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                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549


                                   FORM 10-QSB


[X]  Quarterly  Report Under 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 0-21637


                      BRILLIANT DIGITAL ENTERTAINMENT, INC.
        (Exact Name of Small Business Issuer as Specified in its Charter)

                   DELAWARE                                 95-4592204
         (State  or Other Jurisdiction of                 (I.R.S. Employer
          Incorporation or Organization)                  Identification  No.)

                     6355 TOPANGA CANYON  BOULEVARD,  SUITE 120 Woodland  Hills,
                        California 91367
                    (Address of Principal Executive Offices)


                                 (818) 615-1500
                (Issuer's Telephone Number, Including Area Code)


         Check whether the issuer: (1) filed all reports required to be filed by
Section 13 or 15(d) of the  Exchange  Act during the past 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 past 90 days.

                                         Yes   X           No
                                              ---             ---

         State the number of shares  outstanding of each of the issuer's classes
of common equity,  as of the latest  practicable  date:  Common Stock, par value
$0.001, 9,403,001 shares issued and outstanding as of November 5, 1998.

         Transitional Small Business Disclosure Format (check one):

                                         Yes               No  X
                                             ----            ----


Exhibit index is located on page 21.


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<PAGE>


                      BRILLIANT DIGITAL ENTERTAINMENT, INC.

                                      INDEX


                                                                        PAGE NO.

PART I       Financial Information                                             3

Item 1.      Financial Statements                                              3

             Condensed Consolidated Balance Sheet as of September 30, 1998     3

             Condensed  Consolidated  Statements of Operations for the three and
             nine month periods ended September 30, 1998 and September 30, l9974

             Condensed Consolidated Statements of Cash Flows for the nine
             months ended September 30, 1998 and September 30, 1997            5

             Notes to Consolidated Financial Statements                        6

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


PART II      Other Information                                                19

Item 2.      Changes in Securities and Use of Proceeds                        19

Item 6.      Exhibits and Reports on Form 8-K                                 19


PAGE 2
<PAGE>


                                     PART I

                              FINANCIAL INFORMATION

ITEM 1.      FINANCIAL STATEMENTS

                      BRILLIANT DIGITAL ENTERTAINMENT, INC.
                      CONDENSED CONSOLIDATED BALANCE SHEET

                                 (In thousands)


<TABLE>
<CAPTION>

                                                                                             SEPTEMBER 30,
                                                                                                  1998
                                                                                            ------------------
                                                                                              (UNAUDITED)
<S>                                                                                  <C>


ASSETS

Current assets:

    Cash and cash equivalents..................................................       $                 5,353

    Accounts receivable, net...................................................                         1,976

    Inventory..................................................................                           113

    Other current assets, net..................................................                           154
                                                                                          -------------------
Total current assets...........................................................                         7,596

Property, plant and equipment, net.............................................                           837

Movie software costs...........................................................                         1,381

Other assets...................................................................                           427
                                                                                          -------------------
Total assets...................................................................       $                10,241
                                                                                          ===================

LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:

    Accounts payable and accrued expenses......................................       $                 1,553
                                                                                          -------------------
Total current liabilities......................................................                         1,553

Long term liabilities..........................................................                           154
                                                                                          -------------------
Total Liabilities..............................................................                         1,707
                                                                                          -------------------
Commitments and contingencies

Stockholders' equity:

    Common Stock...............................................................                             9

    Additional paid-in capital.................................................                        21,365

    Accumulated deficit........................................................                      (12,591)

    Cumulative other comprehensive income (loss)...............................                         (249)
                                                                                          -------------------
Total stockholders' equity.....................................................                         8,534
                                                                                          -------------------
Total liabilities and stockholders' equity.....................................       $                10,241
                                                                                           ==================

------------------------------------------------------------------------------------------------------------------
</TABLE>

                             See accompanying notes.

PAGE 3
<PAGE>



                      BRILLIANT DIGITAL ENTERTAINMENT, INC.
                 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                      (In thousands, except per share data)

<TABLE>
<CAPTION>
                                          3 MONTHS      3 MONTHS           9 MONTHS       9 MONTHS
                                            ENDED         ENDED              ENDED          ENDED
                                           9/30/98       9/30/98            9/30/98        9/30/97
                                        --------------  ---------------  --------------  ---------------
                                         (UNAUDITED)     (UNAUDITED )     (UNAUDITED)      (UNAUDITED)
<S>                                    <C>             <C>              <C>              <C>
REVENUE:
    Total revenues.................... $         175   $        2,057   $         207    $         2,377
                                        ------------    -------------    ------------     --------------

COST OF REVENUES AND EXPENSES:

Cost of revenues .....................            50               --              390                17

Sales & marketing.....................           304              185            1,279               387

General and administrative............           776              665            2,008             1,665

Research and development..............         1,297              363            2,989             1,418

Depreciation..........................           123               80              258               198

                                          ----------      -----------      -----------      ------------
Total cost of revenues and expenses...          2550             1293             6924              3685
                                          ----------      -----------      -----------      ------------

Income (loss) from operations                (2,375)              764          (6,717)           (1,308)

OTHER INCOME (EXPENSE):

Export market development grant                   40               --               73               152

Gain (loss) on foreign exchange.......             1                4              (5)               (1)

Interest income (expense), net........            80               45              337               215

                                        ------------    -------------    -------------    --------------
     Total other income (expense).....           121               49              405               366


                                        ------------    -------------    -------------    --------------
Income (loss) before
     income taxes.....................       (2,254)              813         (6,312)             (942)

Provision for income taxes............           (3)              (1)             (19)               (2)

                                        ------------    -------------    -------------    --------------
Net Income (loss)..................... $     (2,257)   $          812   $     (6,331)    $         (944)

Foreign currency translation
      adjustment (net of tax effects)           (58)             (18)            (54)               (21)

Comprehensive income (loss)........... $     (2,315)   $          794   $     (6,385)    $         (965)
                                        ============    =============    ============     ==============
Basic and diluted net income (loss)
per share............................. $      (0.24)   $         0.11   $       (0.67)    $        (0.13)
                                        ============    =============    =============     =============
Weighted average number of shares
       used in computing basic net
       income (loss) per share........         9,403            7,201            9,403             7,200
                                        ============    =============    =============     =============
Weighted average number of shares
       used in computing diluted net
       income (loss) per share........         9,403            7,643            9,403             7,200
                                        ============    =============    =============     =============

                                            See accompanying notes.

</TABLE>

PAGE 4
<PAGE>



                                     BRILLIANT DIGITAL ENTERTAINMENT, INC.
                                CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


                                                (IN THOUSANDS)


<TABLE>
<CAPTION>
                                                                           NINE MONTHS ENDED SEPTEMBER 30,
                                                                        -------------------------------------
                                                                               1998                1997
                                                                        ------------------- ------------------
                                                                           (UNAUDITED)         (UNAUDITED)
<S>                                                                     <C>                 <C>
OPERATING ACTIVITIES
Net income (loss)...................................................... $          (6,331)  $            (944)
Adjustments to reconcile net income (loss) to
   the net cash provided by (used in)
   operating activities:
      Depreciation and amortization....................................                831                 418
      Changes in operating assets and liabilities:
         Accounts receivable...........................................                112             (1,869)
         Inventory.....................................................               (40)                  --
         Movie software costs..........................................              (797)               (424)
         Accounts payable and accruals.................................              (411)                 268
         Other assets..................................................              (120)               (113)
         Deferred revenue..............................................                 --               (158)
      Effect of warrants granted.......................................                 96                 140
      Effect of options granted........................................                 --                  12
                                                                        ------------------  ------------------
Net cash provided by (used in)
   Operating activities................................................
                                                                                   (6,660)             (2,670)

INVESTING ACTIVITIES
Purchases of equipment.................................................
                                                                                     (529)               (537)
                                                                        ------------------  ------------------
Net cash used in investing activities .................................              (529)               (537)

FINANCING ACTIVITIES
Repayment of notes payable.............................................
                                                                                        --                (57)
Proceeds from operating lease agreement................................                132                  --
                                                                        ------------------  ------------------
Net cash provided by financing activities .............................                132                (57)

NET INCREASE (DECREASE) IN CASH AND
   CASH EQUIVALENTS....................................................            (7,057)             (3,264)
Translation adjustments................................................                 72                   1
Cash and cash equivalents at beginning
   of period...........................................................             12,338               7,591
                                                                        ------------------  ------------------
Cash and cash equivalents at end  of
   Period..............................................................  $           5,353    $          4,328
                                                                        ==================  ==================
Supplemental  disclosure of cash flow  information:  Cash paid during the period
  for:
         Interest .....................................................  $               8    $             --
                                                                        ==================  ==================
         Income  taxes.................................................  $              17                   3
                                                                        ==================  ==================

</TABLE>


                                            See accompanying notes.



