<PAGE>

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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, 1997

[  ] 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) 346-3653
               (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, 7,203,001 shares issued and outstanding as of November 4, 1997.

    Transitional Small Business Disclosure Format (check one):  
Yes       No  X
   -----    -----


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                                    1 of 28
<PAGE>

                    BRILLIANT DIGITAL ENTERTAINMENT, INC.

                                    INDEX

                                                                       PAGE NO.

PART I        Financial Information                                        3

Item 1.       Financial Statements (unaudited)                             3

              Condensed Consolidated Balance Sheet - 
              September 30, 1997                                           3

              Condensed Consolidated Statements of Operations - Three
              and nine months ended September 30, 1997 and l996            4

              Condensed Consolidated Statements of Cash Flows - Nine 
              months ended September 30, 1997 and 1996                     5

              Notes to Consolidated Financial Statements                   6

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

              Factors That May Affect Future Results of Operations        14


PART II       Other Information                                           26

Item 2.       Changes in Securities                                       26

Item 6.       Exhibits and Reports on Form 8-K                            26

                                       2
<PAGE>

                                     PART I

                              FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

                    BRILLIANT DIGITAL ENTERTAINMENT, INC.
                     CONDENSED CONSOLIDATED BALANCE SHEET
                                (IN THOUSANDS)

                                                                  SEPTEMBER 30,
                                                                      1997
                                                                  -------------
                                                                   (UNAUDITED)
ASSETS

Current assets:
    Cash and cash equivalents....................................   $  4,328
    Accounts receivable, net.....................................      1,973
    Other assets.................................................         68
                                                                    --------
Total current assets.............................................      6,369
Property, plant and equipment, net...............................        639
Development costs................................................        404
Other assets.....................................................        263
                                                                    --------
Total assets.....................................................   $  7,675
                                                                    --------
                                                                    --------


LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
    Accounts payable and accrued expenses........................   $  1,121
    Amounts payable to related parties...........................         22
                                                                    --------
Total current liabilities........................................      1,143
                                                                    --------
Stockholders' equity:
    Common Stock.................................................          7
    Additional paid-in capital...................................     11,472
    Accumulated deficit..........................................     (4,899)
    Cumulative translation adjustment............................        (48)
                                                                    --------
Total stockholders' equity.......................................      6,532
                                                                    --------
Total liabilities and stockholders' equity.......................   $  7,675
                                                                    --------
                                                                    --------

                           See accompanying notes.

                                       3
<PAGE>

                      BRILLIANT DIGITAL ENTERTAINMENT, INC.
                CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                                  (IN THOUSANDS)

<TABLE>
<CAPTION>
                                         3 MONTHS      3 MONTHS    9 MONTHS     9 MONTHS 
                                           ENDED         ENDED       ENDED        ENDED
                                          9/30/97       9/30/96     9/30/97      9/30/96
                                        -----------  -----------  -----------  ----------
                                        (UNAUDITED)  (UNAUDITED)  (UNAUDITED)  (UNAUDITED)
<S>                                     <C>          <C>          <C>          <C>

REVENUE:
    Total revenue......................  $  2,057     $    281     $  2,377     $  1,139
                                         --------     --------     --------     --------
COST OF REVENUES AND EXPENSES: 
Cost of revenues.......................        --          140           17          411
Sales & marketing......................       185          968          387        1,099
General and administrative.............       665          140        1,665          345
Research and development...............       363        1,518        1,418        1,641
Depreciation...........................        80           31          198           87
                                         --------     --------     --------     --------
Total cost of revenues and expenses....     1,293        2,797        3,685        3,583
                                         --------     --------     --------     --------

Income (loss) from operations..........       764       (2,516)      (1,308)      (2,444)

OTHER INCOME (EXPENSE):
Export market development grant........        --           --          152          125
Gain (loss) on foreign exchange........         4           --           (1)          (4)
Interest income (expense), net.........        45          (21)         215          (48)
                                         --------     --------     --------     --------
    Total other income (expense).......        49          (21)         366           73
                                         --------     --------     --------     --------
Income (loss) before income taxes......       813       (2,537)        (942)      (2,371)
Provision for income taxes.............        (1)          --           (2)          --
                                         --------     --------     --------     --------
Net income (loss)......................  $    812     $ (2,537)    $   (944)    $ (2,371)
                                         --------     --------     --------     --------
                                         --------     --------     --------     --------
Net income (loss) per share............  $   0.11     $  (0.56)    $  (0.13)    $  (0.52)
                                         --------     --------     --------     --------
                                         --------     --------     --------     --------
Common shares used in computing
 income (loss) per share...............     7,643        4,504        7,200        4,539
                                         --------     --------     --------     --------
                                         --------     --------     --------     --------
</TABLE>

                           See accompanying notes.

