INTERACTIVE MAGIC INC /NC/, SB-2, 1999-08-06

INTERACTIVE MAGIC INC /NC/
SB-2, 1999-08-06
PREPACKAGED SOFTWARE

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As filed with the Securities and Exchange Commission on August 6, 1999

Registration No. 333-
===============================================================================
U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM SB-2
REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933
_____________________________________

INTERACTIVE MAGIC, INC.
(Name of small business issuer in its charter)
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<S> <C> <C>
North Carolina 7372 56-2092059
(State or jurisdiction of (Primary Standard Industrial (I.R.S. Employer
incorporation or organization) Classification Code Number) Identification No.)
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215 Southport Drive, Suite 1000
Morrisville, North Carolina 27560
(919) 461-0722
(Address and telephone number of principal executive offices)

215 Southport Drive, Suite 1000
Morrisville, North Carolina 27560
(919) 461-0722
(Address of principal place of business or intended principal place of business)

____________________

J.W. Stealey
Chairman and Chief Executive Officer
Interactive Magic, Inc.
215 Southport Drive, Suite 1000
Morrisville, North Carolina 27560
(919) 461-0722
(Name, address and telephone number of agent for service)

Please send copies of all communications to:

Donald R. Reynolds, Esq.
Kevin A. Prakke, Esq.
Wyrick Robbins Yates & Ponton LLP
4101 Lake Boone Trail, Suite 300
Raleigh, North Carolina 27607

____________________

Approximate date of proposed sale to the public:
As soon as practicable after the registration statement becomes effective.

____________________

If any of the securities being registered on this Form are to be offered on a
delayed or continuous basis pursuant to Rule 415 under the Securities Act of
1933, other than securities offered only in connection with dividend or interest
reinvestment plans, please check the following box. [X]

If this Form is filed to register additional securities for an offering pursuant
to Rule 462(b) under the Securities Act, please check the following box and list
the Securities Act registration statement number of the earlier effective
registration statement for the same offering. [ ]
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If this Form is a post-effective amendment filed pursuant to Rule 462(c) under
the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [ ]

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under
the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [ ]

If delivery of the prospectus is expected to be made pursuant to Rule 434,
please check the following box. [ ]

CALCULATION OF REGISTRATION FEE

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Proposed
Title of Each Class of Proposed Maximum Maximum Amount of
Securities to be Registered Amount to be Offering Price Per Aggregate Registration Fee
Registered (1) Share (2) Offering Price
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<S> <C> <C> <C> <C>
Common Stock, $0.01 par value per
share............................ 2,119,889 $2.2031 $4,670,327 $1,298.35

==================================================================================================================================
</TABLE>
(1) Shares of Common Stock which may be offered pursuant to this Registration
Statement consisting of 2,119,889 shares issuable upon conversion of Convertible
Notes dated January 26, 1999 with an original principal amount of $4,000,000
(the "Note") and upon exercise of related warrants. For purposes of estimating
the number of shares of Common Stock to be included in this Registration
Statement, the Company has used the maximum number of shares of common stock
which may be issued by the Company upon conversion of the Note and exercise of
related warrants without obtaining shareholder approval required under Nasdaq
marketplace rules (This limitation of 20% of the Company's outstanding Common
Stock shall be referred to herein as the Maximum Share Limitation). But for the
Maximum Share Limitation, the number of shares of Common Stock that would be
issuable in connection with the conversion of the Note (based on a conversion
price of approximately $1.75 which is 85% of the average of the lowest closing
bid prices of the Common Stock reported on the Nasdaq National Market on any two
trading days during the 22 consecutive trading day period preceding July 30,
1999) is 2,281,640. In addition to the shares set forth in the table, the amount
to be registered includes an indeterminate number of shares issuable upon
conversion of or in respect of the Notes and the Warrants, as such number may be
adjusted as a result of stock splits, stock dividends and similar transactions
in accordance with Rule 416.
(2) Estimated solely for purposes of calculating the registration fee pursuant
to Rule 457(c) under the Securities Act of 1933 based upon the average high and
low price of our common stock as quoted on the Nasdaq National Market on July
29, 1999.
____________________

The Registrant hereby amends this registration statement on such date or dates
as may be necessary to delay its effective date until the registrant shall file
a further amendment which specifically states that this registration statement
shall thereafter become effective in accordance with Section 8(a) of the
Securities Act of 1933 or until the registration statement shall become
effective on such date as the Commission, acting pursuant to said Section 8(a),
may determine.

==============================================================================
<PAGE>

PROSPECTUS
----------

The information contained in this prospectus is not complete and may be changed.
We cannot sell these securities until the registration statement that we have
filed with the SEC is effective. This prospectus is not an offer to sell, nor
does it solicit offers to buy, these securities in any state where the offer or
sale is not permitted.

SUBJECT TO COMPLETION DATED August 5, 1999

2,119,889 Shares
Interactive Magic, Inc.
Common Stock
__________________

This prospectus covers the resale of 2,119,889 shares of our common stock
which may be sold, from time to time, by RGC International Investors, LDC (the
"Selling Stockholder"). The Selling Stockholder previously received the shares
of common stock from us or will receive these shares of common stock from us by
converting some or all of a $4 million convertible note and/or upon exercise of
related warrants. We will not receive any money from the Selling Stockholder
when it sells the shares. We will pay substantially all of the costs and
expenses relating to this offering. The Selling Stockholder may offer the shares
for resale from time to time through public or private transactions, on or off
the Nasdaq National Market, at prevailing market prices or at privately
negotiated prices. See the "Plan of Distribution" set forth herein.

Our common stock is traded on the Nasdaq National Market under the symbol
"IMGK". On July 29, 1999, the last sale price of our common stock as quoted on
the Nasdaq National Market was $2.0625 per share.

The Selling Stockholder may also resell the shares directly to market
makers acting as principals and/or broker-dealers acting as agents for
themselves or their customers. Such broker-dealers may receive compensation in
the form of discounts, concessions or commissions from the Selling Stockholder
and/or the purchasers of the shares for whom such broker-dealers may act as
agents or to whom they sell as principal or both (which compensation as to a
particular broker-dealer might be in excess of customary commissions). The
Selling Stockholder may attempt to sell shares in block transactions to market
makers or other purchasers at a price per share which may be below the then
market price. The Selling Stockholder and any brokers, dealers or agents, upon
effecting the sale of any shares offered hereby, may be deemed "underwriters" as
that term is defined under the Securities Act or the Exchange Act, or the rules
and regulations thereunder.

Investing in our common stock involves risks. see "Risk Factors" on page 5.

Neither the SEC nor any state securities commission has approved or disapproved
our securities or determined that this prospectus is truthful or complete. Any
representation to the contrary is a criminal offense.

The date of this Prospectus is August 5, 1999
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TABLE OF CONTENTS
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Section Page
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Number
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PROSPECTUS SUMMARY.......................................................................... 3
RISK FACTORS................................................................................ 5
USE OF PROCEEDS............................................................................. 18
MARKET FOR COMMON STOCK AND RELATED STOCKHOLDER MATTERS..................................... 18
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.......................................................................... 19
THE COMPANY................................................................................. 24
DIRECTORS AND EXECUTIVE OFFICERS............................................................ 30
EXECUTIVE COMPENSATION...................................................................... 32
CERTAIN TRANSACTIONS........................................................................ 34
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.............................. 36
SELLING SECURITY HOLDERS.................................................................... 38
PLAN OF DISTRIBUTION........................................................................ 39
DESCRIPTION OF SECURITIES................................................................... 39
DISCLOSURE OF COMMISSION POSITION ON INDEMNIFICATION FOR SECURITIES
ACT LIABILITIES........................................................................ 44
LEGAL MATTERS............................................................................... 44
EXPERTS..................................................................................... 44
WHERE YOU CAN FIND MORE INFORMATION......................................................... 44
INDEX TO FINANCIAL STATEMENTS............................................................... 45
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2
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PROSPECTUS SUMMARY

The following summary is qualified in its entirety by the more detailed
information, including "Risk Factors" and the Financial Statements of the
Company and Notes thereto, appearing elsewhere in this Prospectus. The
discussion in this Prospectus contains forward-looking statements that involve
risks and uncertainties. Our actual results could differ materially from those
discussed herein. Factors that could cause or contribute to such differences
include, but are not limited to, those discussed in "Risk Factors,"
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and "The Company" as well as those discussed elsewhere in this
Prospectus.

The Company

Interactive Magic, Inc. (or the "Company") is a developer and publisher of
Internet and online games and an operator of online game services. The Company
develops and publishes proprietary online multi-player games and is building the
Company Entertainment Network ("iEN"), an Internet distribution infrastructure
which will offer online gamers a variety of free, subscription and pay-per-play
games and services, including simulation, parlor, strategy, role playing and
action games.

The Company is the exclusive game site operator for AT&T WorldNet, an
Internet service provider ("ISP"), and has been contracted to provide online
games for America Online, the world's leading online Internet services company.
The Company seeks to establish itself as a major provider of online gaming
services for ISPs, Internet portals and online services in order to broaden its
audience of users. GameHub, AT&T WorldNet's co-branded online gaming service,
was launched in January 1999 and is currently being marketed by AT&T to new
WorldNet subscribers as a premium service included with their subscription. The
GameHub site offers consumers a mix of free and pay-per-play games in all
categories, including strategy, role playing, simulation, action and parlor
games. In addition to games, GameHub will offer chat rooms, forums and shopping
areas. GameHub is expected to generate revenue from subscriber premiums, e-
commerce and advertising. GameHub complements the Company's online gaming
strategy by expanding the Company's network of player communities.

Recent Developments

The Company announced, on July 20,1999, it was changing its name to
iEntertainment Network. The name change will be submitted for shareholder
approval at the next Annual Shareholder's Meeting. The Company is also in the
process of changing its "ticker symbol" on the Nasdaq exchange to "IENT" from
"IMGK".

The Company has been notified by the Nasdaq Stock Market that we are no
longer in compliance with the net tangible asset listing requirement of $
4,000,000 for continued listing on the Nasdaq National Market. We responded to
Nasdaq with a plan to achieve and sustain compliance, but our request for
continued listing was denied. We have appealed the Nasdaq Staff decision to a
Nasdaq Listing Qualifications Panel pursuant to Nasdaq Marketplace rules. An
oral hearing date has been granted for late August 1999.

Delisting by Nasdaq would have a serious impact on our near-term ability to
raise capital and would limit the liquidity of our capital stock. For a further
explanation of such risks, please refer to the "Risk Factor" section of this
statement.

Effective August 3, 1999, the Company accepted the resignation of Avi
Suriel, a member of the Board of Directors.

On August 4, 1999 the Company announced that it will expand its Board of
Directors by at least 2 positions and begin the search for a senior level
Internet executive to be its new Chief Executive Officer. The Company also
announced that it has set a tentative date for its annual shareholder meeting on
October 19, 1999 and set a record date of August 19, 1999 for such meeting.

The Offering

Shares of common stock offered by us............ None

Shares of common stock which may be sold by
the Selling Stockholder........................ 2,119,889(1)

Use of proceeds................................ We will not receive any
proceeds from the resales
of shares offered hereby,
all of which proceeds
will be paid to the
Selling Stockholder.

Risk Factors................................... The purchase of our common
stock involves a high
degree of risk. You should
carefully review and
consider "Risk Factors."

Nasdaq National Market Trading Symbol.......... IMGK

3
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________________________________________

(1) Consisting entirely of shares of common stock issuable upon conversion
of Convertible Notes dated January 26, 1999 with an original principal
amount of $4,000,000 (the "Note") and upon exercise of related
warrants. For purposes of estimating the number of shares of common
stock that may be offered by the Selling Stockholder under this
Prospectus, the Company has used the maximum number of shares of
common stock which may be issued by the Company upon conversion of the
Note and exercise of the related warrants without obtaining
shareholder approval as required under Nasdaq marketplace rules (the
"Maximum Share Limitation"). But for the Maximum Share Limitation, the
number of shares of Common Stock that would be issuable in connection
with the conversion of the Note (based on a conversion price of
approximately $1.75 which is 85% of the average of the lowest closing
bid prices of the Common Stock reported on the Nasdaq National Market
on any two trading days during the 22 consecutive trading day period
preceding July 30, 1999) is 2,281,640. In addition to the shares set
forth in the table, the amount offered hereby includes an
indeterminate number of shares issuable upon conversion of or in
respect of the Notes and the related warrants, as such number may be
adjusted as a result of stock splits, stock dividends and similar
transactions in accordance with Rule 416.

How You Can Contact Us

Our principal executive offices are located in Research Triangle Park at
215 Southport Drive, Suite 1000, Morrisville, North Carolina 27560, Attention:
Investor Relations. Our telephone number is (919) 461-0722.

4
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RISK FACTORS

Investment in our common stock involves risk. You should carefully consider
the following factors, among others, before making an investment decision.

Company Risks

We have a History of Net Losses and an Accumulated Deficit; We Anticipate Future
- --------------------------------------------------------------------------------
Losses
- ------

We have experienced significant losses since inception. Our losses result
primarily from overhead and other costs incurred in our development and
expansion. For the years ended December 31, 1998 and 1997, we incurred net
losses of approximately $11.7 million and $4.3 million, respectively. At
December 31, 1998, we had an accumulated deficit of approximately $25.9 million.
We expect to incur substantial up-front expenditures and operating costs in
connection with the expansion of our marketing efforts and product lines. These
activities are expected to result in significant losses for the foreseeable
future. We cannot predict the extent of future losses or whether we will ever be
able to achieve or sustain profitable operations.

Risks Related to New Business Focus; We Have a Limited Relevant Operating
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History
- -------

To date, a substantial portion of our revenues have been generated from
sales of our CD-ROM software products. In June 1999 we completed the sale of our
CD-ROM business unit. Our current strategy is to focus our business primarily on
the Internet entertainment business, specifically online games. Although we
recently completed the acquisition of MPG-Net, Inc. to expand our Internet
business, to date, we have generated limited revenues from sales of our Internet
products. As a result, we have a limited relevant operating history upon which
an evaluation of the prospects of our business can be made. Such prospects must
be considered in light of the risks, expenses and difficulties frequently
encountered by companies in connection with the operation and expansion of a new
business. We are subject to the risks associated with the rapidly evolving
interactive entertainment software industry, which is characterized by:

. an increasing number of market entrants;
. intense competition;
. substantial capital requirements; and
. a high failure rate.

Further, online game play is a new and evolving concept. We cannot assess
or predict the size of the market for online games or its prospects for growth.

We Have Significant Capital Requirements; We Experience Negative Cash Flow From
- -------------------------------------------------------------------------------
Operations; We Will Need Additional Financing
- ---------------------------------------------

Our capital requirements have been and will continue to be significant. To
date, our cash requirements have exceeded our cash flow from operations. Based
on our currently proposed plans and assumptions relating to operations
(including assumptions regarding the progress and timing of our new product
development efforts), net proceeds from our recent private placement, together
with anticipated revenues from operations, we anticipate to have sufficient
funds on hand to continue operations. However, our future cash requirements may
vary significantly from what we expect them to be based on factors such as:

. the cost and timing of expansion of research and product development
efforts and the success of these efforts;
. the cost and timing of expansion of sales and marketing activities;
. the extent our existing and new products gain market acceptance;
. competing technological and market developments;
. the cost involved in maintaining and enforcing patent claims and other
intellectual property rights; and

We do not have any current arrangements or commitments for any future
financing. We may not be able to obtain sufficient additional financing to
satisfy cash requirements. We may be required to obtain financing on terms that
are not favorable to us and our shareholders. If we are unable to obtain
additional financing when needed, we may be required to delay or scale back
product development and marketing programs in order to meet our short-term cash
requirements, which could have a material adverse effect on our business,
financial condition and results of operations.

We May Not Be Able to Manage and Sustain Growth; We Face Risks Associated with
- ------------------------------------------------------------------------------
Future Acquisitions
- -------------------

5
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An integral part of our business strategy is growth through acquisition.
The success of our acquisition strategy will depend upon, among other things,
our ability to:

. hire and retain skilled management, marketing, technical and other
personnel;
. develop and improve upon our operational, management and financial
systems and controls in order to properly monitor our expanded
operations; and
. control our costs and maintain effective quality controls.

We cannot predict whether we will be able to expand our operations or
effectively manage any such expansion. Our growth strategy will place
significant demands on our management, technical, financial and other resources.
We may be unable to anticipate and satisfy all of the changing demands and
requirements that such growth will impose upon our operations. Acquisitions
involve numerous additional risks that could materially adversely affect our
business and financial performance. Such risks include:

. difficulties in the assimilation of the operations and products of the
acquired companies;
. the expenses incurred in connection with the acquisition and subsequent
assimilation of operations and products;
. the diversion of management's attention from other business concerns;
and
. the potential loss of key employees of the acquired company.

As part of our acquisition strategy, we may seek opportunities to continue
to expand into markets outside the United States. Acquisitions of foreign
companies also may involve the additional risks of assimilating differences in
foreign business practices and overcoming language barriers. We might not be
able to integrate the acquired operations successfully.

We are currently negotiating the acquisition of two Internet gaming
websites , which are awaiting the completion of definitive asset purchase
agreements. In addition, we intend to evaluate, on an ongoing basis, potential
acquisitions of, or investments in, other software publishers or developers,
distributors or other businesses which we believe will complement or enhance our
existing business. Under North Carolina law, various forms of business
combinations can be effected without shareholder approval. Accordingly, in
certain instances shareholders will neither receive nor otherwise have the
opportunity to evaluate any financial or other information concerning any
potential acquisition. Shareholders will have to rely entirely upon the ability
of management to select, structure and consummate acquisitions that are
consistent with our business objectives.

We May Not Be Able to Retain Our Key Personnel
- ----------------------------------------------

Our success depends to a significant extent on the performance and
continued service of our senior management and certain key employees. During the
second half of 1998, three of our executive officers resigned. The loss of
services of, or a material reduction in, the amount of time devoted to our
business by such individuals could adversely affect our operations and financial
condition. Competition for highly skilled employees with technical, management,
marketing, sales, product development and other specialized training is intense.
We may not be successful in attracting or retaining such qualified personnel.
Specifically, we may experience increased costs in order to attract and retain
skilled employees. Employees might compete against us if they resign.

We Have Substantial Indebtedness
- --------------------------------

As of March 31, 1999, our indebtedness was approximately $5.3 million,
consisting of:

. borrowings under a check overdraft bank facility in the aggregate
maximum principal amount of approximately $1.3, which is payable on
demand; and
. an unsecured convertible note in the aggregate principal amount of $4.0
million.

Accordingly, we are subject to all of the risks associated with substantial
indebtedness, including:

. a substantial portion of our cash flow from operations will be used to
pay our indebtedness;
. we have reduced the funds available to us for operations, future
business opportunities and other purposes;
. our ability to obtain additional financing for acquisitions, working
capital, capital expenditures, general corporate or other purposes may
be impaired; and
. we will be more vulnerable to economic downturns, less able to withstand
competitive pressures and less flexible in reacting to changes in our
industry and general economic conditions.

6
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In the event we default under any of our debt instruments or if our creditors
demand payment of a portion or all of our indebtedness, we may not have
sufficient funds available to make such payments. Failure to repay such
indebtedness would materially adversely affect our operations and financial
condition.

Industry Risks

A number of the following risk factors relate to our former CD-ROM software
business. Accordingly, such risk factors will only be applicable to the extent
we retain an interest in the CD-ROM software business,which is limited to the
on-line rights to the game rights we sold.

We Experience Fluctuations in Quarterly Operating Results
- ---------------------------------------------------------

Our quarterly operating results have fluctuated significantly in the past
and will likely fluctuate significantly in the future. These fluctuations in
operating results depend on a variety of factors, including:

. the demand for our products and the products of our competitors;
. the level of usage of the Internet;
. the size and rate of growth of the interactive entertainment software
market;
. development and promotional expenses related to the introduction of new
products or enhancements;
. the degree of market acceptance for our new product introductions and
enhancements;
. the timing of orders from significant customers; delays in shipment;
. the level of price competition;
. changes in computing platforms;
. the nature and magnitude of product returns;
. order cancellations;
. software defects and other quality problems;
. the length of product life cycles; and
. the percentage of our sales related to international sales.

As a software business, we operate with little backlog and net revenues in any
quarter are substantially dependent on orders booked and shipped in that
quarter. Our operating expenses are based to a significant degree on planned
expenditures and expectations regarding future sales. Failure to meet our sales
expectations could disproportionately adversely affect our operating results in
any given quarter. As a result, we believe that period-to-period comparisons of
operating results should not be relied upon as indicative of future results.

We Depend on the Frequent Introduction of New Products
- ------------------------------------------------------

The market for interactive CD-ROM software games is characterized by short
product life cycles and frequent introduction of new products. Most CD-ROM
software games do not achieve sustained market acceptance or ever generate a
sufficient level of sales to offset the costs associated with product
development. Generally, the majority of sales of new products occur within the
first six months following their release. Our success will depend upon our
ability to develop new, commercially successful products and replace revenues
from such products at the later stages of their life cycles. We believe that
competition in the interactive entertainment software market may require us to
increase our development, acquisition and marketing costs in order to:

. develop higher quality, distinctive products that incorporate
increasingly sophisticated effects; and
. support new product releases with increased marketing.

We Depend On a Limited Number of Products
- -----------------------------------------

We derive a significant portion of our revenues from a limited number of
software products released each year. Many of these products have substantial
development or acquisition costs and marketing budgets. Due to our dependence on
a limited number of products, we may be adversely affected if one or more of our
principal products fail to achieve anticipated results. We cannot predict
whether we will:

. continue to remain dependent upon non-recurring sales of a limited
number of products for a substantial portion of our revenues;

7
<PAGE>

. introduce products which are commercially viable; or
. introduce products which have life cycles sufficient to permit us to
recoup the development, marketing and other costs associated with their
development.

Our Products Have a Lengthy Development Cycle; We Face Product Development Risks
- --------------------------------------------------------------------------------

Our success will depend on the timely introduction of successful new
products. The development of new interactive entertainment software products is
lengthy, expensive and uncertain. The development of a product typically
requires 12 to 24 months to complete from the time a new concept is approved.
Product development of online products continues for the life of the product.
Many of our proposed products are in the early stages of development and will
require us to commit considerable time, effort and resources to complete their
development.

The development of new products is subject to a variety of risks,
including:

. unanticipated delays;
. increased costs and expenses for product development; and
. technical problems or other difficulties prior to or after the
introduction of a new product.

We have, in the past, experienced significant delays in the introduction of
certain new products. It is likely that we will experience delays in developing
and introducing new products in the future. Many of our products are developed
for us by third parties. As a result, we cannot always control the timing of
their introduction. Delays in the work performed by third parties or poor
quality of such work may result in product delays. Unanticipated delays,
expenses, technical problems or difficulties could cause us to miss an important
selling season or result in abandonment or material change in product
commercialization.

Our software products are complex and may contain undetected errors when
first introduced. Despite extensive product testing, we have, in the past,
released products with defects and have discovered software errors in certain of
our product offerings after their introduction. In particular, the personal
computer hardware environment is characterized by a wide variety of non-standard
peripherals (such as sound cards and graphics cards) and configurations that
make pre-release testing for programming or compatibility errors very difficult
and time-consuming. Errors may be found in new products or releases after
commencement of commercial shipments. Remedying such errors may:

. delay sales of our products;
. cause us to incur additional costs; and
. adversely affect our reputation.

Industry Factors May Adversely Affect Our Operating Results; We Face the Risks
- ------------------------------------------------------------------------------
of Changing Consumer Preferences and Uncertainty of Market Acceptance of our
- ----------------------------------------------------------------------------
Products
- --------

The level of demand and market acceptance of our newly introduced products
is subject to a high degree of uncertainty. In recent years, the potential
earnings derived from software sales has decreased. This decrease is due to the
significant increases in:

. software acquisition and development costs;
. promotion and marketing expenses; and
. royalties and third-party participations payable to software developers,
creative personnel, musicians and others.

Our future operating results will depend on numerous factors beyond our
control. These factors include:

. the popularity, price and timing of new entertainment software products
being released and distributed;
. international, national, regional and local economic conditions
(particularly economic conditions adversely affecting discretionary
consumer spending);
. changes in consumer demographics;
. the availability of other forms of entertainment; and
. critical reviews and public tastes and preferences.

Our ability to plan for product development and promotional activities will
be significantly affected by our ability to anticipate and respond to relatively
rapid changes in consumer tastes and preferences. In particular, the tastes and
preferences of those consumers, primarily males over age 25 with annual
household incomes of $50,000 or more, who comprise our principal target

8
<PAGE>

market. A decline in the popularity of software games or in the interactive
entertainment software industry generally or in particular market segments could
adversely affect our business and prospects.

Our strategy is to primarily focus on online games. The level of demand or
the market acceptance for our Internet online game products is uncertain. The
success of our strategy will depend in part upon market acceptance of online
games and a "pay-for-play" model. Online game play is a new and evolving
concept. Demand and market acceptance for recently introduced products and
services are subject to a high level of uncertainty and risk. We cannot predict
whether:

. a viable market for online games will develop;
. we will be able to attract and retain subscribers to our online game
products;
. we will be successful in developing additional products for online use;
or
. our online game products will ever achieve widespread market acceptance.

We Depend on the Continued Growth in Use of the Internet
- --------------------------------------------------------

Rapid growth of interest in and use of the Internet is a recent phenomenon.
Our success is highly dependent upon the increased acceptance and use of the
Internet. The novelty of the Internet may adversely affect our ability to retain
new subscribers. New subscribers who are unfamiliar with the Internet may be
more likely to discontinue our services after an initial trial period.

Risks Related to Online Games
- -----------------------------

We do not currently derive significant revenues from online games. Having
completed the sale of our CD-ROM business, online games will become the primary
factor in the success of our business. Online games, and particularly
multiplayer online games such as our Warbirds product, have risks not associated
with sales of our CD-ROM products. Such risks include:

. the speed and reliability of the Internet and the fact that we do not
control the performance of a player's Internet service provider which
impacts game performance;
. in multiplayer games, unanticipated player conduct can significantly
affect the performance of the game and determine player satisfaction;
. the uncertainty of whether subscription revenues will be sufficient to
maintain the significant support, service and product enhancement
demands of online users;
. our limited experience in pricing strategies for online games or in
predicting usage patterns of our customers; and
. our inability to predict the legal standards that may apply to online
products in the future.

The viability of our online game business, and our ability to compete in this
business, will depend significantly on these and other factors outside our
control.

We Face Infrastructure Risks of Online Game Play
- ------------------------------------------------

The development and maintenance of an industry infrastructure for providing
consumer access to online games will effect the extent and timing of the
revenues we generate from online games. We cannot predict whether the
infrastructure, including a reliable network foundation, and timely development
of complementary products, such as high-speed modems, necessary to make local or
wide area networks or the Internet a viable medium for use of real-time large-
scale multiplayer simulation and strategy games will be developed. Further, if
developed, we cannot predict whether such networks will become a viable medium
for use of multiplayer simulation and strategy games. In addition, hardware
restrictions, such as bandwidth (amount of data capable of transmission at a
single time) and latency (delays introduced by the network), which limit use of
content via local and wide area networks, may inhibit such networks from
becoming a viable medium for delivery of multiplayer simulation and strategy
games. If the necessary infrastructure or complementary products are not
developed, or if such networks do not become a viable medium for delivery of
multiplayer simulation and strategy games, we will be unable to generate
significant revenues from online products.

Changes in Technology and Industry Standards May Make Our Products Obsolete or
- ------------------------------------------------------------------------------
Unmarketable
- ------------

The interactive entertainment software industry is undergoing rapid
changes, including:

. evolving industry standards;
. frequent new platform introductions; and
. changes in consumer requirements and preferences.

9
<PAGE>

The introduction of new technologies, technologies that support multiplayer
games and new media formats such as online delivery and digital video disks,
could render our previously released products obsolete or unmarketable. The
development cycle for products utilizing new operating systems, microprocessors
or formats may be significantly longer than the current development cycle for
our products. We may be required to invest resources in products that may not
become profitable. We cannot predict whether:

. our future product offerings will keep pace with technological changes
. we will be successful in developing and marketing products for any
future operating system or format.

Failure to develop and introduce new products and product enhancements in a
timely fashion could result in significant product returns and inventory
obsolescence.

The overall market for the Internet is characterized by:

. rapidly changing technology;
. evolving industry standards;
. emerging competition; and
. frequent product and service introductions.

We may not successfully identify new product opportunities for Internet use and
develop and bring such new products to market in a timely manner. Products or
technologies developed by others could render our products or technology
obsolete. We are also at risk with respect to fundamental changes in the way
Internet connectivity services are delivered. Currently, Internet services are
accessed primarily by computers and are delivered by telephone lines. We may
have to develop new technology or modify our existing technology if the Internet
becomes:

. accessible by screen-based telephones, television or other consumer
electronic devices; or
. deliverable through other means such as coaxial cable or wireless
transmission.

Pursuit of such technological advances may require us to expend substantial time
and resources. We cannot predict whether we will succeed in adapting our
products to alternate access devices and conduits.

We Face Intense Competition
- ---------------------------

The interactive entertainment software industry is intensely and
increasingly competitive. Industry competition is based primarily upon:

. product quality and features;
. the compatibility of products with popular platforms;
. access to distribution channels (including access to retail shelf
space);
. marketing effectiveness;
. reliability and ease of use; and
. price and the quality of user support services.

