<PAGE>
 
                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION

                            WASHINGTON, D.C. 20549

                                   FORM 10-Q
(Mark One)

[ X ]    Quarterly report pursuant to Section 13 or 15(d) of the Securities
         Exchange Act of 1934.

         For the quarterly period ended September 30, 1998.

                                      or

[   ]    Transition report pursuant to Section 13 or 15(d) of the Securities 
         Exchange Act of 1934.

                        Commission File Number: 0-24507

                         PILOT NETWORK SERVICES, INC.
            (Exact name of registrant as specified in its charter)

           DELAWARE                                      94-3305774
(State or other jurisdiction of                       (I.R.S. Employer
 incorporation or organization)                    Identification Number)

                          1080 MARINA VILLAGE PARKWAY
                               ALAMEDA, CA 94501
         (Address of principal executive offices, including zip code)

                                (510) 433-7800
             (Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.

                                 Yes  X  No 
                                     ---    ---

At September 30, 1998, there were 13,925,092 shares of the Registrant's Common
Stock outstanding.


                                Page 1 of 18
<PAGE>
 
                         PILOT NETWORK SERVICES, INC.
                         QUARTERLY REPORT ON FORM 10-Q
                                     INDEX

<TABLE> 
<CAPTION> 
                                                                                   Page Number
<S>        <C>                                                                    <C>   
PART I      FINANCIAL INFORMATION

Item 1.     Financial Statements                                                        3

            Consolidated Balance Sheets as of September 30, 1998 and 
            March 31, 1998                  

            Consolidated Statements of Operations for the three months
            and six months ended September 30, 1997 and 1998

            Consolidated Statements of Cash Flows for the six months
            ended September 30, 1997 and 1998

            Notes to Financial Statements

Item 2.     Management's Discussion and Analysis of Financial Condition and             7
            Results of Operations

PART II     OTHER INFORMATION                                                          15

Item 2.     Change in Securities and Use of Proceeds                                   15

Item 4.     Submission of Matters to a Vote of Security Holders                        16

Item 6.     Exhibits and Reports on Form 8-K                                           16



SIGNATURES                                                                             17

 
INDEX TO EXHIBITS                                                                      17
</TABLE> 

                                Page 2 of 18

<PAGE>
 
PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS


                         PILOT NETWORK SERVICES, INC.

                          CONSOLIDATED BALANCE SHEET
                       (in thousands, except share data)
                                  (unaudited)

<TABLE> 
<CAPTION> 
                                                                           March 31,        Sept. 30,
                                                                             1998             1998
                                                                             ----             ----
<S>                                                                       <C>              <C>
                                  ASSETS
Current assets:
  Cash and cash equivalents                                                $  1,447         $ 31,221
  Short-term investments                                                          -           11,848
  Trade receivables, less allowance for doubtful accounts                     1,066            1,818
  Prepaid and other current assets                                              273              404
                                                                           --------         --------
    Total current assets                                                      2,786           45,291
Property and equipment, net                                                   5,994            8,140
Other assets, net                                                               142              729
                                                                           --------         --------
                                                                           $  8,922         $ 54,160
                                                                           ========         ========

               LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
  Accounts payable                                                         $  2,057         $  1,911
  Accrued expenses                                                              601            1,404
  Line of credit                                                                  -              726
  Term loan                                                                       -            6,000
  Current portion of capital lease obligation                                 1,549            1,780
  Deferred revenue                                                            1,542            1,395
                                                                           --------         --------
    Total current liabilities                                                 5,749           13,216
Capital lease obligations, net of current portion                             3,444            4,549
                                                                           --------         --------
    Total liabilities                                                         9,193           17,765
                                                                           --------         --------
Commitments
Redeemable convertible preferred stock, $0.001 par value;  
    7,432,810 shares authorized and 6,363,030 shares issued 
    and outstanding as of March 31,1998, and no shares authorized, 
    issued and outstanding as of September 30, 1998.                         12,143                -
Stockholders' equity (deficit):
  Convertible Series A preferred stock, $0.001 par value; 1,400,000 
    shares authorized, issued and outstanding as of March 31, 1998, 
    and no shares authorized, issued and outstanding as of September 
    30, 1998.                                                                     1                -
  Common stock, $0.001 par value; 40,000,000 shares authorized;  
    2,050,536 and 13,925,092 shares issued and outstanding as 
    of March 31, 1998 and September 30, 1998, respectively.                       2               14
  Additional paid-in capital                                                  1,169           60,490
  Accumulated other comprehensive income                                          -              157
  Deferred stock compensation                                                  (891)          (2,361)
  Accumulated deficit                                                       (12,695)         (21,905)
                                                                           --------         --------
     Total stockholders' equity (deficit)                                   (12,414)          36,395
                                                                           --------         --------
                                                                           $  8,922         $ 54,160
                                                                           ========         ========

</TABLE> 
           See accompanying notes to condensed financial statements.

                                  Page 3 of 18
<PAGE>
 
                          PILOT NETWORK SERVICES, INC.

