U.S. Securities and Exchange Commission
                             Washington, D.C. 20549

                                   FORM 10-QSB

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

                For the quarterly period ended September 30, 1998

                        Commission file number 000-29750

                             INTERACTIVE MAGIC, INC.
        (Exact name of small business issuer as specified in its charter)

             North Carolina                     56-2092059
        (State of incorporation) (I.R.S. Employer Identification Number)

                         215 Southport Drive, Suite 1000
                        Morrisville, North Carolina 27560
                     (Address of principal executive office)

                                  (919) 461-0722
                           (Issuer's telephone number)

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

        As of November 10, 1998 (the most recent practicable date), there were
9,811,555 shares of the issuer's Common Stock, $.10 par value per share,
outstanding.

        Transitional Small Business Disclosure Format (check one)
        Yes |_|                    No |X|

<PAGE>
                        INTERACTIVE MAGIC, INC.

                     Form 10-QSB Quarterly Report

                               INDEX

PART I              FINANCIAL INFORMATION                                   PAGE
                                                                            ----

Item 1              Financial Statements                                      3

Item 2              Management's Discussion and Analysis of Financial
                    Condition and Results of Operations                      11

PART II             OTHER INFORMATION                                        20

Item 1              Legal Proceedings                                        20

Item 2              Changes in Securities and Use of Proceeds                20

Item 3              Defaults Upon Senior Securities                          21

Item 4              Other Information                                        21

Item 5              Exhibits and Reports on Form 8-K                         21

SIGNATURES                                                                   22

                                        2
<PAGE>

PART I.       FINANCIAL INFORMATION

ITEM 1.       FINANCIAL STATEMENTS

                      Interactive Magic, Inc.
                 Condensed Consolidated Balance Sheets
                  (IN THOUSANDS, EXCEPT SHARE DATA)

<TABLE>
<CAPTION>
                                                  SEPTEMBER 30,  DECEMBER 31,
                                                        1998         1997
                                                        ----         ----
<S>                                               <C>             <C> 
                                                  (UNAUDITED)     (AUDITED)
ASSETS
Current Assets:
   Cash and cash equivalents                          $6,354          $384
   Accounts receivable, net                            4,775         2,920
   Inventories                                           733           637
   Advance royalties                                   2,435         1,989
   Software development costs                          1,103           425
   Other current assets                                   89           109
                                                         ---        -----
Total current assets                                  15,489         6,464
Property and equipment, net                            1,099         1,196
Other noncurrent assets                                   59            87
                                                         ---         -----
Total assets                                         $16,647        $7,747
                                                     =======        ======


LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
   Accounts payable and accrued expenses              $2,256        $2,776
   Royalties and commissions payable                     950           858
   Lines of credit                                       641         3,983
   Current portion of long-term debt                       -           745
   Current portion of capital lease obligations           35            35
                                                         ---         -----

Total current liabilities                              3,882         8,397

Noncurrent liabilities:
   Accrued interest payable to related parties             -           982
   Long-term debt, less current portion                    -         3,759
   Capital lease obligations                               -            38
   Notes payable to related parties                      178         3,470
                                                         ---         -----
Total noncurrent liabilities                             178         8,249
</TABLE>

                                        3
<PAGE>

                      Interactive Magic, Inc.
            Condensed Consolidated Balance Sheets (continued)
                  (IN THOUSANDS, EXCEPT SHARE DATA)

<TABLE>
<CAPTION>
                                                                       SEPTEMBER 30,  DECEMBER 31,
                                                                            1998         1997
                                                                            ----         ----
                                                                        (UNAUDITED)    (AUDITED)
<S>                                                                         <C>           <C>  
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,           -          314
     3,145,696 shares issued and outstanding at December 31, 1997
   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,                 981
    9,807,055 shares issued and outstanding at September 30, 1998
   Additional paid-in capital                                               31,068        5,047
   Cumulative currency translation adjustment                                  (84)         (59)
   Accumulated deficit                                                     (19,378)     (14,210)
                                                                            ------       ------ 

Total stockholders' equity (deficit)                                        12,587       (8,899)
                                                                            ------       ------ 
Total liabilities and stockholders' equity (deficit)                       $16,647       $7,747
                                                                           =======       ======
</TABLE>

The accompanying notes are an integral part of these condensed consolidated
balance sheets.