PAGE 5
<PAGE>



                      BRILLIANT DIGITAL ENTERTAINMENT, INC.
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

                               SEPTEMBER 30, 1998
                                   (UNAUDITED)

1.       BASIS OF PRESENTATION

         The accompanying  unaudited condensed consolidated financial statements
have been prepared in accordance with generally accepted  accounting  principles
for interim  financial  information and with the instructions to Form 10-QSB and
Item  310  of  Regulation  S-B.  Accordingly,  they  do not  include  all of the
information and footnotes required by generally accepted  accounting  principles
for  complete  financial  statements.   The  accompanying   unaudited  condensed
consolidated  financial  statements reflect all adjustments that, in the opinion
of management, are considered necessary for a fair presentation of the financial
position,  results of operations,  and cashflows for the periods presented.  The
results of  operations  for such periods are not  necessarily  indicative of the
results  expected  for  the  full  fiscal  year or for any  future  period.  The
accompanying financial statements should be read in conjunction with the audited
consolidated financial statements of Brilliant Digital Entertainment,  Inc. (the
"Company")  included  in the  Company's  Form  10-KSB for the fiscal  year ended
December 31, 1997.

2.       STOCKHOLDERS' EQUITY

         On March 20, 1998,  the Company  granted  513,500  options to employees
pursuant to the 1996 Stock Option Plan.

         In March 1998, the Company adopted a stockholder's  rights plan and, in
connection  therewith,  distributed  one preferred share purchase right for each
outstanding  share of the Company's  Common Stock  outstanding on April 2, 1998.
Upon the occurrence of certain events,  each purchase right not owned by certain
hostile  acquirers  will entitle its holder to purchase  shares of the Company's
Series A Preferred  Stock at a value below the then current  market value of the
preferred  stock.  The rights of the holders of Common Stock will be subject to,
and may be  adversely  affected  by,  the  rights  of the  holders  of the share
purchase rights and of any Preferred Stock that may be issued in the future.

         Options  and  warrants  representing  common  shares of  1,202,000  and
1,678,000 were excluded from the average number of common and common  equivalent
shares  outstanding  in the diluted EPS  calculation  for the nine months  ended
September 30, 1997 and 1998, respectively, because they were anti-dilutive.

         In July 1998,  the Company  entered  into a strategic  alliance  with a
computer chip manufacturer. In connection with the alliance, the Company granted
warrants  to  purchase  300,000  shares of Common  Stock of the  Company  to the
computer chip manufacturer.

3.       MOVIE SOFTWARE COSTS

         Technological  feasibility of the Company's  original Digital Projector
was  reached  during  the third  quarter  of 1997.  Since the date of  achieving
technological feasibility,  the costs of developing Multipath Movies intended to
be viewed on the original  projector  have been  capitalized.  Multipath  Movies
developed  by the Company  during the second  quarter of 1998 are intended to be
viewed on the Company's new Internet Digital Projector,  which the Company plans
to release in the fourth quarter of 1998. In  anticipation of the release of the
new Internet  Digital  Projector,  the Company has written off amounts  incurred
during the second and third quarters in the production of Multipath Movies.

4.       COMMITMENTS AND CONTINGENCIES

         The Company leases its office and production  facilities and certain of
its office equipment. The Company has commitments under its lease agreements for
approximately  $1,000,000  at September  30,  1998.  In addition the Company has
obligations of $198,000 under  licensing  commitments at September 30, 1998. The
Company has an obligation  under its joint venture  agreement with KISS Digital,
LLC to fund 75% of the development of a Multipath Movie, up to $900,000.

PAGE 6
<PAGE>

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

OVERVIEW

         Brilliant  is a  production  and  development  studio  producing  a new
generation of digital  entertainment that is being distributed over the Internet
and on CD-ROM. The Company, headquartered in the United States, was incorporated
in July 1996. The Company was formed through the  combination of two businesses:
Brilliant  Interactive  Ideas,  Pty. Ltd. ("BII  Australia"),  an  entertainment
software developer and producer;  and Sega Australia New Development ("SAND"), a
"skunk  works"  research and  development  operation  for leading edge  software
tools. BII Australia became a wholly owned subsidiary of the Company through the
exchange of all 100,000 outstanding shares of BII Australia for 1,000,000 shares
of Common  Stock of the  Company.  In  addition,  the Company  acquired  SAND on
September 30, 1996.  SAND was  established  during the second quarter of 1994 by
Sega Ozisoft Pty.,  Limited ("Sega Ozisoft"),  one of the largest publishers and
distributors of  entertainment  software  products in Australia and New Zealand,
the predecessor of which was co-founded by Mark Dyne and Kevin  Bermeister,  the
Chief Executive Officer and President of the Company, respectively.

         Founded in September 1993, BII Australia  initially  developed and sold
interactive  education and  entertainment  CD-ROM titles primarily for children.
With the completion of the  acquisition of SAND in September 1996, the nature of
the Company's business changed significantly. SAND is responsible for developing
the Multipath Movie suite of proprietary software tools,  production process and
first  Multipath  Movie  product.  The  Company is  focusing  its efforts on the
development of the Multipath Movie tools and production  process, as well as the
commercialization  of the Multipath Movie genre, and has completed the phase-out
of its traditional CD-ROM business.  As a result of this change in the Company's
business,  the following  discussion may not be  representative of the Company's
future  operations.  The  Company  changed  its fiscal  year end from June 30 to
December 31, effective December 31, 1996.

         The Company  intends to generate a  substantial  majority of its future
revenue from the development,  production,  distribution,  licensing and on-line
exhibition of Multipath  Movies and other  three-dimensional  digitally  created
entertainment.  The Company  launched the first of its  Multipath  Movie series,
CYBERSWINE,  its Multipath  Movie for Kids series,  POPEYE AND THE QUEST FOR THE
WOOLLY  MAMMOTH,  and the  first  two of its  StoryTeller  Series,  NIGHT OF THE
WEREWOLF and THE HALLOWEEN  PARTY,  in the fourth quarter of 1997. The Company's
annual and  quarterly  revenue  will  depend  upon the  successful  development,
distribution,  timing and market acceptance of its interactive products and upon
the costs to distribute and promote these products.  Specifically,  the revenues
derived from the production and  distribution of the Company's  Multipath Movies
will depend  primarily on the  acceptance by the market of the  Multipath  Movie
concept and the underlying content of the Multipath Movie,  neither of which can
be predicted nor  necessarily  bear a direct  correlation  to the  production or
distribution  costs  incurred.   See  "Cautionary  Statement  and  Risk  Factors
Acceptance  of Multipath  Movie  Concept;  Successful  Development  of Multipath
Movies and  Appealing  Creative  Content" and  "Cautionary  Statements  and Risk
Factors -  Dependence  on  Development  of  Additional  Multipath  Movies."  The
commercial  success  of a  Multipath  Movie  is also  expected  to  depend  upon
promotion and marketing,  production  costs,  impact and  competition  and other
factors.  Accordingly,  the Company's annual and quarterly revenues are and will
be extremely difficult to forecast.

         The Company incurred  significant  marketing and operating expenses and
development costs as it continued  development of its proprietary software tools
and its Multipath Movies in anticipation of its planned fourth quarter Multipath
Movie  product  launch.  As a result,  the  Company  incurred a loss in the nine
months ended  September 30, 1998.  The Company  expects that these  expenses and
development  costs will result in losses in the quarter ended December 31, 1998,
and that the Company could incur quarterly  losses  thereafter.  See "Cautionary
Statements   and  Risk   Factors  -   Limited   Operating   History;   Uncertain
Profitability."

RESULTS OF OPERATIONS.

         REVENUES.

         The Company  historically  has derived its revenues from software sales
and development  fees. The Company  licenses its traditional  CD-ROM products to
publishers  and  distributors  in  exchange  for  non-refundable  advances,  and
royalties based on product sales.  Royalties based on product sales are due only
to the extent revenues  exceed any associated  non-refundable  royalty  advance.
Royalties  related to  non-refundable  advances are  recognized  when the CD-ROM
master  is  delivered  to  the   licensees.   Royalty   revenues  in  excess  of
non-refundable advances are recognized upon

PAGE 7
<PAGE>

notification by the  distributor  that a royalty has been earned by the Company.
Development fees are paid by customers in exchange for the Company's development
of software  packages in accordance with customer  specifications.  The software
development  agreements  generally  specify certain  "milestones"  which must be
achieved  throughout the development  process. As these milestones are achieved,
the Company  recognizes  the portion of the  development  fee  allocated to each
milestone.  Software  sales  revenues are  recognized  upon shipment of product.
Revenues  decreased from $2,377,000 for the nine months ended September 30, 1997
to $207,000 for the nine months ended  September  30,  1998.  This  represents a
decrease of  $2,170,000.  Revenues for the nine months ended  September 30, 1998
principally  reflect  amounts  earned  under a Multipath  Movie  technology  and
content development agreement.  Revenues for the third quarter of the prior year
were  primarily  the result of  $1,900,000  in revenue from a software  bundling
agreement with Packard Bell NEC.