As compared to us, many of our competitors have:

. significantly greater financial, technical, marketing, sales and
customer support and other resources; and
. established reputations for success in the development, licensing and
sale of their products and technology.

As a result, our competitors may be able to:

. carry larger inventories;
. undertake more extensive marketing campaigns;
. adopt more aggressive pricing policies; and
. make higher offers or guarantees to third party software developers and
licensors.

10
<PAGE>

Increased competition may result in significant price competition, increased
product development and production costs and reduced profit margins. Competition
may also limit our ability to grow and retain our subscriber base for online
game play. We may not be able to compete successfully against current or future
competitors.

We Depend on Third-Party Software Developers
- --------------------------------------------

We rely on third-party software developers to develop a significant number
of our products. Our payment of advances and guaranteed royalties to such
independent software developers has increased and may continue to increase
primarily due to the increased demand for quality interactive entertainment
software programs. Sales of products associated with such royalties may not be
sufficient to cover the amount of our prepayments. Moreover, independent
developers are in high demand. As a result, we cannot predict whether such
developers, including those that have developed products for us in the past,
will be available to develop products for us in the future. The failure to
obtain or renew product development agreements with such developers could
materially adversely affect our future operations. In addition, many independent
developers have limited financial resources. Therefore, we are subject to the
risk that such developers may go out of business prior to completing a project.

We Depend on Third-Party Distribution Channels
- ----------------------------------------------

We intend to expand the distribution of our online products by seeking out
relationships with third-party providers of online or Internet services in the
United States and abroad. We cannot predict whether we will be able to
successfully negotiate relationships with providers of online or Internet
services or, if completed, that such arrangements will generate significant
revenues. Further, we are subject to the risk that:

. the cost of any proposed online or Internet distributor relationship
will exceed our expectations; or
. we will incur significant costs in anticipation of an online or Internet
distributor arrangement and such arrangement is delayed or abandoned.

We Have Limited Protection of Our Proprietary Information
- ----------------------------------------------------------

We rely on a combination of the following to establish and protect our
proprietary rights:

. trademark;
. trade secret;
. copyright;
. other proprietary rights laws;
. license agreements; and
. employee and third-party nondisclosure agreements;

We are at risk that competitors may misappropriate our technology or
independently develop software products with features based upon, or otherwise
similar to, those of our products.

To license our products to end users, we primarily rely on "shrink wrap"
licenses that are not signed by the end-user. As a result, such licenses may be
unenforceable under the laws of certain jurisdictions. In addition, effective
copyright and trade secret protection may be unavailable or limited in certain
foreign countries. The global nature of certain wide area networks, particularly
the Internet, makes it virtually impossible to control the ultimate destination
of our products. Despite our efforts to protect our proprietary rights,
unauthorized parties may attempt to copy aspects of our products or to obtain
and use information that we regard as proprietary. Unauthorized copying is
common within the software industry. A significant amount of unauthorized
copying of our products could adversely affect our business. As the number of
software products in the industry increases and the functionality of these
products further overlaps, software developers may become increasingly subject
to infringement claims. Third parties may assert infringement claims against us
in the future with respect to current or future products. As is common in the
industry, from time to time, we receive notices from third parties claiming
infringement of intellectual property rights of such parties. We investigate
these claims and respond as we deem appropriate. Litigation may be necessary in
the future:

. to enforce our intellectual property rights;
. to protect our trade secrets;
. to determine the validity and scope of the proprietary rights of others;
or

11
<PAGE>

. to defend against claims of infringement of invalidity.

Even if we win, any such litigation could result in substantial costs and
diversion of our resources.

We Face the Risks of Increased Government Regulation
- ----------------------------------------------------

There are currently few laws or regulations directly applicable to access
to or commerce on the Internet. Due to the increasing popularity and use of the
Internet, it is possible that laws and regulations may be adopted both in the
United States and abroad, covering issues such as:

. user privacy;
. defamation;
. pricing;
. taxation;
. content regulation;
. quality of products and services; and
. intellectual property ownership and infringement.

Such legislation could:

. expose us to substantial liability;
. dampen the growth in use of the Internet;
. decrease the acceptance of the Internet as a communications and
commercial medium; or
. require us to incur significant expense in complying with any new
regulations.

Because the growing popularity and use of the Internet has burdened the
existing telecommunications infrastructure and many areas with high Internet use
have begun to experience interruptions in phone service, local telephone
carriers have petitioned for increased regulations and the imposition of access
fees. Increased regulation or the imposition of access fees could substantially
increase the costs of communicating on the Internet, potentially decreasing the
demand for our products. Also, a number of laws have recently been enacted in
the United States intended to:

. reduce the liability of online service providers for listing or linking
to third-party Web sites that include materials that infringe
copyrights; and
. restrict the distribution of certain materials deemed harmful to
children and impose additional restrictions on the ability of online
services to collect user information from minors.

We are currently reviewing these pieces of legislation, and cannot currently
predict the effect, if any, that such legislation will have on our business. In
addition, a number of other countries have announced or are considering
additional regulations. Such laws and regulations could fundamentally impair our
ability to provide Internet navigation or other services, or substantially
increase the cost of doing so. Moreover, the applicability to the Internet of
existing laws governing issues such as property ownership, copyright,
defamation, obscenity and personal privacy is uncertain. Any such new
legislation or regulation in the United States or abroad or the application of
existing laws and regulations to the Internet could have a material adverse
effect on our business, operating results, and financial condition.

We are Subject to Risks Related to International Revenues and Operations
- ------------------------------------------------------------------------

We distribute our on-line products in over 30 countries worldwide and
maintain sales offices in the United Kingdom and Germany. International
operations and sales of our products are subject to inherent risks, including:

. fluctuations in exchange rates;
. the impact of possible recessionary environments in economies outside
the United States;
. the costs of transferring and localizing products for foreign markets;
. longer accounts receivable collection periods and difficulty in
collection of accounts receivable;
. unexpected changes in regulatory requirements;
. tariffs and other barriers;
. difficulties and costs of staffing and managing foreign offices; and

12
<PAGE>

. potential political and economic instability.

Revenues and expenses from our foreign operations generally are denominated
in local currencies. As a result, exchange rate fluctuations between such local
currencies and the U.S. dollar will subject us to currency translation risk from
the reported results of our foreign operations. We intend to continue to expand
our direct and indirect sales and marketing activities worldwide. We cannot
predict whether we will be able to maintain or increase international market
demand for our products.

Control by Shareholders

Our Officers, Directors and their Affiliated Entities Control Interactive Magic
- -------------------------------------------------------------------------------

As of March 31, 1999, our officers, directors and their affiliated entities
owned approximately 44% of our outstanding shares of Common Stock. As a result,
such persons are in the position to influence:

. the election of the Company's directors; and
. the outcome of corporate actions or other matters requiring shareholder
approval.

The concentration of ownership may have the effect of delaying or preventing a
change in control of Interactive Magic.

Stock and Market Risks

Our Stock Price May be Volatile
- -------------------------------

The market price of our Common Stock has been and could be subject to wide
fluctuations in response to the following:

. variations in quarterly operating results;
. announcements of new products by us or our competitors;
. failures to meet or exceed the expectations of securities analysts or
investors; or
. general economic conditions.

Furthermore, the stock market has experienced significant price and volume
fluctuations unrelated or disproportionate to the operating performance of
particular companies. These market fluctuations may also adversely affect the
market price of our Common Stock.

We Do Not Intend to Pay Dividends to Our Shareholders
- -----------------------------------------------------

We have not paid any cash dividends on our common stock and do not expect
to do so in the foreseeable future.

Future Sales of Our Common Stock in the Public Market Could Adversely Affect Our
- --------------------------------------------------------------------------------
Stock Price
- ------------

Sales of shares of our common stock by existing shareholders could have an
adverse effect on stock prices. As of June 30, 1999, we had 10,690,183 shares
of common stock outstanding. All of these shares are eligible for sale, subject
to Rule 144.

In general, under Rule 144 as currently in effect, a person (or persons whose
shares are aggregated), including persons who may be deemed to be "affiliates"
of the Company as that term is defined under the Securities Act of 1933, is
entitled to sell within any three-month period a number of restricted shares
beneficially owned for at least one year that does not exceed the greater of:

. one percent (1%) of the then outstanding shares of common stock, or
. the average weekly trading volume in the common stock during the four
calendar weeks preceding such sale.

Sales under Rule 144 are also subject to certain requirements as to the
manner of sale, notice and the availability of current public information about
us. However, a person who is not an affiliate and has beneficially owned such
shares for at least two years is entitled to sell such shares without regard to
the volume or other requirements. No prediction can be made as to the effect, if
any, that sales of such securities or the availability of such securities for
sale will have on the market prices prevailing from time to time.

In addition, holders of 3,218,114 shares of common stock and warrants to
purchase 500,000 shares of common stock have registration rights with respect to
their respective securities The possibility that a substantial number of our
securities may be sold in

13
<PAGE>

the public market may adversely affect prevailing market prices for our common
stock and could impair our ability to raise capital through the sale of our
equity securities.

We Face the Adverse Effects of Outstanding Options; Warrants and Convertible
- ----------------------------------------------------------------------------
Securities
- ----------

As of June 30, 1999, we have outstanding:

. warrants to purchase an aggregate of approximately 1,249,172 shares of
Common Stock;
. a convertible note, together with related warrants, which are
convertible into and exercisable for an aggregate of up to 2,119,889
shares of Common Stock.

We have authorized for issuance and granted the following options:

. 2,875,000 shares of Common Stock in connection with our 1995 Incentive
Stock Option Plan, 2,047,400 of which have been granted;
. 800,000 shares of Common Stock in connection with our 1998 Stock Plan,
under which options to purchase 484,750 shares have been granted; and
. 500,000 shares of Common Stock in connection with our 1998 Stock
Purchase Plan, none of which have been granted.

The existence of these securities may adversely affect us or our
shareholders for many reasons, including:

. the market price of our stock may be adversely affected;
. if any of these securities are exercised, the value of the stock held by
our shareholders will be diluted if the value of such stock immediately
prior to the exercise of such securities exceeds the exercise price;
. some of these securities give the holders the opportunity, at nominal
cost, to profit from a rise in the market price of our stock;
. the terms upon which we could issue additional common stock or obtain
additional financing may be adversely affected.

Holders of warrants and options are also likely to exercise them when, in
all likelihood, we could obtain additional capital on terms more favorable than
those provided by the warrants and options.

We cannot predict the actual number of shares of our stock that may be
issued upon conversion of the note and exercise of related warrants, which
depends on:

. the conversion price in effect from time to time during the term of the
note;
. the timing of any conversion; and
. the decision by us to make any payments of interest in the form of
shares of common stock.

However, the maximum number of shares of our common stock that we can issue
upon conversion of the Convertible Note, payment of interest and exercise of
related warrants without stockholder approval is 2,119,889 shares. The
conversion price of the Convertible Note is likely to be below the market price
of our common stock on any date of conversion.

All or any portion of the Convertible Note is convertible into such number
of shares of common stock as is determined by dividing the portion of the
principal amount of the Convertible Note being converted, plus all accrued and
unpaid interest thereon plus any default payments, if any, as of the relevant
conversion date by the then current conversion price (which is determined by
reference to the lower of the then current market price or a fixed conversion
price, as each of such prices are defined in the Convertible Note). Without
giving effect to the Maximum Share Limitation, if converted on July 30, 1999,
the Note would have been convertible into approximately 2,281,640 shares of
Common Stock. However this number of shares could prove to be significantly
greater in the event of a decrease in the trading price of the Common Stock.
Upon the conversion of all or any portion of the Convertible Note on a day when
the common stock trades at a price higher than the fixed conversion price, the
Company shall also deliver to the holder of the Convertible Note warrants (the
"Warrants") exercisable for one share of common stock for every two shares of
common stock issued as a result of such conversion at an exercise price equal to
the applicable conversion price for an exercise period of three years.
Purchasers of common stock could therefore experience substantial dilution of
their investment upon conversion of the Convertible Note or the exercise of any
Warrants. The Convertible Note and the Warrants are not registered and may be
sold only if registered under the Securities Act or sold in accordance with an
applicable exemption from registration, such as Rule 144. The shares of common
stock issuable upon conversion of the

14
<PAGE>

Convertible Note or upon the exercise of any Warrants are being registered
pursuant to this Registration Statement. As of the date of this Prospectus, no
Warrants have been issued.

As of June 30, 1999, the Company had reserved 3,762,096 shares of common
stock for issuance upon exercise of the Company's outstanding warrants and
options (excluding the Warrants) and an additional 2,119,889 shares of Common
Stock were reserved for issuance upon conversion of the Convertible Note and the
Warrants.

Our Common Stock May be Delisted from the Nasdaq National Market if We do Not
- -----------------------------------------------------------------------------
Meet the Listing Criteria.
- --------------------------

We have been notified by Nasdaq that we no longer meet their criteria for
continued listing on the Nasdaq National Market. If we are unable to satisfy the
continued listing requirements, our stock may be delisted from the Nasdaq
National Market. If our stock is delisted from the Nasdaq National Market, the
liquidity of our stock could be impaired, not only in the number of securities
which could be bought and sold, but also through delays in the timing of
transactions, reduction in coverage by security analysts and the news media and
lower prices for our common stock than might otherwise be attained. We cannot
assure that we will continue to meet the criteria for continued listing on the
Nasdaq National Market.

If our stock is delisted from the Nasdaq National Market, trading, if any, in
our stock would thereafter be conducted:

. on the Nasdaq SmallCap Market, assuming we meet the requirements for
listing on the Nasdaq SmallCap Market;
. in the over-the-counter market in the "pink sheets;" or
. on the National Association of Securities Dealers, Inc.'s "Electronic
Bulletin Board."

Continued inclusion on the Nasdaq National Market generally requires that we
maintain:

. at least $4,000,000 in "net tangible assets" (total assets less total
liabilities and goodwill);
. a minimum bid price of the Common Stock of $1.00 per share;
. at least 750,000 shares in the public float valued at $5,000,000 or
more;
. at least two active market makers for the Common Stock; and
. a least 400 holders of the Common Stock.

If our Common Stock is Delisted from Nasdaq it May Be Subject to Investor
- -------------------------------------------------------------------------
Suitability Requirements Which may Adversely Affect Our Stock's Liquidity.
- --------------------------------------------------------------------------

If our stock was delisted from Nasdaq National Market and could not be
quoted on Nasdaq SmallCap Market, it could become subject to Rule 15g-9 under
the Exchange Act, which imposes additional sales practice requirements on
broker-dealers that sell such securities to persons other than established
customers and "accredited investors" (generally, individuals with net worth in
excess of $1,000,000 or annual incomes exceeding $200,000, or $300,000 together
with their spouses). For transactions covered by this rule, a broker-dealer must
make a special suitability determination for the purchaser and have received the
purchaser's written consent to the transaction prior to sale. Consequently, such
rule may adversely affect the ability of broker-dealers to sell our common stock
and may adversely affect the ability of shareholders to sell any of the shares
of common stock in the secondary market.

If Our Common Stock is Delisted from Nasdaq it May Be a "Penny Stock" Which
- ---------------------------------------------------------------------------
Requires Significant Disclosure in Connection with Stock Trades, Which may
- --------------------------------------------------------------------------
Adversely Affect Our Stock's Liquidity.
- ---------------------------------------

If our stock is delisted from Nasdaq or we do not meet certain minimum net
tangible assets or average revenue criteria, we may be subject to the
Commission's "penny stock" rules. For any transaction involving a penny stock,
unless exempt, the rules require:

. delivery, prior to any transaction in a penny stock, of a disclosure
schedule relating to the penny stock market;
. disclosure about commissions payable to both the broker-dealer and the
registered representative and current quotations for the securities; and
. monthly statements to be sent disclosing recent price information for
the penny stock held in the account and information on the limited
market in penny stocks.

Commission regulations, subject to certain exceptions, define a "penny stock" to
be any non-exchange listed equity security:

. that has a market price of less than $5.00 per share; or

15
<PAGE>

. with an exercise price of less than $5.00 per share.

We cannot predict whether our common stock will qualify for exemption from these
restrictions. In any event, even if our stock was exempt from such restrictions,
it would remain subject to Section 15(b)(6) of the Exchange Act, which gives the
Commission the authority to prohibit any person that is engaged in unlawful
conduct while participating in a distribution of a penny stock from associating
with a broker-dealer or participating in a distribution of a penny stock, if the
Commission finds that such a restriction would be in the public interest. If our
stock were subject to the rules on penny stocks, the market liquidity for our
stock could be severely adversely affected.

We are Subject to Risks Associated with Year 2000 Compliance
- ------------------------------------------------------------

Many currently installed computer systems and software products are coded
to accept only two digit entries in the date code field. These date code fields
will need to accept entries to distinguish 21st century dates from 20th century
dates. The inability to recognize or properly treat the year 2000 may cause our
systems and applications to process critical financial and operational
information incorrectly. In addition, we are assessing the readiness of our
customers and suppliers for the Year 2000 issue. We cannot assess the likelihood
of third parties' year 2000 compliance or the impact that any non compliance may
have on our operations at this time. If there are significant delays or
unanticipated year 2000 issues with key business vendors, the year 2000 issue
could have a material adverse effect on our product development and our future
results of operations and financial condition.

Forward-Looking Information May Prove Inaccurate
- ------------------------------------------------

This Prospectus contains various forward-looking statements that are based
on our beliefs as well as assumptions made by and information currently
available to us. When used in this Prospectus, the words "believe," "expect,"
"anticipate," "estimate" and similar expressions are intended to identify
forward-looking statements. The accuracy of such forward-looking statements is
subject to certain risks, uncertainties and assumptions, including those
identified above under "Risk Factors." Should one or more of these risks or
uncertainties materialize, or should underlying assumptions prove incorrect,
actual results may vary materially from those anticipated, estimated or
projected.

USE OF PROCEEDS

The Company previously received $4,000,000 in gross proceeds from the sale
of the Convertible Note. In addition, the Company may receive additional
proceeds from the exercise of the Warrants issuable in connection with the
conversion of the Convertible Note. All shares offered by this Prospectus are
being re-sold by the Selling Stockholder and all proceeds from the sales of such
shares will go to the Selling Stockholder. The Company will receive no proceeds
from this offering.

MARKET FOR COMMON STOCK AND
RELATED STOCKHOLDER MATTERS

The Company's common stock began trading July 22, 1998 (the date of its
initial public offering) on the Nasdaq National Market (ticker symbol IMGK). The
approximate number of record holders of the Company's common stock as of
December 31, 1998 was 160. The following sets forth the quarterly high and low
bid prices during each of the three quarters shown as reported on Nasdaq. These
prices are based on quotations between dealers, which do not reflect retail
mark-up, markdown or commissions and may not reflect actual transactions.

<TABLE>
<CAPTION>
- ----------------------------------------------------------------------
Price
- ----------------------------------------------------------------------
Quarter Ended High Low
- ----------------------------------------------------------------------
<S> <C> <C>
September 30, 1998 $14.00 $6.50
- ----------------------------------------------------------------------
December 31, 1998 $ 6.50 $4.13
- ----------------------------------------------------------------------
March 31, 1999 $ 7.75 $3.50
- ----------------------------------------------------------------------
June 30, 1999 $ 4.03 $2.06
- ----------------------------------------------------------------------
</TABLE>

16
<PAGE>

The Company has never paid a cash dividend on its Common Stock. The Company
does not anticipate paying any cash dividends in the foreseeable future and
intends to retain future earnings, if any, for the development of its business.
In addition, certain of the Company's loan agreements prohibit cash dividends.

17
<PAGE>

MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

The Company develops, publishes and distributes interactive real-time 3D
simulation and strategy entertainment software. The Company historically
generated revenues primarily from delivering its CD-ROM products for retail sale
through its worldwide distribution network and from subscription and hourly fees
for play of its online product. The Company has also historically generated
revenues from licensing its CD-ROM products to OEMs, distributors outside of
North America and other third parties. Since inception, the Company has
published over 40 CD-ROM products, which have been distributed through more than
15,000 retail outlets in over 30 countries. Additionally, the Company has sold
over 2.0 million hours of online game time over the Internet to players in more
than 70 countries.

RECENT DEVELOPMENTS

On May 25, 1999, the Company executed an Agreement Regarding Assignment of
Contracts (the "Agreement') to sell its rights under certain development
contracts for CD-ROM products between the Company and third party developers
(and assume certain liabilities thereto) for $2.5 million. This Agreement
provides for the Company to retain the on-line rights to use these products.
This transaction was consummated on June 30, 1999. The Company disposed of the
portion of its business relating to CD-ROM products in order to focus solely on
Internet entertainment.

First Quarter 1999 vs. First Quarter 1998

RESULTS OF OPERATIONS

NET REVENUES

Net revenues decreased by 76% to $ 1.2 million for the three months ended March
31, 1999 from $4.9 million for the three months ended March 31, 1998.

The following is a reconciliation of net revenue for the first quarter of 1998
to the same period for 1999:

$ Thousand
-----------
Net revenue, first three months 1998 $ 4,913

Lower CD-ROM revenue (4,534)
Increased Online revenue 109
Increased advertising revenue Online 127
Lower royalty & licensing revenue (491)
Lower returns, allowances & discounts 1,038
-------

Net revenue, first three months 1999 $ 1,162
-------

The decrease in CD-ROM revenue reflects our intention to exit this line of
business. As a comparison, the following table lists the CD-ROM titles released
during the first quarter of 1999 and 1998:

---------------------------------------------
1999 1998
---------------------------------------------
North v. South Battles of Caesar
---------------------------------------------
IF-22
---------------------------------------------
IPanzer
---------------------------------------------
Liberation Day
---------------------------------------------
Semper Fi
---------------------------------------------

Online revenues and related advertising continued to increase as our usage hours
and ad impressions both grew. The number of registered users at our Internet
Entertainment Network (iEN) web sites is now over 500,000. The number of monthly
ad impressions exceeded 12 million in March 1999.

COST OF REVENUES.

18
<PAGE>

Cost of revenues consist of costs of products sold (including cost of Internet
access) and royalties and amortization of software development costs. Cost of
revenues in the first quarter of 1999 decreased by 73% to $ .5 million from $1.9
million in the same period of 1998. This decrease was due almost entirely to the
lower level of CD-ROM revenue. Gross margins for the first three months of 1999
and 1998 were 57% and 62% respectively.

19
<PAGE>

OPERATING EXPENSES

Operating expenses increased $1.2 million or 37% from the first quarter of 1998
to the same period in 1999. The following is a summary of major variances:

$ Thousand
----------
Operating expenses, first three months 1998 $3,219

Decrease in sales & marketing expense (145)
Increase in product development expense 742
Increase in goodwill amortization 191
Increase in general & administrative expense 403
------

Operating expenses, first three months 1999 $4,410
------

SALES AND MARKETING. Sales and marketing expenses for the first three months of
1999 decreased 9% from the same period in 1998. The decrease was attributable to
the lower number of titles released in 1999.

PRODUCT DEVELOPMENT. Product development expense increased $ 742 thousand in the
first quarter of 1999 versus 1998, or 67%. Nearly all of this increase was due
to our write-offs of capitalized development costs associated with a revaluation
of estimated revenues to be derived from products to be released in 1999.

GENERAL AND ADMINISTRATIVE. General and administrative expense was $403
thousand higher in the first quarter of 1999 than the same period last year. The
increase was due to the higher costs associated with being a public-traded
corporation and the effect of the MPG-Net acquisition on professional fees in
the quarter.

GOODWILL AMORTIZATION. Goodwill from the MPG-Net acquisition in the first
quarter of 1999 is being amortized on a straight-line basis over a 36 month
period.

OTHER EXPENSE

Other (income) / expense increased $2.0 million in the first three months of
1999 compared to 1998. The increase was due to higher interest expense relating
to the $4,000,000 convertible debenture financing.

As explained in Footnote 6 of the Financial Statements, we recorded, as
additional interest expense, the beneficial conversion feature and contingently
issuable warrants related to the $4.0 million convertible debenture issued in
the first quarter of 1999. This item is a non-cash charge to earnings with a
corresponding increase in additional paid in capital. Therefore there is no net
effect on total equity for the item.

INCOME TAX EXPENSE

The Company recorded $35,000 income tax expense for the first quarter of 1999
compared to $128,000 for the same period in 1998.

LIQUIDITY AND CAPITAL RESOURCES

The Company's capital requirements have been and will continue to be
significant, and, to date, its cash requirements have exceeded its cash flow
from operations. The Company historically has satisfied cash requirements
through borrowings, the private sale of equity securities, and its initial
public offering.

20
<PAGE>

Net cash used in operations of $3.3 million during the three months ended March
31, 1999 is due primarily to the Company's operating loss. Offsetting the cash
used from operations in the quarter was the $3.7 million proceeds from the
issuance of the convertible debentures.

We do not have any current arrangements or commitments for any future financing.
We may not be able to obtain sufficient additional financing to satisfy cash
requirements. We may be required to obtain financing on terms that are not
favorable to us and our shareholders. If we are unable to obtain additional
financing when needed, we may be required to delay or scale back product
development and marketing programs in order to meet our short-term cash
requirements, which could have a material adverse effect on our business,
financial condition and results of operations.

1998 vs. 1997

RESULTS OF OPERATIONS

NET REVENUES. Net revenues decreased by 24% to $12.6 million in 1998 from $16.5
million in 1997. The decline was attributable to lower net revenues in the CD-
ROM business. Although the Company released a greater number of game titles in
1998, the average sales per title were lower than the prior year.

COST OF REVENUES. Cost of revenues consist of costs of products sold (including
cost of Internet access) and royalties and amortization of software development
costs. Cost of revenues in 1998 decreased by 3% to $ 6.1 million from $6.3
million in the same period of 1997, resulting in gross margins of 52% and 62%,
respectively. The decrease in gross margin performance reflects the lower
average sales per title in 1998 compared to 1997.

OPERATING EXPENSES

SALES AND MARKETING. Sales and marketing increased in 1998 to $8.5 million from
$6.8 million in 1997. Increased expenditures in this area reflect an increase in
staffing; in addition, there was a higher level of advertising and market
support spending related to the greater number of titles released in 1998
compared to 1997.

PRODUCT DEVELOPMENT. Product development increased 54% to $6.0 million in 1998
from $3.9 million in 1997. The increase was due to the Company devoting more of
its resources in 1998 to internally-developed products, as opposed to third
party products, combined with the larger number of products developed and
released in 1998 compared to 1997.

GENERAL AND ADMINISTRATIVE. General and administrative expenses increased to
$2.7 million in 1998 from $1.9 million in 1997. The increased level of spending
was due to a slight increase in staffing, and to the additional expenses
associated with being a publicly held corporation.

OTHER EXPENSE. Other expense, comprised primarily of interest (income) expense,
decreased in 1998 to $.5 million from $1.9 million in 1997. The decrease was due
to the lower level of interest expense as the Company paid down debt with
proceeds from the Company's initial public offering.

EXTRAORDINARY ITEM. The Company incurred a $.4 million extraordinary loss from
the early extinguishment of debt in 1998. In conjunction with the repayment of
debt from the proceeds from the initial public offering; the unamortized costs
to obtain the original debt were written-off at repayment.

LIQUIDITY AND CAPITAL RESOURCES

Net cash used in operations of $10.7 million in 1998 was due primarily to the
Company's operating loss.

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The Company's financial statements include an explanatory paragraph from the
Company's independent auditors that indicates substantial doubt may exist about
the Company's ability to continue as a going concern based on net losses of
$11.7 million and $4.3 million for the years ended December 31, 1998 and 1997,
respectively, and negative cash flows from operations. The Company's
continuation as a going concern is dependent on its ability to generate
sufficient cash flow to meet its obligations on a timely basis, to obtain
additional financing or refinancing as may be required, and ultimately attain
profitability.

The Company maintains a revolving line of credit arrangement with a bank for up
to $2.8 million. The principal balance outstanding at any point in time is
payable on demand with interest payable monthly at the bank's current prime rate
(7.75% at December 31, 1998). The balance outstanding under this line as of
December 31, 1998 was $1.3 million. Advances on the line of credit are
collateralized by a personal guarantee of the Company's majority shareholder. In
consideration for this guarantee, the stockholder will receive from the Company
an amount equal to 6% of the outstanding balance on the line of credit. At
December 31, 1998 and 1997, the Company incurred $64,000 and $144,000 and owed
the stockholder $117,000 and $174,000 relating to this guarantee, respectively.
These amounts are due no earlier than December 31, 2000.

On January 25, 1999, the Company issued a convertible note for net proceeds to
the Company of approximately $3.7 million. The note accrues interest at an
annual interest rate of 6% and is due with principal on January 25, 2002. The
holder of the convertible note may convert all or any portion of the note into
the Company's common stock based on the conversion amount defined in the
securities purchase agreement. The beneficial conversion feature will result in
a portion of the proceeds of the convertible note being allocated to the
conversion feature which will significantly increase the reported interest
expense associated with this note. The Company granted to the holder of the note
warrants to purchase one share of the Company's stock for every two shares of
common stock issued as a result of the note conversion at an exercise price
equal to the note conversion price.