                                        4
<PAGE>
                      Interactive Magic, Inc.
             Condensed Consolidated Statements of Operations
                          (UNAUDITED)
             (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

<TABLE>
<CAPTION>
                                                         THREE MONTHS ENDED             NINE MONTHS ENDED
                                                             SEPTEMBER 30,                 SEPTEMBER 30,
                                                             -------------                 -------------
                                                         1998           1997           1998           1997
                                                         ----           ----           ----           ----
<S>                                                  <C>            <C>            <C>            <C>        
Net revenues:
   CD-ROM product sales                              $     1,903    $     4,635    $     8,455    $     9,550
   Online sales                                              473            413          1,257          1,225
   Royalties and licenses                                    293            459          1,692            700

Total net revenues                                         2,669          5,507         11,404         11,475
                                                       ---------      ---------      ---------      ---------

Cost of revenues:
   Cost of products sold                                     957          1,318          2,529          2,570
   Royalties and amortized software costs                    709            946          2,079          1,713
                                                       ---------      ---------      ---------      ---------

Total cost of revenues                                     1,666          2,264          4,608          4,283
                                                       ---------      ---------      ---------      ---------

Gross profit                                               1,003          3,243          6,796          7,192

Operating expenses:
   Sales and marketing                                     2,446          1,701          6,161          5,236
   Product development                                     1,273          1,219          3,234          2,936
   General and administrative                                460            456          1,479          1,454
                                                       ---------      ---------      ---------      ---------

Total operating expenses                                   4,179          3,376         10,874          9,626
                                                       ---------      ---------      ---------      ---------

Operating loss                                            (3,176)          (133)        (4,078)        (2,434)
                                                       ---------      ---------      ---------      ---------

Other (income) expense:
   Interest expense - third parties                           78            232            593            547
   Interest expense - related parties                         22            188            114            526
   Interest Income                                          (150)                         (150)
   Other                                                     (29)             1            (10)           110

Total other (income) expense                                 (79)           421            547          1,183
                                                       ---------      ---------      ---------      ---------

Loss before income taxes and extraordinary item           (3,097)          (554)        (4,625)        (3,617)
Income tax (expense) benefit                                 (28)            --           (156)            32
                                                       ---------      ---------      ---------      ---------

Loss before extraordinary item                            (3,125)          (554)        (4,781)        (3,585)

Extraordinary loss on early extinguishment of debt          (387)            --           (387)            --

Net loss                                             $    (3,512)   $      (554)   $    (5,168)   $    (3,585)
                                                       =========      =========      =========      =========

Basic loss per share ($):
Loss before extraordinary item                       $     (0.35)   $     (0.18)   $     (0.88)   $     (1.14)

Extraordinary item                                   $     (0.04)            --    $     (0.07)            --
                                                       ---------      ---------      ---------      ---------

Net loss                                             $     (0.39)   $     (0.18)   $     (0.95)   $     (1.14)
                                                       =========      =========      =========      =========

Weighted average shares used in computing
  basic loss per share                                 8,992,650      3,153,571      5,420,773      3,154,361
                                                       =========      =========      =========      =========
</TABLE>

The accompanying notes are an integral part of these condensed consolidated
financial statements.

