirements

Our capital requirements, including development costs related to the opening of new restaurants, have historically been significant. Over the last several years, we have funded development of new restaurants primarily from the proceeds of equity financing, debt financing, and cash flows from operations. Our future cash requirements and the adequacy of available funds will depend on many factors, including the operating performance of our restaurants, the pace of expansion, real estate markets, site locations, the nature of the arrangements negotiated with landlords and the credit market environment.

Our current operations generate sufficient cash flow to fund operations and general and administrative costs. We believe existing cash and short-term investments of $3.0 million in addition to cash flow from operations is sufficient to fund restaurant development costs required by existing leases. Any reduction of our cash flow from operations may cause a delay or cancellation of planned future restaurant development. As of September 30, 2009, we had a working capital deficit of $3.7 million. We plan to reduce this deficit through cost containment efforts and cash flow from operations. Financing to construct new restaurants may not be available on acceptable terms, or at all, and our failure to raise capital when needed could impact our growth plans, financial condition, and results of operations. Additional equity financing may result in dilution to current shareholders and debt financing, if available, may involve significant cash payment obligations or financial covenants and ratios that may restrict our ability to operate our business.

Bridge Loan

On March 6, 2009, and as amended on April 7, 2009, we entered into a Note and Warrant Purchase Agreement (the “Agreement”) with certain accredited investors whereby we sold $1.2 million aggregate principal amount of 10% unsecured subordinated notes (“Notes”) and warrants to purchase shares of our common stock. The principal and accrued interest outstanding under the Notes were due and payable upon the closing of any offering of equity securities by the Company generating gross proceeds to us of at least $2.5 million. For each $100,000 issued in Notes, we issued to the noteholder three-year warrants to purchase 10,000 shares of our common stock at an aggregate exercise price per share of $2.29, which was equal to 120% of the five-day average of the closing price of our common stock during the five trading days prior to the date of issuance. The bridge loan, including accrued interest, was repaid during June 2009 upon completion of the rights offering described below. The holders of the Notes exercised over-subscription rights granted in the Agreement and purchased 482,178 shares or 18.5% of the total shares sold in the rights offering.

Rights Offering

As part of the Agreement, we filed with the SEC a registration statement on Form S-3 to conduct a rights offering with targeted gross proceeds to the Company of $3,520,000 (the “Rights Offering”) pursuant to which each stockholder of the Company received one non-transferrable subscription right for every 2.5 shares of common stock owned on April 17, 2009. Each subscription right entitled the holder to purchase one share of common stock at a price of $1.35 per share. The terms of the Agreement provided that any shares of common stock that were not subscribed for in the Rights Offering by existing stockholders were offered to the holders of the Notes on a pro rata basis based on the aggregate principal amount of Notes outstanding and at the same subscription price as offered to the holders of subscription rights granted under the Rights Offering. We sold 2,608,045 shares of common stock pursuant to the Rights Offering and received net proceeds of $3,245,000 after deducting $276,000 in expenses. A portion of the net proceeds was used to repay amounts owed on the Notes, and the remaining proceeds are being utilized to fund capital expenditure requirements.

Equipment Loans

As of September 30, 2009, we had five equipment term loans with a lender, each collateralized by restaurant equipment. The outstanding principal balance under these loans aggregated $1.5 million. The loans bear interest at rates ranging from 7.0% to 8.5% and require monthly principal and interest payments aggregating approximately $71,000. The loans mature between June 2010 and June 2012. The loans also require us to maintain certain financial covenants, including a Fixed Charge Coverage Ratio of 1.25:1.00 calculated at the end of each calendar year, and we were in compliance with all such financial covenants as of December 31, 2008.

Credit Facility

During October 2008, as part of the settlement agreement with UBS, our broker from which we purchased auction rate security instruments, we entered into a line of credit that is secured by the auction rate security instruments held with UBS. Available borrowings under the line of credit are based upon terms specified in the agreement and subject to adjustment by UBS after consideration of various factors. At September 30, 2009, $5,798,000 was outstanding under the line of credit. Borrowings under the line of credit are callable by UBS at any time. The line of credit is classified as short-term in the accompanying consolidated balance sheets as the loan expires on June 30, 2010. The cost of the line of credit effectively offsets the interest earned on the auction rate securities. See Note 3 to the unaudited consolidated financial statements for further information on the auction rate securities and the settlement agreement.