                      CONSOLIDATED STATEMENT OF OPERATIONS
                     (in thousands, except per share data)
                                  (unaudited)
<TABLE>
<CAPTION>
 
                                               Three months ended               Six months ended
                                                 September 30,                    September 30,
                                             1997            1998              1997              1998
                                          ---------        ---------         ---------        ---------
<S>                                       <C>             <C>               <C>              <C>
Service revenues                           $ 2,774          $ 3,770           $ 5,235          $ 7,490
Cost of service revenues                     2,290            4,581             4,035            8,604
                                           -------          -------           -------          -------
Gross margin                                   484             (811)            1,200           (1,114)
                                           -------          -------           -------          -------
Operating costs and expenses:
 Sales and marketing                           850            2,134             1,717            4,268
 Engineering and development                   184              386               327              685
 General and administrative                    390              728               731            1,416
                                           -------          -------           -------          -------
 
 Operating expenses                          1,424            3,248             2,775            6,369
                                           -------          -------           -------          -------
 
Operating loss                                (940)          (4,059)           (1,575)          (7,483)
Interest expense, net                          (94)          (1,031)             (177)          (1,239)
                                           -------          -------           -------          -------
Net loss                                   $(1,034)         $(5,090)          $(1,752)         $(8,722)
 
 Accretion on redeemable convertible
  preferred stock                             (364)            (151)             (496)            (488)
 
 Net loss attributable to common           
  stockholders                             $(1,398)         $(5,241)          $(2,248)         $(9,210)
                                           =======          =======           =======          =======
 
Basic and diluted net loss per share       $ (0.69)         $ (0.60)          $ (1.12)         $ (1.68)
                                           =======          =======           =======          =======
 
Shares used in computing net loss per        
  share                                      2,014            8,752             2,010            5,477
                                           =======          =======           =======          =======
 
Pro forma basic and diluted net loss
  per share                                                 $ (0.42)                           $ (0.79)
                                                            =======                            =======
 
 Shares used in computing pro forma net
  loss per share                                             12,202                             11,084
                                                            =======                            =======
 
 
</TABLE>
           See accompanying notes to condensed financial statements.

                                  Page 4 of 18
<PAGE>
 
                         PILOT NETWORK SERVICES, INC.

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                           (in thousands, unaudited)

<TABLE> 
<CAPTION> 

                                                                           Six months ended
                                                                             September 30,
                                                                          1997          1998
                                                                          ----          ----
<S>                                                                  <C>            <C> 
Cash flows from operating activities:
  Net loss                                                             $ (1,752)     $ (8,722)
  Adjustments to reconcile net loss to net cash used in operating 
  activities:
    Depreciation and amortization                                           969         1,790
    Amortization of deferred compensation                                    20           705
    Amortization of financing costs                                           -           750
    Changes in operating assets and liabilities:
      Trade receivables                                                    (504)         (752)
      Prepaid and other assets                                               12          (271)
      Accounts payable                                                      389          (146)
      Accrued expenses                                                      221           803
      Deferred revenue                                                      700          (146)
                                                                       ---------     ---------
      Net cash provided by (used in) operating activities                    55        (5,989)
                                                                       ---------     ---------
Cash flows used in investing activities:
  Purchases of property and equipment                                      (566)       (1,560)
  Purchase of short-term investments                                          -       (11,691)
                                                                       ---------     ---------
      Net cash used in investing activities                                (566)      (13,251)
                                                                       ---------     ---------
Cash flows from financing activities:
  Net proceeds from issuance of preferred and common stock                    2        43,326
  Proceeds from working capital line of credit                                -           726
  Proceeds from term loan                                                     -         6,000
  Payments under capital lease obligations                                 (550)       (1,038)
                                                                       ---------     ---------
      Net cash provided by (used in) financing activities                  (548)       49,014
                                                                       ---------     ---------

Net increase (decrease) in cash and cash equivalents                     (1,059)       29,774

Cash and cash equivalents, beginning of period                            3,081         1,447
                                                                       ---------     ---------
Cash and cash equivalents, end of period                               $  2,022      $ 31,221
                                                                       =========     =========

Supplemental disclosure of cash flow information:
  Cash paid during the period-interest                                 $    238      $    706
                                                                       =========     =========
Noncash financing activities:    
  Assets acquired under capital lease obligations                      $  1,349      $  2,373
                                                                       =========     =========
  Accretion on preferred stock                                         $    496      $    488
                                                                       =========     =========
</TABLE> 

           See accompanying notes to condensed financial statements.

                                  Page 5 of 18
<PAGE>
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


1.        Basis of presentation

          The financial statements included herein for Pilot Network Services,
Inc. have been prepared by the Company, without audit, pursuant to the rules and
regulations for Form 10-Q of the Securities and Exchange Commission. In
management's opinion, the interim financial data presented includes all
adjustments (which include only normal and recurring adjustments) necessary for
a fair presentation. Certain information and footnote disclosures normally
included in the financial statements prepared in accordance with generally
accepted accounting principles have been condensed or omitted pursuant to such
rules and regulations. However, the Company believes that the disclosures are
adequate to understand the information presented. The results of operations for
the three months and the six months ended September 30, 1998, are not
necessarily indicative of the operating results expected for the entire year.
The financial statements included herein should be read in conjunction with the
Company's March 31, 1998, financial statements and notes thereto included in the
Company's prospectus filed with the Securities and Exchange Commission and dated
August 10, 1998.

2.        Initial public offering

          On August 10, 1998, the Company completed an initial public offering
in which it sold 3,110,000 shares of common stock at $14.00 per share. Upon the
closing of this offering, all of the Series A through Series F Preferred Stock
converted to 7,763,030 shares of common stock. Additionally, Series F Preferred
Warrants were exercised and converted to 600,000 shares of common stock.

3.        Basic and diluted net loss per share

          The Company adopted Statement of Financial Accounting Standards No.
128,"Earnings per Share" (SFAS 128) and SEC Staff Accounting Bulletin No. 98
during the year ended March 31, 1998. Net loss per share is computed using the
weighted average number of common shares outstanding during the period.
Inclusion of common share equivalents would be dilutive and have been excluded
from per share calculations. Pro forma net loss per share includes the Company's
preferred stock on an as-converted basis.