                                        5
<PAGE>

                             Interactive Magic, Inc.
                 Condensed Consolidated Statements of Cash Flows
                                   (UNAUDITED)
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                           FOR THE NINE MONTHS ENDED SEPTEMBER 30,
                                                                  1998                 1997
                                                                  ----                 ----
<S>                                                              <C>                 <C>            
   OPERATING ACTIVITIES:
   Net loss                                                      $ (5,168)           $ (3,585)      
   Adjustments to reconcile net loss to net cash used                                               
    in operating activities:                                                                        
    Depreciation and amortization                                     305                 311       
    Amortization of capitalized software development costs            745                 494       
    Issuance of common stock for services                               0                  15       
    Extraordinary Loss                                                387                           
    Noncash interest expense                                           59                  --       
    Changes in operating assets and liabilities:                                                    
    Accounts receivable                                            (1,855)               (989)      
    Inventories                                                       (96)               (468)      
    Advance royalties                                                (446)               (504)      
    Other current and noncurrent assets                                48                (116)      
    Accounts payable and accrued expenses                            (520)              1,394       
    Royalties and commissions payable                                  92                (109)      
    Accrued interest                                                 (485)                457       
                                                                 --------            --------       
   Net cash used in operating activities                           (6,934)             (3,100)      
                                                                 --------            --------       
   INVESTING ACTIVITIES:                                                                            
   Purchase of property and equipment                                (208)               (337)      
   Software development costs                                      (1,423)               (560)      
                                                                 --------            --------       
   Net cash used in investing activities                           (1,631)               (897)      
                                                                 --------            --------       
       FINANCING ACTIVITIES:                                                                        
   (Repayments) / proceeds on long-term debt                       (4,950)              4,091       
   (Repayments) / proceeds on notes payable to related parties       (870)                200       
   Net repayments on lines-of-credit                               (3,342)               (300)      
   Payments on capital lease obligations                              (38)                (43)      
       Proceeds from issuance of  preferred stock                   3,169            --------       
   Proceeds from issuance of common stock                          20,591                   0       
                                                                 --------            --------       
   Net cash provided by financing activities                       14,560               3,948       
                                                                 ========            ========       
                                                                                                    
Effect of currency exchange rate changes on cash and cash                                           
   equivalents                                                        (25)                 10       
                                                                                                    
Net increase (decrease) in cash and cash equivalents                5,970                 (39)      
Cash and cash equivalents at beginning of period                      384                 292       
                                                                 --------            --------       
Cash and cash equivalents at end of period                          6,354                 253       
                                                                 ========            ========       
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:                                                   
Cash paid for interest                                           $  1,142            $    429       
                                                                 --------            --------
Cash paid for income taxes                                       $      4            $      3       
                                                                 ========            ========       
NONCASH INVESTING AND FINANCING ACTIVITIES:                                                         
Conversion of notes payable into common and preferred stock      $  2,600            $     --       
Issuance of common stock in settlement of accrued interest                                          
   payable to related parties                                    $    319            $     --       
Conversion of preferred stock into common stock                  $  3,169            
</TABLE>

The accompanying notes are an integral part of these condensed consolidated
financial statements.

                                        6

<PAGE>

                             Interactive Magic, Inc.
              Notes To Condensed Consolidated Financial Statements
                                   (UNAUDITED)

1.  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.

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 for the year ended
December 31, 1997 included in its Registration Statement on Form SB-2 declared
effective on July 21, 1998.

2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS

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.
Actual results could differ from those estimates.

REVENUE RECOGNITION

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. Per copy royalties on sales that exceed the guarantee are recognized
as earned. The Company accepts product returns and

                                        7
<PAGE>

                             Interactive Magic, Inc.
Notes To Condensed Consolidated Financial Statements (continued)
                                   (UNAUDITED)

2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED):

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.

BASIC NET LOSS PER  SHARE

Basic net loss per share has been calculated in accordance with Statement of
Financial Accounting Standards ("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 (note 7).


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.

                                        8

<PAGE>

                             Interactive Magic, Inc.
Notes To Condensed Consolidated Financial Statements (continued)
                                   (UNAUDITED)

3.  LINES OF CREDIT:

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 are
limited to the lesser of $5 million or 65% of the Company's outstanding eligible
receivables and inventory. Borrowings on the line of credit are collateralized
by the Company's accounts receivable, inventory, and intellectual property. The
line of credit expires on April 30, 1999. As of September 30, 1998, borrowings
on the line were $.6 million. The Company maintains other lines of credit as
described in its Form SB-2 declared effective on July 21, 1998.

4.  NOTES PAYABLE TO RELATED PARTIES:

Notes payable to related parties consist of the following (IN THOUSANDS):

<TABLE>
<CAPTION>
                                                                     SEPTEMBER 30,   DECEMBER 31,
                                                                         1998           1997
                                                                         ----           ----
<S>                                                                    <C>              <C> 
                                                                      (UNAUDITED)     (AUDITED)
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 July
  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. Utilizing proceeds
from the Company's initial public offering, the $870,000 note payable to a
related party was paid in full.