         As a result of  delays  in the  commencement  of the U.S.  shipment  of
Packard  Bell NEC  personal  computers  upon which the  Company's  products  are
bundled,  the first U.S.  Multipath  Movie bundles began shipping during July of
1998. Further,  Packard Bell NEC is attempting to achieve the volume commitments
of its agreement  with the Company by bundling the Company's  products with mid-
and high-end computers only, thereby  distributing fewer Multipath Movies.  This
delay and the  inclusion  only on mid- and  high-end  computers  will impact the
Company's  1998 and 1999 revenues and earnings  since users will not be equipped
to purchase on-line episodes over the Internet as early as expected,  and places
significant  doubt on Packard Bell NEC's ability to ship the required  number of
units.  The Company is currently in discussion with Packard Bell NEC intended to
facilitate  distribution  of the Company's  products on a wider range of Packard
Bell NEC computers, but no assurance can be given that this will occur.

         COST OF REVENUES. Cost of revenues related to development fees consists
primarily of salaries,  benefits and overhead associated with the development of
specific  software  products  to  customer  specifications,  as well as costs of
outside  contractors  engaged from time to time in creating  aspects of software
products such as animation,  voice recording and music. Cost of revenues related
to  software  sales  consists  primarily  of  amortized  movie  software  costs,
royalties  to third  parties  and the direct  costs and  manufacturing  overhead
required to reproduce and package software products.  Cost of revenues increased
from  $17,000 for the nine months ended  September  30, 1997 to $390,000 for the
nine months ended  September 30, 1998.  This represents an increase of $373,000.
Cost of revenues in the 1997 period  included  costs  associated  with  software
sales. The increase in cost of revenues in the 1998 period is primarily a result
of the  amortization  ($188,000) and write down ($161,000) of capitalized  movie
software  costs for  previously  released  titles.  The Company will monitor the
level of commercial success of the slate of Multipath Movies to be introduced in
the fourth  quarter  and,  depending  upon  results,  may write down  additional
capitalized movie software costs in subsequent periods.

         SALES AND MARKETING.  Sales and marketing  expenses  include  primarily
costs for salaries, advertising,  promotions, brochures, travel and trade shows.
Sales and marketing  expenses  increased from $387,000 for the nine months ended
September 30, 1997 to $1,279,000  for the nine months ended  September 30, 1998.
The increase is primarily  attributable to increased  costs  associated with the
Company's  promotional  efforts.  Sales and  marketing  expenses are expected to
increase in future periods due to the continued expansion of the Company's sales
and  marketing  efforts.  The Company is  implementing  a  marketing  program in
connection  with the  release  of its slate of  Multipath  Movies in the  fourth
quarter and expects  that this program  will result in  significantly  increased
marketing expense in the fourth quarter.

         GENERAL  AND  ADMINISTRATIVE.   General  and  administrative   expenses
include,  primarily,  salaries and benefits for  management  and  administrative
personnel,   rent,   insurance  costs  and   professional   fees.   General  and
administrative  expenses  increased  from  $1,665,000  for the nine months ended
September 30, 1997 to $2,008,000  for the nine months ended  September 30, 1998.
The increase is most  significantly  attributable to increased  employment costs
resulting from additional personnel.

         RESEARCH AND  DEVELOPMENT.  Research and development  expenses  include
salaries and  benefits of  personnel  conducting  research  and  development  of
software products.  Research and development costs also include costs associated
with creating the Company's  software  tools used to develop  Multipath  Movies.
Research and development  expenses increased from $1,418,000 for the nine months
ended  September 30, 1997 to $2,989,000 for the nine months ended  September 30,
1998.  In accordance  with  Statement of Financial  Accounting  Standards No. 86
("SFAS No. 86"),  the results of operations  include  Multipath  Movie  software
development   costs  in  research  and   development   expenses.   Technological
feasibility of the Company's  original Digital  Projector was reached during the
third quarter of 1997.  Since the date of achieving  technological  feasibility,
the costs of developing  Multipath  Movies intended to be viewed on the original
projector  have been  capitalized.  Multipath  Movies  developed  by the Company
during the second quarter of 1998 are intended to be viewed on the Company's new
Internet Digital Projector, which the Company plans to release in the fourth

PAGE 8
<PAGE>

quarter of 1998.  In  anticipation  of the release of the new  Internet  Digital
Projector,  the Company has written off amounts  incurred  during the second and
third quarters in the production of Multipath Movies. To the extent  capitalized
Multipath  Movie software costs are  attributable  to titles which have begun to
ship, they are subject to amortization.  Amortized amounts have been included in
costs of revenues.

         DEPRECIATION.  Depreciation  expense  relates to  depreciation of fixed
assets such as computer  equipment  and  cabling,  furniture  and  fixtures  and
leasehold improvements.  These fixed assets are depreciated over their estimated
useful lives (up to five years)  using the  straight-line  method.  Depreciation
expense  increased from $198,000 for the nine months ended September 30, 1997 to
$258,000  for the  nine  months  ended  September  30,  1998.  The  increase  is
attributable to the increase in depreciable assets.

         OTHER INCOME AND EXPENSE.  Other income includes amounts received under
an export market  development  grant, as well as interest income and expense and
gains and losses on foreign exchange transactions. Net interest income increased
from  $215,000 for the nine months ended  September 30, 1997 to $336,000 for the
nine months ended September 30, 1998. These increases are due to the higher cash
balances as a result of the secondary offering in December 1997.

LIQUIDITY AND CAPITAL RESOURCES

         As of September 30, 1998, the Company's  principal  source of liquidity
was  approximately  $5,353,000 in cash. In November 1996, the Company's  initial
public  offering (the "Initial Public  Offering") of 2,000,000  shares of Common
Stock  at  $5  per  share  provided  approximately   $8,500,000  in  cash  after
underwriters'  discounts and commissions and offering expenses.  On December 10,
1997,  the Company  closed a secondary  offering (the  "Secondary  Offering") of
2,500,000  shares of Common Stock at $5 per share,  2,200,000 of which were sold
by  the  Company.   The  Secondary   Offering  resulted  in  gross  proceeds  of
approximately  $9,800,000 in cash after underwriters'  discounts and commissions
and  offering  expenses.  Approximately  $5,353,000  of the net  proceeds of the
Secondary Offering remains available for product development and working capital
and general corporate purposes.

         Net cash used in  operating  activities  during the nine  months  ended
September 30, 1998 was primarily  attributable to a net loss of $6,331,  000 and
an increase in movie  software  costs of  $797,000.  Net cash used in  investing
activities in the nine months ended  September 30, 1998 was due primarily to the
acquisition of computer equipment.

         The Company has an obligation  under its agreement with Morgan Creek to
fund entirely the development of two Multipath  Movies,  the first of which, ACE
VENTURA, is currently under development. The Company has an obligation under its
joint venture  agreement with Crawfords to jointly fund two Multipath Movies. To
date no projects  have been  identified  for  development  by the  parties.  The
Company has an obligation  under its joint venture  agreement with KISS Digital,
LLC to fund 75% of the  development of a Multipath  Movie,  up to $900,000.  The
Company  also is required  to make  minimum  payments  of up to  $198,000  under
various  licensing  agreements.  At September  30, 1998,  the Company had rental
commitment  for its offices and production  facilities of $868,000,  and leasing
commitments for fixed assets of $132,000, payable over the next 5 years.

     The Company  believes that current funds and cash generated from operations
will be sufficient to meet its  anticipated  cash needs for working  capital and
capital  expenditures  for the next  year  with  the  exception  of  anticipated
expenditures  required to complete the planned slate of Multipath Movie episodes
during this period.  The Company intends to raise  additional funds through debt
or  equity  financings  or other  means.  The  Company  is  currently  exploring
alternate  sources of  financing.  No  assurance  can be given  that  additional
financing  will be available or that, if available,  it can be obtained on terms
favorable  to the  Company  and its  stockholders.  If the  Company is unable to
obtain additional  financing the Company  anticipates that it may be required to
defer  completion of several titles and reduce its overhead  significantly.  The
Company's  inability to obtain adequate funds may adversely affect the Company's
operations and ability to implement its strategy. See "Cautionary Statements and
Risk Factors - Future Capital Needs; Uncertainty of Additional Funding."

FLUCTUATING OPERATING RESULTS

         Historically,  the Company has experienced significant  fluctuations in
its operating results from quarter to quarter and expects these  fluctuations to
continue in the future.  For  instance  the Company had  anticipated  completing
foreign

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distribution  and licensing  relationships  in the fourth quarter of 1997. These
relationships were expected to generate substantial revenues in 1997.

