<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 December 31, 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 December 31, 1998, there were 13,487,872 shares of the Registrant's Common
Stock outstanding.

                                  Page 1 of 17
<PAGE>
 
                        PILOT NETWORK SERVICES, INC.
                        QUARTERLY REPORT ON FORM 10-Q
                                    INDEX

                                                                     Page Number

PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements...........................................   3
 
         Condensed Balance Sheets as of.................................   3
         March 31, 1998 and December 31, 1998
 
         Condensed Statements of Operations for the three months........   4
         and nine months ended December 31, 1997 and 1998
 
         Condensed Statements of Cash Flows for the.....................   5
         nine months ended December 31, 1997 and 1998
 
         Notes to Financial Statements..................................   6
 
Item 2.  Management's Discussion and Analysis of Financial Condition 
         and Results of Operations......................................   7
 
PART II. OTHER INFORMATION..............................................  15
 
Item 2.  Changes in Securities and Use of Proceeds......................  15
 
Item 6.  Exhibits and Reports on Form 8-K...............................  15
 
SIGNATURES..............................................................  16

INDEX TO EXHIBITS.......................................................  16

                                  Page 2 of 17
<PAGE>
 
PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

                          PILOT NETWORK SERVICES, INC.

                            CONDENSED BALANCE SHEETS
                       (in thousands, except share data)
                                  (unaudited)
<TABLE>
<CAPTION>
                                                                               March 31,          Dec. 31,
                                                                                 1998              1998
                                                                                 ----              ----
<S>                                                                        <C>               <C>
                                  ASSETS
Current assets:
 Cash and cash equivalents                                                     $  1,447          $ 15,808
 Short-term investments                                                               -            14,723
 Trade receivables, net                                                           1,066             3,217
 Prepaid and other current assets                                                   273               642
                                                                               --------          --------
  Total current assets                                                            2,786            34,390
Property and equipment, net                                                       5,994             9,583
Other assets, net                                                                   142               756
                                                                               --------          --------
                                                                               $  8,922          $ 44,729
                                                                               ========          ========
               LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
 Accounts payable                                                              $  2,057          $  2,217
 Accrued expenses                                                                   601             1,403
 Line of credit                                                                       -               673
 Term loan                                                                            -             3,000
 Current portion of capital lease obligation                                      1,549             1,910
 Deferred revenue                                                                 1,542             1,719
                                                                               --------          --------
  Total current liabilities                                                       5,749            10,922
Capital lease obligations, net of current portion                                 3,444             4,340
                                                                               --------          --------
  Total liabilities                                                               9,193            15,262
                                                                               --------          --------
Commitments and contingencies
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
 December 31, 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 December 31, 1998                   1                 -
 Common stock, $0.001 par value; 40,000,000 shares authorized; 2,050,536
  and 13,487,872 shares issued and outstanding as of March 31, 1998 and
  December 31, 1998, respectively                                                     2                14
 Additional paid-in capital                                                       1,169            60,500
 Accumulated other comprehensive income                                               -               169
 Deferred stock compensation                                                       (891)           (1,955)
 Accumulated deficit                                                            (12,695)          (26,567)
 Treasury stock, 450,936 shares of common stock at cost
        as of December 31, 1998                                                       -            (2,694)
                                                                               --------          --------
  Total stockholders' equity (deficit)                                          (12,414)           29,467
                                                                               --------          --------
                                                                               $  8,922          $ 44,729
                                                                               ========          ========
</TABLE>

           See accompanying notes to condensed financial statements.

                                  Page 3 of 17
<PAGE>
 
                          PILOT NETWORK SERVICES, INC.

                       CONDENSED STATEMENTS OF OPERATIONS
                     (in thousands, except per share data)
                                  (unaudited)

<TABLE>
<CAPTION>
 
                                                      Three months ended              Nine months ended
                                                         December 31,                    December 31,
                                                     1997            1998            1997            1998
a                                                    ----            ----            ----            ----       
<S>                                             <C>             <C>             <C>             <C>
Service revenues                                   $  2,977        $  4,480          $  8,212        $ 11,970
Cost of service revenues                              2,623           5,263             6,658          13,867
                                                   --------        --------          --------        --------
Gross margin                                            354            (783)            1,554          (1,897)
                                                   --------        --------          --------        --------
Operating costs and expenses:
 Sales and marketing                                  1,082           2,724             2,799           6,992
 Engineering and development                            243             386               570           1,071
 General and administrative                             435             722             1,166           2,138
                                                   --------        --------          --------        --------
 Operating expenses                                   1,760           3,832             4,535          10,201
                                                   --------        --------          --------        --------
Operating loss                                       (1,406)         (4,615)           (2,981)        (12,098)
Interest expense, net                                  (145)            (47)             (322)         (1,286)
                                                   --------        --------          --------        --------
Net loss                                           $ (1,551)       $ (4,662)         $ (3,303)       $(13,384)
 