                                        9

<PAGE>

                             Interactive Magic, Inc.
Notes To Condensed Consolidated Financial Statements (continued)
                                   (UNAUDITED)

5. LONG-TERM DEBT:

Long-term debt, other than to related parties, consists of the following (IN
THOUSANDS):

<TABLE>
<CAPTION>
                                                          SEPTEMBER 30, DECEMBER 31,
                                                              1998         1997
                                                              ----         ----
<S>                                                           <C>           <C> 
                                                          (UNAUDITED)    (AUDITED)
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, 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
Current portion                                                    -        (745)
                                                                   -       -----

Long-term debt, less current portion                         $     -      $3,759
                                                             =======      ======
</TABLE>

All of the aforementioned long-term debt was paid 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, in the accompanying
financial statements, an extraordinary loss of $387,000 which consists of the
difference between the principal amount and the net carrying amount of the
extinguished debt. The net carrying amount reflected the unpaid principal amount
of the debt along with the unamortized amount of the related debt discount.

                                        10
<PAGE>

                             Interactive Magic, Inc.
Notes To Condensed Consolidated Financial Statements (continued)
                                   (UNAUDITED)

6.   EMPLOYEE STOCK PLANS:

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 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 the Company 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
the 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 value 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.

7.   CAPITAL:

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's 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.

On July 27, 1998, the Company consummated an initial public 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 of such shares
were sold by the Company. The net proceeds to the Company from the offering were
approximately $21.3 million. Concurrent with the closing of the offering, all of
the Company's outstanding preferred stock was converted into 2,261,027 shares of
common stock. The Company utilized proceeds from the offering to repay $8.9
million of indebtedness. The remaining proceeds received by the Company from
such offering were invested in short-term, investment-grade, interest-bearing
instruments. See "Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations-Liquidity and Capital Resources".

8.    SUBSEQUENT EVENT

On October 30, 1998 the Company signed a letter of intent to acquire MPG-Net,
Inc., an Internet gaming service and online technologies company.

                                        11


<PAGE>



ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

This Form 10-QSB, including Management's Discussion and Analysis of Financial
Condition and Results of Operations, contains forward looking statements within
the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934 which are based upon current expectations and
involve a number of risks and uncertainties. There are a number of important
factors that could cause actual results to differ materially from those
expressed in any forward-looking statements made by the Company. These factors
include, but are not limited to, risks of delays in development and introduction
of new products, dependence on new product introductions which achieve
significant market acceptance and the uncertainties of consumer preferences, the
rate and degree of market acceptance of online gaming, the ability to negotiate
profitable terms for online gaming products and services, dependence on third
party software developers for a significant portion of new products, risks of
rapid technological change and platform changes, intense competition,
seasonality, dependence upon third party distribution and risks associated with
international business. See Exhibit 99.01 for additional factors that could
cause the Company's actual results to differ.

OVERVIEW

The Company develops, publishes and distributes interactive real-time 3D
simulation and strategy entertainment software. The Company generates 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 also generates 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 30 CD-ROM products,
which have been distributed through more than 15,000 retail outlets in over 30
countries. Additionally, the Company has sold over 1.5 million hours of online
game time over the Internet to players in more than 70 countries.

In April 1997, the Company acquired Interactive Creations, Inc, ("ICI"), a
leader in the development and delivery of interactive large-scale multiplayer
real-time online games. The Company exchanged 655,696 shares of the Company's
Common Stock for all of the outstanding shares of ICI. This transaction was
accounted for as a pooling of interests; accordingly, the Company restated all
historical financial data to include the historical financial data of ICI. In
connection with the ICI acquisition, the Company acquired ICI's WARBIRDS product
and the associated MEGAplayer technology for which a patent application has been
filed. In fiscal year 1997, the Company published 11 CD-ROM products while
developing new products incorporating the technology acquired from ICI. In the
first nine months of 1998, the Company has published 14 CD-ROM products and
released it's second online product, DAWN OF ACES.

                                        12


<PAGE>



The Company recognizes net revenues from the sale of CD-ROM products at the time
of product shipment. Net revenues from CD-ROM product sales are reflected after
the deduction of what management believes to be an appropriate allowance for
returns, markdowns, price protection and warranty costs. Revenue from usage of
its online product is recognized at the time the game is played and is based
upon actual usage by the customer on an hourly basis. Revenues from licenses to
OEMs, international distributors and other third parties are recognized when
earned under the terms of the relevant agreements. Subject to certain
limitations, the Company accepts product returns and provides price protection
on certain unsold merchandise. With respect to license agreements that provide
customers the right to multiple copies in exchange for guaranteed amounts, net
revenues are recognized upon delivery of the product master or the first copy.
Per copy royalties on sales that exceed the guarantee are recognized as earned.