On July 27, 1998, the Company consummated an initial public offering (the
"offering") of 2,600,000 shares of its Common Stock at an initial public
offering price of $8.00 per share. During August 1998, BlueStone Capital
Partners, L.P. and Royce Investment Group, Inc. (collectively, the
"underwriters") exercised in full their overallotment option to purchase an
additional 390,000 shares of the Company's common stock at the initial public
offering price. All such shares were sold by the Company. The net proceeds to
the Company from the offering, including the net proceeds from exercise of the
underwriters' overallotment option, were approximately $20.5 million. Concurrent
with the closing of the offering, 82,634 shares of Series A Convertible
Preferred Stock and 132,744 shares of Series C Redeemable Convertible Preferred
Stock were converted into an equivalent number of shares of common stock, and
778,746 shares of Series B Convertible Preferred Stock were converted into
2,045,649 shares of common stock. The Company utilized $8.9 million in proceeds
from the offering to repay indebtedness as described in the Company's
Registration Statement on Form SB-2 declared effective on July 21, 1998. The
remaining proceeds received by the Company from such offering were used to fund
the operations and support the working capital of the Company.

On April 30, 1998, the Company closed on a one-year $5.0 million revolving line
of credit bearing an interest rate of prime plus 2%. Borrowings on the line of
credit were limited to the lesser of $5.0 million or 65% of the Company's
outstanding eligible receivables and inventory. Borrowings on the line of credit
were collateralized by the Company's accounts receivable, inventory, and
intellectual property. The revolving line of credit was paid off by the Company
in October 1998.

The Company's forecast of the period of time through which its financial
resources will be adequate to support its operations is a forward-looking
statement that involves risks and uncertainties, and actual results could vary.
The factors described in the preceding paragraph will impact the Company's
future capital requirements and the adequacy of its available funds.

Year 2000 Issue

The Company's products are of a nature that they are not date dependent or
subject to failure because of Year 2000 issues. The Company however, has
assigned full-time information technology professionals to the task of
identifying and resolving Year 2000 problems that may affect the Company's
business, and has adopted a Year 2000 compliance plan. Under the Company's Year
2000 compliance plan, the Company has and will continue to inventory and collect
documentation on all of its computers, computer related equipment, and equipment
with embedded processors. In addition, the Company will contact critical vendors
and suppliers to obtain assurances of their ability to ensure smooth delivery of
products and services after December 1999. Additionally, the Company will
prioritize and implement any necessary repairs or replacements to equipment in
order to achieve Year 2000 compliance, which it expects to complete by the end
of 1999. The Company will also implement a testing program, scheduled for
completion by the end of 1999. The Company has not prepared estimates of costs
for correction of Year 2000 problems. Based on information available at this
time, including the Year 2000 compliance status of equipment that has been
examined as well as the anticipated replacement schedule for equipment, the
Company does not believe that the cost of remedial actions will have a material
adverse effect on the Company's

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results of operations or financial condition. There can be no assurance,
however, that there will not be a delay in, or increased costs associated with,
the implementation of corrections as the Year 2000 compliance plan is performed.
Failure to implement such changes could have an adverse effect on future results
of operations. In addition, unexpected costs of correcting equipment that has
not yet been fully evaluated could have an adverse effect on future results of
operations.

Euro Conversion

On January 1, 1999, the European Community began denominating significant
financial transactions in a new monetary unit, the Euro. The Euro is intended to
replace the traditional currencies of the individual EU member countries. The
Company's operations in Europe are continuing to operate in the traditional
currencies and are not converting internal financial systems to the Euro as a
functional currency. The Company is evaluating when to convert its local
currency in Europe to the Euro with as little disruption to customer and vendors
as possible. The Company does not intend to make such a conversion in 1999.

Impact Of Adoption Of New Accounting Standards

As of January 1, 1998 the Company adopted Statement of Financial Accounting
Standards No. 130, Reporting Comprehensive Income, ("SFAS130"). SFAS 130
requires all non-owner changes in equity that are excluded from net
earnings/loss under existing FASB standards to be included as items of
comprehensive income/loss. Comprehensive loss consists of net loss and foreign
currency translation adjustments and is presented in the consolidated statements
of stockholders' equity (deficit). The adoption of SFAS 130 had no impact on
previously reported stockholders' equity (deficit). Prior year financial
statements have been reclassified to conform with these requirements.

Effective January 1, 1998, the Company adopted Statement of Financial
Accounting Standards No. 131, Disclosures about Segments of an Enterprise and
Related Information ("SFAS 131"), which superceded Statement of Financial
Accounting Standards No. 14, Financial Reporting for Segments of a Business
Enterprise. SFAS 131 establishes standards for the way that public business
enterprises report information about operating segments in annual financial
statements and requires that those enterprises report selected information about
operating segments in interim financial reports. SFAS 131 also establishes
standards for related disclosures about products and services, geographic areas
and major customers. The adoption of SFAS 131 did not affect the Company's
results of operations, cash flows nor financial position.

In June 1998, the Financial Accounting Standards Board issued SFAS
133,"Accounting for Derivative Instruments and Hedging Activities", which is
required to be adopted in years beginning after June 15, 2000. Because the
Company's minimal use of derivatives, management does not anticipate the
adoption of the new Statement will have a significant effect on earnings or the
financial position of the Company.

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THE COMPANY

Overview

Interactive Magic, Inc. (or the "Company") is a developer and publisher of
Internet and online games and an operator of online game services. The Company
develops and publishes proprietary online multi-player games and is building the
Interactive Magic Entertainment Network ("iEN"), an Internet distribution
infrastructure which will offer online gamers a variety of free, subscription
and pay-per-play games and services, including simulation, parlor, strategy,
role playing and action games.

The Company is the exclusive game site operator for AT&T WorldNet, an
Internet service provider ("ISP"), and has been contracted to provide online
games for America Online ("AOL"), the world's leading online Internet services
company. The Company seeks to establish itself as a major provider of online
gaming services for ISPs, Internet portals and online services in order to
broaden its audience of users. GameHub, AT&T WorldNet's co-branded online gaming
service, was launched in January 1999 and is currently being marketed by AT&T to
new WorldNet subscribers as a premium service included with their subscription.
The GameHub site offers consumers a mix of free and pay-per-play games in all
categories, including strategy, role playing, simulation, action and parlor
games. In addition to games, GameHub will offer chat rooms, forums and shopping
areas. GameHub is expected to generate revenue from subscriber premiums, e-
commerce and advertising. GameHub complements the Company's online gaming
strategy by expanding the Company's network of player communities.

Historically, the Company has generated revenue primarily from developing,
publishing and distributing simulation and strategy games on CD-ROM for the PC
platform. In June 1999, the Company sold the retail CD-ROM portion of its
business for $2,500,000 in cash to focus its efforts exclusively on the
development of its Internet properties and strategies. By focusing on delivering
realistic games with high quality graphics, the Company believes it has built
strong brand recognition and consumer loyalty among game enthusiasts.

The Company introduced its first large-scale online multi-player game in
April 1997 following the acquisition of Interactive Creations, Inc. ("ICI").
ICI's WarBirds, an award winning World War II air combat simulation game, has
logged over 2.5 million hours of online game time with players in more than 70
countries.

The Company operates its own Internet-based gaming service, the iEN, where
it currently offers a variety of proprietary large-scale multi-player simulation
games such as WarBirds, Dawn of Aces and ShockForce. The Company currently
offers its online games through monthly subscriptions.

To further expand its customer base and brand recognition, the Company has
entered into a partnership with AOL to provide high-quality, large-scale multi-
player games for AOL's game channel. Raider Wars, scheduled to be launched in
the fourth quarter of 1999, is an online space combat simulation game that
allows hundreds of players to fly different types of spaceships against one
another. The Company also plans to launch Fighter Ops, a simplified, mass-
market version of WarBirds, on AOL's games channel in the fourth quarter of
1999.

The Company is a technological leader within the online gaming industry
with a number of leading edge online and multi-player gaming technologies which
enhance the play value of its games and augment its service capabilities. The
Company's MEGAplayer technology enables the implementation of large-scale multi-
player games on the Internet, allowing over 300 players to play simultaneously
in the same game arena by minimizing latency and addressing problems such as
onscreen "warping". The Company's MEGAvoice technology allows groups of up to
four players to engage in real-time voice communication over the Internet while
playing a game together.

Through its acquisition of MPG-Net in February 1999, the Company has
acquired the ICONS gaming services platform, which enables implementation of the
key elements of a fully-integrated online gaming service. These elements
include real-time chat, player tracking, customer e-mail, e-commerce,
advertising, billing, database management and marketing. The Company's ICONS
platform allows the Company to expand its online offerings from multiple
individual online games to a comprehensive online gaming service incorporating a
variety of community-building features.

Online Gaming Industry

The evolution of the Internet into an accessible, easy-to-use, platform-
independent global network capable of supporting multimedia applications, has
led to the development of online gaming. Online gaming is an emerging market
covering several

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gaming paradigms, including: (i) the electronic distribution of pay-for-play or
subscription-based games and (ii) the implementation of multi-player features on
traditional games with the use of the Internet or on-line services as the wide-
area network connecting physically-distant players.

The Internet and online services present a new platform on which
traditional game publishers and distributors can market, advertise and
distribute their products, whether through direct sales from Web sites or
through sponsoring multi-player on-line tournaments featuring their games. The
ability to compete on-line is an additional product feature that may increase
demand for interactive entertainment software products. The development of the
Internet has also led to the emergence of online gaming services that aggregate
numerous licensed and/or proprietary software titles and online developers that
make their server-based titles exclusively available online. As PC and Internet
access prices continue to decline, these gaming services are attracting a
rapidly growing number of users.

Online gaming presents many distinct advantages for game developers and
publishers over traditional CD-ROM publishing. The online gaming model
eliminates traditional cost of sales such as product packaging, warehousing and
physical distribution, and minimizes distribution issues such as return
allowances and rebates. Online gaming allows for higher margins and encourages
recurring revenues through subscription-based revenue models. Unlike CD-ROM
products which have a limited shelf life, online-only games are often perpetual
products which are continually under development and require continuous updates
and maintenance. Revenue sources in the online gaming model include pay-for-
play fees, subscriptions, e-commerce transaction fees, advertising and direct
merchandising. Online gaming presents more favorable economics, eliminates
distribution channel issues, provides for a larger number of potential revenue
sources and enables the publisher to maintain a more intimate relationship with
its customers.

A 1998 Jupiter Communications report estimates that more than 3.7 million
consumers in the United States are currently playing games over the Internet,
generating revenues of approximately $81 million in 1998, and projects that 26.8
million consumers will generate $1.1 billion in revenues in 2002. These figures
include subscription and pay-for-play revenues generated from online games and
CD-ROM games with an online component, as well as advertising revenues from
online gaming sites. Jupiter expects that by 2002, consumer revenues will
account for $622 million, or 57% of total online gaming revenues. Advertising,
in the form of sponsorships, banners and interstitials, is also expected to
become an important revenue stream for online gaming sites, generating $464
million, or 43% of total online gaming revenues by 2002.

The emerging popularity of online games is evidenced by the increasing
number of industry participants. Two major categories of market participants
have emerged in the online gaming industry: online gaming software developers
and online gaming aggregators.

Online gaming developers offer server-based games directly to consumers
over the Internet or through retail channels involving an upfront charge to the
buyer. These developers also maintain Web sites where they host their games and
match up opponents. Under the online publishing model, game developers publish
server-based titles (typically massively multi-player or "immersive" games)
exclusively for online play and typically sell unlimited usage or time-based
subscriptions to the game, typically ranging from $4.95 to $19.95 a month.

Online gaming aggregators offer a variety of third-party games and related
services and seek to generate revenues through a combination of usage fees
and/or advertising. Online aggregators focus on providing server hosting,
match-making services and tournaments for multi-player games published by third-
parties, as well as community-building services such as chat rooms and bulletin
boards. Typically, these services offer many of the same games on a non-
exclusive basis. Chat accounts for as much as 50 percent of usage on
aggregation sites, as consumers come for games and stay for community.
Furthermore, aggregators seek to enhance their customers' online gaming
experience by minimizing latency for Internet-based games. Latency, or the
length of time it takes to communicate from the host server to the player's
computer, is the most important technical constraint impeding game play on the
Internet. The typical delay on the Internet is of the order of 4/10th of a
second, which significantly affects the quality of multi-player action games. A
majority of the competitors vying for the on-line and Internet gaming market are
focused on multi-player action games which require low latency data links
between the players and the host. Online game networks include Mpath's Mplayer,
America Online's WorldPlay, Microsoft's Internet Gaming Zone, Kesmai's
Gamestorm, Total Entertainment Network ("TEN"), Engage Games Online, SegaSoft's
Heat.Net and Dwango.

Traditional publishers of games for the PC platform are also increasingly
including options for online play in their game software.

As the Internet develops into a popular medium for online gaming,
traditional game publishers, which are primarily focused on retail distribution,
are increasingly using the Internet to directly promote traditional retail
titles by providing free online play on

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their Web sites as an added benefit to retail buyers. According to a study
conducted by Jupiter Communications, by offering free online play, publishers
are able to increase retail sales of their products by 10%-15%.

Online Products

The Company acquired ICI in April 1997 as a vehicle to enter the online
gaming market. ICI had developed and launched a pioneer Internet gaming service
with the online-only game WarBirds. WarBirds has been named "Online Only Game
of the Year" every year since 1996 by PC Games magazine and is recognized as one
of the world's leading real-time large-scale online multi-player games.

The recent acquisition of MPG-Net provides the Company with the ICONS(TM)
fully integrated gaming network platform which seamlessly controls game play,
player tracking, chat, advertising, billing and e-commerce. Using the ICONS
platform, the Company plans to position itself as a leading entertainment
destination on the Web by expanding the scope of its services to include
advertising and e-commerce and enhancing the community-building features of its
gaming networks, such as chat and messaging.

The Company currently operates two online gaming networks, Interactive
Magic Online and AT&T WorldNet's GameHub, and has been contracted by AOL to
provide exclusive online games for AOL's WorldPlay channel. The Company plans
to fully integrate its the Company Online and GameHub gaming sites into a
seamless network of distributed servers and databases which will form the basis
for iEN. The acquisition of MPG-Net and its technology portfolio has enabled
the Company to accelerate the development of its online game service offerings
and to plan the launch of iEN, its fully integrated online gaming service, in
the first quarter of 1999.

iEN

The Company's iEN site currently offers four real-time large-scale online
games, three of which are undergoing pre-release testing. WarBirds, the
Company's only commercially released online game, is available on a subscription
basis with membership to the Interactive Magic Online site. The Company
currently offers players three subscription options on the Interactive Magic
Online site. Users choose to pay $9.95, $19.95 or $29.95 for five, thirteen or
twenty hours, respectively, of game play per month. Users pay an additional
$1.99 for each hour played beyond this subscription allocation. The Company
believes that this pricing plan caters to the needs of a variety of players
ranging from novices to experts and provides players with an incentive for added
game play.

Interactive Magic Online is distinguished by the real-time large-scale
nature of its online games. While a number of multi-player games are available
over the Internet, generally only four, eight or 16 players can play
simultaneously with or against each other. By contrast, large-scale multi-
player games permit a significantly greater number, frequently hundreds, of
simultaneous players. The Company is one of the few online developers that have
the knowledge, skill and experience necessary and are recognized within the
industry for their ability to successfully develop and operate large-scale
online multi-player games.

The Company hosts numerous playing arenas for large-scale multi-player
online games on its highly scalable, redundant and secure high performance
client-server network. This game server network can be expanded and distributed
as needed to accommodate growth in the Company's customer base. The Company
believes that its massively multi-player online games create a gaming experience
that constantly engage the player, presenting fresh challenges. Large-scale
online games are infinitely expandable and can grow organically through regular
development and modification. As such, unlike the mission-oriented or level-
based CD-ROM games, they have a perpetual shelf life. These games present
ongoing submersive play experiences where players can chose to reenter the game
environment at any time, 24 hours a day, seven days a week.

The Company believes that as its massively multi-player games develop a
loyal following, they become ideal environments around which to form
communities. The Company believes that its customers wish to socialize and form
relationships while competing online against one another. Accordingly, the
Company designs its massively multi-player online games to be inherently
conducive to community building by allowing hundreds of people from around the
world to play simultaneously. WarBirds, for example, allows players to fly in
squadrons, participate in organized special events, gain status and build
careers as pilots for their online personas. In addition to playing games, the
Company's customers are given the opportunity participate in a rich social
environment, including chat, competitive tournaments and live event broadcasts.

The Company's iEN game site currently includes the following online titles:

WarBirds, an award winning World War II air combat simulation game,
allows hundreds of players from around the world to simultaneously fly air
combat missions in a single campaign. To date, there have been as many as
[350] WarBirds

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players online at one time. WarBirds combines strategy, realism and
community building to offer players a unique, compelling and engaging
online gaming experience. Players choose to fly for one of four teams,
select an airplane from an array of 50 historically accurate bombers or
fighters and choose a role as a pilot, gunner or bomber. Individual
combatants then engage in dogfights or fly bombing missions over enemy
territories, with the outcome of each individual mission affecting the
outcome of the overall campaign. The incorporation of 3D rolling terrain
graphics, the Company's MEGAvoice technology, which allows groups of up to
four players to engage in real-time voice communication, and the Company's
MEGAplayer technology, which minimizes latency and onscreen "warping", add
to the realism of the playing experience.

WarBirds is played on a continuous basis, allowing players to enter
the game 24 hours a day, seven days a week. WarBirds also incorporates a
number of features that are conducive to community-building: players can
fly in a squadron, participate in organized special events and advance and
build careers as pilots. To encourage recurring play, the Company promotes
the development of communities of regular WarBirds players that participate
in special promotional events such as squadron conferences, conventions and
competitions around the world. WarBirds has been named "Online Only Game
of the Year" every year since 1996 by PC Games and in 1996 and 1997 by
Computer Games/Strategy Plus.

Dawn of Aces, launched in beta version in the third quarter of 1998,
is a WWI air combat simulation game based on the WarBirds engine. Dawn Of
Aces places players in the middle of an ongoing WWI air battle over
Continental Europe and carries a more historic feel than WarBirds. Dawn of
Aces allows players to fly either as Allied (British or French) or Central
(German) pilots, with the goal of helping their side capture enemy
aerodromes and advance front lines. Players can chose their aircraft from
a variety of historically accurate models available to their team and can
change sides in the on-going battle each time they rejoin the game.

Gamehub

GameHub is an AT&T-sponsored and co-branded online gaming service primarily
aimed at AT&T WorldNet's 1.4 million subscribers. AT&T WorldNet has begun
marketing GameHub to its subscribers as a premium service option included with
their subscription.

GameHub complements the Company's online gaming strategy by expanding the
Company's network of player communities. The GameHub site offers consumers a mix
of free and pay-per-play games in all categories, including strategy, role-
playing, simulation, action and parlor games. GameHub will charge for premium
games exclusively available through the Company's sites, including WarBirds,
Dawn of Aces and Shockforce. In addition to games, GameHub will offer chat
rooms, forums and shopping areas. The Company expects GameHub to generate
revenue from AT&T subscription fees, premium game subscriptions, e-commerce and
advertising.

The following MPG-Net games are currently offered on the GameHub site:

The Kingdoms of Drakkar is a large-scale multi-player fantasy
adventure role playing game where players choose characters, develop
skills, and team with other players to explore fantasy lands using magical
weapons and spells. The Kingdoms of Drakkar is a premium game on the
GameHub site.

Drakkar II is an advanced version of The Kingdoms of Drakkar role
playing game which is currently in pre-release testing. Drakkar II
features improved graphics and an overall enhanced gaming experience over
the original title.

GameHub also offers traditional parlor-style games developed by MPG-Net
such as Chess, Checkers, Tic Tac Toe, Backgammon, Bingo, and Wari (based on the
African board game). The Company plans to add the full roster of online games
available on the Company Online to its GameHub offerings and has begun hosting
other publishers' popular titles on the GameHub site. Third-party titles
currently available on GameHub include Unreal and Total Annihilation by GT
Interactive, Quake World and Quake II by id Software and Forsaken by Acclaim.

America Online

The Company announced an online distribution relationship with AOL, the
world's leading online services company, in October 1998. Under this agreement,
the Company will receive royalties from AOL in exchange for contributing two
exclusive online games to AOL's games channel.

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iEN

Beginning in the first quarter of 1999, the Company plans to fully
integrate its Company Online and GameHub gaming sites into a seamless network of
distributed servers and databases which will form the basis for iEN. The
Company's branded and private label online gaming sites will serve as gateways
to iEN. With the introduction of iEN, the Company plans to shift to a three-
tier service structure in order to expand its user base and build a successful
mainstream online entertainment service:

The first tier of the Company's services will consist of free entertainment
in the form of chat, messaging and online parlor games such as chess, checkers,
Poker, Hearts, Spades, Bingo and backgammon to attract a large user audience to
the Company's site. Following the lead of major Internet portals which have
used free services to aggregate large communities of online users, the Company
plans to offer these online gaming services free of charge in order to build a
large and loyal customer base.

The Company's second tier of services will consist of subscription-based
access to more traditional action, simulation and strategy games and related
services. The Company will also host multi-player arenas for a variety of
popular Internet-enabled CD-ROM titles published by the Company and third-party
publishers. Additional services will include tournament play with rankings,
contests, special events and prizes. Players will be charged $9.95 per month
for unlimited usage of these services.

The third-tier of the Company's services will target avid gamers. In
addition to all of the services included in the second-tier, the third tier will
offer the most sophisticated online only games on a pay-per-play basis,
including massively multi-player games such as WarBirds and Dawn of Aces. These
games will only include titles that are differentiated enough from generic
online gaming offerings to warrant premium pricing. The Company plans to offer
hourly, daily and monthly game time purchases.

The Company plans to expand the community-orientation of its services by
providing feature-rich, easy-to-use chat and messaging services which enhance
the social experience of playing the Company's broad offering of free,
subscription-based and pay-per-play games. The Company believes that these chat
rooms and messaging services will encourage player congregation at its sites and
facilitate social interaction and player matching for multi-player games. These
chat and messaging services will be enhanced in 1999 with the introduction of
the Company's new Internet voice technology for chat rooms, messaging and voice-
enabled games. To support these free services, the Company will leverage its
Web traffic and draw revenue from advertising, sponsorship and e-commerce
offerings. The Company will launch an online store which will sell both the
Company and third-party products and will introduce interstitial and banner
advertising throughout the Company site.

CD-ROM Products

In June 1999, the Company sold the retail CD-ROM portion of its business
for $2,500,000 in cash to focus its efforts exclusively on the development of
its Internet properties and strategies.

Marketing

The Company's online marketing focuses on strategies for increasing
recurring revenues from the current customer base while recruiting new
customers. The Company seeks to increase revenues from its current customer
base through community building programs such as regular e-mail information
updates, sponsorship of online events, contests and conventions attended by
subscribers. For example, the Company is promoting the development of
"communities" of regular WarBirds flyers that participate in special promotional
events, such as squadron conferences, conventions and competitions around the
world. To date, over 200 of these informal squadrons or communities exist. In
addition, the Company is committed to providing extensive technical support to
its customers. The Company believes that as a result of these efforts, it has
developed significant customer loyalty, encouraging long term customer game
play.

The Company has begun developing distribution partnerships with ISPs as a
means of marketing its online games. Beginning in December 1998, GTE's new
dial-up and ADSL customers are being offered WarBirds software as part of their
introductory service package.

Technology

The Company has developed proprietary technologies that create an enhanced
gaming experience for the user and enable the Company to create highly realistic
games. The Company has filed a patent application on its MEGAplayer technology,
which minimizes latency and addresses problems such as "warping", which is
inherent in high and variable latency networks such as the

28
<PAGE>

Internet. The Company also has developed its MEGAvoice technology, which allows
groups of up to four players to engage in real-time voice communication over the
Internet while playing the Company's games. This technology utilizes bandwidth
efficiently while limiting any impact on latency and networked game play. In
1999, the Company plans to launch new Internet voice technology which will
further enhance the chat features of its online gaming sites.

As part of the MPG-NET acquisition, the Company obtained the ICONS online
gaming platform which provides features such as player tracking, chat, messaging
and billing and enables advertising and e-commerce. The acquisition of MPG-
Net's ICONS software technology enables the Company to expand its online
offering from multiple individual online games to a comprehensive online gaming
service incorporating a variety of community-building features. The ICONS
system involves the use of trained systems operators available online within the
Company services to offer tours, answer questions and to generally assist both
new visitors and service members with the utilization of services and the
purchase of various products, games and game-related merchandise.

Product Development

While the development cycle for new CD ROM products ranges from 6 to 24
months, the development cycle for new online products is continuous throughout
the life of the product. Generally, each new internally developed product
begins as brief design document proposed by the Company's internal development
staff. Following management approval, the product's designer drafts a detailed
product design specification, programmers develop the software design and create
a schedule based on that design, and artists develop storyboards and the art
production schedule. The Company then develops the overall project schedule and
budget, including a scheduled release date and a marketing and sales plan.

The Company typically reviews externally developed products in various
stages of development, and, once the Company has selected and contracted for a
product, the Company's product development staff then manages the product
development process with the external developer in a manner similar to the
Company's internal development process.

Throughout the development phase of each product, whether internally or
externally developed, the Company implements a number of quality control
procedures. The software is carefully designed, implemented and tested by the
programmers, followed by frequent testing releases. Each product is played and
critiqued by the Company's in-house playtest staff and other Company employees.
Products are then submitted to groups of up to 50 external playtesters. This
product test process reduces implementation defects and provides design and
playability feedback in a timely manner for incorporation in the finished
product.

Properties

The Company leases approximately 15,000 square feet in an office park in
Morrisville, North Carolina. The lease is noncancellable and expires in May
2001. All of the Company's United States and Corporate operations are conducted
from this facility. The Company also leases space for its offices in the United
Kingdom and Germany.

Legal Proceedings

The Company is not currently a party to any material pending legal
proceeding.

29
<PAGE>

DIRECTORS AND EXECUTIVE OFFICERS

Current Directors

The following table sets forth information regarding the Directors of the
Company:

<TABLE>
<CAPTION>
Year First
Elected As Term
Name Director Expires Age
- -----------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
J.W. Stealey (2) 1995 1999 50
- -----------------------------------------------------------------------------------------------------
J. Nicholas England (1) 1997 1999 50
- -----------------------------------------------------------------------------------------------------
David H. Kestel (2) 1997 1999 65
- -----------------------------------------------------------------------------------------------------
W. Joseph McClelland (1) (2) 1997 1999 52
- -----------------------------------------------------------------------------------------------------

- -----------------------------------------------------------------------------------------------------
(1) Member of Audit Committee
- -----------------------------------------------------------------------------------------------------
(2) Member of Compensation Committee
- -----------------------------------------------------------------------------------------------------
</TABLE>

The current executive officers of the Company are as follows:

<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------
Name Office Officer Since
- -----------------------------------------------------------------------------------------------------
<S> <C> <C>
J.W. Stealey Chairman of the Board of Directors and Chief 1995
Executive Officer
- -----------------------------------------------------------------------------------------------------
Carl L. Linke Vice President-Operations 1998
- -----------------------------------------------------------------------------------------------------
Michael W. Oliver Chief Financial Officer, Secretary and Treasurer 1999
- -----------------------------------------------------------------------------------------------------
Joseph Rutledge Senior Vice President-Technology 1995
- -----------------------------------------------------------------------------------------------------
Raymond Rutledge Vice President-Licensing 1995
- -----------------------------------------------------------------------------------------------------
</TABLE>

Biographies of the Directors and Executive Officers

J. W. Stealey has been Chairman of the Board of Directors and Chief Executive
Officer of the Company since January 1995. Previously, he was founder, Chairman
and Chief Executive Officer of MicroProse, Inc., a developer and publisher of
flight simulation and strategy software titles from 1982 to 1993. Prior to 1982,
Mr. Stealey was Group Director of Business Development of General Instruments.
Prior to joining General Instruments Corporation, Mr. Stealey held management
consulting positions with Cresap, McCormick and Paget and McKinsey & Co. in New
York, New York. Mr. Stealey earned a B.S. degree in Aeronautical Engineering
from the United States Air Force Academy. After graduation from the Academy, Mr.
Stealey spent six years as an operational pilot in the United States Air Force.
Mr. Stealey also received an M.B.A. in finance and strategic management from the
Wharton School of Business of the University of Pennsylvania.

J. Nicholas England has served as a Director of the Company since February 1997.
Since 1993, Mr. England has been a Research Professor in the Department of
Computer Science at the University of North Carolina at Chapel Hill. From 1987
to 1993, he worked as Director of Product Development for advanced graphics,
imaging and visualization hardware and software for Sun Microsystems, Inc.
Previously, Mr. England founded two computer graphics companies. Mr. England is
a Director of Numerical Design Limited in Chapel Hill, North Carolina, a private
software company. He received a B.S. in Electrical Engineering from North
Carolina State University.

David H. Kestel, CLU, has served as a Director of the Company since February
1997. Since 1992, Mr. Kestel has served as President of The Kestel Group, Inc.,
an estate planning, executive compensation and employee benefits company based
in Potomac, Maryland. From 1978 to 1992, he worked at Blue Cross and Blue Shield
of the National Capital Area, most recently as Senior Vice President, Marketing,
and served as President of two domestic life insurance companies and two
offshore reinsurance companies. Mr. Kestel received a B.B.A. and an M.B.A. from
the University of Michigan. Mr. Kestel is a Member, Chartered Life Underwriter.