Accretion on redeemable convertible preferred
 stock                                                 (254)              -              (750)           (488)
                                                   --------        --------          --------        --------
Net loss attributable to common stockholders       $ (1,805)       $ (4,662)         $ (4,053)       $(13,872)
                                                   ========        ========          ========        ========
Basic and diluted net loss per share               $  (0.89)       $  (0.34)         $  (2.01)       $  (1.68)
                                                   ========        ========          ========        ========
Shares used in computing net loss per share           2,033          13,580             2,018           8,266
                                                   ========        ========          ========        ========
 
Pro forma basic and diluted net loss per share                                                       $  (1.12)
                                                                                                     ========
Shares used in computing pro forma net loss
 per share                                                                                             11,947
                                                                                                     ========          

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

                                  Page 4 of 17
<PAGE>
 
                          PILOT NETWORK SERVICES, INC.

                       CONDENSED STATEMENTS OF CASH FLOWS
                           (in thousands, unaudited)
<TABLE>
<CAPTION>
                                                                         Nine months ended
                                                                            December 31,
                                                                        1997            1998
                                                                        ----            ----        
 
Cash flows from operating activities:
<S>                                                                <C>             <C>
 Net loss                                                             $ (3,303)       $(13,384)
 Adjustments to reconcile net loss to net cash used in operating
  activities:
  Depreciation and amortization                                          1,571           2,816
  Amortization of deferred compensation                                     68           1,111
  Amortization of loan fees                                                  -             900
  Changes in operating assets and liabilities:
   Trade receivables                                                      (362)         (2,150)
   Prepaid and other assets                                                (96)           (688)
   Accounts payable                                                        387             160
   Accrued expenses                                                        517             802
   Deferred revenue                                                        849             177
                                                                      --------        --------
   Net cash used in operating activities                                  (369)        (10,256)
                                                                      --------        --------
Cash flows used in investing activities:
 Purchases of property and equipment                                    (1,021)         (3,646)
 Purchase of short-term investments                                          -         (14,553)
                                                                      --------        --------
   Net cash used in investing activities                                (1,021)        (18,199)
                                                                      --------        --------
Cash flows from financing activities:
 Net proceeds from issuance of preferred and common stock                2,006          43,335
 Proceeds from working capital line of credit                                -             673
 Proceeds from term loan                                                     -           6,000
 Payments of term loan                                                       -          (3,000)
 Purchases of treasury stock                                                 -          (2,694)
 Payments under capital lease obligations                                 (867)         (1,498)
                                                                      --------        --------
   Net cash provided by financing activities                             1,139          42,816
                                                                      --------        --------
 
Net increase (decrease) in cash and cash equivalents                      (251)         14,361
 
Cash and cash equivalents, beginning of period                           3,081           1,447
                                                                      --------        --------
Cash and cash equivalents, end of period                              $  2,830        $ 15,808
                                                                      ========        ========
 
Supplemental disclosure of cash flow information:
 Cash paid during the period for interest                             $    399        $  1,095
                                                                      ========        ========
 Noncash financing activities:
  Assets acquired under capital lease obligations                     $  2,038        $  2,754
                                                                      ========        ========
  Accretion of preferred stock                                        $    750        $    488
                                                                      ========        ========
</TABLE>


           See accompanying notes to condensed financial statements.

                                  Page 5 of 17
<PAGE>
 
NOTES TO CONDENSED 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. The results of operations for the three months and the
nine months ended December 31, 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 into 7,763,030 shares of common stock. Additionally, Series F
Preferred Warrants were exercised and converted into 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 anti-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.

     Excluded from the computation of diluted earnings per share for the period
ending December 31, 1997, are options to acquire 1,476,146 shares of common
stock and 8,205,940 common share equivalents resulting from the assumed
conversion of the Series A, B, C, D, E and F preferred stock and related
warrants because their effects would be anti-dilutive. Excluded from the
computation of diluted earnings per share for the period ending December 31,
1998, are options to acquire 1,901,568 shares of common stock and 292,910 common
share equivalents from the assumed exercise of common stock warrants because
their effects would be anti-dilutive.

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.

                                  Page 6 of 17
<PAGE>
 
     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 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, its Quarterly Report on Form 10-Q
filed by the Company on November 16, 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 DECEMBER 31, 1997 AND 1998

     SERVICE REVENUES. In the three months ended December 31, 1998, service
revenues increased 50% to $4.5 million from $3.0 million in the three months
ended December 31, 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. Additionally, the Company was able to shorten the
implementation time for certain new services, allowing for earlier recognition
of implementation fees and billing of fees for recurring services.

