<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

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

          FOR THE TRANSITION PERIOD FROM _____ TO _____.

                        Commission file number: 0-27794

                             SEGUE SOFTWARE, INC.
            (Exact name of registrant as specified in its charter)

          Delaware                                         95-4188982
(State or other jurisdiction of                         (I.R.S. Employer
 incorporation or organization)                        Identification No.)



                     201 Spring Street Lexington, MA 02421
                   (Address of principal executive offices)

      Registrant's telephone number, including area code: (781) 402-1000


     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 a 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 [_]

     The number of shares of Registrant's Common Stock outstanding as of
November 3, 1998, was 8,336,374.
<PAGE>
 
                             SEGUE SOFTWARE, INC.
                                     INDEX
 
                                                                      Page No.
                                                                      --------
PART I.   FINANCIAL INFORMATION

Item 1.   Consolidated Financial Statements:

          Consolidated Balance Sheets (unaudited)
             September 30, 1998 and December 31, 1997                       2

          Consolidated Statements of Operations (unaudited)
             Three and nine months ended September 30, 1998 and 1997        3

          Consolidated Statements of Cash Flows (unaudited)
             Nine months ended September 30, 1998 and 1997                  4

          Notes to Consolidated Financial Statements (unaudited)            5

Item 2.   Management's Discussion and Analysis of Financial
             Condition and Results of Operations                            8

PART II.  OTHER INFORMATION

Item 2.   Changes in Securities and Use of Proceeds                        15

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

Signatures                                                                 17

Exhibits Index                                                             18

                                       1
<PAGE>
 
PART I.  FINANCIAL INFORMATION

ITEM 1.  CONSOLIDATED FINANCIAL STATEMENTS

                             SEGUE SOFTWARE, INC.
                          CONSOLIDATED BALANCE SHEETS
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
                                  (UNAUDITED)
                                        
<TABLE>
<CAPTION>
                                                                             September 30,        December 31,
                                                                                 1998                1997
                                                                             -------------        ------------
<S>                                                                         <C>                 <C>
ASSETS                                                                 
Current assets:                                                        
 Cash and cash equivalents                                                      $ 37,679            $ 22,975
 Short-term investments                                                                -              14,385
 Accounts receivable, net of allowances of $230 and $345                           8,685               4,308
 Other current assets                                                              1,590                 615
                                                                                --------            --------
   Total current assets                                                           47,954              42,283
                                                                       
Property and equipment, net                                                        2,906               2,252
Other assets                                                                       1,489               1,502
                                                                                --------            --------
   Total assets                                                                 $ 52,349            $ 46,037
                                                                                ========            ========
                                                                       
LIABILITIES AND STOCKHOLDERS' EQUITY                                   
Current liabilities:                                                   
 Short-term subordinated notes payable                                          $    883            $    883
 Accounts payable                                                                  1,078                 860
 Accrued compensation and benefits                                                 1,359               1,127
 Accrued royalties                                                                   347                 147
 Accrued expenses                                                                  1,582               1,268
 Deferred revenue                                                                  3,142               2,477
                                                                                --------            --------
   Total current liabilities                                                       8,391               6,762
                                                                       
Subordinated notes payable                                                         3,532               3,532
                                                                       
Stockholders' equity:                                                  
 Series A preferred stock, par value $.01 per share;  4,000 shares     
  authorized; no shares issued and outstanding                                         -                   -
                                                                       
 Common stock, par value $.01 per share; 30,000 shares authorized;     
  8,322 and 7,630 shares issued and outstanding                                       83                  76
                                                                       
 Additional paid-in capital                                                       51,190              48,479
 Unearned compensation                                                               (26)               (105)
 Cumulative translation adjustment                                                   (41)                  -
 Accumulated deficit                                                             (10,780)            (12,707)
                                                                                --------            --------
                                                                       
   Total stockholders' equity                                                     40,426              35,743
                                                                                --------            --------
                                                                       
   Total liabilities and stockholders' equity                                   $ 52,349            $ 46,037
                                                                                ========            ========

  The accompanying notes are an integral part of the consolidated financial statements.
</TABLE> 

                                       2
<PAGE>
 
                             SEGUE SOFTWARE, INC.
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
                                  (UNAUDITED)
                                        