         Also, as a result of delays in the  commencement  of U.S.  shipments of
personal computers upon which the Company's products are bundled, the first U.S.
Multipath  Movie bundles began shipping  during July of 1998.  Further,  Packard
Bell NEC is attempting to achieve the volume  commitments  of its agreement with
the Company by bundling the Company's  products with mid- and high-end computers
only, thereby  distributing fewer Multipath Movies. This delay and the inclusion
only on mid- and  high-end  computers  will impact the  Company's  1998 and 1999
revenues  and  earnings  since users will not be  equipped  to purchase  on-line
episodes over the Internet as early as expected, and places significant doubt on
Packard Bell NEC's ability to ship the required number of units.

         Factors that may influence the Company's  quarterly  operating  results
include customer demand for the Company's  products,  shipping  schedules for PC
hardware with which Multipath Movies are bundled, introduction or enhancement of
products  by the  Company  and its  competitors,  the  ability of the Company to
produce and distribute  retail packaged  versions of Multipath Movies in advance
of peak  retail  selling  seasons,  the timing of  releases  of new  products or
product  enhancements  by the  Company  and  its  competitors,  introduction  or
availability  of new hardware,  market  acceptance  of the Multipath  Movies and
other  new  products,  development  and  promotional  expenses  relating  to the
introduction of new products or enhancements  of existing  products,  reviews in
the industry press  concerning  the products of the Company or its  competitors,
changes or anticipated changes in pricing by the Company or its competitors, mix
of distribution  channels through which products are sold, mix of products sold,
product returns, the timing of orders from major customers, order cancellations,
delays in shipment and other developments and decisions including the timing and
extent of the  development  expenditures,  management's  evaluation and judgment
regarding a title's  acceptance,  other  unanticipated  operating  expenses  and
general economic conditions.

         Additionally,  a  majority  of unit  sales for a product  typically  is
expected  to occur in the  quarter  in which the  product  is  introduced.  As a
result, the Company's revenues may increase  significantly in a quarter in which
a major product  introduction occurs and may decline in following quarters.  The
Company's   revenues  both   domestically   and   internationally   have  varied
significantly between monthly and quarterly periods.  Therefore,  in the future,
the operating  results for any quarter  should not be taken as indicative of the
results for any quarter in subsequent periods.

         The Company's expense levels are, to a large extent, fixed. The Company
may be unable to  adjust  spending  in a timely  manner  to  compensate  for any
revenue shortfall.  As a result,  any significant  shortfall in revenue from the
Company's  Multipath  Movies would have an immediate  material adverse effect on
the Company's business,  operating results and financial condition.  The Company
has increased its operating  expenses to fund greater levels of Multipath  Movie
production  and research and  development,  increased  marketing  operations and
expanded  distribution  channels.  As was the case during 1997 and in the first,
second and third  quarters of 1998 and as is expected to be the case in at least
the fourth quarter of 1998, to the extent that such expenses  precede or are not
subsequently followed by increased revenues,  the Company's business,  operating
results and financial condition will be materially adversely affected.

         The entertainment software business is highly seasonal.  Typically, net
revenues are highest  during the fourth  calendar  quarter  (which  includes the
holiday buying season),  decline in the first calendar quarter and are lowest in
the second and third calendar  quarters.  This seasonal pattern is due primarily
to the increased demand for entertainment  software products during the year-end
holiday buying season.  As a result, a  disproportionate  share of the Company's
net  revenues  historically  have been  generated  in the fourth  quarter of the
Company's  fiscal year. The Company  expects its revenues and operating  results
will continue to reflect these seasonal factors.

         The entertainment industry historically has been subject to substantial
cyclical variation, with consumer spending for entertainment products tending to
decline during recessionary periods.  There can be no assurance that the Company
will be able to adjust its  anticipated  product  development  expenditures  and
other  expenses in the event of an economic  downturn  during such  development.
Accordingly,  if a recessionary  period  occurs,  tending to result in decreased
sales of the Company's products, product development expenses likely will remain
constant and the Company's  business,  operating results and financial condition
could be materially adversely affected.

YEAR 2000

         The Company has begun a project to address the potential  impact of the
Year  2000  problem  on the  processing  of

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<PAGE>

date-sensitive  information by the Company's information  technology systems and
the information  technology systems used by the Company's  significant customers
and  vendors.  The Year 2000  problem is the result of computer  programs  being
written using two digits to define the  applicable  year.  As a result,  certain
computer  programs may  recognize a date using "00" as the year 1900 rather than
2000, which could cause  miscalculations or systems failures.  The objectives of
the  Company's  Year 2000 project are to  determine  and assess the risks of the
Year 2000 problem and to plan and institute mitigating actions to minimize those
risks to acceptable level.

         The Company is  dependent  upon both  internally  developed  and vendor
supplied  information  technology systems. The Company's core operations systems
are largely  standard  package  systems for business  management  and  inventory
control,  which have been developed by vendors whose products are widely used in
the  industry.  The  Company  has  already  contacted  many  of its  information
technology  vendors and suppliers as to their Year 2000  compliance to determine
what changes,  if any, must be made to the vendor  supplied  systems used by the
Company in its operations.

         The  Company  is also  in the  process  of  evaluating  its  internally
developed   information   technology   systems  to  determine  their  Year  2000
compliance,  which is being  coordinated  by the  Company's  Vice  President  of
Technology. The Company anticipates conducting Year 2000 compliance tests of its
internally developed systems in the fourth quarter of 1998. The Company does not
presently  anticipate any material Year 2000 issues or significant expenses from
the conversion of its own information systems,  databases or programs.  However,
if the  Company's  current  estimates of the  resources  required to address and
resolve  Year 2000 issues  prove to be  understated,  the  additional  costs and
resources  required to address the Year 2000 problem  could result in a material
financial risk.

         The Company intends to communicate  with its significant  customers and
vendors  to  understand  their  Year 2000  issues  and how they may  affect  the
Company,  and to determine what steps these  customers and vendors have taken to
prepare and manage their Year 2000 issues as they relate to the  Company.  These
customers and vendors include the host of the Company's web site and significant
distributors of the Company's products.  At this time, the Company does not know
what  measures  its  customers  and vendors  have taken to address the Year 2000
problem or how that  problem's  effect on its  customers and vendors will impact
the Company. The failure by any of these third parties to adequately address the
Year 2000  problem  could  result in  disruptions  in the  supply or sale of the
Company's products,  either of which would have a material adverse effect on the
Company's business,  financial condition and results of operations.  The Company
plans to devote the  necessary  resources to resolve all  significant  Year 2000
issues in a timely manner.

Readers are cautioned that this Year 2000  disclosure  contains  forward-looking
statements.  Readers  should  understand  that the  dates on which  the  Company
believes the Year 2000 project  will be  completed  are based upon  Management's
best  estimates,  which were derived  utilizing  numerous  assumptions of future
events,   including  the   availability   of  certain   resources,   third-party
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 the Company's Year 2000
compliance  project.  A delay in 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 of
locating and correcting  all relevant  computer  code,  timely  responses to and
corrections by third parties and suppliers,  the ability to implement interfaces
between  any  new  systems   and  systems  not  being   replaced,   and  similar
uncertainties. Due to the general uncertainty inherent in the Year 2000 problem,
resulting  in part  from the  uncertainty  of the Year 2000  readiness  of third
parties and the inter-connection of national and international  businesses,  the
Company  cannot  ensure  that it will be able to  timely  and  cost  effectively
resolve  problems  associated  with the Year 2000  issue,  which may  effect its
operations and business, or expose it to third party liability.

CAUTIONARY STATEMENTS AND RISK FACTORS

         Several of the  matters  discussed  in this  document  contain  forward
looking statements that involve risks and uncertainties. Factors associated with
the  forward  looking  statements  which could  cause  actual  results to differ
materially from those projected or forecast in the statements that appear below.
In addition to other  information  contained in this  document,  readers  should
carefully consider the following cautionary statements and risks factors:

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         ACCEPTANCE  OF  MULTIPATH  MOVIE  CONCEPT;  SUCCESSFUL  DEVELOPMENT  OF
MULTIPATH MOVIES WITH APPEALING  CREATIVE CONTENT.  The success of the Company's
Multipath  Movie  products will depend to a significant  extent on acceptance by
the market of the Multipath Movie concept. The market for entertainment software
is emerging  and is dependent  upon a number of  variables,  including  consumer
preferences, the installed base of personal computers and a sufficient number of
entertainment software titles to stimulate market development.  Any competitive,
technological or other factor materially adversely affecting the introduction or
sale of  personal  computers  or  entertainment  software  would have a material
adverse effect on the Company.  Because the market for entertainment software is
relatively  small in  comparison  to the overall  market for  consumer  software
products,  it is  impossible  to predict with any degree of certainty the future
rate of growth, if any, and the size of the market for the Company's products.