W. Joseph McClelland has served as a Director of the Company since February
1997. Since 1990, Mr. McClelland has been Vice

30
<PAGE>

President and a Member of the Board of GEC-Marconi Defense Systems Inc., an
Arlington, Virginia-based subsidiary of GEC-Marconi Ltd., which produces and
sells electronic warfare equipment to government customers. From 1988 to 1990,
he was Director, Avionics, Armament and Electronic Combat, at the HQ United
States Air Force Systems Command at Andrews Air Force Base in Maryland, where he
supervised headquarters staff and provided corporate oversight of advanced
programs. From 1986 to 1988, he was Director, United States Air Force Research
and Development Liaison Office in London, England, where he initiated and
managed U.S./U.K. cooperative research and development programs. Mr. McClelland
received a B.S. in Engineering Mechanics and Mathematics from the United States
Air Force Academy. He received an M.S. in Applied Mechanics from the University
of Utah. Mr. McClelland is a graduate of the United States Air Force Test Pilot
School.

Avi Suriel has served as a Director of the Company since February 1998. Since
1996, Mr. Suriel has been a Director of Vertical Financial Holdings, a European-
based merchant banking firm focusing primarily on investments in the high
technology industry. From 1993 to 1996, Mr. Suriel was a Director in the
Investment Banking Division of Salomon Smith Barney. From 1990 to 1993, he was a
Senior Associate in the Fixed Income Division at Morgan Stanley & Co.
Incorporated. From 1988 to 1990, he was a Research Analyst in the Fixed Income
Division at Merrill Lynch, Pierce, Fenner & Smith. Mr. Suriel also provides
consulting services as a principal of Suriel Financial Consulting, which he
founded. Mr. Suriel received a B.A. degree in Economics and International
Relations from Hebrew University, Israel, and an M.B.A. in Finance from Fordham
University.

Carl E. Linke has been Vice President of Operations since October 1998. Prior to
joining the Company, Mr. Linke was responsible for the opening and operations of
an office of Academy Graduates Executive Search, a personnel search boutique
focused on former officers from the Nation's military forces. From 1990 to 1995
Mr. Linke served as Vice President of Operations for two software related
companies in the Chicago area. For over twenty years Mr. Linke was an officer in
the United States Army serving in operations positions and unit commands. He
completed his service as a Lieutenant Colonel. Mr. Linke received a B.S. degree
in Engineering from the United States Military Academy in 1970 and a Master of
Science degree in Industrial Relations from the Krannert School of Management at
Purdue University in 1977.

Michael W. Oliver was appointed Chief Financial Officer, Secretary and Treasurer
effective January 1, 1999. Mr. Oliver was President of The Oliver Group from
October 1997 to December, 1998. He was Treasurer of Reichhold Chemicals, Inc.
from July 1990 to September 1997. He was Executive Vice President and Chief
Financial Officer of The Harris Organization from January 1988 to June 1990; and
Controller-Natural Resources of Eastern Enterprises from November 1979 to
December 1987. Mr. Oliver received his B.A. in Economics from the University of
Pittsburgh at Johnstown in 1975 and his M.B.A. from the Katz School of Business
in 1977.

Joseph Rutledge has been Senior Vice President of Development for the Company
since September 1994. Mr. Rutledge oversees the Company's internal software
development activities. Prior to joining the Company, Mr. Rutledge founded and
operated JR Associates, a private software consulting company which designed
multimedia and "edutainment" products. From 1978 to 1994, Mr. Rutledge served as
a technical systems consultant for Honeywell Inc., McDonnell Douglas Corp. and
other defense technology companies. Mr. Rutledge is a graduate of the University
of Pittsburgh with a B.S. degree in Mathematics. Mr. Rutledge is the brother of
Raymond Rutledge.

Raymond Rutledge has served as the Company's Vice President of Licensing since
February 1995. Mr. Rutledge oversees product development from external sources.
From 1993 to 1995, Mr. Rutledge served as Vice President of Development for
MicroProse, Inc., where he was responsible for overseeing development of hit
releases such as F-15 Strike Eagle III, F-14 Fleet Defender, 1942 Pacific Air
War and Ultimate Football. From 1988 to 1992, Mr. Rutledge served as Executive
Vice President of RJO Enterprises, Inc., a systems engineering and software
company. Mr. Rutledge graduated from the University of Pittsburgh with a B.S.
degree in Electrical Engineering. He also earned a master's degree in Computer
Science from Adelphi University. Mr. Rutledge is the brother of Joseph Rutledge.

31
<PAGE>

EXECUTIVE COMPENSATION

<TABLE>
<CAPTION>
Other Restricted
Annual Stock
Name and Principal Position Year Salary $ Bonus $(1) Compensation Awards
<S> <C> <C> <C> <C> <C>
J.W. Stealey 1998 170,742 - 14,306(2) (3)
Chairman of the Board and 1997 160,000 - 16,832(2) (3)
Chief Executive Officer 1996 150,000 - 16,760(2) (3)

Robert L. Pickens 1998 138,750 20,000 7,215(2) (3)
President (4) 1997 114,000 - 5,071(2) (3)
1996 122,124 - 3,454(2) (3)

Joseph Rutledge 1998 125,000 12,508 - (3)
Senior Vice President 1997 93,000 - - (3)
Technology 1996 92,000 - - (3)

Raymond Rutledge 1998 120,000 24,396 - (3)
Vice President Licensing 1997 93,000 - - (3)
1996 92,000 - - (3)

Douglas B. Kubel 1998 120,000 14,746 - (3)
Vice President (5) 1997 93,000 - - (3)
1996 92,000 - - (3)
Stock Options Granted During 1998
</TABLE>

(1) Amount paid during year, earned in prior year
(2) Use of Company auto and country club expenses
(3) None awarded
(4) Mr. Pickens resigned as President effective October 23,1998.
(5) Mr. Kubel resigned as Vice President effective March 15, 1999.

Stock Options Granted During 1998

Number % of Total Potential Realizable Value at
Of Securities Options Assumed Annual Rates of Stock
Underlying Granted to Exercise or Price Appreciation for the
Options Employees in Base Price Expiration Option Term/(2)/
Name Granted Fiscal Year (1) ($ / Share) Date 5% 10%
<S> <C> <C> <C> <C> <C> <C>
Douglas Kubel 30,000 6% $4.1250 10/8/03 $ 77,826 $197,226
Carl Linke 100,000 21% $4.2500 10/7/03 $267,280 $677,341
Joseph Rutledge 50,000 10% $4.1250 10/8/03 $129,710 $328,709
Raymond Rutldge 50,000 10% $4.1250 10/8/03 $129,710 $328,709
J.W. Stealey 50,000 10% $4.1250 10/8/03 $129,710 $328,709
</TABLE>

(1) Based upon 484,750 total options granted under the 1998 Stock Option Plan.
(2) The compounding assumes a 10-year exercise period for all option grants.
These amounts represent certain assumed rates of appreciation only. Actual
gains, if any, on stock option exercises are dependent on the future
performance of the Common Stock and overall stock market conditions. The
amounts reflected in this table may not be necessarily achieved.

No options were exercised by the Named Officers during 1998. The following table
sets forth certain information concerning the number and value of unexercised
options held by the Named Officers as of December 31, 1998:

Number of Securities Value of Unexercised
Underlying Unexercised Options at In-the-Money Options
December 31, 1998 at December 31, 1998/(1)/
- ---------------------------------- --------------------------

32
<PAGE>

<TABLE>
<CAPTION>
Excercisable Unexercisable Excercisable Unexercisable
Name
<S> <C> <C> <C> <C>
Douglas Kubel 97,554 82,446 $270,391 $160,829
Carl Linke 0 100,000 - $ 3,100
Robert Pickens 62,813 64,687 $206,089 $212,238
Joseph Rutledge 138,125 111,875 $453,188 $210,812
Raymond Rutledge 124,938 105,062 $409,921 $188,458
J.W. Stealey 37,500 243,750 $123,038 $643,494
</TABLE>

(1) Options are considered in-the-money if the market value of shares covered
thereby is greater than the option exercise price. Value is calculated
based on the difference between the fair market value of the shares of
Common Stock at December 31, 1998 ($4.28), as quoted on the Nasdaq Stock
Market, and the exercise price of the options.

33
<PAGE>

CERTAIN TRANSACTIONS

The Company, Mr. Stealey and Mr. Pickens are parties to a January 3, 1995
Stock Purchase and Stockholder Agreement (the "Co-Sale Agreement"). The Co-Sale
Agreement grants Mr. Pickens a co-sale right to participate in any transfer of
shares of Common Stock by Mr. Stealey on the same terms and conditions as
offered to the third party by Mr. Stealey. The co-sale right entitles Mr.
Pickens to participate in such transfer in the same proportion to the number of
shares to be sold by Mr. Stealey that the number of shares of Common Stock owned
by Mr. Pickens prior to the transfer bears to the number of shares of Common
Stock owned by Mr. Stealey prior to the transfer. Mr. Pickens resigned from his
position as President of the Company in October 1998.

The Company has also entered into a marketing agreement, dated January 3,
1995, with Mr. Stealey, pursuant to which Mr. Stealey makes his T-28 Trojan
aircraft and his services as a pilot available to the Company in consideration
for which the Company pays all of the expenses to store, operate and maintain
such aircraft and to maintain Mr. Stealey's pilot license.

On March 6, 1995, the Company issued a demand Promissory Note to Mr.
Pickens in the principal amount of $600,000 at an annual interest rate of 12%,
which increased to 14% on June 30, 1996 because the balance thereunder exceeded
$400,000 on that date. In consideration of this loan, the Company issued
warrants to Mr. Pickens to purchase 13,845 shares of Common Stock at an exercise
price of $1.00 per share. In connection with the Company's Series B Preferred
Stock financing, Mr. Pickens, on February 4, 1998, converted the outstanding
principal of $600,000 into 132,744 shares of Series C Preferred Stock, which
shares will be converted into 132,744 shares of Common Stock in connection with
the Recapitalization. Also in connection with the Recapitalization, Mr. Pickens
has forgiven $50,000 of the accrued interest outstanding in connection with this
loan in payment of the $1.00 per share exercise price of his 50,000
Recapitalization Options. The Company paid Mr. Pickens $111,421 of the remaining
$183,864 in accrued interest due to him under this loan upon the consummation of
the Company's initial public offering in July 1998.

On April 11, 1995, the Company entered into a joint development agreement
with NDL for the development of the Company's DEMON technology. J. Nicholas
England, a director of the Company, is a director of NDL. To date, the Company
has paid $322,500 to NDL for the rights to the technology which includes amounts
paid pursuant to a royalty of 1% of net sales based on products that incorporate
the DEMON technology.

On December 4, 1995, the Company entered into a leasehold agreement with
Southport Business Park Limited Partnership ("Southport") for the Company's
principal executive offices located at 215 Southport Drive in Morrisville, North
Carolina. The term of the lease is for a period of five years commencing April
1, 1996 at a monthly rent of $13,962, subject to adjustment in certain
circumstances. J. W. Stealey has executed a personal guarantee in favor of
Southport in connection with the leasehold agreement.

Since the Company's inception, Mr. Stealey has executed several personal
guaranties and pledges of personal collateral in favor of BB&T, one of the
Company's primary bank creditors, in connection with revolving and term loans
extended by BB&T to the Company. On January 24, 1997, the Company issued a
$2,500,000 Promissory Note to BB&T secured by Mr. Stealey's guarantee and pledge
of collateral. The January 24, 1997 note has been paid in full, and Mr.
Stealey's guarantee and pledge in respect thereof have been extinguished. On
August 25, 1997, the Company issued a $2,750,000 Promissory Note to BB&T secured
by Mr. Stealey's guarantee and pledge of collateral in replacement of the
January 24, 1997 note. On November 25, 1997, the Company issued a $250,000
Promissory Note to BB&T secured by Mr. Stealey's guarantee and pledge of
collateral. The November 25, 1997 note has been paid in full, and Mr. Stealey's
guarantee and pledge in respect thereof have been extinguished. On March 27,
1998, the Company issued a $250,000 Promissory Note to BB&T secured by Mr.
Stealey's guarantee and pledge of collateral. In connection with his guaranties
to BB&T, the Company is obligated to pay Mr. Stealey a fee equal to 6% per annum
of the indebtedness borrowed. As of March 31, 1998, the Company owed Mr. Stealey
an aggregate of $144,385 in consideration of his guaranties to BB&T.

On May 20, 1996, the Company issued a Promissory Note to Mr. Stealey in the
principal amount of $1,000,000, payable on November 17, 1996, with interest at
the annual rate of 15%, increasing to 17% if the Company did not repay Mr.
Stealey by November 17, 1996. In connection with this loan, the Company issued
warrants to Mr. Stealey to purchase 25,000 shares of Common Stock at a price of
$2.00 per share. Under the original terms of the note, if the note was not
repaid by November 17, 1996, the Company was obligated to issue additional
warrants to Mr. Stealey to purchase 25,000 shares of Common Stock per 180 days
prorated over the time until repayment occurred. On March 20, 1997, in
connection with a loan to the Company made by Petra, Mr. Stealey waived his
right under the note to accrue additional warrants after November 16, 1997. On
February 4, 1998, in connection with the Company's Series B Preferred Stock
financing, Mr. Stealey converted the $1,000,000 principal outstanding under the
May 20, 1996 note into 221,239 shares of Common Stock. [In connection with the
recapitalization effected in connection with the Company's initial public
offering in July 1998 (the "Recapitalization"), Mr. Stealey has forgiven
$268,750 of the accrued interest outstanding under this note in payment of the
$1.00 per share exercise price of his 268,750 Recapitalization options.

34
<PAGE>

On July 10, 1996, the Company issued a Promissory Note to Mr. Stealey in
the principal amount of $1,000,000, payable on January 6, 1997, with interest at
the annual rate of 15%, increasing to 17% if the Company did not repay Mr.
Stealey by January 6, 1997. In connection with this loan, the Company issued
warrants to Mr. Stealey to purchase 50,000 shares of Common Stock at a price of
$6.00 per share. Under the original terms of the note, if the note was not
repaid by January 6, 1997, the Company was obligated to issue additional
warrants to Mr. Stealey to purchase 250,000 shares of Common Stock per 180 days
prorated over the time until repayment occurred. On March 20, 1997, in
connection with a loan to the Company by Petra, Mr. Stealey waived his right
under the note to accrue additional warrants after January 6, 1998. On February
4, 1998, in connection with the Company's Series B Preferred Stock financing,
Mr. Stealey converted the $1,000,000 principal outstanding under the July 10,
1996 note into 221,239 shares of Common Stock. The Company paid Mr. Stealey
$234,729 accrued interest due to him in connection with the loan upon
consummation of the Company's initial public offering.

The Company has borrowed approximately $870,000 from Laura M. Stealey, the
former wife of Mr. Stealey, under a $1,000,000 credit line established by Ms.
Stealey in favor of the Company, which is guaranteed by Mr. Stealey, pursuant to
a Letter Agreement dated October 31, 1996. In consideration of the credit line,
the Company granted to Ms. Stealey a warrant exercisable for 14,948 shares of
Common Stock at a purchase price of $5.82 per share. On March 24, 1997, in
connection with a loan to the Company by Petra, Ms. Stealey waived her right to
convert debt under the credit line into shares of the Company's Common Stock.
The Company repaid the entire principal amount, plus the $117,175 in accrued
interest thereon through March 31, 1998, of this credit line upon the
consummation of the Company's initial public offering.

On February 4, 1998, Vertical Financial Holdings, Suriel Financial
Consulting and several other investors purchased an aggregate of 778,746 shares
of the Company's Series B Preferred Stock for $3,500,000. Mr. Suriel, a director
of the Company, is a Director of Vertical Financial Holdings and founder and a
principal of Suriel Financial Consulting. All of the Series B Preferred Stock
investors have signed a proxy agreement with Vertical Financial Holdings
granting Vertical Financial Holdings voting rights with respect to their shares.
In connection with the Recapitalization, the 778,746 shares of Series B
Preferred Stock converted into 2,045,649 shares of Common Stock.

The Company and General Capital, an affiliate of Vertical Financial
Holdings, have also signed a Marketing Agreement dated February 4, 1998,
pursuant to which the Company is obligated to pay $400,000 to General Capital
for marketing services when the Company's shareholders' equity equals or exceeds
$5,000,000. The Company satisfied such obligation upon the consummation of the
Company's initial public offering.

35
<PAGE>

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The following table sets forth the only shareholders known by the Company to be
the beneficial owners, as of March 31, 1999, of more than five percent (5%) of
the outstanding shares of the Company:

<TABLE>
<CAPTION>
Name and Address Shares Beneficially Owned Percent of Shares Outstanding (1)
<S> <C> <C>
J.W. Stealey 2,725,617 (2) 25.5%
215 Southport Drive
Morrisville, NC 27560

Vertical Financial Holdings 2,045,649 (3) 19.1%
Hambrechtikerstrasse 61
Ch-8640 Rapperswil
Switzerland
</TABLE>

(1) Based on 10,690,183 shares outstanding
(2) Includes 50,000 shares subject to options and 236,389 shares subject to
warrants. Excludes 600,000 shares held in trusts for Mr. Stealey's children over
which Mr. David Kestel is the trustee. Mr. Stealey has neither voting power nor
dispositive power over the shares held in the trusts. Mr. Stealey disclaims
beneficial ownership of the shares held in the trusts.
(3) Includes 427,394 shares owned by entities beneficially owned by Vertical
Financial Holdings and 1,220,084 shares owned by other entities over which
Vertical Financial Holdings has voting power pursuant to a proxy agreement.

The table below gives the number of shares of Common Stock of the Company
beneficially owned as of March 31, 1999 by persons who were members of the Board
and executive officers of the Company during 1998.

<TABLE>
<CAPTION>
Name and Position Shares Beneficially Owned Percent of Shares Outstanding (1)
<S> <C> <C>
J.W. Stealey 2,725,617 (2) 25.5%
Chairman of the Board and
Chief Executive Officer

Robert L. Pickens 300,401 (4) 2.8%
President (3)

Joseph Rutledge 151,038 (5) 1.4%
Vice President

Raymond Rutledge 138,831 (6) 1.3%
Vice President

Doug Kubel 187,582 (8) 1.8%
Vice President (7)

J. Nicholas England 41,000 (9) 0.4%
Director

David H. Kestel 41,000 (9) 0.4%
Director

W. Joseph McClelland 41,000 (9) 0.4%
Director

</TABLE>

36
<PAGE>

Director

(1) Based on 10,690,183 shares outstanding.
(2) Includes 50,000 shares subject to options and 236,389 shares subject to
warrants. Excludes 600,000 shares held in trusts for Mr. Stealey's children over
which Mr. David Kestel is the trustee. Mr. Stealey has neither voting power nor
dispositive power over the shares held in the trusts. Mr. Stealey disclaims
beneficial ownership of the shares held in the trusts.
(3) Mr. Pickens resigned as President effective October 23,1998.
(4) Includes 62,813 shares subject to options and 13,845 subject to warrants.
(5) Includes 144,375 shares subject to options.
(6) Includes 129,625 shares subject to options.
(7) Mr. Kubel resigned as Vice President effective March 15, 1999.
(8) Includes 180,000 shares subject to options.
(9) Includes 41,000 shares subject to warrants.

37
<PAGE>

SELLING SECURITY HOLDERS

The following table sets forth certain information regarding the beneficial
ownership of common stock by the Selling Stockholder as of July 30, 1999, and
the number of shares of common stock covered by this Prospectus:

<TABLE>
<CAPTION>
Beneficial Ownership Beneficial Ownership
Prior to Offering (1) After Offering(2)
-------------------------- -------------------------
Name and Address Number Percent Number of Shares Number Percent
of Selling Stockholder of Shares of Class Offered Hereby(1) of Shares of Class
- ---------------------- ---------- -------- ----------------- ---------- -------
<S> <C> <C> <C> <C> <C>
RGC International Investors, LDC 2,119,889 19.99% 2,119,889 -- --
c/o Rose Glen Capital
Management, LP
Three Bala Plaza East, Suite 200
251 St. Asaphs Road
Bala Cynwyd, PA 19004
</TABLE>

_______________________________________
(1) The number of shares set forth in the table represents the maximum number of
shares of common stock which may be issued by the Company upon conversion of
the Convertible Note and exercise of the Warrants without obtaining
shareholder approval as required by Nasdaq marketplace rules (the "Maximum
Share Limitation"). The actual number of shares of common stock issuable
upon conversion of the Convertible Note and exercise of the Warrants is
indeterminate, is subject to adjustment and could be materially less or more
than such number depending on factors which cannot be predicted by the
Company at this time, including, among other factors, the future market
price of the common stock. The actual number of shares of common stock
offered hereby, and included in the Registration Statement of which this
Prospectus is a part, includes such additional number of shares of common
stock as may be issued or issuable upon conversion of the Note and exercise
of the Warrants by reason of any stock split, stock dividend or similar
transaction involving the common stock, in accordance with Rule 416 under
the Securities Act. Pursuant to the terms of the Convertible Note, if the
Convertible Note had been actually converted on July 30, 1999, the
conversion price would have been approximately $1.75 (85% of the average of
the lowest closing bid prices of the Common Stock reported on the Nasdaq
National Market on any two trading days during the 22 consecutive trading
day period ending on the trading day immediately preceding such date). At
that price and without giving effect to the Maximum Share Limitation, the
Convertible Note would be convertable into approximately 2,281,640 shares of
common stock. No warrants would have been issued in connection with such
conversion. Pursuant to the terms of the Convertible Note and the Warrants,
the Convertible Note is convertible and the Warrants are exercisable by any
holder only to the extent that the number of shares of Common Stock thereby
issuable, together with the number of shares of common stock owned by such
holder and its affiliates (but not including shares of common stock
underlying the unconverted portion of the Convertible Note or unexercised
portions of the Warrants) would not exceed 4.99% of the then outstanding
common stock as determined in accordance with Section 13(d) of the Exchange
Act. Accordingly, the number of shares of common stock set forth in the
table for this Selling Stockholder exceeds the number of shares of common
stock that this Selling Stockholder could own beneficially at any given time
through its ownership of the Convertible Note. In that regard, beneficial
ownership of this Selling Stockholder set forth in the table is not
determined in accordance with Rule 13d-3 under the Exchange Act.

(2) Assumes the sale of all shares offered hereby.

38
<PAGE>

PLAN OF DISTRIBUTION

The shares of common stock (the "Shares") being offered by the Selling
Stockholder or its respective pledgees, donees, transferees or other successors
in interest, will be sold from time to time in one or more transactions (which
may involve block transactions) on the Nasdaq National Market or on such other
market on which the common stock may from time to time be trading, in privately-
negotiated transactions, through the writing of options on the Shares, short
sales or any combination thereof. The sale price to the public may be the market
price prevailing at the time of sale, a price related to such prevailing market
price, at negotiated prices or such other price as the Selling Stockholder
determines from time to time. The Shares may also be sold pursuant to Rule 144.
The Selling Stockholder shall have the sole and absolute discretion not to
accept any purchase offer or make any sale of Shares if it deems the purchase
price to be unsatisfactory at any particular time.

The Selling Stockholder or its respective pledgees, donees, transferees or
other successors in interest, may also sell the Shares directly to market makers
acting as principals and/or broker-dealers acting as agents for themselves or
their customers. Such broker-dealers may receive compensation in the form of
discounts, concessions or commissions from the Selling Stockholder and/or the
purchasers of Shares for whom such broker-dealers may act as agents or to whom
they sell as principal or both (which compensation as to a particular broker-
dealer might be in excess of customary commissions). Market makers and block
purchasers purchasing the Shares will do so for their own account and at their
own risk. It is possible that a Selling Stockholder will attempt to sell shares
of common stock in block transactions to market makers or other purchasers at a
price per share which may be below the then market price. There can be no
assurance that all or any of the Shares offered hereby will be issued to, or
sold by, the Selling Stockholder. The Selling Stockholder and any brokers,
dealers or agents, upon effecting the sale of any of the Shares offered hereby,
may be deemed "underwriters" as that term is defined under the Securities Act or
the Exchange Act, or the rules and regulations thereunder.

The Selling Stockholder, alternatively, may sell all or any part of the
Shares offered hereby through an underwriter. The Selling Stockholder has not
entered into any agreement with a prospective underwriter and there is no
assurance that any such agreement will be entered into. If the Selling
Stockholder enters into such an agreement or agreements, the relevant details
will be set forth in a supplement or revisions to this Prospectus.

The Selling Stockholder and any other persons participating in the sale or
distribution of the Shares will be subject to applicable provisions of the
Exchange Act and the rules and regulations thereunder, including, without
limitation, Regulation M, which provisions may restrict certain activities of,
and limit the timing of purchases and sales of any of the Shares by the Selling
Stockholder or any other such person. Furthermore, under Regulation M, persons
engaged in a distribution of securities are prohibited from simultaneously
engaging in market making and certain other activities with respect to such
securities for a specified period of time prior to the commencement of such
distributions, subject to specified exceptions or exemptions. The foregoing may
affect the marketability of the Shares.

The Company has agreed to indemnify the Selling Stockholder, or its transferees
or assignees, against certain liabilities, including liabilities under the
Securities Act, or to contribute to payments the Selling Stockholder or its
respective pledgees, donees, transferees or other successors in interest, may be
required to make in respect thereof.

DESCRIPTION OF SECURITIES

Common Stock

As of the date of this Prospectus, the Company has authorized 50,000,000
shares of Common Stock, $.10 par value per share. As of the date of this
Prospectus, 10,690,183 shares of Common Stock were issued and outstanding and
held of record by approximately 200 shareholders. Holders of Common Stock are
entitled to one vote for each share held on matters which are submitted to a
vote of shareholders and are not entitled to cumulative voting in the election
of directors. Subject to any preferential rights of holders of Preferred Stock,
holders of Common Stock are entitled to receive dividends, if any, as declared
from time to time by the Board of Directors out of assets legally available for
such purpose. On liquidation, holders of Common Stock are entitled to a pro rata
portion of all assets available for distribution after payment of creditors and
the liquidation preference of any outstanding shares of Preferred Stock. Holders
of Common Stock have no preemptive rights or other rights to subscribe for
additional shares. All outstanding shares of Common Stock are, and the shares
offered hereby will be, upon issuance, validly issued, fully paid and non-
assessable.

Preferred Stock

39
<PAGE>

As of the date of this Prospectus, the Company has authorized 25,000,000
shares of Preferred Stock, $.10 par value per share, and (giving effect to the
Recapitalization) there are no shares of Preferred Stock outstanding. The
Company may issue shares of Preferred Stock in one or more series as may be
determined by the Company's Board of Directors, who may establish, from time to
time, the number of shares to be included in each series, may fix the
designation, powers, preferences and rights of the shares of each such series
and any qualifications, limitations or restrictions thereof, and may increase or
decrease the number of shares of any such series without any further vote or
action by the shareholders. Any Preferred Stock so issued by the Board of
Directors may rank senior to the Common Stock with respect to the payment of
dividends or upon liquidation, dissolution or winding up of the Company, or
both. In addition, any such shares of Preferred Stock may have class or series
voting rights. Under certain circumstances, the issuance of Preferred Stock or
the existence of the unissued Preferred Stock may tend to discourage or render
more difficult a merger or other change in control of the Company.

Warrants

As of the date of this Prospectus, the Company has the following warrants
outstanding:

<TABLE>
<CAPTION>
Number of Shares Exercise Price Expiration Date
Underlying Warrants
<S> <C> <C> <C>
73,845 $ 1.00 August 31, 2002 - December 31, 2004
132,933 $1.03 - $ 3.19 March 6, 2001 - December 31, 2004
60,000 $ 3.75 January 20, 2004
131,334 $4.31 - $ 4.65 July 15, 1999 - December 31, 2004
203,334 $5.00 - $ 5.38 January 26, 2004 -December 31, 2004
178,952 $ 6.00 July 10, 2003 - December 31, 2004
493,774 $6.00 - $ 8.27 March 6, 2001 - November 25, 2003
Total 1,274,172 $ 4.95
</TABLE>

Certain Articles of Incorporation and Bylaws Provisions Having Potential Anti-
Takeover Effects

General

A number of provisions of the Company's Articles of Incorporation and
Bylaws address matters of corporate governance and the rights of shareholders.
The following summary of such provisions is not intended to be complete and is
qualified in all respects by the Company's Articles of Incorporation and Bylaws.
Certain of these provisions, as well as the ability of the Board of Directors to
issue shares of Preferred Stock and to set the voting rights, preferences and
other terms thereof, may delay or prevent takeover attempts not first approved
by the Board of Directors (including takeovers which certain shareholders may
deem to be in their best interests). These provisions also could delay or
frustrate the removal of incumbent directors or the assumption of control by
shareholders.

Classification of Board of Directors

The Board of Directors currently consists of five members. The Articles of
Incorporation provide that if the size of the Board increases to nine or more
members, the Board of Directors of the Company will be divided into three
classes as nearly equal in number as possible. The directors of each class will
serve a term of three years. As a result of a classification of the Board of
Directors, approximately one-third of the members of the Board of Directors will
be elected each year, and two annual meetings will be required for the Company's
shareholders to change a majority of the members constituting the Board of
Directors.