                                       4
<PAGE>

                    BRILLIANT DIGITAL ENTERTAINMENT, INC.
               CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                          NINE MONTHS ENDED SEPTEMBER 30,
                                                       -------------------------------------
                                                          1997                      1996
                                                       -----------               -----------
                                                       (UNAUDITED)               (UNAUDITED)
<S>                                                    <C>                       <C>
OPERATING ACTIVITIES
Net loss.............................................  $     (944)               $  (2,371)
Adjustments to reconcile net loss to
 the net cash provided by (used in) operating 
 activities:
  Depreciation and amortization......................         418                       87
  Effect of warrants granted.........................         140                    1,096
  Effect of stock options granted....................          12                       --
  Effect of SAND note................................          --                    1,350
  Changes in operating assets and liabilities:
  Accounts receivable................................      (1,869)                     290
  Development costs..................................        (424)                      --
    Other assets.....................................        (113)                      --
    Accounts payable and accruals....................         268                       61
    Deferred revenue.................................        (158)                      --
    Other liabilities................................          --                       13
                                                       -----------               -----------
Net cash provided by (used in) 
 operating activities................................      (2,670)                     526

INVESTING ACTIVITIES
Purchases of equipment...............................        (537)                     (51)
                                                       -----------               -----------
Net cash used in investing activities................        (537)                     (51)

FINANCING ACTIVITIES
Costs related to offering............................          --                     (145)
Increases in notes payable...........................          --                      815
Repayments of notes payable..........................         (57)                  (1,166)
                                                       -----------               -----------
Net cash provided by financing activities............         (57)                    (496)
                                                       -----------               -----------
Net decrease in cash and cash equivalents............      (3,264)                     (21)

Translation adjustments..............................           1                       21
Cash and cash equivalents at beginning 
 of period...........................................       7,591                       86
                                                       -----------               -----------
Cash and cash equivalents at end of period...........  $    4,328                $      86
                                                       -----------               -----------
                                                       -----------               -----------
Supplemental disclosure of cash flow information:
  Cash paid during the period for:
    Interest.........................................  $       --                $      --
                                                       -----------               -----------
                                                       -----------               -----------
    Income taxes.....................................  $        3                $      --
                                                       -----------               -----------
                                                       -----------               -----------
</TABLE>

                           See accompanying notes.

                                       5
<PAGE>

                    BRILLIANT DIGITAL ENTERTAINMENT, INC.
            NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 
                              SEPTEMBER 30, 1997
                                 (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 
which, 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 transition period from July 1, 1996 to December 
31, 1996.  The results for the three and nine months ended September 30, 1996 
and 1997 include the operations of the parent company (Brilliant Digital 
Entertainment, Inc.), which was incorporated in July 1996, BII Australia, and 
SAND, which was acquired by the Company in September 1996 (see the Overview 
section of Management's Discussions and Analysis of Financial Condition and 
Results of Operations). As a result of the restructuring of the group and the 
change in the focus of the business, the results for the three and nine 
months ended September 30, 1996 are not comparable to those for the three and 
nine months ended September 30, 1997.

2.  NET INCOME (LOSS) PER SHARE

    Net income (loss) per share is computed using the weighted average number 
of shares of common stock outstanding.  Common equivalent shares from stock 
options and warrants (using the treasury stock method) have been included in 
the computation when dilutive.  Pursuant to the Securities and Exchange 
Commission Staff Accounting Bulletins and Staff policy, all common and common 
equivalent shares issued by the Company at an exercise price below the public 
offering price during the twelve-month period prior to the Company's initial 
public offering of Common Stock (in November 1996) have been included in the 
calculation as if they were outstanding for all periods presented (using the 
treasury stock method at an initial public offering price of $5.00 per share 
for stock options and warrants).