Cash Flows

The following table summarizes our primary sources and uses of cash during the periods presented (in thousands).

		Nine Months Ended
		September 30,
		2009				2008
Net cash provided by (used in):
Operating activities		$	4,273			$	4,422
Investing activities			(10,309	)			(5,373	)
Financing activities			6,075				(1,427	)
Net increase (decrease) in cash and cash equivalents		$	39			$	(2,378	)

Operating Activities. During the first nine months of 2009, net cash provided by operating activities was $4.3 million and exceeded our net loss by $6.6 million, due principally to the effect of depreciation and amortization and the timing of payments for accrued expenses. During the first nine months of 2008, net cash provided by operating activities was $4.4 million and exceeded our net loss by $9.5 million due principally to the effect of depreciation and amortization, non-cash asset impairment charges of $2.2 million, and deferred rent.

Investing Activities. We fund the development and construction of our new restaurants primarily with cash, proceeds from equity transactions, and borrowings under our line of credit. Net cash used in investing activities was $10.3 million during the first nine months of 2009, reflecting $11.0 million to fund construction of our Richmond, Virginia; Woodbridge, New Jersey; and Eden Prairie, Minnesota restaurants as well as our Tampa, Florida restaurant scheduled to open during the fourth quarter of 2009. Net cash used in investing activities was $5.4 million during the first nine months of 2008 including $12.5 million primarily to fund construction at our Gilbert, Arizona restaurant and four restaurants opened during the next three quarters offset by $7.2 million in net sales of investments.

Financing Activities. Net cash provided by financing activities was $6.1 million during the first nine months of 2009 reflecting $3.3 million in net borrowings under our line of credit and $3.2 million in net proceeds from the subscription rights offering completed during June 2009, partially offset by $0.5 million in principal payments on equipment loans. Net cash used in financing activities was $1.4 million for the first nine months of 2008 principally consisting of the purchase of 116,200 shares of our common stock at a cost of $1.0 million and $0.5 million in principal payments on equipment loans.

Critical Accounting Policies

Critical accounting policies are those that we believe are most important to the portrayal of our financial condition and results of operations and also require our most difficult, subjective, or complex judgments. Judgments or uncertainties regarding the application of these policies may result in materially different amounts being reported under various conditions or using different assumptions. There have been no material changes to the critical accounting policies previously reported in our Annual Report on Form 10-K for the year ended December 31, 2008.

Item 3.		Quantitative and Qualitative Disclosures about Market Risk

The following discussion of market risks contains forward-looking statements. Actual results may differ materially from the following discussion based on general conditions in the financial and commodity markets.

Primary Market Risk Exposures

Our primary market risk exposures are in the areas of commodity costs, labor costs, and construction costs. Many of the food products purchased by us are affected by changes in weather, production, availability, seasonality, and other factors outside our control. In addition, we believe that almost all of our food and supplies are available from several sources, which helps to control food commodity risks. We also believe that we have the ability to increase certain menu prices in response to food commodity price increases. Our labor costs are impacted by increases in the minimum wage rate as many of our employees are paid labor rates related to federal and state minimum wage laws. We have exposure to rising construction costs, which may impact our actual cost to develop new restaurants. Although the cost of restaurant construction will not impact significantly the operating results of the restaurant, it would impact the return on investment for such restaurant. In addition, many of our leases require us to pay taxes, maintenance, repairs, insurance, and utilities, all of which are generally subject to inflationary increases.