Nomination and Removal of Directors; Filling Vacancies

The Company's Bylaws provide that nominations to the Board of Directors may
only be made by the Board of Directors, a nominating committee of the Board or
by any shareholder entitled to vote in elections of directors who complies with
certain notice procedures. In addition, the Articles of Incorporation and Bylaws
provide that a director may be removed by the shareholders only upon the
affirmative vote of the holders of two-thirds of the voting power of all shares
of capital stock entitled to vote generally in the election of directors, and
the Bylaws specify that vacancies on the Board of Directors may be filled only
by the Board of Directors. The purpose of these provisions is to prevent a
majority shareholder from circumventing the classified board system by removing
directors and filling the vacancies with new individuals selected by that
shareholder. Accordingly, these provisions may have the effect of impeding
efforts to gain control of the Board by anyone who obtains a controlling
interest in the Company's Common Stock.

40
<PAGE>

Amendment of Articles of Incorporation

The Articles of Incorporation of the Company provide that amendments to the
Articles of Incorporation may be adopted only upon the affirmative vote of the
holders of at least two-thirds of the voting power of all shares of capital
stock of the Company entitled to vote thereon. However, if such amendment has
received the prior approval by an affirmative vote of a majority of
Disinterested Directors, as defined below, then the affirmative vote of the
holders of at least a majority of the voting power of all shares of capital
stock of the Company entitled to vote thereon, or such greater percentage
approval as required by North Carolina law, is sufficient to adopt such
amendment. A Disinterested Director is defined as any member of the Board of
Directors who is unaffiliated with, and not a nominee of, a Control Person, as
defined below, and was a member of the Board of Directors prior to the time a
Control Person became such, and any successor of a Disinterested Director who is
unaffiliated with, and not a nominee of, a Control Person, who is recommended to
succeed a Disinterested Director by a majority of Disinterested Directors then
on the Board of Directors. A Control Person is defined as any corporation,
person, group, or other entity, which together with its affiliates, prior to a
Business Combination, as defined below, beneficially owns 10% or more of the
shares of any class of equity or convertible securities of the Company, and any
affiliate of any such corporation, person, group, or other entity; provided,
however, any corporation, person, group or other entity which, together with its
affiliates, prior to July 2, 1998 beneficially owned 10% or more of the shares
of any class of equity or convertible securities of the Company, and any
affiliate of any such party is not considered to be a Control Person.

Amendment of Bylaws

Subject to certain restrictions described below, either the Board of
Directors or the shareholders of the Company may amend the Company's Bylaws. The
Board of Directors may amend the Bylaws and adopt new Bylaws except that: (i) a
bylaw adopted or amended by the shareholders may not be readopted, amended, or
repealed by the Board of Directors if neither the Articles of Incorporation nor
a bylaw adopted by the shareholders authorizes the Board of Directors to adopt,
amend, or repeal that particular bylaw or the Bylaws generally; (ii) a bylaw
that fixes a greater quorum or voting requirement for the Board of Directors may
not be adopted by the Board of Directors by a vote of less than a majority of
the directors then in office and may not itself be amended by a quorum or vote
of directors less than the quorum or vote therein prescribed or prescribed by a
bylaw adopted or amended by the shareholders; and (iii) if a bylaw fixing a
greater quorum or voting requirement for the Board of Directors is originally
adopted by the shareholders, it may be amended or repealed only by the
shareholders, unless the Bylaws permit amendment or repeal by the Board of
Directors. The shareholders of the Company generally may adopt, amend, or repeal
the Bylaws upon the affirmative vote of the holders of two-thirds of the voting
power of all shares of capital stock entitled to vote thereon.

Supermajority Vote Requirement

The Articles of Incorporation of the Company provide that, unless otherwise
more restrictively required by applicable law, any Business Combination, as
defined below, must be approved by a majority of a quorum of the Board of
Directors and must receive the level of shareholder approval, if any, as
follows: (i) to the extent shareholder approval is otherwise required by law, by
an affirmative vote of the shareholders holding at least a majority of the
shares of capital stock of the Company entitled to vote thereon, provided that
such Business Combination has been approved by an affirmative vote of at least
two-thirds of the full Board of Directors before such Business Combination is
submitted for approval to the shareholders or (ii) by an affirmative vote of the
shareholders holding at least two-thirds of the shares of capital stock of the
Company entitled to vote thereon provided that such Business Combination has
been approved by an affirmative vote of at least a majority of a quorum of the
Board of Directors (but less than two-thirds of the full Board of Directors). In
addition, if the Business Combination is approved by the affirmative vote of the
shareholders holding at least two-thirds of the shares of Common Stock entitled
to vote and by a majority of a quorum of the Board of Directors but less than
two-thirds of the full Board of Directors, the Business Combination must grant
to shareholders not voting to approve the Business Combination certain "fair
price" rights.

The Company's Articles of Incorporation define a Business Combination as
(i) any merger or consolidation of the Company into any other corporation,
person, group, or other entity where the Company is not the surviving or
resulting entity; (ii) any merger or consolidation of the Company with or into
any Control Person or with any corporation, person, group or other entity where
the merger or consolidation is proposed by or on behalf of a Control Person;
(iii) any sale, lease, exchange, or other disposition of all or substantially
all of the assets of the Company; (iv) any sale, lease, exchange, or other
disposition of more than 10% of the total assets of the Company to a Control
Person; (v) the issuance of any securities of the Company to a Control Person;
(vi) the acquisition by the Company of any securities of a Control Person unless
such acquisition begins prior to the person becoming a Control Person or is an
attempt to prevent the Control Person from obtaining greater control of the
Company; (vii) the acquisition by the Company of all or substantially all of the
assets of any Control Person or any entity where the acquisition is proposed by
or on behalf of a Control Person; (viii) the adoption of any plan or proposal
for the liquidation or dissolution of the Company which is proposed by or on
behalf

41
<PAGE>

of a Control Person; (ix) any reclassification of securities or recapitalization
of the Company which has the effect of increasing the proportionate share of the
outstanding shares of any class of equity or convertible securities of the
Company which is beneficially owned or controlled by a Control Person; (x) any
of the above transactions which are between the Company and any of its
subsidiaries and which are proposed by or on behalf of any Control Person; or
(xi) any agreement, plan, contract, or other arrangement providing for any of
the above transactions.

The requirement of a supermajority vote of shareholders to approve certain
business transactions, as described above, may discourage a change in control of
the Company by allowing shareholders holding less than a majority of the shares
of Common Stock to prevent a transaction favored by shareholders holding a
majority of such shares. Also, in some circumstances, the Board of Directors
could cause a two-thirds vote to be required to approve a transaction thereby
enabling management to retain control over the affairs of the Company and their
positions with the Company.

Fair Price Provision

The "fair price" provision of the Company's Articles of Incorporation
applies to Business Combinations that have not received the approval of two-
thirds of the full Board of Directors and only to shareholders who vote against
such Business Combinations and who elect to sell their shares to the Company for
cash at their fair price. This "fair price" provision requires that the
consideration for such shares be paid in cash by the Company and that the price
per share be at least equal to the greater of the following:

(i) The highest price per share paid for the Company's Common Stock
during the four years immediately preceding the Business Combination vote by
any shareholder who beneficially owned five percent or more of the Company's
Common Stock and who votes in favor of the Business Combination;

(ii) The cash value of the highest price per share previously offered
pursuant to a tender offer to the shareholders of the Company within the four
years immediately preceding the Business Combination vote; or

(iii) The highest price per share, including commissions and fees, paid by
a Control Person in acquiring any of its holdings of the Company's Common
Stock.

The fair price provision is intended to prevent some of the potential
inequities of two-step takeover attempts by encouraging negotiations with the
Company. However, some shareholders may find the fair price provision
disadvantageous to the extent it discourages changes in control in which
shareholders might receive for at least some of their shares a substantial
premium above the market price at the time an acquisition transaction is made.

The Company is not aware of any pending or threatened effort to acquire
control of the Company or to change management. The Board of Directors does not
presently intend to propose any additional anti-takeover provisions.

Constituencies

The Company's Articles of Incorporation expressly authorize the Board of
Directors of the Company, any committee of the Board of Directors, or any
individual director in determining what is in the best interest of the Company
and its shareholders, to consider, in addition to the long-term and short-term
interests of the shareholders, the social and economic effects of the matter to
be considered on the Company and its subsidiaries, their employees, clients,
creditors, and the communities in which the Company and its subsidiaries operate
or are located. When evaluating a business combination or a proposal by another
person to make a business combination or a tender offer or any other proposal
relating to a potential change in control of the Company, the Board of Directors
may consider such matters as (i) the business and financial condition and
earnings prospects of the acquiring person, and the possible effect of such
condition upon the Company and its subsidiaries and the communities in which the
Company and its subsidiaries operate, (ii) the competence, experience, and
integrity of the acquiring person and its management and (iii) the prospects for
successful conclusion of the business combination, offer or proposal. The
consideration of any of the above factors is completely discretionary with the
Company's Board of Directors. The constituency provision of the Company's
Articles of Incorporation may discourage or make more difficult certain
acquisition proposals or business combinations and therefore, may adversely
affect the ability of shareholders to benefit from certain transactions opposed
by the Company's Board of Directors.

Special Meetings of Shareholders

The Company's Bylaws provide that special meetings of shareholders may be
called only by the Board of Directors, the Chairman of the Board, the President
or holders of 20% or more of the voting power of the outstanding shares of the
Company. As a result, this provision would prevent shareholders owning less than
20% of the voting power of the outstanding Common Stock from

42
<PAGE>

compelling shareholder consideration of any proposal (such as a proposal for a
Business Combination) over the opposition of the Company's Board of Directors.

Shareholder Proposals

The Company's Bylaws provide that shareholders who desire to bring any
business before a meeting of shareholders must follow specified procedures,
including advance written notice to the Company. The shareholder proposal
provision may make it more difficult for shareholder proposals to be considered
at shareholder meetings.

43
<PAGE>

DISCLOSURE OF COMMISSION POSITION
ON INDEMNIFICATION FOR SECURITIES ACT LIABILITIES

As permitted by North Carolina law, Article IX of the Company's Articles of
Incorporation provides for the limitation of the personal liability of directors
for monetary damages for breach of duty as a director provided that the
limitation of liability does not apply to (i) acts or omissions not made in good
faith that the director at the time of such breach knew or believed were in
conflict with the best interests of the corporation; (ii) any liability under
the North Carolina Business Corporation Act for unlawful distributions; (iii)
any transaction from which the director derived an improper personal benefit or
(iv) acts or omissions occurring prior to the date the provision became
effective.

The North Carolina Business Corporation Act also contains provisions
prescribing the extent to which present or former directors, officers, or
employees of a corporation shall or may be indemnified against liabilities which
they may incur in those capacities. Under those provisions, the availability or
requirement of indemnification or reimbursement of expenses is dependent upon
numerous factors, including whether the action is brought by the corporation or
by outsiders and the extent to which the potential indemnitee is successful in
his defense. The statute also permits a corporation to purchase and maintain
insurance on behalf of its directors and officers against liabilities which they
may incur in their capacities as such, whether or not the corporation would have
the power to indemnify them under other provisions of the statute.

As permitted by North Carolina law, Article IX of the Bylaws of the Company
provides for the indemnification of directors and officers, employees or agents
of the Company within the limitations permitted by North Carolina law.

Insofar as indemnification for liabilities arising under the Securities Act
of 1933 may be permitted to directors, officers and persons controlling the
Company pursuant to the foregoing provision, or otherwise, the Company has been
advised that in the opinion of the Securities and Exchange Commission such
indemnification is against public policy as expressed in the Securities Act of
1933 and is, therefore, unenforceable.

LEGAL MATTERS

The validity of the common stock offered under this Prospectus will be
passed upon for us by our counsel, Wyrick Robbins Yates & Ponton LLP, Raleigh,
North Carolina.

EXPERTS

The consolidated financial statements of the Company at December 31, 1998
and 1997, and for the years then ended appearing in this Prospectus and the
Registration Statement have been audited by Ernst & Young LLP, independent
auditors, as set forth in their report thereon appearing elsewhere herein and in
the Registration Statement, and are included in reliance upon such report given
upon the authority of such firm as experts in accounting and auditing.

WHERE YOU CAN FIND MORE INFORMATION

We file annual, quarterly and special reports, proxy statements and other
information with the Commission. You may read and copy any document we file at
the Commission's public reference rooms in Washington, D.C., New York, New York
and Chicago, Illinois. Please call the Commission at 1-800-SEC 0330 for further
information on the public reference rooms. Our Commission filings are also
available to the public from the SEC's website at http://www.sec.gov.
------------------

This prospectus is part of a registration statement we filed with the
Commission. As such, it does not contain all of the information set forth in the
registration statement and the exhibits and schedules filed with the
registration statement. For further information about us and the common stock
described by this prospectus, please see the registration statement and the
exhibits and schedules filed with it, copies of which can be inspected at, or
obtained from, the Commission's public reference rooms.

We have authorized no one to provide you with different information. We are
not making an offer of these securities in any state where the offer is not
permitted. You should not assume that the information in this prospectus is
accurate as of any date other than the date on the front of this document.

44
<PAGE>

INDEX TO FINANCIAL STATEMENTS
<TABLE>

<S> <C>

Report of Independent Auditors............................ F-1

Consolidated Balance Sheets............................... F-2

Consolidated Statements of Operations..................... F-4

Consolidated Statements of Stockholder's Equity (Deficit). F-5

Consolidated Statements of Cash Flows..................... F-7

Notes to Consolidated Financial Statements................ F-9

Unaudited Interim Financial Statements and Notes Thereto.. F-32
</TABLE>

45
<PAGE>

Report of Independent Auditors

The Board of Directors and Stockholders
Interactive Magic, Inc.

We have audited the accompanying consolidated balance sheets of Interactive
Magic, Inc. (the "Company") as of December 31, 1998, and 1997, and the related
consolidated statements of operations, stockholders' equity (deficit), and cash
flows for the years then ended. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
Interactive Magic, Inc. at December 31, 1998, and 1997, and the consolidated
results of its operations and its cash flows for the years then ended in
conformity with generally accepted accounting principles.

As discussed in Note 2 to the consolidated financial statements, the Company's
recurring losses and negative cash flows from operations raise substantial doubt
about its ability to continue as a going concern. Management's plans as to
these matters are also described in Note 2. The 1998 consolidated financial
statements do not include any adjustments that might result from the outcome of
this uncertainty.

/s/ Ernst & Young LLP

Raleigh, North Carolina
February 19, 1999

F-1
<PAGE>

Interactive Magic, Inc.

Consolidated Balance Sheets
(In thousands, except share data)

<TABLE>
<CAPTION>
December 31
1998 1997
----------------------------
<S> <C> <C>
Assets
Current assets:
Cash and cash equivalents $ 2,943 $ 384
Trade receivables, net of allowances of $2,871 and $3,650,
respectively 2,109 2,830
Inventories 892 637
Advance royalties, net 1,586 1,989
Software development costs, net 912 425
Prepaid expenses and other 252 109
----------------------------
Total current assets 8,694 6,374

Property and equipment, net 1,082 1,196

Noncurrent assets:
Royalties receivable 726 90
Other 18 87
----------------------------
Total noncurrent assets 744 177

----------------------------
Total assets $ 10,520 $ 7,747
============================
</TABLE>

F-2
<PAGE>

<TABLE>
<CAPTION>
December 31
1998 1997
----------------------------
<S> <C> <C>
Liabilities and stockholders' equity (deficit)
Current liabilities:
Accounts payable and accrued expenses $ 1,698 $ 2,776
Royalties and commissions payable 768 858
Lines of credit 1,348 3,983
Current portion of long-term debt - 745
Current portion of capital lease obligations 23 35
----------------------------
Total current liabilities 3,837 8,397

Noncurrent liabilities:
Accrued interest payable to related parties 117 982
Long-term debt, less current portion - 3,759
Capital lease obligations, less current portion 15 38
Notes payable to related parties - 3,470
----------------------------
Total noncurrent liabilities 132 8,249

Stockholders' equity (deficit):
Series A Convertible Preferred Stock, $.10 par value; 82,634
shares authorized, issued and outstanding at December 31, 1997 - 8
Class A Common Stock, $.10 par value; 10,000,000 shares
authorized; 3,145,696 shares issued and outstanding at
December 31, 1997 - 314
Class B Common Stock, $.10 par value; 10,000,000 shares
authorized; 7,875 shares issued and outstanding at December
31, 1997 - 1
Common stock, $.10 par value; 50,000,000 shares authorized
9,850,867 shares issued and outstanding at December 31, 1998 985 -
Additional paid-in capital 31,522 5,047
Accumulated deficit (25,862) (14,210)
Accumulated other comprehensive loss (94) (59)
----------------------------
Total stockholders' equity (deficit) 6,551 (8,899)
----------------------------
Total liabilities and stockholders' equity (deficit) $ 10,520 $ 7,747
============================
</TABLE>

F-3
<PAGE>

Interactive Magic, Inc.

Consolidated Statements of Operations
(In thousands, except share and per share data)

<TABLE>
<CAPTION>
Year ended December 31
1998 1997
--------------------------
<S> <C> <C>
Net revenues:
CD-ROM product sales $ 9,177 $ 14,067
Online sales 1,773 1,615
Royalties and licenses 1,616 820
--------------------------
Total net revenues 12,566 16,502

Cost of revenues:
Cost of products and services 3,157 3,715
Royalties and amortized software costs 2,942 2,634
--------------------------
Total cost of revenues 6,099 6,349
--------------------------
Gross profit 6,467 10,153

Operating expenses:
Sales and marketing 8,490 6,760
Product development 5,983 3,878
General and administrative 2,684 1,941
--------------------------
Total operating expenses 17,157 12,579
--------------------------
Operating loss (10,690) (2,426)

Other (income) expense:
Interest expense - third parties 554 622
Interest expense - related parties 134 1,053
Other (161) 230
--------------------------
Total other (income) expense 527 1,905
--------------------------
Loss before income taxes and extraordinary item (11,217) (4,331)
Income tax (expense) benefit (28) 33
--------------------------
Loss before extraordinary item (11,245) (4,298)
Extraordinary loss on early extinguishment of debt (407) -
==========================
Net loss $ (11,652) $ (4,298)
==========================

Basic loss per share:
Loss before extraordinary item $ (1.73) $ (1.36)
Extraordinary item (0.06) -
--------------------------
Net loss per share $ (1.79) $ (1.36)
==========================

Weighted average shares used in computing basic loss per share 6,515,213 3,152,930
==========================
</TABLE>

F-4
<PAGE>

Interactive Magic, Inc.

Consolidated Statements of Stockholders' Equity (Deficit)
(In thousands, except share data)

<TABLE>
<CAPTION>
Series A Convertible Series B Convertible
Preferred Stock Preferred Stock Common Stock
---------------------------------------------------------------------------
Shares Amount Shares Amount Shares Amount
---------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1996 82,634 $ 8 - $ - - $ -
Issuance of common stock - - - - - -
Issuance of warrants - - - - - -
Exercise of stock options - - - - - -
Comprehensive loss
Net loss - - - - - -
Other comprehensive loss - - - - - -
Total comprehensive loss
---------------------------------------------------------------------------
Balance at December 31, 1997 82,634 8 - - - -
Exercise of stock options - - - - - -
Issuance of common stock - - - - - -
Exercise of warrants - - - - - -
Issuance of preferred stock - - 778,746 78 - -
Conversion of notes payable into common stock - - - - - -
Recapitalization contemporaneous with the initial
public offering (Note 8) (82,634) (8) (778,746) (78) 6,793,699 679
Issuance of common stock - - - - 2,990,000 299
Exercise of warrants - - - - 18,330 2
Exercise of stock options - - - - 48,838 5
Issuance of warrants - - - - - -
Comprehensive loss
Net loss - - - - - -
Other comprehensive loss - - - - - -
Total comprehensive loss - - - - - -
---------------------------------------------------------------------------
Balance at December 31, 1998 - $ - - $ - 9,850,867 $ 985
===========================================================================
</TABLE>

F-5
<PAGE>

<TABLE>
<CAPTION>
Accumulated
Class A Class B Additional Other
Common Stock Common Stock Paid-in Comprehensive Accumulated
- -----------------------------------------------
Shares Amount Shares Amount Capital Loss Deficit Total
- ----------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
3,145,178 $ 314 6,750 $ 1 $ 4,703 $(62) $ (9,912) $ (4,948)
518 - - - 15 - - 15
- - - - 328 - - 328
- - 1,125 - 1 - - 1

- - - - - - (4,298) (4,298)
- - - - - 3 - 3
--------
(4,295)
- ----------------------------------------------------------------------------------------------------------------
3,145,696 314 7,875 1 5,047 (59) (14,210) (8,899)
268,750 27 102,500 10 381 - - 418
- 48,604 5 (5) - - -
516,769 52 - - (52) - - -
- - - - 3,091 - - 3,169
- - 442,478 44 1,956 - - 2,000

(3,931,215) (393) (601,457) (60) 460 - - 600
- - - - 20,176 - - 20,475
- - - - (2) - - -
- - - - 76 - - 81
- - - - 394 - - 394

- - - - - - (11,652) (11,652)
- - - - - (35) - (35)
--------
- - - - - - - (11,687)
- ----------------------------------------------------------------------------------------------------------------
- $ - - $ - $31,522 $(94) $(25,862) $ 6,551
================================================================================================================
</TABLE>

See accompanying notes.

F-6
<PAGE>

Interactive Magic, Inc.

Consolidated Statements of Cash Flows
(In Thousands)

<TABLE>
<CAPTION>
Year ended December 31
1998 1997
-------------------------
<S> <C> <C>
Operating activities
Net loss $(11,652) $(4,298)
Adjustments to reconcile net loss to net cash used in operating
activities:
Extraordinary loss 407 -
Issuance of warrants 394 -
Depreciation and amortization 461 422
Amortization of capitalized software development costs 963 576
Issuance of common stock for services - 15
Noncash interest expense 39 147
Write-off of investment - 120
Changes in operating assets and liabilities:
Trade and royalties receivables 85 (1,752)
Inventories (255) (227)
Advance royalties 403 (911)
Prepaid expenses and other 126 (87)
Accounts payable and accrued expenses (1,078) 1,084
Royalties and commissions payable (90) 374
Accrued interest (546) 764
-------------------------
Net cash used in operating activities (10,743) (3,773)

Investing activities
Increase in note receivable (200) -
Purchase of property and equipment (347) (382)
Software development costs (1,450) (849)
-------------------------
Net cash used in investing activities (1,997) (1,231)

Financing activities
Proceeds from issuance of common stock 20,655 -
Proceeds from issuance of preferred stock 3,169 -
Proceeds from long-term debt 350 4,192
Payments on long-term debt (5,300) -
Proceeds from notes payable to related parties - 500
Payments on notes payable to related parties (870) -
Net (payments on) borrowings from lines-of-credit (2,635) 469
Payments on capital lease obligations (35) (68)
-------------------------
Net cash provided by financing activities 15,334 5,093
</TABLE>

F-7
<PAGE>

Interactive Magic, Inc.

Consolidated Statements of Cash Flows (continued)
(In Thousands)

<TABLE>
<CAPTION>
December 31
1998 1997
--------------------------
<S> <C> <C>
Effect of currency exchange rate changes on cash and cash
equivalents (35) 3
--------------------------
Net increase in cash and cash equivalents 2,559 92
Cash and cash equivalents at beginning of year 384 292
--------------------------
Cash and cash equivalents at end of year $ 2,943 $ 384
==========================

SUpplemental disclosure of cash flow information
Cash paid for interest $ 1,376 $ 760
==========================
Cash paid for income taxes $ - $ 8
==========================

Noncash investing and financing activities
Conversion of notes payable into stock $ 2,600 $ -
==========================
Exercise of stock options for forgiveness of accrued interest $ 319 $ -
==========================
</TABLE>

See accompanying notes.

F-8
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements

December 31, 1998

1. Description of Business

Interactive Magic, Inc. (the "Company") develops, publishes, and distributes 3-D
interactive, simulation and strategy entertainment software to customers around
the world via (1) retail distribution through international and domestic
software outlets and (2) proprietary, pay-for-play online service on the
Internet. The Company has agreements with various software licensors to
manufacture, market, sell and distribute software in the United States. Through
its wholly owned subsidiaries located in the United Kingdom and Germany, and
through its online services, the Company also distributes its products
internationally.

2. Basis of Presentation

The accompanying consolidated financial statements have been prepared on a going
concern basis, which contemplates the realization of assets and the satisfaction
of liabilities in the normal course of business. As shown in the consolidated
financial statements during the years ended December 31, 1998 and 1997, the
Company incurred losses of $11,652,000 and $4,298,000, respectively, and has
experienced negative cash flows from operations. These factors, among others,
indicate that the Company may be unable to continue as a going concern for a
reasonable period of time. The consolidated financial statements do not include
any adjustments relating to the recoverability and classification of liabilities
that might be necessary should the Company be unable to continue as a going
concern.

The Company's continuation as a going concern is dependent upon its ability to
generate sufficient cash flow to meet its obligations on a timely basis, to
obtain additional financing or refinancing as may be required, and ultimately to
attain profitability. The Company is actively pursuing potential acquirers for
the purchase of the retail CD-ROM portion of its business (see Note 16).
Management expects the anticipated disposition of its CD-ROM operations will
substantially reduce or eliminate its operating losses and expects to be able to
attract additional capital, if needed, for its online operations. However,
there can be no assurance that management's plans will be executed as
anticipated.

F-9
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

3. Business Combination

On April 23, 1997, the Company acquired 100% of the outstanding capital stock of
Interactive Creations, Inc. ("ICI") in exchange for 655,696 shares of the
Company's Class A Common Stock (the "Merger"). Subsequent to the merger, ICI's
name was changed to iMagic Online Corporation. The merger constituted a tax-
free reorganization and was accounted for under the pooling of interests method
of accounting in accordance with Accounting Principles Board Opinion No. 16.
The accompanying consolidated financial statements include the operations of the
combined entities for the years ended December 31, 1998 and 1997.

4. Significant Accounting Policies and Other Matters

Consolidation

The consolidated financial statements include the accounts of the Company and
its wholly owned subsidiaries, iMagicOnline Corporation, Interactive Magic Ltd.
and Interactive Magic GmbH. All significant intercompany accounts and
transactions have been eliminated in consolidation.

Cash and Cash Equivalents

Cash and cash equivalents include amounts in demand deposit accounts and
investments with an original maturity date of three months or less when
purchased.

Inventories

Inventories consist of pre-packaged CD-ROM software packages and related
materials and are stated at the lower of cost or market. Costs are determined
using the first-in, first-out ("FIFO") cost flow assumption.

Inventories consist of the following (in thousands):

<TABLE>
<CAPTION>
December 31
1998 1997
-------------------------
<S> <C> <C>
Finished goods $ 1,065 $ 645
Components 117 79
-------------------------
1,182 724
Inventory valuation reserve (290) (87)
-------------------------
$ 892 $ 637
=========================
</TABLE>

F-10
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

4. Significant Accounting Policies and Other Matters (continued)

Advance Royalties

Advance royalties represent prepayments made to independent software developers
under development agreements. Advance royalties are expensed as part of
royalties and amortized software costs at the contractual royalty rate based on
actual net product sales. Management continuously evaluates the future
realization of advance royalties, and charges to cost of revenues any amount
that management deems unlikely to be amortized at the contractual royalty rate
through product sales. At December 31, 1998 and 1997, the reserve for advance
royalties was $1,654,000 and $1,050,000, respectively.

Note Receivable

In connection with the merger with MPG-Net, Inc. (Note 15), the Company entered
into a loan agreement to assist MPG-Net, Inc. in funding its current operations.
As of December 31, 1998 the Company had advanced MPG-Net, Inc. funds totaling
$200,000 at an 18% annual interest rate. The note receivable is included in
prepaid expenses and other current assets on the balance sheet.

Property and Equipment

Property and equipment are stated at cost. Depreciation for equipment,
furniture and fixtures and purchased software is computed using the straight-
line method over the estimated useful lives of the assets, ranging from five to
seven years. Leasehold improvements are amortized on a straight-line basis over
the term of the estimated useful life of the asset or the remaining lease term,
whichever is less. Depreciation expense, including amortization of equipment
leased under capital leases, was $461,000 and $415,000 for the years ended
December 31, 1998 and 1997, respectively.

Property and equipment consists of the following (in thousands):

<TABLE>
<CAPTION>
December 31
1998 1997
--------------------------
<S> <C> <C>
Equipment 1,547 $1,287
Furniture and fixtures 188 167
Software 488 425
Leasehold improvements 59 54
--------------------------
2,282 1,933
Less accumulated depreciation and amortization (1,200) (737)
--------------------------
$ 1,082 $1,196
==========================
</TABLE>

F-11
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

4. Significant Accounting Policies and Other Matters (continued)

Software Development Costs

Costs incurred in the development of software for sale to customers are
capitalized after a product's technological feasibility has been established.
Capitalization of such costs is discontinued when a product is available for
general release to customers. Capitalized software development costs are
capitalized at the lower of cost or net realizable value and amortized using the
greater of the revenue curve method or the straight-line method over the
estimated economic life of the related product. Amortization begins when a
product is ready for general release to customers.