    In February 1997, the Financial Accounting Standards Board issued 
Statement of Financial Accounting Standards No. 128, "Earnings Per Share" 
("SFAS No. 128").  SFAS No. 128, effective for periods ending after December 
15, 1997, revises the computation and disclosure of earnings per share.  
Principal among computation revisions is the replacement of primary earnings 
per share with basic earnings per share, which does not consider common stock 
equivalents.  In addition, SFAS No. 128 modifies certain dilutive 
computations and replaces fully diluted earnings per share with diluted 
earnings per share.  Disclosure requirements include, among others, dual 
presentation of basic and diluted earnings per share, along with a 
reconciliation of the elements used in computing basic and diluted earnings 
per share.  At this time, the Company does not expect that the adoption of 
SFAS No 128 will have a material impact on the Company's reported results. 

3.  SIGNIFICANT CUSTOMER

    During the three and nine months ended September 30, 1997,  a single 
customer, Packard Bell NEC, accounted for  96% and 83%, respectively, of 
total revenue.  The revenue resulted from recognition of a minimum guarantee 
related to the Company's distribution agreement with Packard Bell NEC.

                                       6
<PAGE>


4.  WARRANTS

    In connection with its strategic relationship with Packard Bell NEC, in 
September 1997 the Company issued to Packard Bell NEC warrants to purchase 
200,000 shares of the Company's Common Stock, exercisable at $10.  The 
warrants expire in February 1999.  The value of the warrants is calculated to 
be approximately $140,000 which has been recorded as an expense charge to 
operations with a corresponding credit to stockholders' equity during the 
three and nine months ended September 30, 1997.

5.  COMMITMENTS AND CONTINGENCIES

    The Company has a commitment under its rental agreements for 
approximately $850,000 at September 30, 1997.

                                       7
<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 Developments ("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 Company's historical operations prior to September 1996 discussed in
this section reflect only the operations of BII Australia. 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 substantially 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 its 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 and production of Multipath Movies and other 
three-dimensional digitally created entertainment. The Company began the 
launch of the first of its Multipath Movies, CYBERSWINE, in the fourth 
quarter of 1997. The first products in the Storyteller Series and the 
Multipath Movies for Kids series are expected to be completed in the fourth 
quarter of 1997. The Company's annual and quarterly revenue will depend upon 
the successful development, 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. The 
commercial success of a Multipath Movie is also expected to depend upon 
promotion and marketing, production costs, impact of competition and other 
factors. Accordingly, the Company's annual and quarterly revenues are and 
will be extremely difficult to forecast.

                                       8
<PAGE>

    The Company incurred significant operating expenses and development costs 
as it continued development of its proprietary software tools and its 
Multipath Movies and as it continued to expand in anticipation of growth. In 
connection with the Company's acquisition of SAND in September 1996, the 
Company expensed $1,350,000 attributable to in-process research and 
development. Also, the Company entered into strategic relationships with 
Packard Bell NEC and Morgan Creek. In September 1996, the Company issued to 
Packard Bell NEC and Morgan Creek warrants to purchase 600,000 and 85,000 
shares of Common Stock, respectively, resulting in a $1,096,000 expense and 
corresponding credit to equity in September 1996. In September 1997, Packard 
Bell NEC was issued an additional 200,000 warrants resulting in an expense of 
$140,000 and a corresponding credit to equity, based on the value of the 
warrants issued. The Company also incurred compensation expense of $125,000 
in connection with directors' stock options in November 1996. As a result of 
these operating expenses and charges, the Company incurred a significant loss 
in the six months ended December 31, 1996, and in the three months ended 
March 31, 1997 and June 30, 1997. The Company was profitable for the three 
months ended September 30, 1997 as a result of revenue recognized under its 
distribution agreement with Packard Bell NEC. However, costs associated with 
development of its Multipath Movies in prior quarters resulted in a net loss 
for the nine months ended September 30, 1997. 

RESULTS OF OPERATIONS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 
   1997 AS COMPARED TO THREE AND NINE MONTHS ENDED SEPTEMBER 30, 1996

    REVENUES.  The Company historically has derived its revenues from royalties,
development fees and software sales. 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 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. See Note 2 of Notes to Consolidated
Financial Statements.

    For those distribution contracts under which the Company is entitled to a
fixed minimum guaranteed amount which has not yet been received, the minimum
guaranteed amount is recognized as revenue when the CD-ROM master is delivered
to the distributor. Revenues from the sale of electronic tickets to view
Multipath Movies over the Internet will be recognized when such tickets are
sold.