4.        Recent accounting pronouncements

          In June 1997, the Financial Accounting Standards Board issued SFAS
130,"Reporting Comprehensive Income." SFAS 130 establishes standards for
reporting and displaying comprehensive income and its components in a full set
of general-purpose financial statements. Adoption of SFAS 130 did not have a
material effect on the Company's financial statements for the quarter ended
September 30, 1998.
 
          In June 1997, the Financial Accounting Standards Board issued SFAS
131,"Disclosures about Segments of an Enterprise and Related Information." This
statement establishes standards for the way companies report information about
operating segments in annual financial statements. It also establishes standards
for related disclosures about products and services, geographic areas, and major
customers. The Company has not determined what separately reportable business
segments, if any, it may have under SFAS 131.
 
          In June 1998, the Financial Accounting Standards Board issued SFAS
133, "Accounting for Derivative Instruments and Hedging Activities." This
statement establishes standards for derivative instruments and hedging
activities. The Company is required to adopt SFAS 133 in the first quarter of

                                  Page 6 of 18
<PAGE>
 
fiscal year 2001. The Company does not anticipate that SFAS 133 will have a
material impact on its financial statements.


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


    In addition to historical information, this Quarterly Report contains
forward-looking statements. The forward-looking statements are subject to
certain risks and uncertainties that could cause actual results to differ
materially from those reflected in such forward-looking statements. Factors that
might cause such a difference include, but are not limited to, those discussed
in the section entitled "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Factors That May Affect Future Results and
Market Price of Stock." Readers are cautioned not to place undue reliance on
these forward-looking statements, which reflect management's opinions only as of
the date hereof. The Company undertakes no obligation to revise or publicly
release the results of any revision to these forward-looking statements. Readers
should carefully review the risk factors that may be described in other
documents the Company files from time to time with the Securities and Exchange
Commission, including its Registration Statement on Form S-1 filed by the
Company on August 10, 1998, and any Annual and Quarterly Reports on Forms 10-K
and 10-Q filed by the Company in the future.

OVERVIEW

    Pilot Network Services, Inc. provides comprehensive security services that
incorporate high bandwidth connectivity and enable secure electronic commerce
over the Internet. Pilot's services include secure access and gateway services,
secure hosting and electronic commerce services, and secure extranet and virtual
private networking services. The Company delivers its services from
geographically dispersed Network Security Centers that are connected through its
secure high performance Internet backbone.


RESULTS OF OPERATIONS

THREE MONTHS ENDED SEPTEMBER 30, 1997 AND 1998

    SERVICE REVENUES. In the three months ended September 30, 1998, service
revenues increased 36% to $3.8 million from $2.8 million in the three months
ended September 30, 1997. This growth was due primarily to increases in the
number of new customers and to additional services sold to existing customers.
To a lesser extent, annual price increases for various offered services also
contributed to this growth.

    COST OF SERVICE REVENUES. Cost of service revenues increased to $4.6
million, or 122% of service revenues, in the three months ended September 30,
1998, compared to $2.3 million, or 83% of service revenues, in the three months
ended September 30, 1997. The increase in cost of service revenue was a result
of an increase in security implementation, customer service and operations
personnel to 63 at September 30, 1998, as well as increases in recruiting,
consulting, telecommunications and depreciation directly related to the
Company's revenue growth. Additionally, incremental costs associated with
preparations to open three new Network Security Centers contributed to the
increase in cost service revenue. The Company expects that its cost of service
revenues as a percentage of service revenues may remain above 100% for at least
the remaining quarters of the current fiscal year as a result of the continuing
expansion of the Company's Network Security Centers.

    SALES AND MARKETING. Sales and marketing expenses increased 151% to $2.1
million in the three months ended September 30, 1998 from $0.9 million in the
three months ended September 30, 

                                  Page 7 of 18
<PAGE>
 
1997 and increased as a percentage of service revenues to 57% for the three
months ended September 30, 1998 from 31% for the three months ended September
30, 1997. The increase in sales and marketing expense was a result of an
increase in sales and marketing personnel to 44 at September 30, 1998, as well
as increases in recruiting, commissions and sales promotion directly related to
the expanded sales activity.

    ENGINEERING AND DEVELOPMENT. Engineering and development expenses increased
110% to $0.4 million in the three months ended September 30, 1998 from $0.2
million in the three months ended September 30, 1997 and increased as a
percentage of service revenues to 10% for the three months ended September 30,
1998 from 7% for the three months ended September 30, 1997. The increase in
engineering and development expense was a result of an increase in personnel to
9 at September 30, 1998, as well as increases in recruiting and consulting. The
Company expects that its engineering and development expenses will continue to
increase in absolute dollars as the Company makes additional investments in
developing its secure electronic commerce services.

    GENERAL AND ADMINISTRATIVE. General and administrative expenses increased
87% to $0.7 million in the three months ended September 30, 1998 from $0.4
million in the three months ended September 30, 1997 and increased as a
percentage of service revenues to 19% for the three months ended September 30,
1998 from 14% for the three months ended September 30, 1997. The increase in
general and administrative expense was a result of an increase in personnel to
13 at September 30, 1998, as well as increases in recruiting, professional fees,
business taxes and amortization of deferred compensation. The Company expects
that its general and administrative expenses will continue to increase in
absolute dollars as the Company continues to expand its operations and incur
additional costs associated with being a public company.