     COST OF SERVICE REVENUES. Cost of service revenues increased to $5.3
million, or 117% of service revenues, in the three months ended December 31,
1998, compared to $2.6 million, or 88% of service revenues, in the three months
ended December 31, 1997. The increase in cost of service revenue was a result of
an increase in security implementation, customer service and operations
personnel to 75 at December 31, 1998, as well as increases in recruiting,
consulting, telecommunications and depreciation directly related to the
Company's revenue growth. Additionally, incremental costs associated with three
new Network Security Centers contributed to the increase in cost of service
revenues. The Company expects that its cost of service revenues as a percentage
of service revenues may remain above 100% the next nine months as a result of
the continuing expansion of the Company's Network Security Centers.

                                  Page 7 of 17
<PAGE>
 
     SALES AND MARKETING. Sales and marketing expenses increased 152% to $2.7
million in the three months ended December 31, 1998 from $1.1 million in the
three months ended December 31, 1997 and increased as a percentage of service
revenues to 61% for the three months ended December 31, 1998 from 36% for the
three months ended December 31, 1997. The increase in sales and marketing
expense was a result of an increase in sales and marketing personnel to 43 at
December 31, 1998, as well as increases in recruiting, commissions and sales
promotion directly related to the expanded sales activity. The Company expects
that its sales and marketing expenses will continue to increase in absolute
dollars for at least the next twelve months as the Company makes additional
investments in expanding its sales and marketing activities.

     ENGINEERING AND DEVELOPMENT. Engineering and development expenses increased
59% to $386,000 in the three months ended December 31, 1998 from $243,000 in the
three months ended December 31, 1997 and increased as a percentage of service
revenues to 9% for the three months ended December 31, 1998 from 8% for the
three months ended December 31, 1997. The increase in engineering and
development expense was a result of an increase in personnel to 11 at December
31, 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 for at least the next twelve months as the Company makes
additional investments in developing its secure electronic commerce services.

     GENERAL AND ADMINISTRATIVE. General and administrative expenses increased
66% to $0.7 million in the three months ended December 31, 1998 from $0.4
million in the three months ended December 31, 1997 and increased as a
percentage of service revenues to 16% for the three months ended December 31,
1998 from 15% for the three months ended December 31, 1997. The increase in
general and administrative expense was a result of an increase in personnel to
15 at December 31, 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 for at least the next twelve months as the Company continues to
expand its operations and incur additional costs associated with being a public
company.

NINE MONTHS ENDED DECEMBER 31, 1997 AND 1998

     SERVICE REVENUES. In the nine months ended December 31, 1998, service
revenues increased 46% to $12.0 million from $8.2 million in the nine 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 $13.9
million, or 116% of service revenues, in the nine months ended December 31,
1998, compared to $6.7 million, or 81% of service revenues, in the nine months
ended December 31, 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 operations and the opening of three new Network
Security Centers contributed to the increase in cost of service revenues. 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% for
the next nine months as a result of the expansion of the Company's Network
Security Centers.

     SALES AND MARKETING. Sales and marketing expenses increased 150% to $7.0
million in the nine months ended December 31, 1998 from $2.8 million in the nine
months ended December 31, 1997 and increased as a percentage of service revenues
to 58% for the nine months ended December 31, 1998 from 34% for the nine months
ended December 31, 1997. The increase in sales and marketing expense was a
result of hiring additional sales and marketing personnel and expanding
marketing programs in connection 

                                  Page 8 of 17
<PAGE>
 
with the Company's expansion of its operations. The Company expects that sales
and marketing expenses will continue to increase in absolute dollars for at
least the next twelve months.

     ENGINEERING AND DEVELOPMENT. Engineering and development expenses increased
88% to $1.1 million in the nine months ended December 31, 1998 from $0.6 million
in the nine months ended December 31, 1997 and increased as a percentage of
service revenues to 9% for the nine months ended December 31, 1998 from 7% for
the nine months ended December 31, 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 at least the next twelve months as a result of this
increased investment in engineering and development.

     GENERAL AND ADMINISTRATIVE. General and administrative expenses increased
83% to $2.1 million in the nine months ended December 31, 1998 from $1.2 million
in the nine months ended December 31, 1997 and increased as a percentage of
service revenues to 18% for the nine months ended December 31, 1998 from 14% for
the nine months ended December 31, 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 at least the next twelve months as the Company
continues to expand its operations and incur additional costs associated with
being a public company.

LIQUIDITY AND CAPITAL RESOURCES

     At December 31, 1998, the Company's cash, cash equivalents and short-term
investments totaled $30.5 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 into 600,000 shares of common
stock were exercised resulting in additional net proceeds to the Company of $3.8
million.