                                       9
<PAGE>

    The Company anticipates that revenues from the sale of Multipath Movies
through retail outlets will be recognized when the product is shipped. 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.

    Revenues increased from $1,139,000 for the nine months ended September 30,
1996 to $2,377,000 for the nine months ended September 30, 1997. This represents
an increase of $1,238,000. Revenues increased from $281,000 for the three months
ended September 30, 1996 to $2,057,000 for the three months ended September 30,
1997. This represents an increase of $1,776,000. Revenues in the 1997 periods
included $1,973,333 of revenue from its distribution agreement with Packard Bell
NEC recognized in the third quarter of 1997. Revenues in the 1996 periods were
generated from sales of the Company's traditional CD-ROM products, a business
which is being phased out.

    COST OF REVENUES.  Cost of revenues related to royalties consists 
primarily of royalty obligations to third parties. 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 royalties to third parties and the direct costs and 
manufacturing overhead required to reproduce and package software products. 
Cost of revenues decreased from $411,000 for the nine months ended September 
30, 1996 to $17,000 for the nine months ended September 30, 1997. This 
represents a decrease of $394,000, or 96%. Cost of revenues decreased from 
$140,000 for the three months ended September 30, 1996 to $44 for the three 
months ended September 30, 1997. Cost of revenues in the 1996 periods include 
costs associated with development of the Company's traditional CD-ROM 
products. During the 1997 periods, most of the costs associated with the 
development of the Company's Multipath Movies were charged to research and 
development expenses, in accordance with Statement of Financial Accounting 
Standards No. 86 ("SFAS No. 86") See "--Accounting Treatment for Development 
Costs and Research Expenditures."

    SALES AND MARKETING.  Sales and marketing expenses include primarily costs
for advertising, promotions, brochures, travel and trade shows. Sales and
marketing expenses decreased from $1,099,000 for the nine months ended September
30, 1996 to $387,000 for the nine months ended September 30, 1997, and from
$969,000 for the three months ended September 30, 1996 to $185,000 for the three
months ended September 30, 1997. Sales and marketing expenses include expenses
related to grants of warrants to Packard Bell NEC of $140,000 in September 1997
and $960,000 in September 1996. Sales and marketing expenses are expected to
increase in future periods due to the expansion of the Company's sales force.

                                       10
<PAGE>

    GENERAL AND ADMINISTRATIVE.  General and administrative expenses include
primarily salaries and benefits of management and administrative personnel,
rent, insurance costs and professional fees. General and administrative expenses
increased from $345,000 for the nine months ended September 30, 1996 to
$1,665,000 for the nine months ended September 30, 1997, and from $140,000 for
the three months ended September 30, 1996 to $665,000 for the three months ended
September 30, 1997. These increases are attributable to increased costs
associated with the development of internal management and infrastructure to
support the Company's increased development activity, and other services.

    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 traditional CD-ROM software tools and the software
tools used to develop Multipath Movies. Research and development expenses
decreased from $1,641,000 for the nine months ended September 30, 1996 to
$1,418,000 for the nine months ended September 30, 1997, and from $1,518,000 for
the three months ended September 30, 1996 to $363,000 for the three months ended
September 30, 1997. These decreases are attributable to the addition in
September 1996 of $1,350,000 in-process research and development costs incurred
in connection with the SAND acquisition. Costs in 1997 include continuing
development of Multipath Movies and the Multipath Movie software tools. In
accordance with SFAS No. 86, the results of operations for the nine months ended
September 30, 1997 include in-process research and development expenses incurred
in connection with development of the Multipath Movie and the Company's
proprietary software tools.

    The Company has chosen to focus on the development of Multipath Movies for
the PC and has deferred development for other platforms, including game
consoles, until warranted by market conditions. This focus allows the Company to
devote more of its resources to development of Multipath Movie technology and
development of additional titles. The Company believes that its decision will
have no adverse impact on revenues in the near or medium term.

    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 four years) using the straight-line method. 
Depreciation expense increased from $31,000 and $87,000 for the three and 
nine months, respectively, ended September 30, 1996 to $80,000 and $198,000 
for the three and nine months, respectively, ended September 30, 1997. These 
increases are primarily attributable to additional computer equipment put in 
place and leasehold improvements made during 1997.