SIX MONTHS ENDED SEPTEMBER 30, 1998 AND 1997

    SERVICE REVENUES. In the six months ended September 30, 1998, service
revenues increased 43% to $7.5 million from $5.2 million in the six months ended
September 30, 1997. This growth was due primarily to increases in the number of
new customers and to additional services sold to existing customers. To a lesser
extent, annual price increases for various offered services also contributed to
this growth.

    COST OF SERVICE REVENUES. Cost of service revenues increased to $8.6
million, or 115% of service revenues, in the six months ended September 30,
1998, compared to $4.0 million, or 77% of service revenues, in the six months
ended September 30, 1997. The increase in cost of service revenue was a result
of an overall increase in customer service and operations personnel as well as
an increase in the average cost of such personnel. Additionally, increases in
recruiting, consulting, telecommunications, equipment leases and depreciation,
all associated with existing and the opening of four new Network Security
Centers contributed to the increase in cost of service revenue. The Company also
incurred higher than usual expenses due to the conversion of its backbone
network from a "frame relay" network to an ATM network completed within the
first quarter of fiscal year 1999. The Company expects that its cost of service
revenues as a percentage of service revenues may remain above 100% through the
remainder of the fiscal year as a result of the continuing expansion of the
Company's Network Security Centers.

    SALES AND MARKETING. Sales and marketing expenses increased 149% to $4.3
million in the six months ended September 30, 1998 from $1.7 million in the six
months ended September 30, 1997 and increased as a percentage of service
revenues to 57% for the six months ended September 30, 1998 from 33% for the six
months ended September 30, 1997. The increase in sales and marketing expense was
a result of hiring additional sales and marketing personnel and expanding
marketing programs in connection with the Company's expansion of its operations.
The Company expects that sales and marketing expenses will continue to increase
in absolute dollars for the remainder of the fiscal year.

                                  Page 8 of 18
<PAGE>
 
    ENGINEERING AND DEVELOPMENT. Engineering and development expenses increased
110% to $0.7 million in the six months ended September 30, 1998 from $0.3
million in the six months ended September 30, 1997 and increased as a percentage
of service revenues to 9% for the six months ended September 30, 1998 from 6%
for the six months ended September 30, 1997. The increase in engineering and
development expense was a result of increases in personnel and consulting
related expenses in connection with continuing efforts to develop new security
methodologies, integrate and enhance acquired third-party technologies to
support the Company's security and add new service offerings. The Company
expects that its engineering and development expenses will continue to increase
in absolute dollars for the remainder of the fiscal year as a result of this
increased investment activity.

    GENERAL AND ADMINISTRATIVE. General and administrative expenses increased
94% to $1.4 million in the six months ended September 30, 1998 from $0.7 million
in the six months ended September 30, 1997 and increased as a percentage of
service revenues to 19% for the six months ended September 30, 1998 from 14% for
the six months ended September 30, 1997. The increase in general and
administrative expense was a result of increases in personnel, recruiting,
professional fees, business taxes and amortization of deferred compensation. The
Company expects that its general and administrative expenses will continue to
increase in absolute dollars for the remainder of the fiscal year as the Company
continues to expand its operations and incur additional costs associated with
being a public company.


LIQUIDITY AND CAPITAL RESOURCES

    At September 30, 1998, the Company's cash, cash equivalents and short term
investments totaled $43.1 million as compared to cash and equivalents of $1.4
million at March 31, 1998. The Company completed an initial public offering of
3,250,000 shares of common stock, including 3,110,000 shares by the Company and
140,000 shares by selling stockholders, on August 10, 1998 at $14.00 per share
resulting in net proceeds to the Company of $39.4 million. Immediately prior to
the initial public offering, common stock options and warrants to purchase
shares of Series F Preferred Stock convertible to 600,000 shares of common stock
were exercised resulting in additional net proceeds to the Company of $3.8
million.

    As of September 30, 1998, the Company had an $8.0 million equipment line of
credit and lease facility for financing of equipment purchases at interest rates
of approximately 15%. Borrowing under the financing is repayable in monthly
installments of principal and interest over 48 months and is secured by a lien
on the financed equipment. As of September 30, 1998, the Company had borrowed an
aggregate of $5.2 million under these lines of credit and lease facilities.

    On May 11, 1998, the Company negotiated a line of credit with a financial
institution for an aggregate amount of $1.5 million. The line of credit
currently bears interest of 10.5% per annum and is secured by assets of the
Company. At September 30, 1998, $774,000 of this debt facility was available.

    On June 30, 1998, the Company completed a borrowing arrangement with two
lenders providing $6.0 million of short term financing. The loans expires in
June 1999 and bear interest at 13.5% per annum. The loans contain various pre-
payment options available after the Company's initial public offering date of
August 10, 1998. As additional consideration, the Company issued 150,000
warrants to purchase common stock at $11.20 per share. The Company calculated a
fair value of the warrants of $1.2 million which amount was capitalized and
amortized over the expected terms of the loans. In September 1998 one of the
lenders informed the Company of its intent to exercise its option for repayment
of $3.0 million which was subsequently repaid on October 1, 1998.

    The Company's working capital and capital requirements will depend upon
numerous factors including plans to incur substantial additional capital
expenditures primarily for additions to and 

                                  Page 9 of 18
<PAGE>
 
expansions of its Network Security Centers, developing, acquiring or licensing
new applications and technologies, and the level of resources that the Company
devotes to its sales and marketing activities. The Company believes that its
existing capital resources and available equipment lease financing arrangements
will be adequate to fund its current operations for at least the next 12 months.
However, there can be no assurance that the Company will be successful in
generating anticipated levels of cash from operations or borrowings. If the
Company is unable to generate sufficient cash flow from operations or additional
borrowings, it may be required to sell assets, scale down its operations and
expansion plans, refinance all or a portion of its existing indebtedness or
obtain other sources of financing earlier than planned, any of which could have
a material adverse impact on the Company's business, results of operations and
financial condition. There can be no assurance that any such refinancing would
be available on commercially reasonable terms, or at all, or that any other
financing could be obtained.