The Company's internal product development costs incurred prior to establishing
technological feasibility are expensed in accordance with the Financial
Accounting Standards Board Statement of Financial Accounting Standards ("SFAS")
No. 86, "Accounting for the Costs of Computer Software to be Sold, Leased or
Otherwise Marketed." In accordance with SFAS No. 86, the Company capitalizes
product development costs subsequent to establishing technological feasibility
and amortizes previously capitalized product development costs by using: (i) the
revenue curve method; or (ii) the straight-line method over the estimated
economic life of the product, which typically ranges from six months to two
years.

In addition to the internal development of products, the Company enters into
publishing agreements with third-party developers pursuant to which the Company
typically advances royalties before the product is published. After product
release, the Company expenses advance royalties based on product sales and pays
the developer incremental royalties after the advance royalties have been fully
expensed. The Company also incurs internal costs related to product development
by third parties, including costs related to supervising the development process
for quality assurance and developing technology for incorporation into
third-party products. The Company typically expenses these costs as a product
development expense.

The Company has experienced significant losses in prior years, resulting
primarily from overhead and other costs incurred in the development and growth
of the Company. Moreover, the Company expects to incur substantial up-front
expenditures and operating costs in connection with the expansion of its
marketing efforts and product lines, which may result in significant losses for
the foreseeable future. The Company's plan of operation is to increase its
online and retail product lines and to expand its distribution network. This
plan is intended to increase sales volume of both online and retail products and
to enable the Company to improve financial results. The Company intends to
increase net revenues from online products by offering additional content over
the Company's online service and to utilize distribution partners, primarily
online service providers ("OSPs") and Internet service providers ("ISPs") to
enable the Company to access additional customers. The extent and timing of
revenues generated by online games are uncertain, however, because this market
is emerging and depends upon a number of variables, including the availability
of an infrastructure for providing local access to wide area networks with

                                        13


<PAGE>



acceptable response times and consumer acceptance of such networks as a medium
for playing multi-user simulation and strategy games. The Company intends to
increase net revenues from CD-ROM sales by offering more titles and increasing
the Company's brand awareness. Although the Company believes that this plan of
operation will lead to improved financial results, there can be no assurance
that the Company will be able to successfully implement its growth and business
strategies, that its revenues will continue to increase in the future or that it
will be able to achieve or sustain profitable operations.

The Company has experienced, and expects to continue to experience, significant
variability in its quarterly and annual results due to a number of factors, many
of which are outside of the Company's control. The Company believes that one of
the factors in such variability is the fluctuation in the rates at which OEMs
purchase the Company's products and services, which is impacted by OEMs' own
business cycles. Another factor in such variability is the timing of
introduction of new products. From time to time, the introduction of new
products by the Company has been delayed beyond the Company's projected shipping
date. In each instance, such delays have resulted in increased costs and delayed
revenues. Because future revenues are dependent on the timely introduction of
new product offerings, any such future delays could have a material adverse
effect on the Company's business, operating results and financial condition. The
Company's expense levels are based, in significant part, on expectations of
future revenues. Consequently, if revenue levels are below expectations, expense
levels could be disproportionately high as a percentage of total revenues, and
operating results would be immediately and adversely affected.

RESULTS OF OPERATIONS

NET REVENUES. Net revenues decreased by 51.5% to $2.7 million for the three
months ended September 30, 1998 from $5.5 million for the three months ended
September 30, 1997. Net revenues decreased slightly to $11.4 million for the
nine months ended September 30, 1998 from $11.5 million for the nine months
ended September 30, 1997. The decrease in third quarter revenue was attributable
to a decline in the number of CD ROM titles issued in the period. In addition, a
one-time charge to revenues of $1.4 million was recorded in the third quarter of
1998 related to the realignment of a major distributor relationship.
                                        14