Item 4T.		Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We have evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this report. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have each concluded that our disclosure controls and procedures are effective to ensure that we record, process, summarize, and report information required to be disclosed by us in our quarterly reports filed under the Securities Exchange Act within the time periods specified by the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting

During the quarterly period covered by this report, there have not been any changes in our internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION

Item 1.		Legal Proceedings

On April 1, 2009, Samuel Beren, as trustee for the Samuel Beren Trust, filed a stockholder derivative suit in the Court of Chancery of the State of Delaware. The suit was brought on behalf of us against our directors and the purchasers of our promissory notes issued on March 5, 2009, and named us as a nominal defendant. The complaint alleged that our directors breached their fiduciary duties of loyalty, good faith, and due care to us, and that the noteholders aided and abetted such breach, in connection with certain of our fundraising efforts. The suit originally sought unspecified damages, interest, reasonable attorneys’ fees, expert witness fees, and other costs, and any further relief the court deems just and proper.

During June 2009, the plaintiffs filed an amended complaint that, among other things, eliminated the allegation that the noteholders aided and abetted the alleged breaches of fiduciary duty; seeks to include in the litigation as a class all owners of our common stock; and sought to enjoin us from effecting the subscription rights offering, or, if the subscription rights offering was consummated, to rescind and set aside the subscription rights offering.

On June 16, 2009, we filed a motion to dismiss the claim. On August 28, 2009, we filed an opening brief in support of the motion to dismiss this claim. On October 26, 2009, the plaintiffs filed a demand pursuant to Section 220 of the Delaware General Corporation Law that we make certain books, records, and documents available for inspection. We believe that the allegations in the complaint, including the amended complaint, are without merit and we intend to defend vigorously this action.

Item 1A.		Risk Factors

A description of the risk factors associated with our business is contained in Part I, Item 1A, “Risk Factors,” of our Annual Report on Form 10-K for the year ended December 31, 2008 and the Registration Statement on Form S-3 filed on April 10, 2009 (SEC file no. 333-158278). These cautionary statements are to be used as a reference in connection with any forward-looking statements. The factors, risks and uncertainties identified in these cautionary statements are in addition to those contained in any other cautionary statements, written or oral, which may be made or otherwise addressed in connection with a forward-looking statement or contained in any of our subsequent filings with the SEC.

Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds

Not applicable.

Item 3.		Defaults Upon Senior Securities

Not applicable.

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

Not applicable.

Item 5.		Other Information

Not applicable.

Item 6.		Exhibits

(a)

Exhibits

	3.1			Amended and Restated Certificate of Incorporation of Kona Grill, Inc. (1)
	3.3			Amended and Restated Bylaws of Kona Grill, Inc. (2)
	3.4			Certificate of Designations, Preferences, and Rights of Series A Junior Participating Preferred Stock of Kona Grill, Inc. (4)
	4.1			Form of Common Stock Certificate (3)
	4.2			Kona Grill, Inc. Stockholders’ Agreement, dated August 29, 2003 (3)
	4.3			Kona Grill, Inc. Series A Investor Rights Agreement, dated August 29, 2003 (3)
	4.4			Amendment No. 1 to Kona Grill, Inc. Series A Investor Rights Agreement, dated May 31, 2005 (3)
	4.7			Form of Warrant (March 2009 Note Offering) (6)
	4.9			Form of First Amended and Restated Promissory Note (March 2009 Note Offering) (5)
	10.21			Note and Warrant Purchase Agreement, dated March 6, 2009, among Kona Grill, Inc. and the investor parties thereto (6)
	10.23	*		Employment Agreement, dated as of May 11, 2009, between the Company and Mark L. Bartholomay (7)
	10.24	*		Employment Agreement, dated as of May 11, 2009, between the Company and Mark S. Robinow (7)
	10.25	*		Separation Agreement, dated as of August 6, 2009, between the Company and Marcus E. Jundt (8)
	10.26	*		Employment Agreement, dated as of November 2, 2009, between the Company and Marc A. Buehler (9)
	31.1			Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended
	31.2			Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended
	32.1			Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
	32.2			Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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.

Date: November 3, 2009

EXHIBIT INDEX

	31.1			Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended
	31.2			Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended
	32.1			Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
	32.2			Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002