<TABLE>
<CAPTION>
                                                             Three months ended                     Nine months ended
                                                                September 30,                         September 30,
                                                       -------------------------------         ------------------------------
                                                           1998               1997                 1998              1997
                                                       ------------      -------------         ------------       -----------
<S>                                                    <C>                <C>                 <C>                <C>
Revenue:
 Software                                                  $ 6,512            $ 3,436             $18,209            $11,306
 Services                                                    3,709              1,601               8,277              4,484
                                                           -------            -------             -------            -------
   Total revenue                                            10,221              5,037              26,486             15,790
 
Cost of revenue:
 Cost of software                                              528                392               1,507                779
 Cost of services                                            1,905                705               3,954              1,926
                                                           -------            -------             -------            -------
   Total cost of revenue                                     2,433              1,097               5,461              2,705
 
Gross margin                                                 7,788              3,940              21,025             13,085
 
Operating expenses:
 Sales and marketing                                         4,796              3,006              12,828              8,406
 Research and development                                    1,496              1,288               4,662              3,665
 General and administrative                                    953                781               2,720              2,344
                                                           -------            -------             -------            -------
   Total operating expenses                                  7,245              5,075              20,210             14,415
                                                           -------            -------             -------            -------
 
Income (loss) from operations                                  543             (1,135)                815             (1,330)
Other income, net                                              411                550               1,225              1,630
                                                           -------            -------             -------            -------
Income (loss) before provision for income taxes                954               (585)              2,040                300
Provision for income taxes                                      57                  -                 113                 56
                                                           -------            -------             -------            -------
 
Net income (loss)                                          $   897            $  (585)            $ 1,927            $   244
                                                           =======            =======             =======            =======
 
Net income (loss) per common share -basic                  $   .11            $  (.08)            $   .24            $   .03
Net income (loss) per common share - diluted               $   .10            $  (.08)            $   .22            $   .03
 
Weighted average common shares outstanding -
 basic                                                       8,234              7,374               8,017              7,299
 
Weighted average common shares outstanding -
 diluted                                                     8,965              7,374               8,764              7,908
 
The accompanying notes are an integral part of the consolidated financial statements.
 
</TABLE> 

                                       3
<PAGE>
 
                             SEGUE SOFTWARE, INC.
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                (IN THOUSANDS)
                                  (UNAUDITED)
                                        
<TABLE>
<CAPTION>
                                                                                      Nine months ended
                                                                                         September 30,
                                                                              ---------------------------------
                                                                                   1998               1997
                                                                              -------------       -------------
<S>                                                                           <C>                 <C>
Cash flows from operating activities:
 Net income                                                                      $  1,927            $    244
 Adjustments to reconcile net income to net cash provided by (used
   in) operating activities:
   Depreciation and amortization                                                    1,715                 759
   Loss on disposal of property and equipment                                           7                   4
   Noncash compensation charges                                                        25                 108
   Changes in operating assets and liabilities:
     Accounts receivable                                                           (4,377)               (430)
     Other current assets                                                            (939)               (248)
     Accounts payable                                                                 218                (180)
     Accrued expenses, royalties, compensation and benefits                           546                (317)
     Deferred revenue                                                                 665                 295
                                                                                 --------            --------
Net cash provided by (used in) operating activities                                  (213)                235
                                                                                 --------            --------
 
Cash flows from investing activities:
 Additions to property and equipment                                               (1,677)             (1,067)
 Additions to other assets                                                           (564)               (279)
 Maturities of short-term investments                                              16,200              47,500
 Purchases of short-term investments                                               (1,815)            (37,313)
                                                                                 --------            --------
Net cash provided by investing activities                                          12,144               8,841
                                                                                 --------            --------
 
Cash flows from financing activities:
 Proceeds from exercise of stock options and stock purchase plan                    2,773                 663
                                                                                 --------            --------
Net cash provided by financing activities                                           2,773                 663
                                                                                 --------            --------
 
Net increase in cash and cash equivalents                                          14,704               9,739
Cash and cash equivalents, beginning of period                                     22,975               7,112
                                                                                 --------            --------
 
Cash and cash equivalents, end of period                                         $ 37,679            $ 16,851
                                                                                 ========            ========
 
   The accompanying notes are an integral part of the consolidated financial
                                  statements.
</TABLE> 

                                       4
<PAGE>
 
                             SEGUE SOFTWARE, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (UNAUDITED)
                                        
1.   BASIS OF PRESENTATION

     The financial statements included herein have been prepared by the Company,
without audit, pursuant to the rules and regulations of the Securities and
Exchange Commission.  Certain information and footnote disclosures normally
included in financial statements prepared in accordance with generally accepted
accounting principles have been condensed or omitted pursuant to such rules and
regulations.  The Company believes that the disclosures are adequate to make the
information presented not misleading.  However, it is suggested that these
financial statements be read in conjunction with the Company's audited financial
statements for the year ended December 31, 1997, included in its 1997 Annual
Report on Form 10-K.