<PAGE>



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 the third quarter of 1998 decreased by 26% to $1.7
million from $2.3 million in the same period of 1997, representing gross margins
of 38% and 59%, respectively. Cost of revenues for the nine months ended
September 30, 1998 increased by 8% to $4.6 million from $4.3 million in the same
period of 1997, representing gross margins of 60% and 63%, respectively. The
cost of products sold decreased in the three months ended September 30, 1998 by
$0.4 million (27%) and was unchanged for the comparable nine-month periods. The
decrease in the cost of products sold for the three months ended was due to a
decrease in unit sales from the unit sales in the comparable period in 1997.
Royalties and amortized costs decreased in the three months ended September 30,
1998 by $0.2 million (25%) due to lower revenues. Royalties and amortized costs
for the nine month period increased $.4 million or 21 %. The decrease in gross
margins for both the quarter and nine month comparisons was due to the effect of
the charge relating to the realignment with a distributor, referred to above,
which offset increased product licensing revenues in the nine months ended
September 30, 1998, which have substantially higher gross margins than CD-ROM
product sales.

OPERATING EXPENSES

SALES AND MARKETING. Sales and marketing expenses for the third quarter of 1998
increased by 44% to $2.4 million from $1.7 million in the same period of 1997.
Sales and marketing expenses for the nine months ended September 30, 1998
increased to $6.2 million from $5.2 million from the same period of 1997. For
both the three-month and nine-month periods, the increases represent the effect
of additions to the marketing staff in 1998 versus 1997.

PRODUCT DEVELOPMENT. Product development expenses increased slightly to $1.3
million for the three months ended September 30, 1998, from 1.2 million for the
three months ended September 30, 1997. Product development expenses for the nine
months ended September 30, 1998 increased to $3.2 million from $2.9 million in
the same period of 1997. The increased level of year-to-date spending reflects a
higher level of internal development in 1998 versus 1997 which is somewhat
offset by the amount of capitalized software development costs year-to-date.

                                        15
<PAGE>


GENERAL AND ADMINISTRATIVE. General and administrative expenses for the third
quarter of 1998 increased to $460,000 from $456,000 in the same period in 1997.
General and administrative expenses for the nine months ended September 30, 1998
were unchanged at $1.5 million from the same period in 1997.

OTHER EXPENSE. Other (income) expense, comprised primarily of interest (income)
expense, changed to $79,000 income for the third quarter of 1998 from $421,000
expense for the comparable period in 1997. Other expense for the nine months
ended September 30, 1998 decreased to $.5 million from $1.2 million for the
comparable period in 1997. The changes in both the quarter and nine-month
comparison periods were primarily due to the 1998 conversion of certain
shareholder notes into common and preferred stock. Utilizing proceeds from its
private placement of preferred stock in February 1998, as well as the proceeds
from the Initial Public Offering in July 1998, the Company reduced its high
interest bearing debt during 1998. In addition, third quarter interest income
was earned on invested proceeds from the initial public offering.

INCOME TAX (EXPENSE) BENEFIT. The Company recorded $28,000 income tax expense
for the third quarter 1998 and $156,000 of income tax expense for the nine
months ended September 30, 1998. The Company recorded an income tax benefit of
approximately $0 and $32,000 for the three months ended and nine months ended
September 30, 1997, respectively. The tax benefit recorded in 1997 was due to a
refund from a net operating loss carryforward. The Company recorded income tax
expense during the nine months ended September 30, 1998 attributable to taxable
income from its European subsidiaries.

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, customer advances,
capital lease financings and its recent initial public offering.

Net cash used in operations of $6.9 million during the nine months ended
September 30, 1998 is due primarily to the Company's operating loss and an
increase in accounts receivable. Accounts receivable grew by $1.0 million from
December 31, 1997 to September 30, 1998, primarily due to slower collections.

                                        16


<PAGE>

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 are 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
are collateralized by the Company's accounts receivable, inventory, and
intellectual property. As of September 30, 1998, borrowings on the line were $.6
million, which the Company used to extinguish certain high-interest debt and
provide additional working capital.

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
(8.25% at September 30, 1998). The balance outstanding under this line as of
September 30, 1998 was zero. Advances on the line of credit are collateralized
by a personal guarantee of the Company's majority shareholder.

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 $21.3 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 invested in
short-term, investment-grade, interest-bearing instruments.