         Each  Multipath  Movie will be an  individual  artistic  work,  and its
commercial  success  primarily  will be  determined by user  reaction,  which is
unpredictable.  The Company introduced CYBERSWINE, its first Multipath Movie, at
the end of the fourth quarter of 1997.  The commercial  success of the Company's
Multipath  Movies will depend on its ability to predict the type of content that
will  appeal to a broad  audience  and to develop  stories and  characters  that
capture the attention and imagination of the market. In addition, the success of
the Company's Multipath Movies will depend upon the Company's ability to develop
popular  characters and to license  recognized  characters  and properties  from
third  parties  for its  software  titles.  There can be no  assurance  that the
Company will be able to develop or license  popular  stories or characters.  The
success  of a  Multipath  Movie  also  depends  upon  the  effectiveness  of the
Company's marketing and successful  introduction of Multipath Movies through the
Company's bundling relationship with Packard Bell NEC and the retail channel, as
well as the quality and acceptance of other competing programs released into the
market  at or  near  the  same  time,  critical  reviews,  the  availability  of
alternative forms of entertainment and leisure time activities, general economic
conditions and other tangible and  intangible  factors,  all of which can change
and cannot be  predicted  with  certainty.  There can be no  assurance  that the
Company will be able to  successfully  introduce the Multipath Movie through its
bundling relationship with Packard Bell NEC, in the retail channel or otherwise.
Accordingly,  there exists  substantial  risk that some or all of the  Company's
Multipath Movies will not be commercially successful, resulting in certain costs
not being  recouped or  anticipated  profits not being  realized.  Further,  the
success of the Multipath Movie genre will  substantially  depend on the market's
reception of the slate of Multipath  Movies  scheduled  for launch in the fourth
quarter  of 1998.  The  failure  of this  slate of  Multipath  Movies to achieve
commercial  success  might  damage  the  ability  of the  Company  to  introduce
additional  titles,  and could have a material  adverse  affect on the business,
operating results and financial condition of the Company.

         PRODUCT DELAYS. The Company's current production schedules  contemplate
that it will release a number of Multipath  Movies in the fourth quarter of 1998
and 1999.  As with any  software  product,  however,  until all  aspects  of the
development and initial distribution of a product are completed, there can be no
assurance  of its release  date.  Release  dates will vary  depending on quality
assurance testing and other development  factors.  If the Company were unable to
commence  volume  shipments of a  significant  new product  during the scheduled
quarter,  its revenue and earnings  would  likely be  materially  and  adversely
affected in that quarter.  In the past, the Company has experienced  significant
delays in the  introduction  of certain new products.  For  instance,  delays in
duplication,  packaging and  distribution  caused the Company's  first Multipath
Movies,  CYBERSWINE,  POPEYE AND THE QUEST FOR THE WOOLLY MAMMOTH,  NIGHT OF THE
WEREWOLF and THE  HALLOWEEN  PARTY to begin  arriving at retailers at the end of
December 1997, after the holiday selling season. It is likely in the future that
such delays will  continue to occur and that  certain new  products  will not be
released in accordance with the Company's internal  development  schedule or the
expectations of public market analysts and investors. A significant delay in the
introduction  of, or the presence of a defect in, one or more new products could
have a material  adverse affect on the ultimate  success of such products and on
the Company's business, operating results and financial condition,  particularly
in the quarter in which such products are scheduled to be completed.

         LIMITED OPERATING  HISTORY;  UNCERTAIN  PROFITABILITY.  The Company was
founded in September  1993,  shipped its initial  traditional  CD-ROM product in
November 1994 and  substantially  curtailed this aspect of its business in 1996.
The Company acquired the software tools necessary to produce Multipath Movies in
August 1996 and has only recently  introduced  its first  Multipath  Movie.  The
Company has only a limited  operating  history upon which an  evaluation  of the
Company and its prospects can be based. In the third quarter of 1997 the Company
was  profitable  due to revenues  associated  with its Packard Bell NEC bundling
agreement.  However,  revenues  in the  fourth  quarter  of 1997 were  adversely
affected by delays in duplication,  packaging and distribution  which caused the
Company's  first  Multipath  Movies to begin arriving at retailers at the end of
December,  after the holiday selling season. In order for the Company to achieve
sustained  profitability,  the Company must  continue to enter into a variety of
distribution and revenue  generating  arrangements as well as arrangements  with
Internet service providers, traditional CD-ROM publishers and

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retailers.  There can be no assurance  that the Company will enter into any such
arrangements,   or  that  the  Company   will  be  able  to  sustain   quarterly
profitability.

     FUTURE  CAPITAL  NEEDS;  UNCERTAINTY  OF  ADDITIONAL  FUNDING.  The Company
believes  that  current  funds  and  cash  generated  from  operations  will  be
sufficient to meet its  anticipated  cash needs for working  capital and capital
expenditures  for the next year with the exception of  anticipated  expenditures
required to complete the planned slate of Multipath  Movie episodes  during this
period.  The Company  intends to raise  additional  funds through debt or equity
financings or other means. The Company is currently  exploring alternate sources
of  financing.  No  assurance  can be given that  additional  financing  will be
available or that,  if available,  it can be obtained on terms  favorable to the
Company  and its  stockholders.  If the  Company is unable to obtain  additional
financing the Company anticipates that it may be required to defer completion of
several titles and reduce its overhead  significantly.  In addition,  any equity
financing could result in dilution to the Company's stockholders.  The Company's
inability to obtain adequate funds may adversely affect the Company's operations
and ability to implement its strategy.

         SUBSTANTIAL   DEPENDENCE  UPON  THIRD  PARTIES.   The  Company  depends
substantially  upon third parties for several critical  elements of its business
including the development  and licensing of content and the  distribution of its
products.

         DEPENDENCE UPON STRATEGIC  RELATIONSHIPS.  The Company has entered into
strategic  relationships with Packard Bell NEC, Morgan Creek and CompuServe,  as
well as licensing  arrangements with numerous additional  companies that own the
stories  underlying  and/or  characters  in many of the  Company's  current  and
planned  products.  The  Company's  business  strategy  is based  largely on its
strategic and  licensing  relationships  with these and other  companies and its
ability to continue to enter into similar strategic and licensing  relationships
in the  future.  In these  relationships,  mutual  agreement  of the  parties is
generally required for significant matters, or approval of the strategic partner
or both parties is required to release  products or to commence  distribution of
products.  For  example,  the Company  will be dependent on Packard Bell NEC and
other  OEMs to  bundle  Multipath  Movies  with  their  hardware  products  as a
significant  element  of the  Company's  launch of the  Multipath  Movie  genre.
Packard Bell NEC's  obligation to distribute  such Multipath  Movies will depend
upon  Packard  Bell  NEC's  acceptance  of  master  CD-ROMs  complying  with the
Company's specifications. Consequently, Packard Bell NEC may, in the exercise of
its  approval  rights,  delay  the  introduction  of  certain  of the  Company's
Multipath  Movie  titles.  The  Company  is also  unable to  control,  manage or
accurately  predict the  shipping  schedules  of Packard  Bell NEC and other OEM
distributors.  Delays in such shipping schedules or other distribution  problems
affecting OEM distributors may materially adversely affect the Company's ability
to release its products.  For instance, the Company expected Packard Bell NEC to
commence U.S. shipment of personal  computers bundled with CYBERSWINE in January
1998. As a result of delays in Packard Bell NEC's  shipping  schedules,  Packard
Bell NEC began U.S.  shipment of the Company's  first Multipath Movie bundles in
mid-1998.  Further,  Packard  Bell  NEC is  attempting  to  achieve  the  volume
commitments of its agreement with the Company by bundling the Company's products
with mid- and high-end  computers  only.  The Company is currently in discussion
with Packard  Bell NEC  intended to  facilitate  distribution  of the  Company's
products on a wider range of Packard Bell NEC computers, but no assurance can be
given that this will occur or that Packard  Bell NEC will achieve its  committed
shipment level. Also, Morgan Creek and many other content licensers have various
creative controls and approval rights pursuant to their joint venture agreements
with the Company. These creative controls and approval rights allow Morgan Creek
as well as content licensers to arbitrarily  reject or delay the Multipath Movie
productions of the respective joint ventures. There can be no assurance that the
Company will not be subject to delays  resulting from  disagreements  with or an
inability to obtain  approvals  from its strategic  partners or that the Company
will  achieve  its  objectives  in  respect  of any  or  all  of  its  strategic
relationships  or  continue to maintain  and  develop  these or other  strategic
relationships,  or that  licenses  between  the Company and any such third party
will be renewed or extended at their expiration  dates.  Many content  licensers
are also reluctant to grant broad licenses  covering  multiple  formats (e.g., a
license covering both Internet and television  distribution rights) to companies
without proven track records in the television  production business,  and, where
rights are available,  there is often significant competition for licenses. As a
result of such  competition,  and the  reluctance  by owners of content to grant
broad  licenses,  there  can be no  assurance  that  licensed  content  will  be
available to the Company at prices,  or upon terms or  conditions  acceptable to
the Company or which permit the Company to  implement  its strategy of producing
Multipath Movies for multiple formats.  Delays resulting from disagreements with
licensers or joint venture partners or the Company's  failure to renew or extend
a key license,  maintain any of its  strategic  relationships  or enter into new
licenses and strategic  relationships  on sound financial terms could materially
adversely  affect  the  Company's  business,  operating  results  and  financial
condition.