     This financial information reflects, in the opinion of management, all
adjustments of a normal recurring nature necessary to present fairly the results
for the interim periods.  Results of interim periods may not be indicative of
results for the full year.

2.   NET INCOME (LOSS) PER COMMON SHARE

     The following table sets forth the computation of basic and diluted net
income (loss) per share (in thousands, except per share data):


<TABLE>
<CAPTION>
                                                         Three months ended              Nine months ended
                                                            September 30,                  September 30,
                                                       -----------------------        ----------------------
                                                         1998           1997            1998          1997
                                                       --------       --------        --------      --------
<S>                                                   <C>            <C>             <C>            <C>
Net income (loss)                                       $  897         $ (585)         $1,927         $  244
 
Weighted average shares used in net income
 (loss) per share - basic                                8,234          7,374           8,017          7,299
 
 
Effect of dilutive securities:  
 Employee and director stock options                       731              -             747            609
                                                        ------         ------          ------         ------
 
Weighted average shares used in net income
 (loss) per share - diluted                              8,965          7,374           8,764          7,908
                                                        ======         ======          ======         ======
 
Net income (loss) per common share-basic                $  .11         $ (.08)         $  .24         $  .03

Net income (loss) per common share-diluted              $  .10         $ (.08)         $  .22         $  .03
</TABLE>

                                       5
<PAGE>
 
     Options to purchase approximately 82,000 shares of common stock outstanding
at September 30, 1998 were excluded from the calculation of diluted net income
per share because the exercise prices of those options exceeded the average
market price of common stock for the three months ended September 30, 1998.
Options to purchase approximately 695,000 shares of common stock outstanding at
September 30, 1997 were excluded from the calculation of diluted loss per share
as the effect of their inclusion would have been anti-dilutive for the three
months ended September 30, 1997. Options to purchase 207,000 and 633,000 shares
of common stock outstanding at September 30, 1998 and 1997, respectively, were
excluded from the calculation of diluted net income (loss) per share because the
exercise prices of those options exceeded the average market price of common
stock for the nine months ended September 30, 1998 and 1997, respectively.

3.   OTHER ASSETS

     In March 1998, the Company entered into an agreement with a vendor whereby
the vendor licensed specific software to the Company for purposes of marketing
and distribution.  Under the initial terms of the agreement, the Company paid
$780,000 during the second quarter of 1998, which represented a nonrefundable
non-recurring engineering and initial license fee ("NRE") of $480,000 and
$300,000 of guaranteed royalties.  An additional $200,000 for guaranteed
royalties was to be paid by September 30, 1998.  As of September 30, 1998, other
current assets included $290,000 related to the guaranteed royalties, and other
long-term assets included $360,000 related to NRE payments.

     In October 1998, the Company amended this agreement as follows:  (i) the
remaining payment for guaranteed royalties was removed, (ii) the Company
committed to spend $200,000 in the initial 18-month term and each subsequent
one-year term of the agreement on defined marketing activities, and (iii) the
Company agreed to make guaranteed annual royalty payments beginning on October
1, 1999 of $300,000 for each one-year term of the agreement.  The agreement
terminates on September 30, 2001 unless earlier voluntarily terminated by the
Company at the conclusion of any current one-year term.

     The NRE fee is being amortized into cost of software revenue on a straight-
line basis over two years, beginning in the second quarter of 1998, and the
royalty expense is being recognized as cost of software revenue based upon sales
of the related products.  For the three and nine months ended September 30,
1998, royalty expense related to this agreement was immaterial.

4.   COMMITMENTS

     In August 1998, the Company moved its corporate headquarters to Lexington,
Massachusetts under a nine year lease for 40,500 to 67,500 square feet, which
expires in October 2007.  The Company has the right to terminate the lease on
September 30, 2004 for a fee of approximately $2.2 million.