                                        17


<PAGE>

The Company's future liquidity and capital requirements will depend upon
numerous factors, including the costs and timing of expansion of research and
product development efforts and the success of these efforts, the costs and
timing of expansion of sales and marketing activities, the extent to which the
Company's existing and new products gain market acceptance, competing
technological and market developments, the costs involved in maintaining and
enforcing patent claims and other intellectual property rights, available
borrowings under line of credit arrangements and other factors. Although the
Company anticipates, based on its proposed plans and assumptions relating to its
operations (including assumptions regarding the progress and timing of its new
product development efforts), that the net proceeds of the offering, together
with anticipated revenues from operations, availability under the Company's bank
lines of credit and cash and cash equivalents, will be sufficient to fund the
Company's operations and capital requirements for at least the next 12 months,
there can be no assurance that such funds will not be expended prior thereto due
to unanticipated changes in economic conditions or other unforeseen
circumstances. In the event the Company's plans change or its assumptions change
or prove to be inaccurate, the Company could be required to seek additional
financing sooner than currently anticipated. The Company has no current
arrangements with respect to, or potential sources of, any additional financing,
and it is not anticipated that existing shareholders will provide any portion of
the Company's future financing requirements. Consequently, there can be no
assurance that any additional financing will be available to the Company when
needed, on commercially reasonable terms, or at all. Any inability to obtain
additional financing when needed would require the Company to delay or scale
back its product development and marketing programs, which could have a material
adverse effect on the Company. In addition, any additional equity financing may
involve substantial dilution to the interests of the Company's then existing
shareholders.

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, as well as other factors
described in Exhibit 99.01 hereto, will impact the Company's future capital
requirements and the adequacy of its available funds.

IMPACT OF ADOPTION OF NEW ACCOUNTING STANDARDS

In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No.
130, "Reporting Comprehensive Income", which establishes standards for reporting
and presentation of comprehensive income. SFAS No. 130, which was adopted by the
Company in the first quarter of 1998, requires companies to report a new
measurement of income. "Comprehensive Income (Loss)" is to include foreign
currency translation gains and losses and other unrealized gains and losses that
have historically been excluded from net income (loss) and reflected instead in
equity. The Company's adoption of this standard did not have a material effect
on reported net loss or financial position for the periods presented.

                                        18

<PAGE>

In June 1997, FASB issued SFAS No. 131, "Disclosures About Segments of an
Enterprise and Related Information", which establishes standards for disclosure
of segment information. SFAS No. 131 is effective for fiscal years beginning
after December 15, 1997 and will be adopted by the Company in the fourth quarter
of 1998. The Company does not believe that adoption of this standard will have a
material impact on the Company's financial position or results of operations.

In December 1997, the American Institute of Certified Public Accountants
("AICPA") issued Statement of Position ("SOP") 97-2 which superseded SOP 91-1,
"Software Revenue Recognition". In addition, the AICPA issued SOP 98-4,
"Deferral of the Effective Date of a Provision of SOP 97-2, 'Software Revenue
Recognition' in March 1998. SOP 97-2 and SOP 98-4 are effective for fiscal
years beginning after December 15, 1997. The Company does not believe that
adoption of these standards has had a material impact on the Company's financial
position or results of operations.

YEAR 2000 ISSUE

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 the
Company's systems and applications to process critical financial and operational
information incorrectly. The Company continues to assess the impact of the Year
2000 issue on its reporting system and operations. In addition, the Company is
assessing the readiness of its customers and suppliers for the Year 2000 issue;
however, there can be no assurance that these third parties will timely convert
their systems or that their systems will not have an adverse effect on the
Company. While uncertainty exists concerning the potential effects associated
with such compliance, the Company does not believe that Year 2000 compliance
will result in a material adverse effect on its financial condition or results
of operations.
                                        19


<PAGE>

PART II. OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS

None.

ITEM 2.  CHANGES IN SECURITIES AND USE OF PROCEEDS

(a)   Not applicable.
(b)   Not applicable.
(c)   From June 1, 1998 to September 30, 1998, the Company issued no incentive
      nor performance incentive stock options to purchase Common Stock pursuant
      to the Company's stock option plans to officers and employees of the
      Company.

     On July 21, 1998, the Company issued an aggregate of 516,769 shares of
     Common Stock to certain warrantholders upon the exercise of outstanding
     warrants for $10,335. The issuance of such shares was made in reliance on
     the exemption provided by section 4(2) of the Securities Act of 1933, as
     amended (the "Securities Act") as transactions not involving a public
     offering.