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         USE OF  INDEPENDENT  SOFTWARE  DEVELOPERS  AND  CONTENT  PROVIDERS.  In
addition to internally  developing  software and creating  content,  the Company
uses entertainment  software created by independent  software developers as well
as content  developed  by third  parties.  The Company has less control over the
scheduling and the quality of the software generated by independent  contractors
than over that developed by its own employees. Additionally, the Company may not
be able to secure the services of talented  content  developers.  The  Company's
business  and future  operating  results  will  depend in part on the  Company's
continued ability to maintain  relationships with skilled  independent  software
developers  and  content  providers,   and  to  enter  into  and  renew  product
development agreements with such developers.  There can be no assurance that the
Company will be able to maintain such relationships or enter into and renew such
agreements.

         DEPENDENCE ON DEVELOPMENT OF ADDITIONAL MULTIPATH MOVIES. The Company's
success  will  depend  largely  upon its  ability in the future to  continuously
develop  new,  commercially-successful  Multipath  Movie  titles  and to replace
revenues from  Multipath  Movie titles in the later stages of their life cycles.
If revenues  from new  products or other  activities  fail to replace  declining
revenues  from  existing  products,  the  Company's  business,   operations  and
financial  condition could be materially  adversely affected.  In addition,  the
Company's success will depend upon its ability to develop popular characters and
to license  recognized  characters  and  properties  from third  parties for its
digital  entertainment  products.  If the  Company is unable to develop  popular
characters  or if the cost of licensing  characters  and  properties  from third
parties  becomes  prohibitive,  the Company's  business,  operating  results and
financial condition could be adversely affected. Also, the Company may from time
to time enter into  agreements  with  licensers of  intellectual  property  that
involve advance payments of royalties and guaranteed  minimum royalty  payments.
If the sales volumes of products subject to such arrangements are not sufficient
to recover such advances and  guarantees,  the Company will be required to write
off unrecovered  portions of such payments.  If the Company is required to write
off a material portion of any advances, or ultimately accrue for the guarantees,
its  business,  operating  results and financial  condition  could be materially
adversely affected.

         RISKS  ASSOCIATED WITH INTERNET  DELIVERY.  The Company also intends to
distribute certain of its Multipath Movies through its Internet site and through
a site on the CompuServe on-line service.  Accordingly,  any system failure that
causes  interruption  or an increase in response time on the Company's  Internet
site or the  CompuServe  site,  could  result  in less  traffic  to and  reduced
distribution of Multipath Movies via the Internet and, if sustained or repeated,
could reduce the attractiveness of the Company's  products.  The Company is also
dependent upon Web browsers and Internet and on-line service providers to ensure
user access to its products.  User  acceptance  with respect to payment  methods
over the  Internet may also create  barriers to  distribution  of the  Company's
products through the Internet. Any disruption in the Internet access provided to
the Company's  Internet  site or any failure by the  Company's  Internet site to
handle higher volumes of  transactions  could have a material  adverse effect on
the Company's business, operating results and financial condition.

         The seamless appearance of Multipath Movies delivered over the Internet
requires  that  while  a  scene  is  being  viewed,  succeeding  scenes  must be
downloaded.  This requires the use of 28.8 kilobits per second or faster modems,
computers equipped with high-speed Pentium (or equivalent)  microprocessors,  24
megabytes  of  random  access  memory  and  appropriately  configured  operating
systems.  These requirements  generally are not satisfied by the majority of the
base of  currently  installed  PCs.  There can be no assurance  that  adequately
equipped and  configured  computers will become  widespread.  Users of computers
with less sophisticated PCs may experience  noticeable  latencies or "lag times"
between  scene  changes.   Additionally,   the  performance  characteristics  of
Multipath  Movies  delivered  via the  Internet may not equal those of Multipath
Movies  delivered  solely on CD-ROMs,  particularly  with  respect to  perceived
seamlessness and sound quality. Moreover, communications between the user and an
Internet site delivering Multipath Movies may require routing of Multipath Movie
instructions  through several servers and may result in brief but noticeable lag
times.  Noticeable  lag  times  or  negative  comparisons  to  Multipath  Movies
distributed on CD-ROM may reduce the  attractiveness  of on-line versions of the
Multipath Movies.

         The Company  presently  serves its Multipath  Movies delivered over the
Internet  through a single  vendor.  Any  significant  interruption  in  service
provided by this vendor could interrupt  sales and delivery of Multipath  Movies
and materially  adversely  affect the Company's  ability to conduct its business
and maintain customer satisfaction,  and thereby materially adversely affect the
Company's business, operating results and financial condition.

         RISKS ASSOCIATED WITH RETAIL DISTRIBUTION. The Company anticipates that
a  significant  proportion  of sales of

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Multipath Movies will be made through distributors and to retailers. The Company
is currently expending  significant resources developing a retail sales channel.
The  expenditures  associated  with this  development  are likely to precede the
realization of significant sales through this channel. Moreover, the Company has
no prior  experience in the  development  or management of the retail channel or
sales through such channel.  The competition for shelf space in retail stores is
intense.  To the  extent  that the  number of  consumer  software  products  and
computer  platforms  increases,  this  competition  for shelf  space may further
intensify.  The Company's products are expected to constitute a small percentage
of a retailer's sales volume,  and there can be no assurance that retailers will
provide  the  Company's  products  with  adequate  levels  of  shelf  space  and
promotional support.  Due to the increased  competition for limited retail shelf
space and promotional resources,  retailers and distributors are increasingly in
a  better  position  to  negotiate  favorable  terms of  sale,  including  price
discounts and product return policies, as well as cooperative market development
funds.  Increased  competition  could  result in loss of shelf  space  for,  and
reduction in sell-through of, the Company's  products at retail stores,  as well
as  significant  price  competition,  any of which  could  adversely  affect the
Company's business, operating results and financial condition.

         Retailers often require software publishers to pay fees in exchange for
preferred shelf space. The amounts paid to retailers by software  publishers and
distributors  for preferred  shelf space are  generally  determined on a case by
case basis and there is, as of yet, no industry  standard for  determining  such
fees, although larger publishers and distributors will likely have a competitive
advantage in this regard to the extent they have greater financial resources and
negotiating leverage.

         At the time of retail  product  shipment  the  Company  will  establish
reserves,  including  reserves  which  estimate the potential for future returns
based on seasonal terms of sale and distributor and retailer  inventories of the
Company's products,  as well as other factors.  The Company intends to recognize
revenue from the sale of its  products  upon  shipment  except for sales made to
certain  distributors  where the right of  ownership  does not pass at delivery.
Product  returns or price  protection  concessions  that  exceed  the  Company's
reserves could  materially  adversely affect the Company's  business,  operating
results and financial  condition  and could  increase the magnitude of quarterly
fluctuations in the Company's operating and financial results.  Furthermore,  if
the Company's  assessment  of the  creditworthiness  of its customers  receiving
product  on  credit  proves   incorrect,   the  Company  could  be  required  to
significantly  increase the  reserves  previously  established.  There can be no
assurance that such future write-offs will not occur or that amounts written off
will not have a material  adverse effect on the Company's  business,  results of
operations and financial condition.

         MANUFACTURING  RISKS. The production of the Company's  Multipath Movies
for  the  retail  distribution   channel  consists  of  pressing  CD-ROM  disks,
assembling  purchased  product  components,  printing product packaging and user
manuals and packaging finished products,  all of which will be performed for the
Company by third party vendors in accordance  with the Company's  specifications
and  forecasts.  Currently,  the Company will use primarily one vendor for these
services.  While these  services  are  available  from  multiple  vendors and at
multiple  sites,  there  can  be  no  assurance  that  an  interruption  in  the
manufacture of the Company's  products could be remedied without undue delay and
without materially adversely affecting the Company's results of operations.  The
Company  does not  have  contractual  agreements  with  any of its  third  party
vendors,  which may result in an  inability  to secure  adequate  services  in a
timely manner.  Demand for the services of these vendors is also seasonal,  with
peak  demand  and  service  and  production  backlogs  and delays  occurring  in
September,  October and November of each year.  The Company's  retail  Multipath
Movies must be manufactured,  assembled,  printed,  packaged and shipped in this
environment of strained capacity and must compete for capacity and priority with
the CD-ROM  products of many  substantially  larger  competitors  of the Company
which  are able to wield  substantially  greater  influence  with the  Company's
vendors than can  currently be exerted by the Company.  If the Company is unable
to secure  adequate  services to timely  produce and  deliver its  products  for
fourth quarter sales, the Company's  business,  operating  results and financial
condition would be materially adversely effected.