                                       11
<PAGE>

    OTHER INCOME AND EXPENSE.  Other income includes interest income and
expenses, gains and losses on foreign exchange transactions and export
development grants paid to BII Australia by the Australian Trade Commission for
BII Australia's participation in certain export activities. Interest increased
from a net expense of $20,000 and $48,000 for the three and nine months,
respectively, ended September 30, 1996 to a net income of $45,000 and $215,000
for the three and nine months, respectively, ended September 30, 1997. These
increases are due to the higher cash balances as a result of the initial public
offering in November 1996 and the repayment of all interest bearing debt.

FLUCTUATING OPERATING RESULTS

    Historically, the Company has experienced significant fluctuations in its 
operating results from quarter to quarter and it expects these fluctuations 
to continue in the future. 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 
development expenditures, management's evaluation and judgment regarding a 
title's acceptance, other unanticipated operating expenses and general 
economic conditions. Additionally, a majority of the unit sales for a product 
typically occurs 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 plans
to increase its operating expenses to fund greater levels of Multipath Movie
production and research and development, increased marketing operations and
expanded distribution channels. 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.

                                       12
<PAGE>

    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.

ACCOUNTING TREATMENT FOR DEVELOPMENT COSTS AND RESEARCH EXPENDITURES

    The Company's current accounting policy follows SFAS No. 86, which provides
for the capitalization of certain software development costs once technological
feasibility is established. The capitalized costs are then amortized on a
straight-line basis over the estimated product life or on a ratio of current
revenues to total projected product revenues, whichever results in the greater
amortization amount. Prior to the establishment of technological feasibility,
these costs are expensed as incurred. Historically, the Company has expensed all
costs related to the development of both its software tools and Multipath Movie
titles. During the third quarter of 1997, the Company began capitalizing certain
development costs related to the production of Multipath Movies in accordance
with SFAS No. 86. In the future, if the Company incurs costs to develop digital
entertainment products for distribution as home video features or television
programming, such discrete costs may be capitalized and amortized in the
proportion that gross revenues realized bear to management's estimate of the
total gross revenues expected to be received, in accordance with Statement of
Financial Accounting Standards No. 53, "Financial Reporting by Producers and
Distributors of Motion Picture Films."

LIQUIDITY AND CAPITAL RESOURCES

    As of September 30, 1997, the Company's principal source of liquidity was
approximately $4.3 million in cash. Prior to the Company's initial public
offering in November 1996, a substantial portion of its operations were financed
through loans from two significant stockholders, PIE and Reefknot.

    In November 1996, the Company's initial public offering of 2,000,000 shares
of Common Stock at $5 per share provided approximately $8.5 million in cash
after underwriters' discounts and commissions and offering expenses. All loans
from Reefknot and PIE were repaid from proceeds of the initial public offering.

    Net cash provided by operating activities during the nine months ended
September 30, 1996 was primarily attributable to revenues of $1,139,000. Net
cash used in operating activities during the nine months ended September 30,
1997 was primarily attributable to a net loss of $944,000 and an increase in
accounts receivable of $1,869,000. Net cash used in investing activities in the
nine months ended September 30, 1997 was due primarily to the purchase of
computer equipment. Cash flows used in financing activities in the nine months
ended September 30, 1996 was primarily attributable to the repayment of loans
from PIE and Reefknot.

    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 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 at least the next twelve months. See "Quote Factors
That May Affect Future Results of Operations -- Future Capital Needs; 
Uncertainty of Additional Funding."