     On July 27, 1998, the Company issued warrants, which will not be
     exercisable for one year, to purchase up to 260,000 shares of Common Stock
     at an exercise price of $9.60 per share to Bluestone Capital Partners, L.O.
     and Royce Investment Group, Inc., the representatives of the underwriters
     of the Company's initial public offering (the "Representatives"), for
     aggregate consideration of $260. These warrants may not be transferred
     until July 21,1999, except to the officers and partners of the
     Representatives or the underwriters or members of the selling group, and
     are exercisable at any time, and from time to time, during the four years
     after July 21,1999. The warrants were issued in reliance on the exemption
     provided by section 4(2) of the Securities Act as transactions not
     involving a public offering.

     On August 17, 1998 the Company issued 19,106 shares of common stock
     pursuant to the exercise of an outstanding warrant. The exercise price of
     the warrant was paid pursuant to a cashless exercise feature in which
     shares of the Company's Common Stock issuable pursuant to the warrant were
     used as consideration for the issuance of the net number of shares issuable
     under the warrant. The shares of Common Stock were issued in reliance on
     the exemption provided by section 4(2) of the Securities Act as
     transactions not involving a public offering.



     (d) The Company's Registration Statement of Form SB-2 (Registration No.
     333-53755) covering certain shares of its common stock was declared
     effective on July 21, 1998. A total of 2,990,000 shares of the Company's
     common stock, par value $0.10 per share, were registered (including an
     over-allotment option for the sale of 390,000 shares). The Company
     consummated an initial public offering of 2,600,000 shares of common stock
     at a price to the public of $8.00 per share on July 27, 1998. The lead
     underwriters in the offering were BlueStone Capital Partners, L.P. and
     Royce Investment Group, Inc.. During August 1998, the underwriters
     exercised their right to purchase an additional 390,000 shares at the
     initial public offering price. The aggregate offering price of the amount
     registered and sold was $23,920,000. The total proceeds received by the
     Company, net of underwriting discounts and estimated expenses of the
     offering, were approximately $21,885,000. The total underwriting discount
     was $1,674,000. Expenses paid to or for the underwriters were approximately
     $361,000. Other expenses in connection with the offering are approximately
     $1,409,000 (of which $400,000
                                        20


<PAGE>

        was paid to an affiliate of one of the Company's directors). From the
        effective date through September 30, 1998, the net offering proceeds
        were used as follows: $8,870,000 for repayment of indebtedness (of which
        $483,000 was paid to officers of the Company), $5,206,000 to fund
        current operations (of which $207,000 was paid to officers of the
        Company), and the remaining proceeds received by the Company from such
        offering were invested in short-term, investment-grade, interest-bearing
        instruments and cash. All amounts shown above in the instant paragraph
        are reasonable estimates.

        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.

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

                                      None.

ITEM 4.  OTHER INFORMATION

Effective November 9, 1998 Dale Addink, Vice President of Development, Online
Games, resigned his position to pursue other interests.

Effective October 23, 1998 the Company's President and Chief Operating Officer,
Robert L. Pickens, resigned his position for health reasons.

Effective September 18, 1998 Joseph R. Mannes, Vice President and General
Manager, Online Games, resigned his position to pursue other interests.


ITEM 5.  EXHIBITS AND REPORTS ON FORM 8-K

     (A)   EXHIBITS

       EXHIBIT NO.         DESCRIPTION OF EXHIBIT
       -----------         ----------------------

       27.01               Financial Data Schedule
       99.01               Risk Factors

     (B)   REPORTS ON FORM 8-K

There were no reports on form 8-K filed during the three months ended September
30, 1998. During that period, the Company was not required to file reports under
the Exchange Act.

                                        21

<PAGE>
                                   SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.

                             INTERACTIVE MAGIC, INC.

November 16, 1998                  By: /s/ J.W. Stealey
                                   --------------------

                                   J.W. Stealey
                                   Chairman of the Board of Directors
                                   and Chief Executive Officer

November 16, 1998                  By: /s/ Michael W. Oliver
                                   -------------------------

                                   Michael W. Oliver
                                   Chief Financial Officer
                                   (Principal Financial and Accounting Officer)

                                        22