  On October 19, 1998, the Company announced an open-market common stock
repurchase program under which the Company would repurchase up to 1.5 million
shares of its Common Stock.  As of November 13, 1998, 450,936 shares had been
repurchased, at an aggregate cost to the Company of approximately $2.7 million.


YEAR 2000 RISKS

  The Company has established procedures for evaluating and managing the risks
and costs associated with the Year 2000 problem and believes that the internal
computer systems that the Company has developed are currently Year 2000
compliant.  To date, the Company has not incurred significant incremental costs
in order to comply with Year 2000 requirements and does not believe it will
incur significant incremental costs in order to comply with Year 2000
requirements in the foreseeable future.

  Despite the Company's belief that its internal computer systems are currently
Year 2000 compliant, many of the Company's customers maintain their Internet
operations on commercially available operating systems, which may be impacted by
Year 2000 complications.  In addition, the Company relies on third party vendors
for certain equipment and software included within the Company's services which
may not be Year 2000 compliant.  The Company is in the early stages of
conducting an audit of its third-party suppliers as to the Year 2000 compliance
of their systems.  The Company believes its audit will be complete by the end of
1999.  However, the failure to correct or discover a material Year 2000 problem
could result in an interruption in, or a failure of, certain normal business
activities or operations.  Such failures could materially and adversely affect
the Company's results of operations, liquidity and financial condition.  Due to
the general uncertainty inherent in the Year 2000 problem resulting in part from
the uncertainty of the Year 2000 readiness of third-party suppliers and
customers, the Company is unable to determine at this time whether the
consequences of Year 2000 failures will have a material impact on the Company's
results of operations, liquidity or financial condition.

  The dates on which the Company believes its Year 2000 readiness will be
completed is based on the Company's management's best estimates, which were
derived utilizing numerous assumptions of future events, including the continued
availability of certain resources, third-party cooperation and modification
plans, and other factors.  However, there can be no guarantee that these
estimates will be achieved, or that there will not be a delay in, or increased
costs associated with, the implementation of Year 2000 compliant solutions.
Specific factors that might cause differences between the estimates and actual
results include, but are not limited to, the availability and cost of personnel
trained in these areas, the ability to locate and correct all relevant computer
code, timely responses to and corrections by third-parties and suppliers, the
ability to implement interfaces between the new systems and the systems not
being replaced, and similar uncertainties.  Due to the general uncertainty
inherent in the Year 2000 problem, resulting in part from the uncertainty of the
Year 2000 readiness of third-parties and the interconnection of global
businesses, the Company cannot ensure its ability to timely and cost-effectively
resolve problems associated with the Year 2000 issue and is unable to determine
at this time whether the 

                                 Page 10 of 18
<PAGE>
 
consequences of Year 2000 failures will have a material impact on the Company's
results of operations, liquidity or financial condition.


FACTORS THAT MAY AFFECT FUTURE RESULTS AND MARKET PRICE OF STOCK

  The Company operates in a rapidly changing environment that involves numerous
risks, some of which are beyond the Company's control.  The following discussion
highlights some of these risks.

  LIMITED OPERATING HISTORY; HISTORY OF LOSSES.  The Company began operations in
1993, and has experienced operating losses and negative cash flows from
operations in each quarterly and annual period.  As of September 30, 1998, the
Company had an accumulated deficit of approximately $21.9 million.  The revenue
and income potential of the Company's business and market is unproven, and the
Company's limited operating history makes an evaluation of the Company and its
prospects difficult.  The Company has recently made and expects to continue
making significant investments in new and existing Network Security Centers,
sales and marketing activities, and the development of new services.  As a
result, the Company experienced a decline in gross margin and an increase in net
loss in fiscal 1998 and the first six months of fiscal 1999 and expects to
continue experiencing significant net losses on a quarterly and annual basis for
the foreseeable future, including a negative its gross margin at least through
fiscal 1999. Failure of the Company's services to achieve market acceptance
would have a material adverse effect on the Company's business, results of
operations and financial condition. There can be no assurance that the Company
will ever achieve profitability on a quarterly or an annual basis or will
sustain profitability if achieved.

  POTENTIAL FLUCTUATIONS IN RESULTS OF OPERATIONS.  The Company derives revenue
from its customers primarily through initial setup fees and ongoing monthly
service charges.  For each new customer, the Company must incur costs in
anticipation of the customer's decision to use the Company's services and in
advance of the receipt of sufficient revenues to repay these costs and provide a
return on the Company's investment.  As a result, a relatively large portion of
the Company's expenditures are fixed in the short-term, and the Company's
success is substantially dependent on the continuous growth in its customer base
and the retention of its customers for sufficient periods to provide returns on
the Company's investment.  There can be no assurance that the Company's
customers will maintain or renew their commitments to use the Company's
services.  The Company typically experiences a lengthy sales cycle for its
services, particularly given the importance to customers of adequately securing
Internet connectivity for electronic commerce and the need to educate them
regarding the requirements for effective network security.  Changes in the rate
of growth in the Company's customer base, customer renewal rates and the sales
cycle for the Company's services, have caused, or are expected in the future to
cause, significant fluctuations in the Company's results of operations on a
quarterly and an annual basis.