Information related to net capitalized software development costs is as follows
(in thousands):

<TABLE>
<CAPTION>
1998 1997
----------------
<S> <C> <C>
Balance at beginning of year $ 425 $ 152
Capitalized 1,450 849
Amortized (963) (576)
---------------
Balance at end of year $ 912 $ 425
===============
</TABLE>

Fair Value of Financial Instruments

The carrying value of cash and cash equivalents, trade receivables, accounts
payable and other liabilities approximates fair value at December 31, 1998 and
1997.

Revenue Recognition

In October 1997, the Accounting Standards Executive Committee (AcSEC) issued
Statement of Position (SOP) 97-2 Software Revenue Recognition as amended in
March 1998 by SOP 98-4 and October 1998 by SOP 98-9. These SOPs provide
guidance on applying generally accepted accounting principles in recognizing
revenue on software transactions. The Company adopted SOP 97-2 for software
transactions entered into beginning January 1, 1998. Based on the current
requirements of the SOPs, application of these statements did not have a
material impact on the Company's revenue recognition policies. However, AcSEC
is currently reviewing further modifications to the SOP with the objective of
providing more definitive, detailed implementation guidelines. This guidance
could lead to unanticipated changes in the Company's operations and revenue
recognition practices.

F-12
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

4. Significant Accounting Policies and Other Matters (continued)

Revenue from CD-ROM product sales is recognized at the time of product shipment.
Revenue from online sales is recognized at the time the game is played and is
based upon actual usage by the customer on an hourly basis. Revenue from
royalties and licenses is recognized when earned under the terms of the relevant
agreements with original equipment manufacturers ("OEMs"), international
distributors and other third parties. With respect to license agreements that
provide customers the right to multiple copies in exchange for guaranteed
amounts, net revenue is recognized upon delivery of the product master or the
first copy provided collectibility is probable. Per copy royalties on sales
that exceed the guarantee are recognized as earned. The Company accepts product
returns and provides price protection on certain unsold merchandise. Revenue is
recorded net of an allowance for estimated future returns, markdowns, price
protection and warranty costs. Such reserves are based upon management's
evaluation of historical experience, current industry trends and estimated
costs.

The accounts receivable allowance consists primarily of reserves for product
returns, markdowns, price protection and warranty costs. The allowance also
includes a reserve for doubtful accounts, which management records based on
historical experience and current evaluation of potential collectibility issues.
The Company does not require collateral for unpaid balances. Credit losses have
historically been within management's expectations.

Product Development

Product development expenses (excluding capitalized software development costs)
are charged to operations in the period incurred and consist primarily of
payroll and payroll related costs.

Advertising

The Company expenses advertising costs as incurred. Advertising expense was
approximately $3,590,000 and $2,529,000 for the years ended December 31, 1998
and 1997, respectively.

Use of Estimates

The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosures of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Significant estimates include provisions for doubtful accounts, sales returns
and allowances, warranty provisions, and estimates regarding the recoverability
of prepaid royalty advances and inventory. Actual results could differ from
those estimates.

F-13
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

4. Significant Accounting Policies and Other Matters (continued)

Foreign Currency Translation

The Company follows the principles of the Financial Accounting Standards Board
("FASB") Statement of Financial Accounting Standards ("SFAS") No. 52, "Foreign
Currency Translation," using the local currency of its operating subsidiaries as
the functional currency. Accordingly, all assets and liabilities outside the
United States are translated into U.S. dollars at the rate of exchange in effect
at the balance sheet date. Income and expense items are translated at the
weighted average exchange rate prevailing during the period. Adjustments
resulting from translation of financial statements are reflected as a component
of accumulated other comprehensive income (loss).

Employee Stock Compensation

The Company has elected to continue to follow Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB No. 25") and
related interpretations in accounting for its employee stock options as
permitted by SFAS No. 123 "Accounting for Stock-Based Compensation" and make the
required pro forma disclosures required by SFAS No. 123 (see Note 10). Under
APB No. 25, because the exercise price of the Company's employee stock options
is not less than the estimated fair value of the underlying stock on the date of
grant, no compensation expense is recognized.

Income Taxes

The Company accounts for income taxes under the provisions of SFAS No. 109,
"Accounting for Income Taxes". Under SFAS No. 109, the liability method is used
in accounting for income taxes and deferred tax assets and liabilities are
determined based on differences between the financial reporting and tax bases of
assets and liabilities.

Basic Net Loss Per Share

Basic net loss per share has been calculated in accordance with SFAS No. 128,
"Earnings Per Share". SFAS No. 128 requires companies to compute earnings per
share under two different methods (basic and diluted). Basic net loss per share
is calculated by dividing net loss by the weighted average shares of common
stock outstanding during the period. All shares used in computing basic net
loss per share reflect the retroactive effect of the Company's July 1998 one-
for-two reverse stock split.

F-14
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

4. Significant Accounting Policies and Other Matters (continued)

Had the Company been in a net income position, diluted earnings per share would
have been presented and would have included potential common shares related to
outstanding options and warrants. The diluted earnings per share computation is
not included, as all potential common shares are antidilutive. The Company
evaluated the requirements of the Securities and Exchange Commission Staff
Accounting Bulletin No. 98 ("SAB 98"), and concluded that there are no nominal
issuances of common stock or potential common stock which would be required to
be shown as outstanding for all periods as outlined in SAB 98.

Impact of Recently Issued Accounting Pronouncements

Effective January 1, 1998, the Company adopted SFAS No. 131, "Disclosures about
Segments of an Enterprise and Related Information" which superseded SFAS No. 14,
"Financial Reporting for Segments of a Business Enterprise". SFAS No. 131
establishes standards for the way that public business enterprises report
information about operating segments in annual financial statements and requires
that those enterprises report selected information about operating segments in
interim financial reports. SFAS No. 131 also establishes standards for related
disclosures about products and services, geographic areas and major customers.
The adoption of SFAS No. 131 did not affect net earnings, financial position or
cash flows of the Company in 1998.

As of January 1, 1998, the Company adopted SFAS No. 130, "Reporting
Comprehensive Income". SFAS No. 130 requires all non-owner changes in equity
that are excluded from net earnings/loss under existing FASB standards to be
included as items of comprehensive income/loss. Comprehensive loss consists of
net loss and foreign currency translation adjustments and is presented in the
consolidated statements of stockholders' equity (deficit). The adoption of SFAS
No. 130 had no impact on previously reported stockholders' equity (deficit).
Prior year financial statements have been reclassified to conform with these
requirements.

In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities", which is
required to be adopted in years beginning after June 15, 2000. Because of the
Company's minimal use of derivatives, management does not anticipate the
adopting of the new statement will have a significant effect on earnings or the
financial position of the Company.

F-15
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

5. Lines of Credit

The Company maintains a revolving line of credit arrangement with a bank for up
to $2,750,000. The principal balance outstanding at any point in time is payable
on demand with interest payable monthly at the current prime rate (7.75% at
December 31, 1998). The weighted-average interest rate on the line of credit was
8.5% and 8.1% for the years ended December 31, 1998 and 1997, respectively. The
balance outstanding as of December 31, 1998 and 1997 was $1,316,000 and
$2,439,000, respectively. Advances on the line of credit are collateralized by a
personal guarantee of the Company's majority stockholder. In consideration for
this guarantee, the Company will pay the stockholder as additional interest
expense an amount equal to 6% of the outstanding balance on the line of credit.
At December 31, 1998 and 1997, the Company incurred $64,000 and $144,000 and
owed the stockholder $117,000 and $174,000 relating to this guarantee,
respectively. These amounts are due no earlier than January 1, 2000.

The Company also entered into a line of credit agreement with its bank to borrow
up to $150,000. The line of credit is collateralized by the Company's net
property and equipment. The principal balance outstanding at any point in time
is payable on demand with interest payable monthly at the current prime rate.
The weighted-average interest rate on the line of credit was 8.5% and 8.1% for
the years ended December 31, 1998 and 1997, respectively. The balance
outstanding at December 31, 1998 and 1997 was $32,000 and $44,000, respectively.

During 1996, the Company also executed a line of credit agreement with another
bank, the terms of which stipulated that the Company may borrow up to 75% of its
eligible domestic accounts receivable up to a maximum of $1,500,000. The
agreement entitled the bank to a perfected first lien security interest in all
of the Company's assets. Borrowings under this credit agreement were $1,500,000
at December 31, 1997. Interest was payable monthly at prime plus 2.0%. The
weighted-average interest rate on the line of credit was 10.1% for the year
ended December 31, 1997. Also, monthly fees of an additional 0.5% were paid on
outstanding advances under the line with a $15,000 minimum per quarter. The line
of credit agreement expired and the related outstanding borrowings were repaid
in full in February 1998.

On April 30, 1998, the Company closed on a $5 million line of credit bearing an
interest rate of the bank's prime plus 2%. Borrowings on the line of credit were
limited to the lesser of $5 million or 65% of the Company's outstanding eligible
receivables and inventory. Borrowings on the line of credit were collateralized
by the Company's accounts receivable, inventory, and intellectual property. The
line of credit expired on October 15, 1998 and all outstanding borrowings were
repaid in full.

F-16
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

6. Notes Payable to Related Parties

Notes payable to related parties consisted of the following at December 31,
1997(in thousands):

<TABLE>
<CAPTION>
<S> <C>
Note payable to a stockholder, due on demand after January 1, 1999, interest at
14% per annum $ 600

Note payable to a stockholder, principal and interest due on demand after
January 1, 1999, stated interest at 15% per annum until November 17, 1996, 17%
thereafter 1,000

Note payable to a stockholder, principal and interest due on demand after
January 1, 1999, stated interest at 15% per annum until January 6, 1997, 17%
thereafter 1,000

Note payable to related party, principal and interest due January 1, 1999,
interest at 10% per annum 870
--------------
$ 3,470
==============
</TABLE>

On February 4, 1998, the $600,000 and the two $1 million notes payable to
stockholders were converted into 132,744 shares of Series C Redeemable
Convertible Preferred Stock and 442,478 shares of Class B Common Stock,
respectively. In connection with the Company's July 1998 initial public
offering, the Series C Redeemable Convertible Preferred Stock was converted into
132,744 shares of common stock and the 442,478 shares of Class B Common Stock
were exchanged for an equal number of shares of common stock (see Note 9).
Utilizing proceeds from the Company's initial public offering, the $870,000 note
payable to a related party was repaid in full during 1998.

F-17
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

7. Long-Term Debt

Long-term debt, other than to related parties, consisted of the following at
December 31, 1997 (in thousands):

<TABLE>
<CAPTION>
<S> <C>
Note payable due January 31, 1998, stated interest at prime plus 2% until an
additional round of equity investment is received by the Company at which time
the interest will be prime plus 4%, collateralized by property and equipment
(net of unamortized discount of $5 at December 31, 1997) $ 495

Subordinated note payable due March 24, 2002, stated interest at 13.5% per
annum, collateralized by property, equipment and inventory (net of unamortized
discount of $276 at December 31, 1997) 2,724

Note payable due January 9, 1998, stated interest rate at prime (8.5% at
December 31, 1997), collateralized by a personal guarantee of the Company's
major shareholder 250

Junior, subordinated note payable, due August 30, 2002, interest payable in
arrears every six months, at stated interest rate of 11% per annum for the
first twelve months, 12.0% per annum for next twelve months, and 12.5%
thereafter until maturity, collateralized by the assets of the Company (net of
unamortized discount of $165 at December 31, 1997) 1,035
----------------
4,504
Less current portion 745
----------------
Long-term debt, less current portion $ 3,759
================
</TABLE>

All of the aforementioned long-term debt was repaid in full utilizing proceeds
from the Company's July 1998 initial public offering. As a result of the early
extinguishment of the long-term debt, the Company recorded an extraordinary loss
of $407,000 which consists of the difference between the principal amount and
the net carrying amount of the extinguished debt.

8. Leases

The Company rents its facilities and certain office equipment under
noncancelable operating leases which expire at various times through 2001. The
monthly rent under certain facility leases are periodically adjusted based on
changes in the Consumer Price Index.

F-18
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

8. Leases (continued)

Property and equipment includes the following amounts for capital leases (in
thousands):

<TABLE>
<CAPTION>
December 31
1998 1997
---------------------------------
<S> <C> <C>
Leased equipment $ 157 $ 157
Leased furniture and fixtures 53 53
----------------------------------
210 210
Less: accumulated amortization (125) (85)
$ 85 $ 125
==================================
</TABLE>

The following is a schedule of future minimum lease payments for capital and
operating leases for the years ending December 31 (in thousands):

<TABLE>
<CAPTION>
Capital Operating
Leases Leases
------------------------------------
<S> <C> <C>
1999 $ 28 $ 329
2000 16 247
2001 - 20
------------------------------------
Total future minimum lease payments 44 $ 596
=================
Less: amounts representing interest (6)
-------------------
Present value of future minimum lease payments 38
Less: current portion (23)
-------------------
$ 15
===================
</TABLE>

Total rent expense incurred was approximately $462,000 and $309,000 for the
years ended December 31, 1998 and 1997, respectively.

F-19
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

9. Stockholders' Equity (Deficit)

Stock Split

On July 1, 1998, the Company effected a one-for-two reverse stock split of the
Company's capital stock in connection with the Company reincorporating in North
Carolina. All references in the financial statements with regard to number of
shares of each class of stock have been restated to reflect the reverse stock
split for all periods presented.

Initial Public Offering

On July 27, 1998, the Company consummated an initial public offering ("IPO" or
"Offering") of 2,600,000 shares of its common stock at a price of $8.00 per
share. During August 1998, BlueStone Capital Partners, L.P. and Royce Investment
Group, Inc. (collectively, the "underwriters") exercised in full their
overallotment option to purchase an additional 390,000 shares of the Company's
common stock at the IPO price. All of such shares were sold by the Company. The
net proceeds to the Company from the offering and the exercise of the
overallotment option were approximately $20.5 million.

Recapitalization

The Company was recapitalized through the exchange of securities which was
effective as of the closing date of the Company's initial public offering as
follows:

Class A Common Stock: Exchanged for an aggregate of 3,931,215 shares of
common stock.

Class B Common Stock: Exchanged for an aggregate of 601,457 shares of common
stock.

Series A Convertible Preferred Stock: Converted into an aggregate of 82,634
shares of common stock.

Series B Convertible Preferred Stock: Converted into an aggregate of
2,045,649 shares of common stock.

Series C Redeemable Convertible Preferred Stock: Converted into an aggregate
of 132,744 shares of common stock.

Upon consummation of the offering, the Company has authorized capital of
50,000,000 shares of $.10 par value common stock and 25,000,000 shares of $.10
par value preferred stock.

F-20
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

9. Stockholders' Equity (Deficit) (continued)

During 1997, the Company issued 1,037 shares of its Class A Common Stock for
services rendered. These transactions were valued based on the estimated fair
value of the common stock at the time the related services were performed.

Convertible Preferred Stock

On February 4, 1998, the company issued 778,746 shares of its Series B
Convertible Preferred Stock ("Series B Preferred") for net proceeds of
$3,169,000. These shares were converted into 2,045,649 shares of common stock in
connection with the Company's initial public offering. The Company and an
affiliate of the holders of the Series B Preferred entered into a marketing
agreement pursuant to which the Company was obligated to pay to the affiliate
$400,000 for marketing services related to the Company's IPO. The Company
satisfied its obligation during 1998 from proceeds of the IPO.

10. Stock Options, Stock Plans and Warrants

Employee Stock Options and Stock Plans

Effective January 2, 1995, the Company adopted two employee incentive stock
option plans (the "1995 Plans"). One plan provided for the granting of options
to purchase Class A Common Stock which was voting stock, and one plan provided
for the granting of options to purchase Class B Common Stock which was non-
voting. The 1995 Plans are intended as incentives to induce key employees of the
Company to remain in the employ of the Company or of any subsidiary of the
Company, and to encourage such employees to own stock in the Company. This
purpose is carried out by granting options to purchase shares of Common Stock.
The Company may grant incentive stock options ("ISOs") within the meaning of
Section 422 of the Internal Revenue Code of 1986, as amended to eligible
participants under the 1995 Plans. The exercise price of an ISO may not be less
than 100% of the fair market value of the underlying shares at the time the ISO
is granted.

The 1995 Plans are administered by the Board of Directors. The Board has the
authority to administer the 1995 Plans and determine, among other things, the
interpretation of any provisions of the 1995 Plans, the eligible employees who
are to be granted stock options, the number of shares which may be issued and
the option exercise price.

F-21
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

10. Stock Options, Stock Plans and Warrants (continued)

The Company's incentive stock options vest over time with 20% vesting during the
second year after the date of grant with an additional 5% vesting each calendar
quarter thereafter. Incentive stock options generally may only be exercised if
the participant has been employed by the Company continuously for at least one
year as of the last day of the first twelve-month period following the date of
option grant. The option is only exercisable if the participant is employed by
the Company and for limited periods of time after the participant's termination
of employment. If the participant ceases to be employed on account of
termination by the Company for cause or resignation (other than retirement as
defined in the option agreement), the right to exercise any unexercised portion
of the option terminates. If the participant is terminated by the company
without cause, the participant shall be entitled to purchase, within three
months, option shares equal to an additional 25% of the participant's option
shares that were not exercisable as of the termination date. The option becomes
immediately and fully exercisable in the event of a change in control as defined
in the option agreement.

Performance options vest upon the earlier of the Company's achievement of
certain performance standards or seven years from the date of grant. The number
and exercise price of the options are fixed at the date of grant. Options are
exercisable only in the event the participant is employed by the Company and for
limited periods of time after the participant's termination of employment. If
the participant ceases to be an employee on account of resignation (other than
retirement as defined in the option agreement) or termination for cause, the
right to exercise any unexercised portion of the option shall terminate. The
option becomes immediately and fully exercisable as of a change in control as
defined in the agreement.

As the exercise price of the options was not less than the fair value of the
stock on the date of grant, no compensation expense was recorded related to
these options.

During May 1998, the Company's 1998 Stock Plan (the "Plan") was adopted by the
Board of Directors and approved by the shareholders of the Company. The Company
anticipates that no future grants will be made under the Company's 1995
incentive stock plans after the effective date of the 1998 Plan. A total of
800,000 shares of Common Stock have been reserved for issuance under the Plan.
The Plan provides for grants to employees of incentive stock options. In
addition, the Plan provides for grants of nonqualified stock options and stock
purchase rights to employees, directors and consultants of the Company. The Plan
is administered by the Board of Directors or by a Committee appointed by the
Board. The administrator determines the terms of options and stock purchase
rights granted, including the exercise price and the number of shares subject to
option or stock purchase right. The exercise price of incentive stock options
granted under the Plan must be at least equal to the fair market value of the
Company's Common Stock on the date of the grant. The maximum term of options
granted under the plan is 10 years.

F-22
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

10. Stock Options, Stock Plans and Warrants (continued)

During May 1998, the Company's 1998 Employee Stock Purchase Plan (the "Purchase
Plan") was adopted by the Company's Board of Directors and approved by the
Company's shareholders. The Purchase Plan is intended to qualify under Section
423 of the Internal Revenue Code of 1986, as amended. The Company has reserved
500,000 shares of Common Stock for issuance under the Purchase Plan. Under the
Purchase Plan, an eligible employee may purchase shares of Common Stock from the
Company through payroll deductions of up to 10% of his or her base compensation,
not to exceed $25,000 per year, at a price per share equal to 85% of the fair
market vale of a share of the Company's Common Stock on the last day of the
offering period. The maximum number of shares that an employee may purchase in
any offering period is 2,500 shares. Any employee who is customarily employed
for at least 20 hours per week, and more than five months per calendar year and
who is employed on or before the commencement date of an offering period is
eligible to participate in the Purchase Plan.

The following table summarizes the ISO and PSO activity under the Company's 1995
and 1998 Stock Plans:

<TABLE>
<CAPTION>
Weighted-
Shares Shares Average
Available Available Exercise
for Grant for Grant Options Price Per Options
1995 Plans 1998 Plans Outstanding Share Exercisable
-----------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Balances at December 31, 1996 1,004,880 - 1,863,370 $1.78 54,644
Options authorized for grant 607,500 - - - -
Options granted (330,316) - 330,316 5.63 -
Options exercised - - (1,125) 1.00 -
Options canceled 199,513 - (199,513) 4.90 -
-----------------------------------------------------------------------------------
Balances at December 31, 1997 1,481,577 - 1,993,048 2.14 1,007,328
Options authorized for grant - 800,000 - - -
Options granted (254,684) (484,750) 739,434 4.80 -
Options exercised - - (420,088) 1.19 -
Options canceled 322,626 7,800 (330,426) 4.70 -
-----------------------------------------------------------------------------------
Balances at December 31, 1998 1,549,519 323,050 1,981,968 $2.72 810,797
===================================================================================
</TABLE>

F-23
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

10. Stock Options, Stock Plans and Warrants (continued)

The following summarizes information about the Company's stock options
outstanding at December 31, 1998:

<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
- ------------------------------------------------------------------------------------------------------------------------
Weighted
Average Weighted Weighted
Remaining Average Average
Number Contractual Exercise Number Exercise
Range of Exercise Prices Outstanding Life Price Exercisable Price
- ------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
$1.000 999,500 4.38 $1.00 517,377 $1.00
$2.000 - $4.125 481,389 7.65 3.44 84,561 2.06
$4.250 150,000 6.17 4.25 - -
$6.000 351,079 6.49 6.00 208,859 6.00
------------------------------------------------------------------------------------------
1,981,968 5.68 $2.72 810,797 $2.46
==========================================================================================
</TABLE>

The Company has adopted the disclosure-only provisions of SFAS No. 123. The
fair value for each option was estimated at the date of grant using a Black-
Scholes option pricing model with the following weighted average assumptions:

<TABLE>
<CAPTION>
Year ended December 31
1998 1997
--------------------------
<S> <C> <C>
Expected dividend yield 0% 0%
Risk-free interest rate 5% 6%
Expected volatility 66% 59%
Expected life (in years from vesting) 3.4 1.9
</TABLE>

For purpose of pro forma disclosures, the estimated fair values of the stock
options are amortized to expense over the vesting period. The grant date Black-
Scholes weighted-average value of options was $2.19 and $0.95 per share for 1998
and 1997, respectively.

F-24
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

10. Stock Options, Stock Plans and Warrants (continued)

The following table shows pro forma net loss and net loss per share as if the
fair value accounting method prescribed by SFAS No. 123 had been used to account
for stock based compensation (in thousands, except per share data):

<TABLE>
<CAPTION>
Year Ended December 31
1998 1997
-------------------------------
<S> <C> <C>
Net loss as reported $(11,652) $(4,298)
Pro forma compensation expense (585) (484)
-------------------------------
Pro forma net loss $(12,237) $(4,782)
===============================
Net loss per share:
Historical $ (1.79) $ (1.36)
Pro forma (for SFAS 123 disclosure purposes) $ (1.88) $ (1.52)
</TABLE>

Stock Warrants

Warrants issued in connection with notes payable were recorded at their
estimated fair value and credited to additional paid in capital. The resulting
debt discount was amortized to interest expense over the term of the related
debt. Warrants issued to members of the Board of Directors, consultants and
financial advisors are recorded at their estimated fair value and the related
general and administrative expense is charged when the warrants are issued. The
estimated fair value of warrants issued to the placement agent in connection
with the issuance of preferred stock in February 1998 was recorded as a stock
issuance cost.

The following summarizes the activity of warrants:

Warrants
Outstanding
--------------------
<S> <C>
Balance at December 31, 1996 261,157
Issued 488,897
--------------------
Balance at December 31, 1997 750,054
Issued 514,993
Exercised (535,875)
--------------------
Balance at December 31, 1998 729,172
====================
</TABLE>

F-25
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

10. Stock Options, Stock Plans and Warrants (continued)

All of the Company's outstanding warrants at December 31, 1998 were exercisable
at prices ranging from $1.00 to $8.00 per share.

In connection with the conversion of a note payable, the Company had an
additional commitment to issue 48,604 shares of its Class B common stock to the
former holder of the note. The Company satisfied its commitment in August 1998
by issuing 48,604 shares of the Company's common stock.

Common Stock Reserved for Future Issuance

The Company has reserved authorized shares of Common Stock for future issuance
as follows at December 31, 1998:

<TABLE>
<S> <C>
Outstanding incentive stock options 1,374,468
Outstanding performance based stock options 607,500
Possible future issuance under stock option plan 1,872,569
Stock purchase warrants 729,172
----------------------
4,583,709
======================
</TABLE>

11. Income Taxes

At December 31, 1998, the Company has a cumulative domestic federal net
operating loss carryforward available to offset future taxable income of
approximately $19 million which begins to expire in the year 2011. State tax
losses of approximately $19 million will begin to expire in 2001. The Company
also has $350,000 of research credits to carryforward for use against future
domestic federal income taxes. U.S. tax laws impose limitations on the use of
net operating losses and credits following certain changes in ownership. If such
a change occurs, the limitations could reduce the amount of these benefits that
would be available to offset future taxable income each year, starting with the
year of ownership change.

F-26
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

11. Income Taxes (continued)

Deferred income taxes reflect the net tax effect of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components
of the Company's deferred tax assets and liabilities consisted of the following
at (in thousands):

<TABLE>
<CAPTION>
December 31
1998 1997
------------------------------
<S> <C>
Deferred tax assets: <C>
Net operating loss carryforwards $7,797 $3,669
Sales and accounts receivable reserves 782 1,048
Accrued salaries 42 10
Other reserves 91 191
Accrued interest to related party 77 397
Depreciation (78) 17
Research and development credit carryforward 354 78
------------------------------
Total deferred tax assets 9,065 5,410

Deferred tax liabilities:
Accounting method change 54 72
------------------------------
Total deferred tax liabilities 54 72

Less:
Valuation allowance 9,011 5,338
------------------------------
Total net deferred taxes $ - $ -
==============================
</TABLE>

The Company has recorded a valuation allowance for the full amount of its
deferred income tax assets as of December 31, 1998 and 1997, based on
management's evaluation of the criteria set forth in SFAS No. 109.

For financial reporting purposes, (loss) income before income taxes and
extraordinary item includes the following components (in thousands):

<TABLE>
<CAPTION>
December 31
1998 1997
------------------------------
<S> <C> <C>
Pretax (loss) income:
United States $(11,195) $(4,873)
Foreign (22) 542
------------------------------
$(11,217) $(4,331)
==============================
</TABLE>

F-27
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

11. Income Taxes (continued)

Significant components of the provision for income tax (expense) benefit
attributable to continuing operations are as follows (in thousands):

<TABLE>
<CAPTION>
December 31
1998 1997
--------------------------------------
<S> <C> <C>
Current:
Federal $ - $ 41
Foreign (28) (15)
State - 7
--------------------------------------
Total current (expense) benefit $ (28) $ 33
======================================
</TABLE>

12. Retirement Plan

The Company has a qualified 401(k) Retirement Plan. The Plan covers
substantially all of the Company's full-time employees. Effective November 20,
1996, the Plan requires six months of full-time service for an employee to be
eligible to participate. Participants may contribute up to 15% of their
compensation to the Plan, subject to the yearly maximums established by the
Internal Revenue Service. Employer matching contributions are at the discretion
of the Company's Board of Directors. There were no discretionary employer
contributions made during the years ended December 31, 1998 and 1997.

13. Significant Customers

Revenues from significant customers, those representing 10% or more of net
revenues for the respective periods, are summarized as follows:

<TABLE>
<CAPTION>
Year ended December 31
1998 1997
--------------------------------------
<S> <C> <C>
Customer 1 13% -
Customer 2 16% -
Customer 3 - 19%
Customer 4 - 10%
</TABLE>

Additionally, two customers comprised 22% of accounts receivable at December 31,
1998 and three customers comprised 40% of accounts receivable at December 31,
1997.

F-28
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

14. Geographic Information

In addition to domestic sales, the Company sells its product through its
subsidiaries to international customers. These sales amounted to 54% and 37% of
net revenues during the years ended December 31, 1998 and 1997, respectively.

The following table presents information related to the Company's operations by
geographic location (in thousands):

<TABLE>
<CAPTION>
Year ended December 31
1998 1997
-----------------------------
<S> <C> <C>
Net revenue:
United States $ 6,283 $ 10,396
United Kingdom 2,010 1,650
Germany 1,759 2,310
Other 2,514 2,146
-----------------------------
$ 12,566 $ 16,502
=============================

Long-lived assets:
United States $ 989 $ 1,099
United Kingdom 73 80
Germany 20 17
-----------------------------
$ 1,082 $ 1,196
=============================
</TABLE>

F-29
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

15. Subsequent Events

On January 25, 1999, the Company issued a $4 million convertible debenture ("the
debenture") for net cash proceeds to the Company of approximately $3.7 million.
The Company also issued 200,000 warrants to the debenture broker, which
represented additional debt issuance costs, valued at $390,000. These warrants
were recorded as additional paid-in capital and the resulting debt issuance
costs will be amortized to interest expense over the term of the debenture.
These warrants have a weighted average exercise price of $4.85 and were
exercisable upon issuance.