                                       6
<PAGE>
 
     Future minimum payments under the lease are as follows (in thousands):

<TABLE>
<S>                                                  <C>
August 1, 1998 - December 31, 1998                    $   523
1999                                                    1,860
2000                                                    2,093
2001                                                    2,093
2002                                                    2,093
Thereafter                                             10,406
                                                      -------
                                                      $19,068
                                                      =======
</TABLE>

5.   PROVISION FOR INCOME TAXES

     The Company recorded a provision for foreign and state income taxes of
$57,000 for the third quarter of 1998, no provision for the third quarter of
1997, and a total of $113,000 and $56,000 for the nine months ended September
30, 1998 and 1997, respectively. The Company did not record provisions for
federal income taxes due to utilization of net operating loss carryforwards.

6.   RECENT ACCOUNTING PRONOUNCEMENTS

     Effective January 1, 1998, the Company adopted Statement of Financial
Accounting Standards No. 130 ("SFAS 130"), "Reporting Comprehensive Income".
SFAS 130 requires the reporting of comprehensive income in addition to net
income from operations.  Comprehensive income is a more inclusive reporting
methodology that includes disclosure of certain financial information that
historically has not been recognized in the calculation of net income.  The
adoption of SFAS 130 had no impact on the Company's net income or stockholders'
equity.  Total comprehensive income, net of taxes, for the three and nine months
ended September 30, 1998, was $859,000 and $1,886,000, respectively, which
consists of net income and the net changes in foreign currency translation
adjustment.  For the three and nine months ended September 30, 1997,
comprehensive income (loss) equaled net income (loss).

                                       7
<PAGE>
 
ITEM 2.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
          RESULTS OF OPERATIONS

RESULTS OF OPERATIONS

     The following table sets forth certain unaudited quarterly results of
operations expressed as a percentage of total revenue for the periods indicated:

<TABLE>
<CAPTION>
                                                    Percentage of Revenue for                   Percentage of Revenue for
                                                 Three Months Ended September 30,             Nine Months Ended September 30,
                                                -----------------------------------         ------------------------------------
                                                      1998                1997                   1998                 1997
                                                ---------------     ---------------         ------------------   ---------------
<S>                                               <C>                 <C>                    <C>                 <C>
Revenue:
 Software                                              63.7%               68.2%                  68.7%               71.6%
 Services                                              36.3                31.8                   31.3                28.4
                                                      -----              ------                  -----               -----
   Total revenue                                      100.0               100.0                  100.0               100.0
 
Cost of revenue:
 Cost of software                                       5.2                 7.8                    5.7                 4.9
 Cost of services                                      18.6                14.0                   14.9                12.2
                                                      -----              ------                  -----               -----
   Total cost of revenue                               23.8                21.8                   20.6                17.1
 
Gross margin                                           76.2                78.2                   79.4                82.9
 
Operating expenses:
 Sales and marketing                                   46.9                59.7                   48.4                53.2
 Research and development                              14.7                25.5                   17.6                23.2
 General and administrative                             9.3                15.5                   10.3                14.9
                                                      -----              ------                  -----               -----
   Total operating expenses                            70.9               100.7                   76.3                91.3
 
Income (loss) from operations                           5.3               (22.5)                   3.1                (8.4)
Other income, net                                       4.0                10.9                    4.6                10.3
                                                      -----              ------                  -----               -----
 
Income (loss) before provision for
 income taxes                                           9.3               (11.6)                   7.7                 1.9
Provision for income taxes                               .5                   -                     .4                  .4
                                                      -----              ------                  -----               -----
Net income (loss)                                       8.8%              (11.6)%                   7.3%                1.5%
                                                      =====              ======                  =====               =====
</TABLE>

REVENUE

     Revenue from Software.  Software revenue increased 90% to $6.5 million
during the third quarter of 1998 from $3.4 million in the third quarter of 1997.
For the nine months ended September 30, 1998, software revenue increased 61% to
$18.2 million from $11.3 million for the nine months ended September 30, 1997.
The increases in software revenue are primarily the result of increased unit
shipments due to an increase in the demand for automated testing products;

                                       8
<PAGE>
 
the introduction of new and upgraded products; increased market acceptance of
the families of products including Web application testing and load testing
products introduced in 1997; and expansion of sales and marketing activities.
The absolute dollar increases in software revenue came largely through the
direct domestic channel. International revenue accounted for 13% of total
software revenue in each of the three and nine months ended September 30, 1998,
and 11% of total software for each of the three and nine months ended 
September 30, 1997.