  For these and other reasons, in some future quarters, the Company's results of
operations may fall below the expectations of securities analysts or investors,
which could have a material adverse effect on the market price of the Company's
Common Stock.

  RISKS ASSOCIATED WITH SECURITY BREACHES.  The Company's success is
substantially dependent on the continued confidence of its current and future
customers that the Company provides superior network security protection.
Despite the Company's focus on Internet security, there can be no assurance that
the Company will be able to stop unauthorized attempts, whether made
unintentionally or by computer "attackers," to gain access to or disrupt the
network operations of the Company's customers.  The Company's Network Security
Centers are designed to prevent unauthorized access to customers' networks from
the Internet.  Any failure by the Company to stop unauthorized access from the
Internet or disruptions to related Internet operations of its customers could
materially adversely affect such customers and the Company.  Although the
Company generally limits warranties and liabilities relating to security in its
customer contracts, the Company's customers may seek to hold the Company

                                 Page 11 of 18
<PAGE>
 
responsible for any losses suffered by the customer as a result of unauthorized
access to customers' network systems from the Internet.  This could result in
liability to the Company, which could have a material adverse effect upon its
business, operating results and financial condition.  Moreover, computer
attackers from the Internet could infiltrate the Company's network and seek to
sabotage its network or services by creating bugs or viruses or through other
means.  In addition, any adverse publicity resulting from any such unauthorized
access could deter future customers from using the Company's services and could
cause current customers to cease using the Company's services, which could have
a material adverse effect upon the Company's business, operating results and
financial condition.

  RISKS ASSOCIATED WITH THE EMERGING MARKET FOR OUTSOURCED NETWORK SECURITY
SERVICES.  The market for Internet security monitoring, detection and defense
services in general is new and rapidly evolving.  If the market for such
services fails to grow or grows more slowly than the Company currently
anticipates, the Company's business, operating results and financial condition
would be materially and adversely affected.

  RISKS OF BUSINESS EXPANSION AND MANAGEMENT OF GROWTH.  The Company intends to
expand domestically and internationally by adding Network Security Centers in
new locations and expanding Network Security Centers in existing locations.  The
Company's inability to manage effectively its expansion, including any
disruption of service to current customers, would have a material adverse effect
upon the Company's business, results of operations and financial condition.

  In addition, the Company will be required to expend substantial resources for
leases and improvements of facilities, significant improvements of such
facilities, purchases of equipment, implementation of multiple
telecommunications connections and hiring of network, administrative, customer
support, and sales and marketing personnel.  Furthermore, any problems
encountered in connection with the expansion of existing Network Security
Centers may cause the interruption of service to current customers.

  The Company has recently hired large numbers of new employees.  This growth
has placed and may continue to place a significant strain on the Company's
financial, management, operational and other resources.  If the Company's
executives are unable to manage growth effectively, the Company's business,
results of operations and financial condition would be materially adversely
affected.

  COMPETITION.  The market served by the Company is new, rapidly evolving,
highly competitive and largely undefined.  There are few substantial barriers to
entry, and the Company expects that it will face additional competition from
existing competitors and new market entrants in the future.  There can be no
assurance that the Company will have the resources or expertise to compete
successfully in the future.

  The Company competes with a broad range of products and services.  Many of the
Company's competitors have substantially greater financial, technical and
marketing resources, larger customer bases, longer operating histories, greater
name recognition and more established relationships in the industry than the
Company.  As a result, certain of these competitors may be able to develop and
expand their network infrastructures and service offerings more quickly, adapt
to new or emerging technologies and changes in customer requirements more
quickly, take advantage of acquisition and other opportunities more readily,
devote greater resources to the marketing and sale of their products and adopt
more aggressive pricing policies than the Company.  In addition, the Company
believes that the businesses in which the Company competes are likely to
encounter consolidation in the near future, which could result in increased
price and other competition that could have a material adverse effect on the
Company's business, results of operations and financial condition.

  RISK OF SYSTEM FAILURE.  The Company's success depends on the uninterrupted
operation of its network infrastructure.  Despite existing and planned
precautions by the Company, the occurrence of a natural disaster or other
unanticipated problems at one or more of the Company's Network Security 

                                 Page 12 of 18
<PAGE>
 
Centers could result in interruptions in the services provided by the Company.
Any damage to or failure of the Company's systems or those of its service
providers could result in reductions in, or terminations of, services supplied
to the Company's customers. Such reductions or terminations in service could
materially and adversely impact the Company's customers, which could have a
material adverse effect on the Company's business, results of operations and
financial condition.

  FUTURE CAPITAL NEEDS.  The Company expects to incur significant expenditures
as part of its planned expansion, including expenditures for new and expanded
Network Security Centers, increases in sales and marketing activities and the
development of new services.  There can be no assurance that the Company will be
successful in generating anticipated levels of cash from operations or
borrowings.  If the Company is not successful, it may be required to sell
assets, scale down its operations and expansion plans, seek to refinance all or
a portion of its existing indebtedness or seek to obtain other financing earlier
than planned, any of which could have a material adverse effect on the Company's
business, results of operations and financial condition.  There can be no
assurance that any such refinancing would be available on commercially
reasonable terms, or at all, or that any other financing could be obtained or
would not result in significant dilution to the Company's stockholders.