The debenture accrues interest at an annual interest rate of 6% and the accrued
interest and principal are due on January 25, 2002. The holder of the
convertible debenture may convert all or any portion of the debenture into the
Company's common stock where the number of shares to be issued will be
determined by dividing the principal plus interest due by the conversion price.
The conversion price will be equal to the lesser of a conversion price ranging
from 77% to 93% of the market price of the Company's common stock (as defined in
the securities purchase agreement) or a conversion price ranging from 104% to
120% of a fixed conversion price (as defined in the securities purchase
agreement). On the date of conversion, if the Company's common stock trades at a
price higher than the fixed conversion price, the Company is obligated to issue
to the holder of the debenture warrants to purchase the Company's stock at a
one-for-two ratio of common stock issued as a result of the debenture conversion
at an exercise price equal to the debenture conversion price (the "contingently
issuable warrants").

The contingently issuable warrants were valued at approximately $1.1 million at
the date of issuance and were recorded as additional paid-in capital. The
beneficial conversion feature of the debenture also resulted in a portion of the
proceeds of the debenture being allocated to the conversion feature based on its
intrinsic value of $2.1 million, which was recorded as additional paid-in
capital. The debenture was convertible at the date of issuance and the
value of the conversion feature was therefore immediately recorded as additional
interest expense and accreted into the carrying value of the debenture. Based on
the recorded fair value of the contingently issuable warrants, the carrying
value assigned to the debenture at the date of issuance was $2.9 million. The
difference between the initial carrying value of the debenture and the $4
million face value will be accreted into the carrying value as additional
interest expense over the term of the debenture.

On February 12, 1999 the Company completed the acquisition of MPG-Net, Inc.
("MPG-Net") Company by exchanging 600,000 shares of its common stock valued at
approximately $3.1 million for all of the outstanding common stock of MPG-Net
and issuing 150,000 shares of its common stock valued at approximately $.8
million in full settlement of certain debt obligations of MPG-Net. MPG-Net is
primarily in the business of developing, publishing and distributing
interactive, real time 3-D entertainment for multi-user online/Internet play, as
well as creating entertainment platforms on the Internet such as online game
channels, game hubs and websites. The merger was originally accounted for under
the pooling-of-interests method in accordance with Accounting Principles Board
Opinion No. 16. Subsequent to the merger, the management of the Company began to
explore and evaluate various business strategies, including the potential sale
of its CD-ROM business. During the second quarter, the Company consummated an
agreement to sell a significant portion of its CD-ROM business. Although the CD-
ROM asset disposition was not contemplated at the time of the MPG-Net merger,
the proximity of the transaction to the closing of the merger made it
impracticable to overcome the presumption that the asset disposition was done in
contemplation of the merger. Therefore, the pooling treatment was rescinded, and
the Company accounted for the MPG-Net merger as a purchase business combination.
The excess of the aggregate purchase price over the fair value of the net assets
acquired of approximately $4.3 million is being amortized over 3 years.

F-30
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

F-31
<PAGE>

Interim Financial Statements

Interactive Magic, Inc.

Consolidated Balance Sheets
(In thousands, except share data)

<TABLE>
<CAPTION>
March 31 December 31
1999 1998
(Unaudited) (Audited)
------------------------------
<S> <C> <C>
Assets
Current assets:
Cash and cash equivalents $ 3,255 $ 2,943
Trade receivables, net of allowances of $1,521 and $2,871,
respectively 1,404 2,109
Inventories 834 892
Advance royalties, net 1,812 1,586
Software development costs, net 344 912
Prepaid expenses and other 123 252
------------------------------
Total current assets 7,772 8,694

Property and equipment, net 1,173 1,082

Noncurrent assets:
Royalties receivable 706 726
Goodwill 4,182 0
Other 57 18
------------------------------
Total noncurrent assets 4,945 744

------------------------------
Total assets $13,890 $10,520
==============================
</TABLE>

F-32
<PAGE>

<TABLE>
<CAPTION>
March 31 December 31
1999 1998
(Unaudited) (Audited)
---------------------------------
<S> <C> <C>
Liabilities and stockholders' equity (deficit)
Current liabilities:
Accounts payable and accrued expenses $ 1,380 $ 1,698
Royalties and commissions payable 488 768
Lines of credit 1,323 1,348
Current portion of capital lease obligations 52 23
---------------------------------
Total current liabilities 3,243 3,837

Noncurrent liabilities:
Accrued interest payable to related parties 145 117
Long-term debt 2,296 -
Capital lease obligations, less current portion 35 15
---------------------------------
Total noncurrent liabilities 2,476 132

Stockholders' equity (deficit):
Preferred Stock, $.10 par value; 25,000,000 shares authorized;
none issued and outstanding - -
Common stock, $.10 par value; 50,000,000 shares authorized;
10,675,183 and 9,850,867 shares issued and outstanding at
March 31, 1999 and December 31, 1998, respectively 1,068 985
Additional paid-in capital 39,171 31,522
Accumulated deficit (31,960) (25,862)
Accumulated other comprehensive loss (108) (94)
----------------------------------
Total stockholders' equity (deficit) 8,171 (6,551)
----------------------------------
Total liabilities and stockholders' equity (deficit) $ 13,890 $ 10,520
==================================
</TABLE>

F-33
<PAGE>

Interactive Magic, Inc.

Consolidated Statements of Operations
(In thousands, except share and per share data)
(Unaudited)

<TABLE>
<CAPTION>
Three months ended March 31
1999 1998
----------------------------
<S> <C> <C>
Net revenues:
CD-ROM product sales $ 561 $ 4,057
Online sales 467 358
Royalties and licenses 7 498
Advertising and other 127 0
----------------------------
Total net revenues 1,162 4,913

Cost of revenues:
Cost of products and services 416 968
Royalties and amortized software costs 89 909
----------------------------
Total cost of revenues 505 1,877
----------------------------
Gross profit 657 3,036

Operating expenses:
Sales and marketing 1,522 1,667
Product development 1,845 1,103
General and administrative 852 449
Goodwill amortization 191 0
----------------------------
Total operating expenses 4,410 3,219
----------------------------
Operating loss (3,753) (183)

Other (income) expense:
Interest expense - third parties 2,345 200
Interest expense - related parties 18 107
Other (53) -
----------------------------
Total other expense 2,310 307
----------------------------
Loss before income taxes (6,063) (490)
Income tax expense 35 128
----------------------------
Net loss $ (6,098) $ (618)
============================

Basic loss per share:
Net loss per share $ (0.59) $ (0.18)
============================

Weighted average shares used in computing basic loss per share 10,316,300 3,429,558
============================
</TABLE>

F-34
<PAGE>

Interactive Magic, Inc.

Consolidated Statements of Stockholders' Equity (Deficit)
(In thousands, except share data)

<TABLE>
<CAPTION>
Series A Convertible Series B Convertible
Preferred Stock Preferred Stock Common Stock
------------------------------------------------------------------------------
Shares Amount Shares Amount Shares Amount
------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1997 82,634 $ 8 - $ - - -
Exercise of stock options - - - - - -
Issuance of common stock - - - - - -
Exercise of warrants - - - - - -
Issuance of preferred stock - - 778,746 78 - -
Conversion of notes payable into common stock - - - - - -
Recapitalization contemporaneous with the initial
public offering (Note 8) (82,634) (8) (778,746) (78) 6,793,699 679
Issuance of common stock - - - - 2,990,000 299
Exercise of warrants - - - - 18,330 2
Exercise of stock options - - - - 48,838 5
Issuance of warrants - - - - - -
Comprehensive loss
Net loss - - - - - -
Other comprehensive loss - - - - - -
Total comprehensive loss
------------------------------------------------------------------------------
Balance at December 31, 1998 - - - - 9,850,867 985
Exercise of stock options - - - - 74,316 8
Issuance of warrants - - - - - -
Issuance of convertible debenture (Note 6) - - - - - -
Issuance of common stock (Note 3) - - - - 750,000 75
Comprehensive loss
Net loss - - - - - -
Other comprehensive loss - - - - - -
Total comprehensive loss
------------------------------------------------------------------------------
Balance at March 31, 1999 (Unaudited) - $ - - $ - 10,675,183 $1,068
==============================================================================
</TABLE>

F-35
<PAGE>

<TABLE>
<CAPTION>
Accumulated
Class A Class B Additional Other
Common Stock Common Stock Paid-In Comprehensive Accumulated
Capital Loss Deficit Total
- -----------------------------------------
Shares Amount Shares Amount
- ----------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
3,145,696 $ 314 7,875 $ 1 $ 5,047 $ (59) $(14,210) $ (8,899)
268,750 27 102,500 10 381 - - 418

- - 48,604 5 (5) - - -
516,769 52 - - (52) - - -
- - - - 3,091 - - 3,169
- - 442,478 44 1,956 - - 2,000

(3,931,215) (393) (601,457) (60) 460 - - 600
- - - - 20,176 - - 20,475
- - - - (2) - - -
- - - - 76 - - 81
- - - - 394 - - 394

- - - - - - (11,652) (11,652)
- - - - - (35) - (35)
-------
(14,687)
- ----------------------------------------------------------------------------------------------------
- - - - 31,522 (94) (25,862) 6,551
- - - - 199 - - 207
- - - - 466 - - 466
- - - - 3,201 - - 3,201
- - - - 3,783 - - 3,858

- - - - - - (6,098) (6,098)
- - - - - (14) - (14)
--------
(6,112)
- ----------------------------------------------------------------------------------------------------
- $ - - $ - $39,171 $(108) $(31,960) $ 8,171
====================================================================================================
</TABLE>

See accompanying notes.

F-36
<PAGE>

Interactive Magic, Inc.

Consolidated Statements of Cash Flows
(In Thousands)
(Unaudited)

<TABLE>
<CAPTION>
Three months ended March 31
1999 1998
-------------------------------
<S> <C> <C>
Operating activities
Net loss $(6,098) $ (618)
Adjustments to reconcile net loss to net cash used in operating
activities:
Issuance of warrants 76 -
Depreciation and amortization 317 89
Amortization of capitalized software development costs 212 250
Noncash interest expense 2,194 33
Write-off of capitalized software development costs 393 -
Changes in operating assets and liabilities net of effects
of purchase of MPG-Net (Note 3):
Trade and royalties receivables 767 (1,698)
Inventories 58 (128)
Advance royalties (226) 367
Prepaid expenses and other (46) 22
Accounts payable and accrued expenses (650) 254
Royalties and commissions payable (280) 77
Accrued interest 28 18
-------------------------------
Net cash used in operating activities (3,255) (1,334)

Investing activities
Proceeds from acquisition of MPG-Net (Note 3) 18 -
Purchase of property and equipment (36) (51)
Increase in notes receivable (200) -
Software development costs (37) (583)
-------------------------------
Net cash used in investing activities (255) (634)

Financing activities
Proceeds from issuance of common stock 207 9
Proceeds from issuance of preferred stock - 3,169
Payments on long-term debt - (20)
Proceeds from issuance of convertible debentures 3,660 -
</TABLE>

F-37
<PAGE>

Interactive Magic, Inc.

Consolidated Statements of Cash Flows (continued)
(In Thousands)
(Unaudited)

<TABLE>
<CAPTION>
Three months ended March 31
1999 1998
-------------------------------------
<S> <C> <C>
Net borrowings from lines-of-credit (25) (1,426)
Payments on capital lease obligations (6) (12)
-------------------------------------
Net cash provided by financing activities 3,836 1,720

Effect of currency exchange rate changes on cash and cash
equivalents (14) (20)
-------------------------------------
Net increase (decrease) in cash and cash equivalents 312 (268)
Cash and cash equivalents at beginning of period 2,943 384
-------------------------------------
Cash and cash equivalents at end of period $ 3,255 $ 116
=====================================

Supplemental disclosure of cash flow information
Cash paid for interest $ 26 $ 276
=====================================

Noncash investing and financing activities
Issuance of common stock in connection with acquisition of
MPG-Net (Note 3) $ 3,891 $ -
=====================================
Contingently issuable warrants provided to holder of
convertible debenture (Note 6) $ 1,067 $ -
=====================================
Issuance of warrants to broker in connection with convertible
debenture (Note 6) $ 390 $ -
=====================================
</TABLE>

See accompanying notes.

F-38
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements

(Information as of March 31, 1999 and for the three months ended March 31, 1999
and 1998 is unaudited)

1. Description of Business

Interactive Magic, Inc. (the "Company") develops, publishes, and distributes 3-D
interactive, simulation and strategy entertainment software to customers around
the world via (1) retail distribution through international and domestic
software outlets and (2) proprietary, pay-for-play online service on the
Internet. The Company also provides real-time 3-D entertainment for multi-user
online/Internet play, as well as creating interactive entertainment platforms on
the internet, such as online game channels, game hub and websites. The Company
has agreements with various software licensors to manufacture, market, sell and
distribute software in the United States. Through its wholly owned subsidiaries
located in the United Kingdom and Germany, and through its online services, the
Company also distributes its products internationally.

2. Basis of Presentation

The condensed consolidated financial statements include the accounts of
Interactive Magic, Inc. (the "Company"), a North Carolina corporation, and its
wholly owned subsidiaries, iMagicOnline Corporation, Interactive Magic Ltd. And
Interactive Magic GmbH. All significant intercompany accounts and transactions
have been eliminated.

The accompanying consolidated financial statements have been prepared on a going
concern basis, which contemplates the realization of assets and the satisfaction
of liabilities in the normal course of business. As shown in the consolidated
financial statements during the three months ended March 31, 1999 and 1998, the
Company incurred losses of $6,098,000 and $618,000, respectively, and has
experienced negative cash flows from operations. These factors, among others,
indicate that the Company may be unable to continue as a going concern for a
reasonable period of time. The consolidated financial statements do not include
any adjustments relating to the recoverability and classification of liabilities
that might be necessary should the Company be unable to continue as a going
concern.

The Company's continuation as a going concern is dependent upon its ability to
generate sufficient cash flow to meet its obligations on a timely basis, to
obtain additional financing or refinancing as may be required, and ultimately to
attain profitability. On May 25, 1999, the Company executed an Agreement
Regarding Assignment of Contracts (the "Agreement") to sell its rights under
certain development contracts for CD-ROM products between the Company and third
party developers (and assume certain liabilities thereto) for $2.5 million. The
Agreement provides for the Company to retain the right to use these products on
the Internet. The transaction was consummated during the second quarter of
1999.

While the financial information furnished is unaudited, the condensed
consolidated financial statements included in this report reflect all
adjustments (consisting only of normal recurring adjustments) which the Company
considers necessary for the fair presentation of the results of operations for
the interim periods covered and of the financial condition of the Company at the
date of the interim balance sheet. The results for interim periods are not
necessarily indicative of the results for the entire year. The condensed
consolidated financial statements should be read in conjunction with the
Interactive Magic, Inc. consolidated financial statements and the notes thereto,
included in the Company's Annual Report on Form 10-KSB for the year ended
December 31, 1998.

F-39
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

3. Business Combination

The following unaudited consolidated pro forma data summarizes the combined
operating results of the Company and MPG-Net as if the acquisition had occurred
at January 1, 1998:

<TABLE>
<CAPTION>
Three months ended Three Months Ended
March 31, 1999 March 31, 1998
---------------------------------------------------------
<S> <C> <C>
Net revenues $ 1,256 $ 4,965
Net loss before extraordinary items (6,581) (1,249)
Net loss (6,088) (1,249)
Loss per share $ (0.58) $ (0.32)
</TABLE>

F-40
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

4. Significant Accounting Policies and Other Matters

Cash and Cash Equivalents

Cash and cash equivalents include amounts in demand deposit accounts and
investments with an original maturity date of three months or less when
purchased.

Inventories

Inventories consist of the following (in thousands):

<TABLE>
<CAPTION>
March 31 December 31
1999 1998
------------------------------------
<S> <C> <C>
Finished goods $ 856 $1,065
Components 329 117
------------------------------------
1,185 1,182
Inventory valuation reserve (351) (290)
------------------------------------
$ 834 $ 892
====================================
</TABLE>

Advance Royalties

Advance royalties represent prepayments made to independent software developers
under development agreements. Advance royalties are expensed as part of
royalties and amortized software costs at the contractual royalty rate based on
actual net product sales. Management continuously evaluates the future
realization of advance royalties, and charges to cost of revenues any amount
that management deems unlikely to be amortized at the contractual royalty rate
through product sales. At March 31, 1999 and December 31, 1998, the reserve for
advance royalties was $1,724,000 and $1,654,000, respectively.

F-41
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

4. Significant Accounting Policies and Other Matters (continued)

Property and Equipment

Property and equipment are stated at cost. Depreciation for equipment, furniture
and fixtures and purchased software is computed using the straight-line method
over the estimated useful lives of the assets, ranging from five to seven years.
Leasehold improvements are amortized on a straight-line basis over the term of
the estimated useful life of the asset or the remaining lease term, whichever is
less. Depreciation expense, including amortization of equipment leased under
capital leases, was $126,000 and $89,000 for the three months ended March 31,
1999 and 1998, respectively.

Property and equipment consists of the following (in thousands):

<TABLE>
<CAPTION>
March 31 December 31
1999 1998
---------------------------------------
<S> <C> <C>
Equipment $ 2,413 $ 1,547
Furniture and fixtures 411 188
Software 537 488
Leasehold improvements 77 59
---------------------------------------
3,438 2,282
Less accumulated depreciation and amortization (2,265) (1,200)
---------------------------------------
$ 1,173 $ 1,082
=======================================
</TABLE>

F-42
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

4. Significant Accounting Policies And Other Matters (continued)

Software Development Costs

Information related to net capitalized software development costs is as follows
(in thousands):

<TABLE>
<CAPTION>
March 31, 1999 December 31, 1998
---------------------------------------------
<S> <C> <C>
Balance at beginning of period $ 912 $ 425
Capitalized 37 1,450
Written off (393) -
Amortized (212) (963)
---------------------------------------------
Balance at end of period $ 344 $ 912
=============================================
</TABLE>

Fair Value Of Financial Instruments

The carrying value of cash and cash equivalents, trade receivables, accounts
payable and other liabilities approximates fair value at March 31, 1999 and
December 31, 1998.

Revenue Recognition

F-43
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

4. Significant Accounting Policies And Other Matters (continued)

However, AcSEC is currently reviewing further modifications to the SOP with the
objective of providing more definitive, detailed implementation guidelines.
This guidance could lead to unanticipated changes in the Company's operations
and revenue recognition practices

Revenue from CD-ROM product sales is recognized at the time of product shipment.
Revenue from online sales is recognized at the time the game is played and is
based upon actual usage by the customer on an hourly basis. Revenue from
royalties and licenses is recognized when earned under the terms of the relevant
agreements with original equipment manufacturers ("OEMs"), international
distributors and other third parties. With respect to license agreements that
provide customers the right to multiple copies in exchange for guaranteed
amounts, net revenue is recognized upon delivery of the product master or the
first copy; provided collectibility is probable. Per copy royalties on sales
that exceed the guarantee are recognized as earned. The Company accepts product
returns and provides price protection on certain unsold merchandise. Revenue is
recorded net of an allowance for estimated future returns, markdowns, price
protection and warranty costs. Such reserves are based upon management's
evaluation of historical experience, current industry trends and estimated
costs.

Revenue from certain software development contracts with fixed price components
is recognized on the percentage of completion basis in accordance with the
American Institute of Certified Public Accountants' SOP 81-1, "Accounting for
Performance of Construction-Type and Certain Production-Type Contracts." In
accordance with SOP 81-1, the Company recognizes percentage of completion
revenue based upon the ratio of accumulated incurred costs to the total
estimated costs to complete each contract.

F-44
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

4. Significant Accounting Policies And Other Matters (continued)

Product Development

Product development expenses (excluding capitalized software development costs)
are charged to operations in the period incurred and consist primarily of
payroll and payroll related costs.

Advertising

The Company expenses advertising costs as incurred. Advertising expense was
approximately $521,000 and $638,000 for the three months ended March 31, 1999
and 1998, respectively.

Use Of Estimates

The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosures of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Significant estimates include provisions for doubtful accounts, sales returns
and allowances, warranty provisions, and estimates regarding the recoverability
of prepaid royalty advances and inventory. Actual results could differ from
those estimates.

Foreign Currency Translation

Income Taxes

F-45
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

4. Significant Accounting Policies And Other Matters (continued)

Basic Net Loss Per Share

5. Lines Of Credit

The Company maintains a revolving line of credit arrangement with a bank for up
to $2,750,000. The principal balance outstanding at any point in time is
payable on demand with interest payable monthly at the current prime rate (7.75%
at March 31, 1999). The weighted-average interest rate on the line of credit
was 7.75% and 8.50% for the three months ended March 31, 1999 and 1998,
respectively. The balance outstanding as of March 31, 1999 and December 31,
1998 was $1,316,000. Advances on the line of credit are collateralized by a
personal guarantee of the Company's majority stockholder. In consideration for
this guarantee, the Company will pay the stockholder an amount equal to 6% of
the outstanding balance on the line of credit (which has been recorded as
interest expense). At March 31, 1999 and December 31, 1998, the Company owed
the stockholder $145,000 and $117,000 relating to this guarantee, respectively.
These amounts are due no earlier than January 1, 2000.

The Company also entered into a line of credit agreement with its bank to borrow
up to $150,000. The Company's net property and equipment collateralize the line
of credit. The principal balance outstanding at any point in time is payable on
demand with interest payable monthly at the current prime rate. The weighted-
average interest rate on the line of credit was 7.75% and 8.50% for the three
months ended March 31, 1999 and 1998, respectively. The balance outstanding at
March 31, 1999 and December 31, 1998 was $7,000 and $32,000, respectively.

F-46
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

6. Long-term Debt

The contingently issuable warrants were valued at approximately $1.1 million at
the date of issuance and were recorded as additional paid-in capital. The
beneficial conversion feature of the debenture also resulted in a portion of the
proceeds of the debenture being allocated to the conversion feature based on its
intrinsic value of $2.1 million, which was recorded as additional paid-in
capital. The debenture was convertible at the date of issuance and the
value of the conversion feature was therefore immediately recorded as
additional interest expense and accreted into the carrying value of the
debenture. Based on the recorded fair value of the contingently issuable
warrants, the carrying value assigned to the debenture at the date of issuance
was $2.9 million. The difference between the initial carrying value of the
debenture and the $4 million face value will be accreted into the carrying value
as additional interest expense over the term of the debenture. For the three
months ended March 31, 1999, the Company recorded approximately $59,000 in
interest expense related to such accretion. For the three months ended March 31,
1999, interest expense related to this debenture totaled $2.2 million.

F-47
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

7. Leases

The Company rents its facilities and certain office equipment under
noncancelable operating and capital leases which expire at various times through
2001.The monthly rent under certain facility leases is periodically adjusted
based on changes in the Consumer Price Index.

Property and equipment includes the following amounts for capital leases (in
thousands):

<TABLE>
<CAPTION>
March 31 1999 December 31 1998
----------------------------------------------
<S> <C> <C>
Leased equipment $ 247 $ 157
Leased furniture and fixtures 53 53
------------------------------------------ ----
300 210
Less: accumulated amortization (174) (125)
------------------------------------------ ----
$ 126 $ 85
==============================================
</TABLE>

Total rent expense incurred was approximately $103,000 and $99,000 for the three
months ended March 31, 1999 and 1998, respectively.

8. Stockholders' Equity (Deficit)

Recapitalization

F-48
<PAGE>

The Company was recapitalized through the exchange of securities, which was
effective as of the closing date of the Company's initial public offering in
July 1998, as follows:

Class A Common Stock: Exchanged for an aggregate of 3,931,215 shares of
common stock.

Class B Common Stock: Exchanged for an aggregate of 601,457 shares of common
stock.

Series A Convertible Preferred Stock: Converted into an aggregate of 82,634
shares of common stock.

Series B Convertible Preferred Stock: Converted into an aggregate of
2,045,649 shares of common stock.

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

8. Stockholders' Equity (Deficit) (continued)

Series C Redeemable Convertible Preferred Stock: Converted into an aggregate
of 132,744 shares of common stock.

Upon consummation of the initial public offering, the Company has authorized
capital of 50,000,000 shares of $.10 par value common stock and 25,000,000
shares of $.10 par value preferred stock.

9. Stock Options, Stock Plans And Warrants

Employee Stock Options And Stock Plans

F-49
<PAGE>

F-50
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

9. Stock Options, Stock Plans And Warrants (continued)

date of option grant. The option is only exercisable if the participant is
employed by the Company and for limited periods of time after the participant's
termination of employment. If the participant ceases to be employed on account
of termination by the Company for cause or resignation (other than retirement as
defined in the option agreement), the right to exercise any unexercised portion
of the option terminates. If the participant is terminated by the company
without cause, the participant shall be entitled to purchase, within three
months, option shares equal to an additional 25% of the participant's option
shares that were not exercisable as of the termination date. The option becomes
immediately and fully exercisable in the event of a change in control as defined
in the option agreement

Performance options vest upon the earlier of the Company's achievement of
certain performance standards or seven years from the date of grant. The number
and exercise price of the options are fixed at the date of grant. Options are
exercisable only in the event the participant is employed by the Company and for
limited periods of time after the participant's termination of employment. If
the participant ceases to be an employee on account of resignation) (other than
retirement as defined in the option agreement) or termination for cause, the
right to exercise any unexercised portion of the option shall terminate. The
option becomes immediately and fully exercisable as of a change in control as
defined in the agreement.

During May 1998, the Company's 1998 Stock Plan (the "Plan") was adopted by the
Board of Directors and approved by the shareholders of the Company. The Company
anticipates that no future grants will be made under the Company's 1995
incentive stock plans after the effective date of the 1998 Plan. A total of
800,000 shares of Common Stock have been reserved for issuance under the Plan.
The Plan provides for grants to employees of incentive stock options. In
addition, the Plan provides for grants of nonqualified stock options and stock
purchase rights to employees, directors and consultants of the Company. The
Plan is administered by the Board of Directors or by a Committee appointed by
the Board. The administrator determines the terms of options and stock purchase
rights granted, including the exercise price and the number of shares subject to
option or stock purchase right. The exercise price of incentive stock options
granted under the Plan must be at least equal to the fair market value of the
Company's Common Stock on the date of the grant. The maximum term of options
granted under the plan is 10 years.

During May 1998, the Company's 1998 Employee Stock Purchase Plan (the "Purchase
Plan") was adopted by the Company's Board of Directors and approved by the
Company's shareholders. The

Purchase Plan is intended to qualify under Section 423 of the Internal Revenue
Code of 1986, as amended. The Company has reserved 500,000 shares of Common
Stock for issuance under the Purchase Plan. Under the Purchase Plan, an
eligible employee may purchase shares of Common Stock from the Company through
payroll deductions of up to 10% of his or her base compensation, not to exceed
$25,000 per year, at a price per share equal to 85% of the fair market vale of a
share of the Company's Common Stock on the last day of the offering period. The
maximum number of shares that an employee may purchase in any offering period is
2,500

F-51
<PAGE>

shares. Any employee who is customarily employed for at least 20 hours
per week, and more than five months per calendar year and who is employed on or
before the commencement date of an offering period is eligible to participate in
the Purchase Plan.

F-52
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

9. Stock Options, Stock Plans And Warrants (continued)

The following table summarizes the activity under the Company's Stock Option
Plans:

<TABLE>
<CAPTION>
Options Weighted-Average Exercise Options
Outstanding Price Per Share Exercisable
-----------------------------------------------------------------------------
<S> <C> <C> <C>
Balances at December 31, 1997 1,993,048 $2.14 1,007,328
Options granted 739,434 4.80 -
Options exercised (420,088) 1.19 -
Options canceled (330,426) 4.70 -
-----------------------------------------------------------------------------

Balances at December 31, 1998 1,981,968 2.72 813,072
Options granted 623,330 4.25 -
Options exercised (74,316) 2.92 -
Options canceled (110,770) 5.71 -
-----------------------------------------------------------------------------
Balances at March 31, 1999 (Unaudited) 2,420,212 $3.11 932,815
=============================================================================
</TABLE>

The following summarizes information about the Company's stock options
outstanding at March 31, 1999:

<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
- --------------------------------------------------------------------------------------------------------------------
Weighted
Average Weighted Weighted
Remaining Average Average
Number Outstanding Contractual Exercise Number Exercise Price
Range Of Exercise Prices Life Price Exercisable
- --------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
$1.000 902,500 3.78 $1.00 586,171 $1.00
$2.000 - $4.125 562,986 6.42 $3.56 114,906 $2.73
$4.250 - $4.500 652,150 6.03 $4.29 25,000 $4.25
$6.000 302,576 5.34 $6.00 206,738 $6.00
------------------------------------------------------------------------------------------
2,420,212 5.20 $3.11 932,815 $2.41
==========================================================================================
</TABLE>

The Company has adopted the disclosure-only provisions of SFAS No. 123. The
fair value for each option was estimated at the date of grant using a
Black-Scholes option-pricing model with the following weighted average
assumptions:

F-53
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

9. Stock Options, Stock Plans And Warrants (continued)

<TABLE>
<CAPTION>
Three Months Ended March Three Months Ended March 31,
31, 1999 1998
--------------------------------------------------------------
<S> <C> <C>
Expected dividend yield 0% 0%
Risk-free interest rate 5% 6%
Expected volatility 66% 59%
Expected life (in years from vesting) 2.5 4.9
</TABLE>

Three Months Ended March 31, Three Months Ended March 31,
1999 1998
(Unaudited) (Unaudited)

<S> <C> <C>
Net loss as reported $(6,098) $(618)
Pro forma compensation expense (227) (62)
-------- ------
Pro forma net loss $(6,325) $(680)
-------- ------

Net loss per share:
Historical $ (0.59) $(.18)
Pro forma (for SFAS 123 disclosure purposes) $ (0.61) $(.20)
======= ======
</TABLE>

F-54
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

9. Stock Options, Stock Plans And Warrants (continued)

Stock Warrants

Warrants issued in connection with notes payable and convertible debt were
recorded at their estimated fair value and credited to additional paid in
capital. The resulting debt discount is amortized to interest expense over the
term of the related debt. Warrants issued to members of the Board of Directors,
consultants and financial advisors are recorded at their estimated fair value
and the related general and administrative expense is charged when the warrants
are issued. The estimated fair value of warrants issued to the placement agent
in connection with the issuance of preferred stock in February 1998 was recorded
as a stock issuance cost.