     The mix of software revenue changed from the three and nine months ended
September 30, 1997 to the three and nine months ended September 30, 1998.
SilkTest and SilkPerformer, which target the e-commerce testing markets, were
not available until May 1997 and September 1997, respectively.  SilkTest and
SilkPerformer in total represented 66% and 54% of total software revenue in the
three and nine months ended September 30, 1998, respectively, and 31% and 16% of
total software revenue in the three and nine months ended September 30, 1997,
respectively.  QA Performer and SilkPerformer, which target the load testing
markets, in total represented 37% and 25% of total software revenue in the three
and nine months ended September 30, 1998, respectively, and  7% and 3% of total
software revenue in the three and nine months ended September 30, 1997,
respectively.

     Revenue from Services.  Service revenue increased 132% to $3.7 million
during the third quarter of 1998 from $1.6 million in the third quarter of 1997.
As compared to the three months ended September 30, 1997,  training and
consulting revenue increased 328% and maintenance revenue increased 39% for the
three months ended September 30, 1998.  For the nine months ended September 30,
1998, service revenue increased 85% to $8.3 million from $4.5 million for the
corresponding prior year period.  For the nine months ended September 30, 1998,
training and consulting revenue increased 179%, while maintenance revenue
increased 37% over the comparable period in 1997.  These increases were driven
largely by an increase in software licenses sold.  The increase in training and
consulting revenue is also due to the introduction of the LiveQuality scenario
testing solutions, which consist of a combination of product and consulting
services, in the second quarter of 1998.

COST OF REVENUE

     Cost of Software.  Cost of software increased 35% to $528,000 during the
third quarter of 1998 from $392,000 in the third quarter of 1997.  For the nine
months ended September 30, 1998, cost of software increased 93% to $1.5 million
from $779,000 for the nine months ended September 30, 1997.  As a percent of
software revenue, costs of software in the current quarter decreased to 8% from
11% in the corresponding prior year period.  For the nine months ended September
30, 1998, cost of software as a percent of software revenue increased to 8% from
7% in the corresponding prior year period.  The absolute dollar increases are
mainly due to the amortization of intangible assets primarily related to the
SQLBench acquisition and the NRE fee noted below, and the cost of 

                                       9
<PAGE>
 
upgrading the installed base with new versions of various products, partially
offset by a decrease in royalties payable to third parties.

     In March 1998, the Company entered into an agreement with a vendor whereby
the vendor licensed specific software to the Company for purposes of marketing
and distribution.  Under the initial terms of the agreement, the Company paid
$780,000 during the second quarter of 1998 which represented an NRE fee of
$480,000 and $300,000 of guaranteed royalties.  An additional $200,000 for
guaranteed royalties was to be paid by September 30, 1998.

     In October 1998, the Company amended this agreement as follows:  (i) the
remaining payment for guaranteed royalties was removed, (ii) the Company
committed to spend $200,000 in the initial 18-month term and each subsequent
one-year term of the agreement on defined marketing activities, and (iii) the
Company agreed to make guaranteed annual royalty payments beginning on October
1, 1999 of $300,000 for each one-year term of the agreement.  The agreement
terminates on September 30, 2001 unless earlier voluntarily terminated by the
Company at the conclusion of any current one-year term.

     The NRE fee is being amortized into cost of software revenue over two
years, beginning in the second quarter of 1998, and the royalty expense is being
recognized as cost of software revenue based upon sales of the related products.
For the three and nine months ended September 30, 1998, royalty expense related
to this agreement was immaterial.  To the extent that revenue from these
products does not support the guaranteed royalties, the Company will have to
accelerate amortization of these prepaid royalties. The amortization and the
guaranteed royalty payments may cause the cost of software to increase as a
percentage of revenue in the future.

     Cost of Services.  Cost of services increased 170% to $1.9 million during
the third quarter of 1998 from $705,000 in the third quarter of 1997.  For the
nine months ended September 30, 1998, cost of services increased 105% to $4.0
million from $1.9 million for the nine months ended September 30, 1997. As a
percent of services revenue, costs in the third quarter of 1998 increased to 51%
from 44% in the corresponding prior year period.  For the nine months ended
September 30, 1998, cost of services as a percent of services revenue increased
to 48% from 43% in the corresponding prior year period.  The increases are
largely due to the fact that the Company began to use third party consultants to
assist in LiveQuality solution implementations in the second quarter of 1998.
The cost of third party consultants is generally higher than the cost of
internal resources.  The increases are also due to increased headcount.  From
September 30, 1997 to September 30, 1998, the Company increased its headcount in
the training and consulting and technical support groups by 40%.  The Company
continues to hire employees in the training and consulting groups in order to
support the expanding training and consulting business.