                                       13
<PAGE>

            FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS

    THIS REPORT INCLUDES "FORWARD-LOOKING STATEMENTS" WITHIN THE MEANING OF 
SECTION 27A OF THE SECURITIES ACT OF 1933 ("SECURITIES ACT") AND SECTION 21E 
OF THE EXCHANGE ACT. ALL STATEMENTS OTHER THAN STATEMENTS OF HISTORICAL FACT 
INCLUDED IN THIS REPORT, INCLUDING, WITHOUT LIMITATION, THE STATEMENTS 
REGARDING THE COMPANY'S STRATEGIES, PLANS, OBJECTIVES AND EXPECTATIONS, 
PRODUCT RELEASE SCHEDULES, THE COMPANY'S ABILITY TO DESIGN, DEVELOP, 
MANUFACTURE AND MARKET PRODUCTS, AND THE ABILITY OF THE COMPANY'S PRODUCTS TO 
ACHIEVE OR MAINTAIN COMMERCIAL ACCEPTANCE CONSTITUTE FORWARD-LOOKING 
STATEMENTS. THE COMPANY BELIEVES THAT THE EXPECTATIONS REFLECTED IN SUCH 
FORWARD-LOOKING STATEMENTS ARE REASONABLE AT THIS TIME, BUT CAN GIVE NO 
ASSURANCE THAT SUCH EXPECTATIONS WILL PROVE TO HAVE BEEN CORRECT. IMPORTANT 
FACTORS THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THE 
COMPANY'S EXPECTATIONS ARE SET FORTH BELOW. ALL SUBSEQUENT WRITTEN AND ORAL 
FORWARD-LOOKING STATEMENTS ATTRIBUTABLE TO THE COMPANY OR ANY PERSON ACTING 
ON ITS BEHALF ARE EXPRESSLY QUALIFIED IN THEIR ENTIRETY BY THE RISK FACTORS.

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
with 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 is introducing CYBERSWINE, its first Multipath 
Movie, in 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 the 
first Multipath Movie 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 first Multipath Movie. The failure of the Company's 

                                       14
<PAGE>

initial Multipath Movie to achieve commercial success would damage the 
ability of the Company to introduce additional titles. Accordingly, the 
failure of any of the Company's Multipath Movies, and especially its first 
Multipath Movie, to achieve commercial success, could have a material adverse 
affect on the business, operating results and financial condition of the 
Company.

LIMITED OPERATING HISTORY; UNCERTAIN PROFITABILITY

    The Company was founded in September 1993, and 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. In order for the
Company to achieve sustained profitability, the Company must continue to enter
into a variety of distribution and revenue generating arrangements of this type,
as well as arrangements with Internet service providers, traditional CD-ROM
publishers and 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.

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 AND LICENSING RELATIONSHIPS

    The Company has entered into strategic relationships with Packard Bell 
NEC, Morgan Creek, CompuServe, S3 and Matrox 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 the Company's first 
Multipath Movie. 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. Also, Morgan Creek and many other 
content licensors 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 licensors to 

                                       15
<PAGE>

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 licensors 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 licensors 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.

    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.

PRODUCT DELAYS AND LIFECYCLES

    The Company's current production schedules contemplate that it will 
release a number of Multipath Movies in the fourth quarter of 1997, 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. It is likely 
in the future 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.

                                       16
<PAGE>

    In particular, the Company will expend substantial resources in connection
with the launch of its initial Multipath Movies during the fourth quarter of
1997. Any failure to complete one or more of these titles as scheduled could
result in the inability to recoup such expenditures and loss of marketing
opportunities, retailer fees and consumer interest. Moreover, any delay in the
introduction of, or the presence of a defect in, one or more of the titles
scheduled to be completed in the fourth quarter could cause the Company to miss
the 1997 holiday retail season or other opportunities and could adversely affect
the ultimate success of such titles.

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 licensors 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 online 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 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
online 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.

                                       17
<PAGE>

    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 prior to release of the Company's Multipath Movies. 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 online 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 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.

                                       18
<PAGE>

    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 delivery 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.

COMPETITION

    The markets for the Company's digital entertainment products are 
intensely competitive, subject to rapid change and characterized by constant 
demand for new product features at reduced prices and pressure to accelerate 
the release of new products and product enhancements. The primary competitive 
areas for the Company are identified below.

    COMPUTER GRAPHICS SPECIAL EFFECT FIRMS.  The Company expects to compete with
computer graphics special effects firms, including Pixar, Industrial Light &
Magic Inc. ("ILM"), an affiliate of Lucasfilm Ltd. ("Lucasfilm"), Digital
Domain, Sony ImageWorks, Pacific Data Images, Rhythm & Hues and Boss Film
Studios, Inc. These computer graphics special effects firms are capable of
creating their own three-dimensional computer animated feature films and may
produce three-dimensional computer animated feature films for movie studios that
compete with the Company. Pixar already has produced and successfully released
an animated feature film, TOY STORY, and ILM has created and produced three-
dimensional character animation used for the ghosts in the live action film
CASPER. These firms, each of which has greater financial and marketing resources
than the Company, are expected to compete intensely with the Company in the
production of animated digital products.