  RISKS ASSOCIATED WITH INTERNATIONAL OPERATIONS.  A key component of the
Company's long-term strategy is to expand into international markets.  If
revenue generated by any international Network Security Center is not adequate
to offset the expense of establishing and maintaining any such international
operation, the Company's business, results of operations and financial condition
could be materially adversely affected.  In addition, the Company faces certain
risks inherent in conducting business internationally, any of which could
adversely affect the Company's international operations.

  DEPENDENCE UPON SCALABILITY OF THE COMPANY'S NETWORK.  The Company must
continue to expand and adapt its network infrastructure as the number of users
and the amount of information they wish to transmit increases, and as customer
requirements change.  The expansion and adaptation of the Company's
telecommunications infrastructure will require substantial financial,
operational and management resources.  Due to the limited deployment of the
Company's services to date, the ability of the Company's network to connect and
manage a substantially larger number of customers at high transmission speeds is
as yet unknown, and the Company faces risks related to the network's ability to
operate with higher customer levels while maintaining superior performance.  The
Company's failure to achieve or maintain high capacity data transmission could
significantly reduce customer demand for its services and have a material
adverse effect on its business, results of operations and financial condition.
There can be no assurance that the Company will be able to expand or adapt its
telecommunications infrastructure to meet additional demand or its customers'
changing requirements.

  DEPENDENCE UPON THIRD PARTY NETWORK INFRASTRUCTURE PROVIDERS.  The Company's
success will depend upon third party network infrastructure providers.  In
addition, the Company relies on a number of public and private peering
interconnections (i.e., arrangements among access providers to carry traffic of
each other) to deliver its services.  If the carriers that operate the Internet
exchange points ("IXPs") were to discontinue their support of the peering points
or to refuse to offer services to the Company and no alternative providers were
to emerge, or such alternative providers were to increase the cost of utilizing
the IXPs, the transmission of network traffic by the Company would be
significantly constrained.  If the Company were unable to access on a cost-
effective basis alternative networks to distribute its customers' content or
pass through any additional costs of utilizing these networks to its customers,
the Company's business, results of operations and financial condition could be
materially adversely affected.

  DEPENDENCE ON OTHER THIRD-PARTY RELATIONSHIPS.  The Company is dependent on
other companies to supply certain key components of its telecommunications
infrastructure and system and network management solutions that, in the
quantities and quality demanded by the Company, are available only from sole or
limited sources.  Any failure to obtain required components or software on a

                                 Page 13 of 18
<PAGE>
 
timely basis and at an acceptable cost would have a material adverse effect on
the Company's business, results of operations and financial condition.  The
Company also intends to develop alternative distribution and lead generation
channel partners for the Company's services, such as systems integration firms
and bandwidth providers.  Any failure by the Company to develop these channel
partners could materially and adversely impact the ability of the Company to
generate increased revenues, which could have a material adverse effect on the
Company's business, results of operations and financial condition.

  RAPID TECHNOLOGICAL CHANGE; EVOLVING INDUSTRY STANDARDS.  The Company's future
success will depend, in part, on its ability to offer services that incorporate
leading technology, address the increasingly sophisticated and varied needs of
its current and prospective customers and respond to technological advances and
emerging industry standards and practices on a timely and cost-effective basis.
The market for the Company's services is characterized by rapidly changing and
unproven technology, evolving industry standards, changes in customer needs,
emerging competition and frequent new service introductions.  There can be no
assurance that future advances in technology will be beneficial to, or
compatible with, the Company's business or that the Company will be able to
incorporate such advances on a cost-effective and timely basis into its
business.  The Company believes that its ability to compete successfully is also
dependent upon the continued compatibility and interoperability of its services
with products, services and architectures offered by various vendors as part of
the Company's services.  There can be no assurance that such products will be
compatible with the Company's infrastructure or that such products will
adequately address changing customer needs.  In addition, there can be no
assurance that products, services or technologies developed by others will not
render the Company's services uncompetitive or obsolete.

  DEPENDENCE ON KEY PERSONNEL.  The Company's success depends in significant
part upon the continued services of its key technical, sales and senior
management personnel, including the Company's President and Chief Executive
Officer, Marketta Silvera, and the Company's Vice President, Engineering and
Development, Thomas Wadlow.  Any officer or employee of the Company can
terminate his or her relationship with the Company at any time.  The loss of the
services of one or more of the Company's key employees or the Company's failure
to attract additional qualified personnel could have a material adverse effect
on the Company's business, results of operations and financial condition.

  RISKS ASSOCIATED WITH INFORMATION DISSEMINATED THROUGH THE COMPANY'S NETWORK.
The law relating to the liability of on-line services companies and Internet
access providers for information carried on or disseminated through their
networks is currently unsettled.  It is possible that claims could be made
against on-line services companies and Internet access providers under both
United States and foreign law for defamation, negligence, copyright or trademark
infringement, or other theories based on the nature and content of the materials
disseminated through their networks.  The imposition upon the Company and other
Internet network providers of potential liability for information carried on or
disseminated through their systems could require the Company to implement
measures to reduce its exposure to such liability, which may require the
expenditure of substantial resources, or to discontinue certain service or
product offerings.

  PROTECTION AND ENFORCEMENT OF INTELLECTUAL PROPERTY RIGHTS.  The Company
relies on a combination of copyright, trademark, patent, service mark and trade
secret laws and contractual restrictions to establish and protect certain
proprietary rights in technology underlying its services.  There can be no
assurance that patents or trademarks will be issued or granted from currently
pending or any future applications, or that any patents or trademarks that may
be issued or granted will be sufficient in scope or strength to provide
meaningful protection or any commercial advantage to the Company.  The laws of
certain foreign countries may not protect the Company's products, services or
intellectual property rights to the same extent as do the laws of the United
States.