                                       10
<PAGE>
 
OPERATING EXPENSES

     Sales and Marketing. Sales and marketing expenses increased 60% to $4.8
million during the third quarter of 1998 from $3.0 million in the third quarter
of 1997.  For the nine months ended September 30, 1998, sales and marketing
expenses increased 53% to $12.8 million from $8.4 million for the first nine
months of 1997.  The absolute dollar increases are largely due to increased
headcount in the sales group, commissions as a result of higher revenue levels,
and travel costs. These increases are partially offset by decreases in marketing
programs such as advertising and seminars.  From September 30, 1997 to September
30, 1998, the Company increased its headcount in sales by 82%.

     Research and Development.  Research and development expenses increased 16%
to $1.5 million during the third quarter of 1998 from $1.3 million in the third
quarter of 1997.  For the nine months ended September 30, 1998, research and
development expenses increased 27% to $4.7 million from $3.7 million for the
nine months ended September 30, 1997.  The absolute dollar increases are largely
due to the operations of the Austria facility.

     General and Administrative.  General and administrative expenses increased
22% to $953,000 during the third quarter of 1998 from $781,000 in the third
quarter of 1997.  For the nine months ended September 30, 1998, general and
administrative expenses increased 16% to $2.7 million from $2.3 million for the
nine months ended September 30, 1997.  The absolute dollar increases are largely
due to increased headcount and related recruiting costs.  From September 30,
1997 to September 30, 1998, the Company increased its headcount in the general
and administrative groups by 17%.

OTHER INCOME, NET

     Other income, net decreased 25% to $411,000 during the third quarter of
1998 from $550,000 in the third quarter of 1997.  For the nine months ended
September 30, 1998, other income, net decreased 25% to $1.2 million from $1.6
million for the nine months ended September 30, 1997.  These decreases are
largely due to interest expense resulting from the Company's issuance of
subordinated notes in December 1997.

PROVISION FOR INCOME TAXES

     The Company recorded a provision for foreign and state income taxes of
$57,000 for the third quarter of 1998, no provision for the third quarter of
1997, and a total of $113,000 and $56,000 for the nine months ended September
30, 1998 and 1997, respectively. The Company did not record provisions for
federal income taxes due to utilization of net operating loss carryforwards.

                                       11
<PAGE>
 
LIQUIDITY AND CAPITAL RESOURCES

     As of September 30, 1998, the Company had cash, cash equivalents and short-
term investments totaling $37.7 million as compared to cash, cash equivalents
and short-term investments of $37.4 million as of December 31, 1997.

     In the first nine months of 1998, the Company used $213,000 for operating
activities, resulting from the growth in accounts receivable and other current
assets, offset by net income and increased deferred revenue.

     The Company generated $12.1 million from investing activities in the first
nine months of 1998, mainly as a result of maturities of short-term investments.

     The Company generated funds from financing activities of $2.8 million in
the first nine months of 1998, related to the exercise of stock options and
issuance of stock pursuant to the employee stock purchase plan.

     In August 1998, the Company moved its corporate headquarters to Lexington,
Massachusetts under a nine year lease for 40,500 to 67,500 square feet, which
expires in October 2007.  The Company has the right to terminate the lease on
September 30, 2004 for a fee of approximately $2.2 million.

     Future minimum payments under the lease are as follows (in thousands):

             August 1, 1998 - December 31, 1998     $   523
             1999                                     1,860
             2000                                     2,093
             2001                                     2,093
             2002                                     2,093
             Thereafter                              10,406
                                                    -------
                                                    $19,068
                                                    =======

     See Cost of Revenue for other commitments requiring use of financial
resources in the future.


     Long-term cash requirements, other than normal operating expenses, are
anticipated for the development of new software products and enhancements of
existing products, the opening of additional international offices, and the
possible acquisition of software products or technologies complementary to the
Company's business.