         SOFTWARE  TOOLS AND PRODUCT  DEVELOPMENT.  The suite of software  tools
that will enable the Company to create its  Multipath  Movie has been  developed
over the past three  years,  and  additional  refinement  of these  tools may be
necessary  in order to continue  to enhance  the  Multipath  Movie  format.  The
Company  believes  that  its  future  success  depends  in large  part  upon the
continuous enhancement of the software tools used to create the Multipath Movie.
If problems  in the  development  of the  Company's  software  tools  arise,  no
assurance  can be given that the  Company  will be able to  successfully  remedy
these problems.  Also, entertainment products as complex as those offered by the
Company may contain undetected errors or defects when first introduced or as new
versions are released. The Company has in the past discovered software errors in
certain of its new products and enhancements after their introduction.  Although
the

PAGE 15
<PAGE>

Company has not experienced  material  adverse  effects  resulting from any such
errors to date,  there can be no  assurance  that errors or defects  will not be
found in new products or releases after  commencement  of commercial  shipments,
resulting  in  adverse  product  reviews  and a  loss  of  or  delay  in  market
acceptance,  which  would  have a material  adverse  effect  upon the  Company's
business, operating results and financial condition.

         RAPID  EXPANSION  AND  MANAGEMENT  OF  GROWTH.  Implementation  of  the
Company's business plan,  including  introduction and marketing of the Company's
Multipath  Movies,  management of the Company's joint venture with Morgan Creek,
management  of the  Company's  strategic  relationship  with  Packard  Bell NEC,
negotiation  of  additional  content  licensing  and  distribution   agreements,
management of Internet service providers,  the expansion of the Company's studio
in Australia,  and the general strains of the Company's role as a public company
have  resulted in a  significant  expansion of the Company and will require that
the Company continue to significantly  expand its operations in all areas.  This
growth in the Company's  operations  and activities has placed and will continue
to  place  a  significant  strain  on  the  Company's  management,  operational,
financial  and  accounting  resources.  Successful  management  of the Company's
operations  will  require the Company to continue to  implement  and improve its
financial and management  information systems. In addition, the restructuring of
the Company and resulting management and reporting of Australian  operations and
financial  results from the United States have placed and will continue to place
an  additional  strain  on the  Company's  accounting  and  information  systems
resources.  The Company's  ability to manage its future  growth,  if any, and to
increase  production  levels and  commence  marketing  and  distribution  of its
products  will  also  require  it to hire and  train  new  employees,  including
management  and technical  personnel,  and motivate and manage its new employees
and integrate them into its overall operations and culture. The Company recently
has made additions to its management team and is in the process of expanding its
marketing  and  production  staff,  a process that is expected to continue.  The
Company's  failure to manage  implementation  of its business  plan would have a
material  adverse  effect  on the  Company's  business,  operating  results  and
financial condition.

         RISKS  ASSOCIATED  WITH  ACQUISITIONS.  In the future,  the Company may
acquire complementary companies, products or technologies, and from time to time
engages in discussions relating to possible  acquisitions.  Acquisitions involve
numerous risks,  including adverse  short-term effects on the combined business'
reported operating results, impairments of goodwill and other intangible assets,
the diversion of management's attention, the dependence on retention, hiring and
training of key  personnel,  the  amortization  of  intangible  assets and risks
associated with unanticipated problems or legal liabilities.

         RAPID TECHNOLOGICAL CHANGE; CHANGING PRODUCT PLATFORMS AND FORMATS. The
entertainment  software market and the PC industry in general are  characterized
by rapid and  significant  technological  developments  and frequent  changes in
computer operating  environments.  To compete successfully in these markets, the
Company  must  continually   improve  and  enhance  its  existing  products  and
technologies  and  develop  new  products  and  technologies   that  incorporate
technological  advances while remaining  competitive in terms of performance and
price. The Company's success also will depend  substantially upon its ability to
anticipate the emergence of, and to adapt its products to, popular platforms for
consumer software.

         The  Company  has  designed  its  Multipath  Movies  for use  with  the
IBM-compatible  PC. The Company  intends to design future  products for use with
new  platforms  that  will  require  substantial  investments  in  research  and
development.  Generally, such research and development efforts must occur one to
two years in advance of the widespread  release or use of the platforms in order
to introduce products on a timely basis following the release of such platforms.
The  research  and  development  efforts in  connection  with games for  certain
advanced and emerging  platforms  may require  greater  financial  and technical
resources than currently possessed by the Company. In addition,  there can be no
assurance  that the new platforms for which the Company  develops  products will
achieve market  acceptance and, as a result,  there can be no assurance that the
Company's  development  efforts with respect to such new platforms  will lead to
marketable  products or products that generate sufficient revenues to offset the
research and development  costs incurred in connection  with their  development.
Failure to develop  products for new platforms that achieve  significant  market
acceptance  would  have a material  adverse  effect on the  Company's  business,
operating  results  and  financial  condition.  There can be no  assurance  that
technological  developments  will not render  certain of the Company's  existing
products  obsolete,  that the  Company  will be able to adapt  its  products  or
technologies  to  emerging  hardware  platforms,  that the Company has chosen to
support platforms that ultimately will be successful or that the Company will be
able  successfully  to create  software  titles for such  platforms  in a timely
manner, or at all. See "-Software Tools and Product Development."

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<PAGE>

         DEPENDENCE  ON KEY  PERSONNEL.  The  Company's  success  has  and  will
continue to depend to a significant extent upon certain key management,  product
development and technical personnel, many of whom would be difficult to replace,
particularly  Mark Dyne,  its Chairman and Chief  Executive  Officer,  and Kevin
Bermeister,  its  President.  Although the Company has entered  into  employment
agreements  with certain  officers,  such agreements are terminable upon 30 days
notice  by  either  party.  Accordingly,  there  can be no  assurance  that such
employees will continue to be available to the Company. The loss of the services
of one or more of these key employees  could have a material  adverse  effect on
the Company and the Company's  future success will depend in large part upon its
ability to attract,  retain and motivate  personnel  with a variety of technical
and managerial skills, including software development and programming expertise.
Significant  competition  exists for such personnel and the companies with which
the Company  competes  are often larger and more  established  than the Company.
Additionally,   there  is  currently  an  industry-wide  shortage  of  technical
personnel  which makes it more  difficult to attract and retain such  personnel.
There can be no  assurance  that the Company will be able to retain and motivate
its managerial and technical  personnel or attract additional  qualified members
to management or technical  staff. The inability to attract and retain necessary
technical and managerial personnel could have a material and adverse effect upon
the Company's business, operating results and financial condition.

         SHARED  RESPONSIBILITIES  AND  OTHER  EMPLOYMENT  COMMITMENTS  OF CHIEF
EXECUTIVE  OFFICER AND  PRESIDENT.  The Company's  Chief  Executive  Officer and
Chairman,  Mark Dyne, and its President,  Kevin Bermeister,  also serve as joint
managing  directors of Sega Ozisoft  Pty.,  Limited  ("Sega  Ozisoft") and other
businesses.  Mark Dyne also serves as  Chairman of the Board of Tag-It  Pacific,
Inc.  Kevin  Bermeister  also  serves as managing  director of Sega  Enterprises
(Australia)  Pty., Ltd.  Although Messrs.  Dyne and Bermeister are active in the
management of the Company,  they are not required to spend a specified amount of
time at the Company nor are they able to devote their full time and resources to
the Company.  Further,  the Company  does not have  employment  agreements  with
either  of  Messrs.  Dyne or  Bermeister.  There  can be no  assurance  that the
inability of Messrs. Dyne and Bermeister to devote their full time and resources
to the Company  will not  adversely  affect the  Company's  business,  operating
results or financial condition.

         CONFLICTS OF INTEREST.  Certain of the Company's directors and officers
are directors or officers of potential  competitors and/or strategic partners of
the Company.  These relationships may give rise to conflicts of interest between
the  Company,  on the one hand,  and one or more of the  directors,  or officers
and/or  their  affiliates,  on the other  hand.  The  Company's  Certificate  of
Incorporation  provides  that Mark Dyne and Kevin  Bermeister  are  required  to
present to the Company any corporate  opportunities  for the  development of any
type of  digital  entertainment  with the  exception  of  opportunities  for (i)
minority  participation  in the  development of digital  entertainment  and (ii)
participation  in the  development  by others  of  digital  entertainment  where
publishing and  distribution  rights for the product to be developed are offered
to Messrs.  Dyne and/or  Bermeister  solely for  Australia,  New Zealand  and/or
Southern  Africa.  The  Company's  Certificate  of  Incorporation  provides that
Messrs. Dyne and Bermeister are not required to present to the Company any other
opportunities that potentially may be of benefit to the Company.