    CD-ROM PUBLISHERS.  The CD-ROM industry is intensely competitive and
consumer demand for particular software products may be adversely affected by
the proliferation of competitive products. The Company believes that the primary
competitive factors in the market for CD-ROM products include creative content,
product quality, technological capabilities, pricing, breadth of features,
marketing and distribution resources and customer service and support. The
Company will compete primarily against companies offering entertainment software
and related products. The Company's competitors in this area will include
several large companies with substantially greater name recognition, financial,
technical, marketing and other resources, including Broderbund Software, Inc.
("Broderbund"), GT Interactive Software, Inc. ("GT Interactive"), Electronic
Arts, The Learning Company, Inc. ("Learning Company"), CUC International, Inc.
("CUC"). Moreover, large corporations, such as the Walt Disney Company
("Disney") and Microsoft Corporation ("Microsoft"), with substantial bases of
intellectual property content and substantial financial resources, have entered
or announced their intention to enter the market for CD-ROM entertainment
products.

                                       19
<PAGE>

    MOVIE STUDIOS AND PRODUCTION COMPANIES.  The Company's Multipath Movies will
compete with traditional feature films and television programming produced by
major movie studios, including Disney, Warner Bros. Inc. ("Warner Bros."),
Twentieth Century Fox Film Corporation ("Twentieth Century Fox"), Paramount
Pictures ("Paramount"), Sony Pictures, Inc. ("Sony"), Lucasfilm, Universal City
Studios, Inc. ("MCA Universal") and MGM/UA, as well as numerous other
independent motion picture and television production companies. Several movie
studios already have developed and released animated feature films and the
Company expects additional competition in the animated feature film market from
these and other movie studios. Other movie studios have announced their
intention to enter the animated feature film market, including DreamWorks SKG, a
studio formed in 1994 which is expressly targeting the animated film market. The
Company's broadcast and home video products will compete with the films of these
movie studios for audience acceptance and exhibition over broadcast/cable and
home video channels. In addition, the Company will compete with movie studios
for the acquisition of literary properties, production financing, the services
of performing artists, and the services of other creative and technical
personnel, particularly in the fields of animation and technical direction. Most
of the movie studios with which the Company will compete have significantly
greater name recognition and significantly greater financial, technical,
creative, marketing, and other resources than does the Company. Due to their
substantially greater resources, these movie studios likely will be able to
enter into more favorable distribution arrangements and to promote their films
and television programming more successfully than the Company.

    Several movie studios, including Disney and Lucasfilm (through its 
affiliate ILM), have developed their own internal computer animation 
capability and have created computer animation for special effects in 
animated films. Other movie studios may internally develop, license or 
sub-contract three-dimensional animation capability. Further, the Company 
believes that continuing enhancements in computer hardware and software 
technology will lower barriers to entry for studios or special effects 
companies which intend to produce computer animated feature films or other 
products.

    In response to all of these competitive forces, the Company will be required
to make a high level of investment in content and tool development, marketing
and customer service and support. There can be no assurance that the Company
will have sufficient resources to make such investments or, even if they are
made, that the Company's products will be competitive. Additionally, present or
future competitors may be able to develop products comparable or superior to
those offered by the Company or adapt more quickly than the Company to new
technologies or evolving customer requirements. The Company's competitors also
may increase their efforts to gain and retain market share through competitive
pricing or product giveaways. These competitive pressures may necessitate price
reductions by the Company, thus reducing the Company's profit margins. In
addition, as the number of competitors increases and competition for valuable
leisure time available to be devoted to the products such as those of the
Company and equally scarce retail shelf space becomes more intense, the Company
may need to increase marketing expenditures to maintain sales and product
differentiation. Also, as competition for popular titles and themes that may be
used in entertainment software increases, the cost of acquiring such titles and
properties is likely to increase, resulting in reduced margins. There can be no
assurance that the Company will be able to compete successfully against current
or future competitors or that competitive pressures faced by the Company will
not materially adversely affect its business, operating results and financial
condition.

                                       20
<PAGE>

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 each of 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 two years and additional 
refinement of these tools may be necessary in order 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 
successfully to 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 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.

                                       21
<PAGE>

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 development of a new studio in
California, and the general strains of the Company's role of 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 which is expected to continue
following the Offering. The Company's failure to manage implementation of its
business plan and the changes made to structure and prepare for the Offering
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, although no specific acquisitions currently are pending or under
negotiation. 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.

                                       22
<PAGE>

    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 which 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.

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.