     Assuming there is no significant change in the Company's business, the
Company believes that the existing cash and cash equivalents as well as cash
flows from operations will be sufficient to meet its working capital
requirements for at least the next twelve months.

                                       12
<PAGE>
 
YEAR 2000 COMPLIANCE

     The year 2000 presents potential concerns for business and consumer
computing.  The consequences of this issue may include systems failures and
business process interruption.  It may also include additional business and
competitive differentiation. If the Company, its significant customers, or
suppliers fail to make necessary modifications and conversions on a timely
basis, the year 2000 issue could have a material adverse effect on the Company's
operations.  There are two other related issues which could also lead to
incorrect calculations or failures: i) some systems' programming assigns special
meaning to certain dates, such as 9/9/99, and ii) the year 2000 is a leap year.
To address these year 2000 issues with its internal systems, including
information technology (IT) and non-IT systems, the Company initiated a program
designed to deal with the most critical systems, packaged software applications,
first. Year 2000 compliance testing is complete for the company's internal
software systems.  The internal hardware systems will be tested for year 2000
compliance in the first quarter of 1999.  In addition, the Company will begin
work on various types of contingency planning to address potential problem areas
with internal systems in the first quarter of 1999.  Although the assessment is
still underway, management currently believes that all material systems will be
compliant by the year 2000 and that the cost to address the issues will not be 
more than $100,000 in total. However, this estimate does not include potential
costs related to any customer or other claims or the cost of internal software
and hardware replaced in the normal course of business. The total cost estimate
is based on the current assessment of the projects and is subject to change as
the projects progress. The costs incurred to date related to these programs are
minimal.

     The Company has also initiated formal communications with its significant
vendors, mainly of IT packaged applications, to determine the extent to which
the Company is vulnerable to those third parties' failure to remedy their own
year 2000 issues.  The Company has received written assurances of year 2000
compliance from all significant vendors.  Most of the vendors under existing
contracts with the Company are under no contractual obligation to provide such
information to the Company.  The Company is taking steps with respect to new
vendor agreements to ensure that the vendors' products and internal systems are
year 2000 compliant.  The Company has no mission-critical suppliers of products
or services.

     The Company also assesses the capability of its products to handle the year
2000. To assist customers in evaluating their year 2000 issues, the Company has
a description on its website which indicates the capability of Segue's products
to handle the year 2000.  All Segue products are year 2000 compliant.  However,
the assessment of whether a complete system will operate correctly depends on
the BIOS capability and software design and integration, and for many end-users
this will include BIOS and software provided by companies other than Segue.

     The Company anticipates that substantial litigation may be brought against
vendors, including the Company, of all component products of systems that are
unable to properly manage data related to year 2000.

                                       13
<PAGE>
 
The Company's agreements with customers typically contain provisions designed to
limit the Company's liability for such claims. It is possible, however, that
these measures will not provide protection from liability claims, as a result of
existing or future federal, state or local laws or ordinances or unfavorable
judicial decisions. Any such claims, with or without merit, could result in a
material adverse effect on the Company's business, financial condition and
results of operations, including increased warranty costs, customer satisfaction
issues and potential lawsuits.

     Based on currently available information, management does not believe that
the year 2000 matters discussed above related to internal systems or products
sold to customers will have a material adverse impact on the Company's financial
condition or overall trends in results of operations; however, it is uncertain
to what extent the Company may be affected by such matters. In addition, there
can be no assurance that the failure to ensure year 2000 capability by a
supplier or another third party would not have a material adverse effect on the
Company.

IMPORTANT FACTORS RELATED TO FORWARD-LOOKING STATEMENTS AND ASSOCIATED RISKS

     This Quarterly Report on Form 10-Q contains forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933 and Section 21E
of the Securities Exchange Act of 1934.  The Company's actual results could
differ materially from those set forth in the forward-looking statements.
Various important factors, including but not limited to the following, may cause
the Company's future results to differ materially from those set forth in the
forward-looking statements: risks associated with the Company's limited
operating history; the dependence upon license revenues from the Company's
principal products; uncertainties regarding the development of the automated
software testing marketplace; the dependence upon the growth of a viable
commercial marketplace for the Internet's World Wide Web and Internet-related
products; changes in technology and industry standards; the Company's ability to
develop and introduce product enhancements and new products; risks related to
the management of the Company's growth; risks related to the Company's ability
to integrate acquisitions already completed as well as others that may occur;
risks related to the development of the Company's sales and marketing strategy;
risks related to Year 2000 compliance of the Company's internal systems and
compliance by the Company's suppliers and customers; the Company's ability to
attract, train and retain qualified personnel; the development of an
international market and distribution channel for the Company's products; the
Company's ability to develop strategic partnerships; the timing of the receipt
of orders from major customers; increased competition, including competition
from the recent consolidation in the automated software quality market; and
general economic conditions.  In addition, the Company has significantly changed
the executive management team and the sales management team under the direction
of a new Chief Executive Officer.  In conjunction with these management changes,
the Company has refocused its sales and marketing approach to focus on e-
commerce applications.  There can be no assurance that the Company will be able
to effectively manage such change.  Furthermore, a significant portion of the