         LIMITED  PROPRIETARY  PROTECTION.  The Company's success and ability to
compete is dependent in part upon its proprietary  technology.  The Company also
relies on trademark,  trade secret and copyright laws to protect its technology,
with the source code for the Company's proprietary software being protected both
as a trade secret and as a copyrighted  work.  Also, it is the Company's  policy
that all employees and  third-party  developers sign  nondisclosure  agreements.
However, there can be no assurance that such precautions will provide meaningful
protection  from  competition  or that  competitors  will not be able to develop
similar or superior technology  independently.  Also, the Company has no license
agreements  with the end users of its  products  and does not  copy-protect  its
software,  so it may be  possible  for  unauthorized  third  parties to copy the
Company's   products  or  to  reverse  engineer  or  otherwise  obtain  and  use
information that the Company regards as proprietary. Although the Company is not
aware of  unauthorized  copying  of its  products,  if a  significant  amount of
unauthorized  copying of the  Company's  products  were to occur,  the Company's
business, operating results and financial condition could be adversely affected.
Furthermore,  policing  unauthorized use of the Company's  products is difficult
and costly, and software piracy can be expected to be a persistent  problem.  If
litigation  is  necessary  in the future to enforce the  Company's  intellectual
property  rights,  to protect the  Company's  trade  secrets or to determine the
validity and scope of the proprietary  rights of others,  such litigation  could
result in substantial costs and diversion of resources and could have a material
adverse  effect on the  Company's  business,  operating  results  and  financial
condition.  Ultimately,  the  Company  may be  unable,  for  financial  or other
reasons, to enforce its rights under intellectual  property laws and the laws of
certain countries in which the Company's  products are or may be distributed may
not protect the Company's products and intellectual rights to the same extent as
the laws of the United States.

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<PAGE>

         The Company believes that its products, including its suite of software
tools, do not infringe any valid existing  proprietary  rights of third parties.
Since the software  tools used to create the Multipath  Movies were developed by
SAND,  a  division  of  Sega  Ozisoft,   the  Company  relies  entirely  on  the
representations  of Sega  Ozisoft  contained in the SAND  Acquisition  Agreement
between BII Australia and Sega Ozisoft that, to Sega Ozisoft's  best  knowledge,
the SAND  technology and software  acquired by the Company does not infringe the
proprietary rights of others. Additionally, although the Company has received no
communication from third parties alleging the infringement of proprietary rights
of such  parties,  there can be no assurance  that third parties will not assert
infringement  claims in the future. Any such third party claims,  whether or not
meritorious,  could result in costly  litigation or require the Company to enter
into royalty or licensing agreements. There can be no assurance that the Company
would  prevail  in any  such  litigation  or that  any  such  licenses  would be
available  on  acceptable  terms,  if at all. If the Company  were found to have
infringed upon the proprietary rights of third parties,  it could be required to
pay damages,  cease sales of the infringing products and redesign or discontinue
such products,  any of which alternatives,  individually or collectively,  could
have a material adverse effect on the Company's business,  operating results and
financial condition.

         VOLATILITY OF STOCK PRICE.  The Company's Common Stock is traded on the
American Stock Exchange, and there has been substantial volatility in the market
price of the Common Stock. The trading price of the Common Stock has been and is
likely to  continue  to be subject to  significant  fluctuations  in response to
variations  in  quarterly  operating  results,  the gain or loss of  significant
contracts, changes in management,  announcements of technological innovations or
new  products  by the  Company or its  competitors,  legislative  or  regulatory
changes, general trends in the industry,  recommendations by securities industry
analysts  and other  events or  factors.  In  addition,  the  stock  market  has
experienced  extreme price and trading volume  fluctuations  which have affected
the market price of the common stock of many technology  companies in particular
and which have at times been unrelated to operating  performance of the specific
companies whose stock is affected.  In addition, in the past the Company has not
experienced  significant  trading  volume  in its  Common  Stock,  has not  been
actively  followed by stock market  analysts  and has had limited  market-making
support  from  broker-dealers.  If  market-making  support  does not continue at
present or greater  levels,  and/or the  Company  does not  continue  to receive
analyst  coverage,  the  average  trading  volume  in the  Common  Stock may not
increase  or even  sustain its current  levels,  in which case,  there can be no
assurance that an adequate  trading market will exist to sell large positions in
the Common Stock.

         INFLUENCE BY  MANAGEMENT.  As of  September  30,  1998,  the  Company's
officers and  directors  owned,  in the  aggregate,  approximately  22.3% of the
Company's  outstanding  shares of Common Stock. As a result,  these stockholders
are able to exert influence over the outcome of all matters  submitted to a vote
of the holders of the  Company's  Common  Stock,  including  the election of the
Company's  Board of Directors and thus, the policies of the Company.  The voting
power of these  stockholders  could also  discourage  potential  acquirers  from
seeking to acquire  control of the Company  through  the  purchase of the Common
Stock, which might have a depressive effect on the price of the Common Stock.

         EFFECT  OF  CERTAIN  CHARTER  PROVISIONS;  STOCKHOLDER'S  RIGHTS  PLAN;
ANTI-TAKEOVER EFFECTS OF CERTIFICATE OF INCORPORATION,  BYLAWS AND DELAWARE LAW.
The  Company's  Board of  Directors  has the  authority to issue up to 1,000,000
shares of  Preferred  Stock and to  determine  the price,  rights,  preferences,
privileges and  restrictions,  including voting rights,  of those shares without
any further vote or action by the  stockholders.  The  Preferred  Stock could be
issued with voting, liquidation,  dividend and other rights superior to those of
the Common Stock. In March 1998, the Company adopted a stockholder's rights plan
(the "Rights Agreement") and, in connection therewith, distributed one preferred
share purchase right for each  outstanding  share of the Company's  Common Stock
outstanding  on  April 2,  1998.  Pursuant  to the  Rights  Agreement,  upon the
occurrence  of certain  triggering  events  related to an  unsolicited  takeover
attempt  of the  Company,  each  purchase  right  not owned by  certain  hostile
acquirers will entitle its holder to purchase  shares of the Company's  Series A
Preferred  Stock at a value below the then current market value of the preferred
stock.  The rights of the holders of Common Stock will be subject to, and may be
adversely  affected by, the rights of the holders of the share  purchase  rights
and of any  Preferred  Stock that may be issued in the future.  The  issuance of
Preferred  Stock,  while  providing  desirable  flexibility  in connection  with
possible  acquisitions  and other corporate  purposes,  could have the effect of
making  it more  difficult  for a third  party  to  acquire  a  majority  of the
outstanding  voting stock of the Company.  Further,  certain  provisions  of the
Company's  Certificate  of  Incorporation  and Bylaws and of Delaware  law could
delay or make more difficult a merger,  tender offer or proxy contest  involving
the Company.


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                                     PART II

                                OTHER INFORMATION

ITEM 2.  CHANGES IN SECURITIES AND USE OF PROCEEDS

         In July 1998, the Company issued warrants to purchase 300,000 shares of
Common Stock,  par value $.001 per share, to a computer chip  manufacturer at an
exercise  price  of $4.00  per  share.  The  warrants  were  issued  as  partial
consideration  for the  manufacturer's  obligations  under that certain Software
Development  Agreement,  dated as of July 14, 1998,  between the Company and the
manufacturer. The warrants are currently exercisable and expire in July 2001. In
connection with the issuance,  the manufacturer  represented to the Company, and
the Company  believed,  that the  manufacturer  was  acquiring  the warrants for
investment purposes only and not with a view to, or for sale in connection with,
a distribution of the warrants, and that the manufacturer was capable of bearing
the  economic  risk  of an  investment  in the  Company.  The  warrants  contain
appropriate restrictive legends regarding resale and contain registration rights
in  connection  with  resale of the  underlying  shares  of  Common  Stock . The
issuance  and sale of these  securities  was made in reliance on Section 4(2) of
the Securities Act as a transaction not involving any public offering.

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K.
<TABLE>
<CAPTION>

         (a)      Exhibits.
         <S>      <C>    <C>

                  10.1 Architectural Development and Assistance Agreement, dated
July 14, 1998.

                  10.2 Warrant, dated July 16, 1998.

                  27.1   Financial Data Schedule

         (b)      Reports on Form 8-K.

                  None.

</TABLE>

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<PAGE>


                                   SIGNATURES

         Pursuant to the  requirements  of Section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, the Registrant caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.


                             BRILLIANT DIGITAL ENTERTAINMENT, INC.

Date:  November 16, 1998     /S/ MICHAEL OZEN
                             ----------------
                             By:    Michael Ozen
                             Its:   Chief Financial Officer (Principal Financial
                                    and Accounting Officer) and Secretary

PAGE 20
<PAGE>


                                                 EXHIBIT INDEX
<TABLE>
<CAPTION>

EXHIBIT
NUMBER         EXHIBIT DESCRIPTION
-------        -------------------
  <S>          <C>

  10.1         Architectural Development and Assistance Agreement, dated July 14, 1998.
  10.2         Warrant, dated July 16, 1998.
  27.1         Financial Data Schedule.

</TABLE>


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