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<PAGE>

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 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. ("Sega Enterprises"). Although Messrs. Dyne
and Bermeister are active in the management of the Company, they are not
required to spend a certain 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 which 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 

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<PAGE>

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.

    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.

FUTURE CAPITAL NEEDS; UNCERTAINTY OF ADDITIONAL FUNDING

    The Company's future capital requirements will depend on many factors,
including but not limited to, the number of Multipath Movies developed, the cost
of content development, marketing and distribution, the size and timing of
future acquisitions, if any, and the availability of additional financing. To
the extent that existing resources and future earnings are insufficient to fund
the Company's activities, the Company may need to raise additional funds through
debt or equity financings. No assurance can be given that such additional
financing will be available or that, if available, it can be obtained on terms
favorable to the Company and its stockholders. In addition, any equity financing
could result in dilution to the Company's stockholders. The Company's inability
to obtain adequate funds would adversely affect the Company's operations and
ability to implement its strategy.

                                       25
<PAGE>

                                     PART II

                               OTHER INFORMATION

ITEM 2.  CHANGES IN SECURITIES

    On September 1, 1997, the Company issued warrants to Packard Bell NEC to 
purchase up to 200,000 shares of Common Stock for $200.00 (the "Warrants") in 
connection with an amendment to the Company's distribution agreement with 
Packard Bell NEC. Packard Bell NEC covenanted that (i) it acquired the 
Warrant for its own account with the present intention of holding such 
Warrant for investment purposes only and not with a view to, or for sale in 
connection with, any distribution of such Warrant (other than a distribution 
in compliance with all applicable federal and state securities laws); (ii) it 
is an experienced and sophisticated investor and has such knowledge and 
experience in financial and business matters that it is capable of evaluating 
the relative merits and the risks of an investment in the Warrant and of 
protecting its own interests in connection with the transaction at issue; 
(iii) it is willing to bear and is capable of bearing the economic risk of an 
investment in the Warrant; and (iv) the Company made available, prior to the 
date of issuance of the Warrant, to it the opportunity to ask questions of 
the Company and its officers, and to receive from the Company and its 
officers information concerning the terms and conditions of the Warrant and 
to obtain any additional information with respect to the Company, its 
business, operations and prospects, as reasonably requested by it; and (v) it 
is an "accredited investor" as that term is defined under Rule 501(a)(8) of 
Regulation D promulgated by the Commission under the Securities Act. The 
issuance and sale of these securities was made in reliance on Section 4(2) of 
the Securities Act (in accordance with Rule 506 of Regulation D) as a 
transaction not involving any public offering.

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K.

    (a)  Exhibits.

         10.1   Site Management Agreement, dated June 2, 1997, between
                CompuServe Incorporated and Brilliant Digital Entertainment, 
                Inc. [Confidential Treatment Requested].
         10.2   Letter Agreement, dated September 22, 1997, between Packard 
                Bell NEC and the Company. [Confidential Treatment Requested].
         11.1   Computation of Per Share Earnings (Loss).
         27.1   Financial Data Schedule.

    (b)  Reports on Form 8-K.

         Report on Form 8-K dated July 21, 1997 reporting under Item 4 
         thereof the engagement of Price Waterhouse LLP as the Company's 
         independent auditors for the year ending December 31, 1997 to 
         replace the firm of Ernst & Young LLP, who were dismissed as 
         auditors of the Company effective July 21, 1997.

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<PAGE>

                                   SIGNATURES

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

                                       BRILLIANT DIGITAL ENTERTAINMENT, INC.


Date: November 4, 1997                      /s/Michael Ozen
                                       ---------------------------------------
                                       By:   Michael Ozen
                                       Its:  Chief Financial Officer 
                                             (Principal Financial and 
                                             Accounting Officer) and 
                                             Secretary

                                       27
<PAGE>

                                EXHIBIT INDEX

EXHIBIT
 NUMBER  EXHIBIT DESCRIPTION
-------  -------------------

10.1     Site Management Agreement, dated June 2, 1997, between CompuServe
         Incorporated and Brilliant Digital Entertainment, Inc. [Confidential
         Treatment Requested].

10.2     Letter Agreement, dated September 22, 1997, between Packard Bell
         NEC and the Company. [Confidential Treatment Requested].

11.1     Computation of Earnings (Loss) per Common Share.

27.1     Financial Data Schedule.



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