                                       14
<PAGE>
 
Company's revenue within a quarter is typically not realized until late in that
quarter. As a result, it may be difficult for the Company to predict its total
revenue for a quarter or to quickly adapt its spending levels within a quarter
to reflect changes in demand for its products. The market price of the Company's
common stock has been, and in the future will likely be, subject to significant
fluctuations in response to variations in quarterly operating results and other
factors, such as announcements of technological innovations or new products by
the Company or its competitors, or other events. For a more detailed discussion
of those factors affecting future operating results, see the discussion
contained in the Company's Annual Report on Form 10-K for the year ended
December 31, 1997, under the heading "Certain Factors Affecting Future Operating
Results".

PART II.  OTHER INFORMATION

ITEM 2.   CHANGES IN SECURITIES AND USE OF PROCEEDS

     The Company completed the initial public offering (IPO) of its common stock
in April 1996.  The IPO was made pursuant to a Registration Statement on Form S-
1, filed with the Securities and Exchange Commission pursuant to Rule 462(b)
under the Securities Act of 1933 (Commission File No. 3331488), which was
declared effective as of March 28, 1996.  The IPO commenced on April 2, 1996
and terminated shortly thereafter after the sale into the public market of all
of the registered shares of common stock.

     The 3,162,500 shares of common stock sold by the Company and selling
security holders in the IPO were offered for sale in the United States by a
syndicate of underwriters represented by Alex. Brown & Sons Incorporated, Adams,
Harkness & Hill, Inc., and Soundview Financial Group, Inc.

     The Company registered an aggregate of 2,412,500 shares of common stock
(including 412,500 shares issued upon the exercise of the underwriters'
overallotment options) for sale in the IPO at a per share price of $18.00 for an
aggregate offering price of approximately $43.4 million.  All of such shares
were registered for the Company's account.  Selling security holders registered
an aggregate of 750,000 shares of common stock for sale in the IPO at a per
share price of $18.00 for an aggregate offering price of $13.5 million.  All of
such shares were registered for the selling security holders' accounts.  As
stated above, all of such shares were sold shortly after the commencement of the
offering.

     In connection with the IPO, the Company incurred the following expenses:

          Underwriting discounts and commissions           $3,039,750
          Expenses paid to underwriters                        10,999
          Other direct expenses                               847,281
                                                           ----------
          Total expenses                                   $3,898,030

                                       15
<PAGE>
 
     After deducting the expenses set forth above, the Company received
approximately $39.5 million in net proceeds of the IPO.  As of September 30,
1998, the Company had used $4.4 million of the proceeds to acquire SQLBench in
December 1997, approximately $4.0 million for the purchase of property and
equipment, and approximately $1.5 million for working capital.  The remaining
$29.6 million was invested in temporary investments, mainly consisting of
government agency paper and commercial paper.

     No payments were made to directors, officers, or persons owning 10 percent
or more of the common stock of the Company.

ITEM 6.   EXHIBITS AND REPORTS ON FORM 8-K

          (a)  Exhibits:
               27.1      Financial Data Schedule

          (b)  Reports on Form 8-K:
               None.

                                       16
<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.

Date: November 13, 1998


                                          SEGUE SOFTWARE, INC.
 


                                          /s/ STEPHEN B. BUTLER
                                          ---------------------
                                          Chief Executive Officer


                                          /s/ CARL D. BLANDINO
                                          --------------------
                                          Chief Financial Officer and Senior
                                          Vice President of Administration

                                       17
<PAGE>
 
                               INDEX TO EXHIBITS

Exhibit
No.       Description
-------   -----------

 27.1     Financial Data Schedule


                                      18