     As of December 31, 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%. Borrowings under the facilities are repayable in monthly
installments of principal and interest over 48 months and are secured by a lien
on the financed equipment. As of December 31, 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 9.75% per annum and is secured by assets of the
Company. At December 31, 1998, $827,000 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 expire 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. One of the lenders exercised its option for
repayment of $3.0 million which was repaid in October 1998.

     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 December 31, 1998, 450,936 shares had been
repurchased, at an aggregate cost to the Company of approximately $2.7 million.
The Company does not anticipate making any additional repurchases under this
program.

                                  Page 9 of 17
<PAGE>
 
     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 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.

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. In the quarter ended December 31, 1998,
the Company formed a group of its technical staff on a project to upgrade and
standardize hardware, operating systems and application software versions on
most of the Company's production equipment. The Company believes that this
project is required for general consistency and operating efficiencies. However,
a by-product of this effort will be a greater level of assurance that the
Company is Year 2000 compliant. The project is currently estimated to last at
least through September 1999.

     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, which may contain embedded instructions,
and software included within the Company's services, which may not be Year 2000
compliant. The Company is 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
Company does not have a contingency plan if it is unable to reach Year 2000
readiness prior to December 31, 1999. However, the Company intends to develop
such a plan as it completes the remainder of its readiness efforts. The Company
believes this plan will be in place prior to December 1999.

     The dates on which the Company believes its audit of third party suppliers
and its overall 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 

                                 Page 10 of 17
<PAGE>
 
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 consequences of Year 2000 failures will have a material impact
on the Company's results of operations, liquidity or financial condition. The
Company operates a number of servers on behalf of its customers. The Company has
limited control over most of the software and applications that are running on
such servers and believes that it bears no responsibility for the Year 2000
compliance of such servers. The Company is unable to determine what costs, if
any, it may have to incur to the extent that such customers are unable to
complete their own Year 2000 compliance on such servers. Although the Company
believes that it is not obligated to make such upgrades and believes that any
costs incurred should be billable to its customers, Year 2000 problems on such
customer servers may force the Company to make significant, unplanned
allocations of limited technical and financial resources. Any significant
unplanned allocations could have a material and adverse impact on the Company's
results of operations, liquidity and 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 December 31, 1998, the
Company had an accumulated deficit of approximately $26.6 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 nine 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 gross margin at least for the next
twelve months. 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 continued 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.

                                 Page 11 of 17
<PAGE>
 
     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
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 were 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 

                                 Page 12 of 17
<PAGE>
 
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 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.

                                 Page 13 of 17
<PAGE>
 
     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
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.

                                 Page 14 of 17
<PAGE>
 
     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 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.   CHANGES IN SECURITIES AND USE OF PROCEEDS.

The Company filed a registration statement on Form S-1, File No. 333-57453, for
an initial public offering of Common Stock which was declared effective by the
Securities and Exchange Commission on August 10, 1998. In that offering, the
Company sold an aggregate of 3,110,000 shares of its Common Stock with net
offering proceeds of $39,356,952. As of December 31, 1998, the Company had used
approximately $12.5 million of those proceeds as follows:

 Construction of plant, building and facilities:        $0.1 million
 Purchase and installation of machinery and equipment:  $2.0 million
 Purchases of real estate:                              None
 Acquisition of other businesses:                       None
 Repayment of indebtedness:                             $3.4 million
 Working capital:                                       $1.2 million
 Repurchase of Common Stock:                            $2.7 million
 Cash loss from operations:                             $3.1 million

The foregoing amounts represent the Company's best estimate of its use of
proceeds for the period indicated. No payments were made to directors or
officers of the Company or their associates, holders of 10% or more of any class
of equity securities of the Company or to affiliates of the Company.


ITEM 6.    EXHIBITS AND REPORTS ON FORM 8-K


A. Exhibits

Exhibit Number                  Description of Exhibit

27.1                            Financial Data Schedule

B. Reports on Form 8-K

None

                                 Page 15 of 17
<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.


February 16, 1999       /s/ William C. Leetham
-----------------       -------------------------------------------------
                        William C. Leetham
                        Senior Vice President, Finance and Administration
                        Chief Financial Officer, Treasurer and Secretary
                        (Principal Financial Officer)

February 16, 1999       /s/ Robert G. Carrade
-----------------       -------------------------------------------------
                        Robert G. Carrade
                        Vice President, Finance and Administration
                        (Principal Accounting Officer)



EXHIBIT INDEX


Exhibit Number                          Description of Exhibit

27.1                                    Financial Data Schedule

                                 Page 16 of 17
<PAGE>
 
EXHIBIT 27.l

FINANCIAL DATA SCHEDULE

                                 Page 17 of 17