  There can be no assurance that contractual arrangements or other steps taken
by the Company to protect its intellectual property will prove sufficient to
prevent infringement of or misappropriation of the Company's technology or to
deter independent third-party development of similar technologies.  Any 

                                 Page 14 of 18
<PAGE>
 
such infringement or misappropriation, should it occur, could have a material
adverse effect on the Company's business, results of operation and financial
condition.

  To date, the Company has not been notified that the Company's products
infringe the proprietary rights of third parties, but there can be no assurance
that third parties will not claim infringement or indemnification by the Company
with respect to current or future products.  Any such claim, whether meritorious
or not, could be time-consuming, result in costly litigation, cause product
installation delays, prevent the Company from using important technologies or
methods, subject the Company to substantial damages, or require the Company to
enter into royalty or licensing agreements.  As a result, any such claim could
have a material adverse effect upon the Company's business, results of
operations and financial condition.


PART II.  OTHER INFORMATION.


ITEM 2.   CHANGE IN SECURITIES AND USE OF PROCEEDS.

    (d)   Use of Proceeds

         (1)  The Company filed a Registration Statement on Form S-1 (the
              "Registration Statement"), File No. 333-57453, which was declared
              effective by the Securities and Exchange Commission on August 10,
              1998.

         (2)  The offering pursuant to the Registration Statement commenced on
              August 10, 1998.

         (3)  Not applicable

         (4)  (i)     The offering terminated after the sale of 3,250,000 shares
                      of Common Stock. The over-allotment option to purchase
                      487,500 shares of Common Stock was not exercised by the
                      Underwriters.
              (ii)    The managing underwriters of the offering were Credit
                      Suisse First Boston, BancAmerica Robertson Stephens and
                      Hambrecht & Quist.
              (iii)   The Company registered its Common Stock under the
                      Registration Statement.
              (iv)    The Company and the selling shareholders registered
                      3,597,500 and 140,000 shares of Common Stock,
                      respectively. The aggregate price to the public for the
                      3,250,000 shares sold was $45,500,000, and all of such
                      shares were sold to the public.
              (v)     From August 10, 1998 to September 30, 1998, the Company
                      incurred $4,183,048 of total expenses in connection with
                      the offering as follows:
                         (a)  $3,047,800 in underwriting discounts and
                              commissions; and
                         (b)  $1,135,248 in other expenses (not including
                              finders' fees or expenses paid to or for the
                              underwriters).
                      All of such expenses were direct or indirect payments to
                      others.
              (vi)   The net offering proceeds to the Company after deducting
                     total expenses in clause (v) above were $39,356,952.
              (vii)  From August 10, 1998 to September 30, 1998, the Company
                     used the net offering proceeds, in direct or indirect
                     payments to others, as follows:

                        After deducting underwriting discounts and commissions,
                        and the offering expenses described above, the net
                        proceeds to the Company were $39,356,952. As of
                        September 30, 1998, the net proceeds, totaling
                        $39,356,952, have been invested in short term, interest-
                        bearing, investment-grade securities. 

                                 Page 15 of 18
<PAGE>
 
              (viii)    The use of proceeds in clause (vii) above does not
                        represent a material change in the use of proceeds
                        described in the prospectus.


ITEM 4.         SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

The Company was incorporated in California on August 6, 1992 and was
reincorporated in Delaware on August 4, 1998 (the "Reincorporation").  Prior to
the Reincorporation, the California predecessor of the Company was the Company's
sole security holder and approved the Reincorporation on behalf of the Company
by written consent on August 3, 1998.

The security holders of the California predecessor of the Company approved the
following actions by written consent dated August 3, 1998:  (i)  the
Reincorporation; (ii) the Amendment and Restatement of the California
Predecessor's Articles of Incorporation to permit the Reincorporation; (iii) the
adoption of the 1998 Directors' Stock Option Plan; (iv) the adoption of the 1998
Employee Stock Purchase Plan; and (v) the adoption of the 1998 Stock Option
Plan.  These actions were approved by a vote as follows:

<TABLE>
<CAPTION>
 
Class of Stock        Outstanding      Voted For     Abstained
 
<S>                   <C>            <C>           <C>
Common                  1,153,523      1,120,620        32,903
Series A Preferred        700,000        700,000             0
Series B Preferred        830,822        830,822             0
Series C Preferred        605,034        605,034             0
Series D Preferred        744,100        744,100             0
Series E Preferred        391,559        391,559             0
Series F Preferred        610,000        310,000       300,000
 
</TABLE>

ITEM 6.              EXHIBITS AND REPORTS ON FORM 8-K


A.   Exhibits


Exhibit Number       Description of Exhibit

3.1                  Restated Certificate of Incorporation, dated September 29,
                     1998

27.1                 Financial Data Schedule


B.          Reports on Form 8-K

None

                                 Page 16 of 18
<PAGE>
 
SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.


November 16, 1998            /s/ William C. Leetham
-----------------            ----------------------
                             William C. Leetham
                             Senior Vice President, Finance and Administration
                             Chief Financial Officer, Treasurer and Secretary
                             (Principal Financial Officer)

November 16, 1998            /s/ Robert G. Carrade
-----------------            ---------------------
                             Robert G. Carrade
                             Vice President, Finance and Administration
                             (Principal Accounting Officer)




                                 Page 17 of 18
<PAGE>

EXHIBIT INDEX


Exhibit Number     Description of Exhibit

3.1                Restated Certificate of Incorporation, dated September 29,
                   1998

27.1               Financial Data Schedule

                                 Page 18 of 18