The following summarizes the activity of warrants:

Warrants
Outstanding
------------------
<S> <C>
Balance at December 31, 1997 750,054
Issued 514,993
Exercised (535,875)
------------------
Balance at December 31, 1998 729,172
Issued 260,000
Exercised -
------------------
Balance at March 31, 1999 989,172
==================

</TABLE>

All of the Company's outstanding warrants at March 31, 1999 were exercisable at
prices ranging from $1.00 to $8.00 per share.

Common Stock Reserved For Future Issuance

The Company has reserved authorized shares of Common Stock for future issuance
as follows:

<TABLE>
<CAPTION>
March 31, 1999
------------------------
<S> <C>
Outstanding stock options 2,420,212
Possible future issuance under stock option plan 1,464,325
Stock purchase warrants 989,172
------------------------
4,873,709
========================
</TABLE>

F-55
<PAGE>

Interactive Magic, Inc.

Notes to Consolidated Financial Statements (continued)

10. Disposition Of Assets

On May 25, 1999, the Company executed an Agreement Regarding Assignment of
Contracts (the "Agreement") to sell its rights under certain development
contracts for CD-ROM products between the Company and third party developers
(and assume certain liabilities thereto) for $2.5 million. The Agreement
provides for the Company to retain the right to use these products on the
Internet. The transaction was consummated during the second quarter of 1999.

F-56
<PAGE>

PART II
INFORMATION NOT REQUIRED IN PROSPECTUS

Item 24. Indemnification of Directors and Officers

Sections 55-8-50 through 55-8-58 of the North Carolina Business Corporation
Act permit a corporation to indemnify its directors, officers, employees or
agents under either or both a statutory or non-statutory scheme of
indemnification. Under the statutory scheme, a corporation may, with certain
exceptions, indemnify a director, officer, employee or agent of the corporation
who was, is, or is threatened to be made, a party to any threatened, pending or
completed legal action, suit or proceeding, whether civil, criminal,
administrative, or investigative, because of the fact that such person was a
director, officer, agent or employee of the corporation, or is or was serving at
the request of such corporation as a director, officer, employee or agent of
another corporation or enterprise. This indemnity may include the obligation to
pay any judgment, settlement, penalty, fine (including an excise tax assessed
with respect to an employee benefit plan) and reasonable expenses incurred in
connection with a proceeding (including counsel fees), but no such
indemnification may be granted unless such director, officer, agent or employee
(i) conducted himself in good faith, (ii) reasonably believed (1) that any
action taken in his official capacity with the corporation was in the best
interest of the corporation or (2) that in all other cases his conduct at least
was not opposed to the corporation's best interest, and (iii) in the case of any
criminal proceeding, had no reasonable cause to believe his conduct was
unlawful. Whether a director has met the requisite standard of conduct for the
type of indemnification set forth above is determined by the board of directors,
a committee of directors, special legal counsel or the shareholders in
accordance with Section 55-8-55. A corporation may not indemnify a director
under the statutory scheme in connection with a proceeding by or in the right of
the corporation in which the director was adjudged liable to the corporation or
in connection with a proceeding in which a director was adjudged liable on the
basis of having received an improper personal benefit.

In addition to, and separate and apart from the indemnification described
above under the statutory scheme, Section 55-8-57 of the North Carolina Business
Corporation Act permits a corporation to indemnify or agree to indemnify any of
its directors, officers, employees or agents against liability and expenses
(including attorney's fees) in any proceeding (including proceedings brought by
or on behalf of the corporation) arising out of their status as such or their
activities in such capacities, except for any liabilities or expenses incurred
on account of activities that were, at the time taken, known or believed by the
person to be clearly in conflict with the best interests of the corporation.
The Company's Bylaws provide for indemnification to the fullest extent permitted
under the North Carolina Business Corporation Act, provided, however, that the
Company will indemnify any person seeking indemnification in connection with a
proceeding initiated by such person only if such proceeding was authorized by
the Board of Directors of the Company. Accordingly, the Company may indemnify
its directors, officers and employees in accordance with either the statutory or
the non-statutory standard.

Sections 55-8-52 and 55-8-56 of the North Carolina Business Corporation Act
require a corporation, unless its articles of incorporation provide otherwise,
to indemnify a director or officer who has been wholly successful, on the merits
or otherwise, in the defense of any proceeding to which such director or officer
was a party. Unless prohibited by the articles of incorporation, a director or
officer also may make application and obtain court-ordered indemnification if
the court determines that such director or officer is fairly and reasonably
entitled to such indemnification as provided in Sections 55-8-54 and 55-8-56.

Finally, Section 55-8-57 of the North Carolina Business Corporation Act
provides that a corporation may purchase and maintain insurance on behalf of an
individual who is or was a director, officer, employee or agent of the
corporation against certain liabilities incurred by such persons, whether or not
the corporation is otherwise authorized by the North Carolina Business
Corporation Act to indemnify such party. It is anticipated that the Company's
directors and officers will be covered under directors' and officers' insurance
policies maintained by the Company prior to this offering.

As permitted by North Carolina law, Article IX of the Company's Articles of
Incorporation limits the personal liability of directors for monetary damages
for breaches of duty as a director, provided that such limitation will not apply
to (i) acts or omissions that the director at the time of the breach knew or
believed were clearly in conflict with the best interests of the Company, (ii)
any liability for unlawful distributions under Section 55-8-33, (iii) any
transaction from which the director derived an improper personal benefit, or
(iv) acts or omissions occurring prior to the date the provision became
effective.

The Registration Rights Agreement also contains certain provisions pursuant
to which certain officers, directors and controlling persons of the Company may
be entitled to be indemnified by the Selling Stockholder.

II-1
<PAGE>

Item 25. Other Expenses of Issuance and Distribution.

The estimated expenses of the Company payable in connection with the
issuance and distribution of the Common Stock being registered hereby are as
follows:

<TABLE>
<S> <C>
SEC Registration Fee................................................. $ 1,298
Printing Expenses.................................................... 15,000
Legal Fees and Expenses.............................................. 25,000
Accounting Fees and Expenses......................................... 55,000
Transfer Agent Fees and Expenses..................................... 1,500
-------
Total $97,798
=======
</TABLE>

Item 26. Recent Sales of Unregistered Securities

In the three years preceding the filing of this Registration Statement, the
Company issued the following securities, which were not registered pursuant to
the Securities Act:

From May 1, 1995 to May 21, 1998, the Company issued an aggregate of
2,026,795 incentive and performance incentive stock options to purchase Common
Stock pursuant to the 1995 Plans to officers and employees of the Company, as
described in the Prospectus, at a weighted average exercise price of $2.30 per
share. (1)

On January 2, 1996, the Company issued 144,000 shares of Common Stock to J.
W. Stealey in consideration of the deferral of Mr. Stealey's 1995 salary in the
amount of $144,000. (2)

On March 6, 1996, the Company issued a warrant currently exercisable for
25,882 shares of Common Stock to Venture Lending (a division of Cupertino
National Bank and Trust) in consideration of a $500,000 loan made by Venture
Lending. (2)

On March 6, 1996, the Company issued two warrants, each of which is
currently exercisable for 25,882 shares of Common Stock, to High Point Capital,
LLC in consideration of a $500,000 loan made by High Point Capital, LLC. (2)

On March 29, 1996, the Company issued a warrant exercisable for 10,000
shares of Common Stock in connection with a $500,000 loan made by Southeast
Interactive Technology Fund I, L.L.C. (2)

On March 31, 1996, the Company issued 700,000 shares of Common Stock to
J.W. Stealey in consideration for the conversion of outstanding indebtedness in
the principal amount of $700,000 owed by the Company to Mr. Stealey. The
Company also issued a warrant to purchase 30,000 shares of Common Stock to Mr.
Stealey in consideration of such conversion. (2)

Between April 23, 1996 and June 18, 1996, the Company sold 6,750 shares of
Common Stock for an aggregate purchase price of $6,750 to three former employees
who exercised incentive stock options upon departing the Company. (3)

On May 1, 1996, the Company granted William J. Kaluza 20,000 shares of
Common Stock upon his acceptance of employment with the Company. (1)

On May 20, 1996, the Company issued a warrant currently exercisable for
75,694 shares of Common Stock to J.W. Stealey in consideration of a $1,000,000
loan made by Mr. Stealey to the Company. (2)

On July 10, 1996, the Company issued a warrant currently exercisable for
100,695 shares of Common Stock to J.W. Stealey in consideration of a $1,000,000
loan made by Mr. Stealey to the Company. (2)

On July 15, 1996, the Company issued 82,634 shares of Series A Convertible
Preferred Stock to Southeast Interactive Technology Fund I upon conversion of
indebtedness owed to Southeast Interactive Technology Fund I, in the principal
amount of $500,000 plus accrued interest. (2)

On July 15, 1996, the Company issued a warrant currently exercisable for
22,058 shares of Common Stock to Southeast Interactive Technology Fund I, L.L.C.
in exchange for the March 29, 1996 warrant issued to Southeast Interactive
Technology Fund I, L.L.C. by the Company. (2)

II-2
<PAGE>

On December 31, 1996, the Company issued a warrant to purchase 6,358 shares
of Common Stock to Laura M. Stealey in consideration of amounts outstanding
under the $1,000,000 credit line established by Ms. Stealey in favor of the
Company. (2)

On February 11, 1997, the Company issued warrants to purchase 13,500 shares
of Common Stock to each of J. Nicholas England, David H. Kestel and W. Joseph
McClelland. (2)

On March 24, 1997, the Company issued a warrant that was exercised for
307,823 shares of Common Stock upon the consummation of the Company's initial
public offering in July, 1998 to Petra in consideration of a $3,000,000 loan
made by Petra. (2)

On April 23, 1997, in connection with the Company's acquisition of
Interactive Creations Incorporated, the Company issued an aggregate of 655,696
shares of Common Stock to former shareholders of Interactive Creations
Incorporated and options exercisable for 98,218 shares of Common Stock. (1)(2)

On April 23, 1997, the Company issued warrants to purchase 15,000 shares of
Common Stock to Oppenheimer & Co., Inc. (2)

On September 29, 1997, the Company issued a warrant that will be
exercisable for 208,946 shares of Common Stock upon the consummation of this
offering to Oberlin in consideration of a $1,200,000 loan made by Oberlin. (2)

Between December 1, 1997 and January 30, 1998, the Company sold 8,625
shares of Common Stock pursuant to the exercise of employee stock options for
$10,125. (3)

On December 31, 1997, the Company issued a warrant to purchase 8,591 shares
of Common Stock to Laura M. Stealey in consideration of amounts outstanding
under the $1,000,000 credit line established by Ms. Stealey in favor of the
Company. (2)

On February 4, 1998, the Company issued warrants to purchase 16,667 shares
of Common Stock to Marion Bass, Inc. (2)

On February 4, 1998, the Company issued 778,746 shares of Series B
Preferred Stock to several investors for $3,500,000, which shares of Series B
Preferred Stock were converted into 2,045,649 shares of Common Stock upon the
closing of the Company's initial public offering in July, 1998. (2)

On February 4, 1998, the Company issued 132,744 shares of Series C
Preferred Stock to Robert L. Pickens upon the conversion of $600,000 of the
Company's debt held by Mr. Pickens, which shares will be converted into 132,744
shares of Common Stock upon the closing of the Company's initial public offering
in July, 1998. (2)

On February 4, 1998, the Company issued 442,478 shares of Common Stock to
J. W. Stealey upon the conversion of $2,000,000 of the Company's debt held by
Mr. Stealey. (2)

On February 4, 1998, the Company issued warrants to purchase 12,500 shares
of Common Stock to Avi Suriel. (2)

On March 12, 1998, the Company issued options to purchase 12,500 shares of
Common Stock to Jeff Stealey, an employee of the Company. (1)

On April 30, 1998, the Company issued 45,000 shares of Common Stock to
William Kaluza upon the exercise of outstanding options held by Mr. Kaluza. (3)

On May 12, 1998, the Company issued 48,604 shares of Common Stock to
Southeast Interactive Technology Fund I, L.L.C. pursuant to certain anti-
dilution rights contained in an agreement between the Company and Southeast
Interactive Technology Fund I, L.L.C. (2)

On May 21, 1998, the Company issued 268,750 shares of Common Stock to J.W.
Stealey upon the exercise of outstanding options held by Mr. Stealey. (2)

On May 21, 1998, the Company issued 50,000 shares of Common Stock to Robert
L. Pickens upon the exercise of outstanding options held by Mr. Pickens. (2)

II-3
<PAGE>

In connection with the Company's acquisition of MPG-Net, Inc. on February
12, 1999, the Company issued an aggregate of 675,000 shares of Common Stock and
options to purchase 30,000 shares of Common Stock.

From July 22, 1998 to June 4, 1999, the Company issued an aggregate of
168,154 shares of Common Stock to employees upon exercises of options. (3)

From July 22, 1998 to June 4, 1999, the Company issued an aggregate of
515,999 shares of Common Stock to two accredited venture capital firms upon
exercise of warrants. (2)

No underwriter was engaged in connection with the foregoing sales of
securities.

________________________

(1) In the view of the Company, the options granted pursuant to the 1995 Plans
and the options exchanged in the ICI transaction were issued but not sold
and, therefore, registration thereof was not required.

(2) Sales of Common Stock and the issuance of warrants were made in reliance
upon Section 4(2) of the Securities Act or Regulation D promulgated
thereunder as transactions not involving any public offering. Each of the
purchasers were sophisticated investors.

(3) Sales of Common Stock were made in reliance upon Rule 701 promulgated under
the Securities Act as transactions not involving a public offering.

Item 27. Exhibits

The following documents (unless indicated) are filed herewith and made a
part of this Registration Statement.

Exhibit
Number Description of Exhibit
- ------ ----------------------

II-4
<PAGE>

10.12* -Guaranty Agreement, dated August 25, 1997, between J.W. Stealey and
Branch Banking & Trust Company
10.13* -Loan and Security Agreement, dated September 29, 1997, among the
Company, iMagic Online Corporation and Oberlin Capital, L.P.
10.14* -Loan and Security Agreement, dated April 30, 1997, between Greyrock
Business Credit, a Division of NationsCredit Commercial
Corporation, and the Company
10.15* -Lease Agreement, dated December 4, 1995, as amended February 7, 1996,
by and between Southport Business Park Limited Partnership and
the Company
10.16* -Employment Agreement, dated January 3, 1995, between the Company and
J.W. Stealey, as amended
10.17* -Employment Agreement, dated January 3, 1995, between the Company and
Robert L. Pickens, as amended
10.18* -Employment Agreement, dated March 25, 1996 between the Company and
William J. Kaluza
10.19* -Employment Agreement, dated January 3, 1995, between the Company and
Joseph Rutledge, and form of amendment thereto
10.20* -Employment Agreement, dated February 1, 1995, between the Company and
Raymond Rutledge, and form of amendment thereto
10.21* -Form of Class A Incentive Stock Option Plan
10.22* -Form of Class B Incentive Stock Option Plan
10.23* -Form of ICI Stock Option Plan
10.24* -Form of 1998 Stock Plan
10.25* -Form of 1998 Employee Stock Purchase Plan
10.26* -Letter Agreement, dated as of May 27, 1998, by and among the Company
and the holders of the Company's outstanding Series B Preferred
Stock
10.27* -Agreement and Plan of Merger by and among the Company, iMagic Online
Corporation, MPG-Net, Inc., Multiplayer Games Network, Inc. and
Tantalus, Inc., James Hettinger and Donn A. Clendenon dated as of
January 25, 1999
10.28* -Securities Purchase Agreement dated as of January 25, 1999 between the
Company and RGC International Investors LDC ("RGC")
10.29* -Promissory Note dated January 26, 1999 issued by the Company to RGC
("Note")
10.30* -Registration Rights Agreement dated as of January 25, 1999 between the
Company and RGC
10.31* -Form of Warrant issuable by the Company pursuant to the Note
10.32* -Amendment No. 1 dated February 12, 1999 to the Merger Agreement

10.33* -Escrow Agreement dated as of February 12, 1999 by and among the
Company, Branch Banking and Trust Company, Multiplayer Games
Network, Inc., Tantalus, Inc. and James Hettinger
10.34* -Registration Rights Agreement dated as of February 12, 1999 by and
among the Company, Multiplayer Games Network, Inc. and Tantalus,
Inc.
10.35* -Registration Rights Agreement dated as of February 12, 1999 by and
among the Company, Andrew G. Burch, IFM Venture Group and James
Bailey
10.36* -Agreement Regarding Assignment of Contracts Relating to Sale of the
Company's CD-ROM Operations to Ubi Soft Entertainment S.A.

17.1* -Copy of letter from Avi Suriel tendering his resignation from the
Registrant's Board of Directors effective August 3, 1999.

23.1 -Consent of Ernst & Young LLP.

________________________________________________________________________________

*Previously filed

II-5
<PAGE>

Item 28. Undertakings

The small business issuer hereby undertakes:

1. To file, during any period in which offers or sales of the securities
are being made, a post-effective amendment to this registration statement to:

(i) Include any prospectus required by Section 10(a)(3) of the
Securities Act;

(ii) Reflect in the prospectus any facts or events which,
individually or together, represent a fundamental change in the information
in the registration statement. Notwithstanding the foregoing, any increase
or decrease in volume of securities offered may be reflected in the form of
prospectus filed with the Commission under Rule 424(b) if, in aggregate,
the changes in the volume and price represent no more than a 20% change in
the maximum aggregate offering price set forth in the "Calculation of
Registration Fee" table in the effective registration statement;

(iii) include any additional or changed material information on the
plan of distribution.

2. That, for the purpose of determining liability under the Securities
Act , it shall treat each post-effective amendment as a new registration
statement of the securities offered, and treat the offering of the securities at
that time as an initial bona fide offering.

3. To remove from registration by means of a post-effective amendment any
of the securities being registered which remains unsold at the termination of
the offering.

To the extent that indemnification for liabilities arising under the
Securities Act may be permitted to directors, officers and controlling persons
of the Company pursuant to the provisions described in Item 15, or otherwise,
the Company has been advised that, in the opinion of the Securities and Exchange
Commission, such indemnification is against public policy as expressed in the
Securities Act of 1933 and is, therefore, unenforceable.

In the event a claim for indemnification against such liabilities, other
than the payment by the Company of expenses incurred or paid by a director,
officer of controlling person of the Company in the successful defense of any
action, suit or proceeding, is asserted by such director, officer or controlling
person in connection with the shares being registered hereby, the company will,
unless, in the opinion of its counsel the matter has been settled by controlling
precedent, submit to a court of appropriate jurisdiction the question as to
whether such indemnification by the Company is against public policy as
expressed in the Securities Act of 1933 and will be governed by the final
adjudication of such issue.

II-6
<PAGE>

SIGNATURES

Pursuant to the requirements of the Securities Act of 1933, the registrant
certifies that it has reasonable grounds to believe that it meets all of the
requirements for filing on Form SB-2 and has duly caused this registration
statement on its behalf by the undersigned, thereunto duly authorized, in the
City of Morrisville, State of North Carolina, on the Fifth day of August 1999.

INTERACTIVE MAGIC, INC.

By:/s/ J.W. Stealey
----------------
Name: J.W. Stealey
Title: Chairman of the Board of Directors and
Chief Executive Officer

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints J.W. Stealey, as his true and lawful
attorney-in-fact and agent, with full power of substitution and resubstitution,
for him and in his name, place and stead, in any and all capacities to sign any
and all amendments, including post-effective amendments and related registration
statements, to this registration statement, and to file same, with exhibits
thereto and other documents in connection therewith, with the Securities and
Exchange Commission, granting unto said attorneys-in-fact and agent, full power
and authority to do separately and perform each and every act and thing
requisite and necessary to be done, as fully to all intents and purposes as he
might or could so in person, hereby ratifying and confirming all that said
attorneys-in-fact and agent, or their substitutes may lawfully do or cause to be
done by virtue hereof.

Pursuant to the requirements of the Securities Act of 1933, this
registration statement has been signed by the following persons in the
capacities and on the dates indicated.

<TABLE>
<CAPTION>
Signature Title Date
- --------- ----- ----
<S> <C> <C>
/s/ J.W. Stealey President, Chief Executive Officer and Director August 5, 1999
- ----------------------------------
J.W. Stealey (Principal Executive Officer)

/s/ Michael W. Oliver (Principal Financial and Accounting Officer) August 5, 1999
- ----------------------------------
Michael W. Oliver

/s/ J.Nicholas England Director August 5, 1999
- ----------------------------------
J. Nicholas England

/s/ David H. Kestel Director August 5, 1999
- ----------------------------------
David H. Kestel

/s/ W. Joseph McClelland Director August 5, 1999
- ----------------------------------
W. Joseph McClelland
</TABLE>

II-7
<PAGE>

Exhibits

The following exhibits are filed as part of this registration statement:

Exhibit
Number Description of Exhibit
- ------ ----------------------

2.01* -Plan and Agreement of Merger by and between I-Magic Mergeco, Inc. and
Interactive Magic, Inc.
3.01* -Articles of Incorporation
3.02* -Bylaws
3.03* -Articles of Merger of Interactive Magic, Inc.
4.01* -Specimen Common Stock Certificate
4.02* -Articles of Incorporation (see Exhibit 3.01)
4.03* -Bylaws (see Exhibit 3.02)
4.04* -Form of Representatives' Warrant Agreement, including Form of Warrant
Certificate
5.01 -Opinion of Wyrick Robbins Yates & Ponton LLP.
10.01* -Stock Purchase Agreement, dated February 4, 1998, by and between the
Company and Vertical Financial Holdings
10.02* -Investor's Rights Agreement, dated February 4, 1998, by and between the
Company and Vertical Financial Holdings
10.03* -Marketing Agreement, dated February 4, 1998, between the Company and
General Capital
10.04* -Merger Agreement, dated as of March 24, 1997, as amended April 2, 1997,
by and among the Company, Interactive Creations Acquisition
Corp., certain shareholders of Interactive Creations Incorporated
and Interactive Creations Incorporated
10.05* -Form of Shareholder Agreement between the Company and each shareholder
of Interactive Creations Incorporated
10.06* -Form of Stock Purchase Warrant issued to each of J.W. Stealey, Robert
L. Pickens, Laura Stealey, David H. Kestel, J. Nicholas England,
W. Joseph McClelland, Avi Suriel, Marion Bass and Oppenheimer
10.07* -Corporate Airplane Agreement, dated January 3, 1995, between J.W.
Stealey and the Company
10.08* -Loan and Security Agreement, dated March 24, 1997, as amended April 1,
1997 (See Exhibit 10.10 below), by and between the Company and
Petra Capital LLC
10.09* -Stock Purchase Warrant, dated March 24, 1997, as amended April 1, 1997
(See Exhibit 10.10 below), and January 31, 1998, as amended,
issued by the Company to Petra Capital LLC
10.10* -First Amendment to Loan and Security Agreement and Stock Purchase
Warrant dated April 1, 1997 by and between the Company and Petra
Capital LLC
10.11* -Promissory Note, dated August 25, 1997, issued by the Company to Branch
Banking & Trust Company
10.12* -Guaranty Agreement, dated August 25, 1997, between J.W. Stealey and
Branch Banking & Trust Company
10.13* -Loan and Security Agreement, dated September 29, 1997, among the
Company, iMagic Online Corporation and Oberlin Capital, L.P.
10.14* -Loan and Security Agreement, dated April 30, 1997, between Greyrock
Business Credit, a Division of NationsCredit Commercial
Corporation, and the Company
10.15* -Lease Agreement, dated December 4, 1995, as amended February 7, 1996,
by and between Southport Business Park Limited Partnership and
the Company
10.16* -Employment Agreement, dated January 3, 1995, between the Company and
J.W. Stealey, as amended
10.17* -Employment Agreement, dated January 3, 1995, between the Company and
Robert L. Pickens, as amended
10.18* -Employment Agreement, dated March 25, 1996 between the Company and
William J. Kaluza
10.19* -Employment Agreement, dated January 3, 1995, between the Company and
Joseph Rutledge, and form of amendment thereto
10.20* -Employment Agreement, dated February 1, 1995, between the Company and
Raymond Rutledge, and form of amendment thereto
10.21* -Form of Class A Incentive Stock Option Plan
10.22* -Form of Class B Incentive Stock Option Plan
10.23* -Form of ICI Stock Option Plan
10.24* -Form of 1998 Stock Plan
10.25* -Form of 1998 Employee Stock Purchase Plan
10.26* -Letter Agreement, dated as of May 27, 1998, by and among the Company
and the holders of the Company's outstanding Series B Preferred
Stock
10.27* -Agreement and Plan of Merger by and among the Company, iMagic Online
Corporation, MPG-Net, Inc., Multiplayer Games Network, Inc. and
Tantalus, Inc., James Hettinger and Donn A. Clendenon dated as of
January 25, 1999

II-8
<PAGE>

10.28* -Securities Purchase Agreement dated as of January 25, 1999 between the
Company and RGC International Investors LDC ("RGC")
10.29* -Promissory Note dated January 26, 1999 issued by the Company to RGC
("Note")
10.30* -Registration Rights Agreement dated as of January 25, 1999 between the
Company and RGC
10.31* -Form of Warrant issuable by the Company pursuant to the Note
10.32* -Amendment No. 1 dated February 12, 1999 to the Merger Agreement
10.33* -Escrow Agreement dated as of February 12, 1999 by and among the
Company, Branch Banking and Trust Company, Multiplayer Games
Network, Inc., Tantalus, Inc. and James Hettinger
10.34* -Registration Rights Agreement dated as of February 12, 1999 by and
among the Company, Multiplayer Games Network, Inc. and Tantalus,
Inc.
10.35* -Registration Rights Agreement dated as of February 12, 1999 by and
among the Company, Andrew G. Burch, IFM Venture Group and James
Bailey
10.36* -Agreement Regarding Assignment of Contracts Relating to Sale of the
Company's CD-ROM Operations to Ubi Soft Entertainment S.A.
17.1* -Copy of letter from Avi Suriel tendering his resignation from the
Registrant's Board of Directors effective August 3, 1999.
23.1 -Consent of Ernst & Young LLP.

________________________________________________________________________________

*Previously filed

II-9

<PAGE>

Exhibit 5.1

August 5, 1999

Interactive Magic, Inc.
215 Southport Drive, Suite 1000
Morrisville, North Carolina 27560

RE: Registration Statement on Form SB-2

Ladies and Gentlemen:

We have examined the Registration Statement on Form SB-2 to be filed by
Interactive Magic, Inc., a North Carolina corporation (the "Company"), with the
Securities and Exchange Commission on or about the date hereof (the
"Registration Statement"), in connection with the registration under the
Securities Act of 1933 of up to 2,119,889 shares of the Company's Common Stock,
$0.01 par value per share (the "Shares"). In our examination, we have assumed
the genuineness of all signatures, the authenticity of all documents submitted
to us as originals and the conformity with the original of all documents
submitted to us as copies thereof.

As your legal counsel, we have examined the proceedings taken, and are
familiar with the proceedings proposed to be taken, in connection with the sale
and issuance of the Shares.

It is our opinion that, upon completion of the proceedings being taken or
contemplated by us, as your counsel, to be taken prior to the issuance of the
Shares, including the proceedings being taken in order to permit such
transaction to be carried out in accordance with applicable state securities
laws, the Shares when issued and sold in the manner referred to in the
Registration Statement and in accordance with the resolutions adopted by the
Board of Directors of the Company, will be legally and validly issued, fully
paid and nonassessable.

We consent to the use of this opinion as an exhibit to the Registration
Statement and further consent to the use of our name wherever appearing in the
Registration Statement, including the Prospectus constituting a part thereof,
and any amendments thereto.

Very truly yours,

/s/ Wyrick Robbins Yates & Ponton LLP

<PAGE>

EXHIBIT 23.1

CONSENT OF INDEPENDENT AUDITORS

We consent to the reference to our firm under the caption "Experts" and to the
use of our report dated February 19, 1999 in the Registration Statement and
related Prospectus of Interactive Magic, Inc. for the registration of 2,119,889
shares of its common stock.

/s/ Ernst & Young LLP

Raleigh, North Carolina
August 5, 1999