<PAGE>
 
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549
 
                                   FORM 10-Q
 
(Mark One)
 
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
 
For the quarterly period ended September 30, 1996
 
/ / 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 0-20081
 
                PRUTECH RESEARCH AND DEVELOPMENT PARTNERSHIP III
--------------------------------------------------------------------------------
             (Exact name of Registrant as specified in its charter)
 
California                                    77-0129484
--------------------------------------------------------------------------------
(State or other jurisdiction                (I.R.S. Employer
of incorporation or organization)          Identification No.)
 
440 Mission Court, Suite 250, Fremont, California             94539
--------------------------------------------------------------------------------
(Address of principal executive offices)                    (Zip Code)
 
Registrant's telephone number, including area code (510) 656-1855
 
                                      N/A
--------------------------------------------------------------------------------
Former name, former address and former fiscal year, if changed since last report
 
   Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes _CK_  No __

<PAGE>
                         Part I. FINANCIAL INFORMATION
                          ITEM 1. FINANCIAL STATEMENTS
                PRUTECH RESEARCH AND DEVELOPMENT PARTNERSHIP III
                            (a limited partnership)
                       STATEMENTS OF FINANCIAL CONDITION
                                  (unaudited)
<TABLE>
<CAPTION>
                                                                      September 30,     December 31,
                                                                          1996              1995
<S>                                                                   <C>               <C>
----------------------------------------------------------------------------------------------------
ASSETS
Cash and cash equivalents                                              $   275,618      $   480,692
Investments in equity securities                                        12,421,429       19,182,479
Other asset                                                                     --          216,669
                                                                      -------------     ------------
Total assets                                                           $12,697,047      $19,879,840
                                                                      -------------     ------------
                                                                      -------------     ------------
LIABILITIES AND PARTNERS' CAPITAL
Liabilities
Accrued management fee                                                 $   204,670      $   204,670
Accrued expenses and other liabilities                                      70,602           73,091
                                                                      -------------     ------------
Total liabilities                                                          275,272          277,761
                                                                      -------------     ------------
Contingencies
Partners' capital
Unitholders (40,934 units issued and outstanding)                        7,093,837        7,505,854
General partner                                                            795,942          841,722
Unrealized gain on investments in equity securities                      4,531,996       11,254,503
                                                                      -------------     ------------
Total partners' capital                                                 12,421,775       19,602,079
                                                                      -------------     ------------
Total liabilities and partners' capital                                $12,697,047      $19,879,840
                                                                      -------------     ------------
                                                                      -------------     ------------
----------------------------------------------------------------------------------------------------
                  The accompanying notes are an integral part of these statements
</TABLE>
                                       2
<PAGE>
                PRUTECH RESEARCH AND DEVELOPMENT PARTNERSHIP III
                            (a limited partnership)
                            STATEMENTS OF OPERATIONS
                                  (unaudited)
 
<TABLE>
<CAPTION>
                                                  Nine months ended            Three months ended
                                                    September 30,                 September 30,
                                              -------------------------     -------------------------
                                                 1996           1995           1996           1995
<S>                                           <C>            <C>            <C>            <C>
-----------------------------------------------------------------------------------------------------
Gain on sale of investments in equity
  securities                                  $3,621,513     $7,370,532     $       --     $3,114,306
Royalty income                                   216,665             --             --             --
Termination of royalty rights                         --        516,870             --             --
Interest and other income                         33,994         51,036          7,013         20,157
                                              ----------     ----------     ----------     ----------
                                               3,872,172      7,938,438          7,013      3,134,463
                                              ----------     ----------     ----------     ----------
EXPENSES
Management fee                                   614,010        614,010        204,670        204,670
General and administrative                        77,381        142,215         26,430         61,506
Interest                                              --         18,070             --             --
                                              ----------     ----------     ----------     ----------
                                                 691,391        774,295        231,100        266,176
                                              ----------     ----------     ----------     ----------
Net income (loss)                             $3,180,781     $7,164,143     $ (224,087)    $2,868,287
                                              ----------     ----------     ----------     ----------
                                              ----------     ----------     ----------     ----------
ALLOCATION OF NET INCOME (LOSS)
Unitholders                                   $2,862,703     $6,447,729     $ (201,678)    $2,581,458
                                              ----------     ----------     ----------     ----------
                                              ----------     ----------     ----------     ----------
General partner                               $  318,078     $  716,414     $  (22,409)    $  286,829
                                              ----------     ----------     ----------     ----------
                                              ----------     ----------     ----------     ----------
Net income (loss) per unit                    $    69.93     $   157.52     $    (4.93)    $    63.06
                                              ----------     ----------     ----------     ----------
                                              ----------     ----------     ----------     ----------
-----------------------------------------------------------------------------------------------------
</TABLE>
 
                   STATEMENT OF CHANGES IN PARTNERS' CAPITAL
                                  (unaudited)
<TABLE>
<CAPTION>
                                                                          UNREALIZED
                                                             GENERAL        GAIN ON
                                            UNITHOLDERS      PARTNER      INVESTMENTS        TOTAL
<S>                                         <C>             <C>           <C>             <C>
-----------------------------------------------------------------------------------------------------
Partners' capital--December 31, 1995        $7,505,854      $ 841,722     $11,254,503     $19,602,079
Net income                                   2,862,703        318,078             --        3,180,781
Distribution                                (3,274,720 )     (363,858)            --       (3,638,578)
Change in unrealized gain on investments
  in equity securities                              --             --     (6,722,507 )     (6,722,507)
                                            -----------     ---------     -----------     -----------
Partners' capital--September 30, 1996       $7,093,837      $ 795,942     $4,531,996      $12,421,775
                                            -----------     ---------     -----------     -----------
                                            -----------     ---------     -----------     -----------
-----------------------------------------------------------------------------------------------------
                   The accompanying notes are an integral part of these statements
</TABLE>
                                       3
<PAGE>
                PRUTECH RESEARCH AND DEVELOPMENT PARTNERSHIP III
                            (a limited partnership)
                            STATEMENTS OF CASH FLOWS
                                  (unaudited)
 
<TABLE>
<CAPTION>
                                                                              Nine months ended
                                                                                September 30,
                                                                         ---------------------------
<S>                                                                      <C>             <C>
                                                                            1996            1995
----------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Interest and other income received                                       $    33,994     $    51,036
Royalty income received                                                      216,665          13,942
Management fee paid                                                         (614,010)     (1,432,690)
General and administrative expenses paid                                     (76,298)        (76,672)
Evaluation and monitoring expenses paid                                       (3,572)        (53,219)
Cash received for other asset                                                216,669              --
Interest paid                                                                     --         (55,742)
                                                                         -----------     -----------
Net cash used in operating activities                                       (226,552)     (1,553,345)
                                                                         -----------     -----------
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from the sale of investments in equity securities                 3,660,056       7,382,661
Proceeds from the termination of royalty rights                                   --         516,870
                                                                         -----------     -----------
Net cash provided by investing activities                                  3,660,056       7,899,531
                                                                         -----------     -----------
CASH FLOWS FROM FINANCING ACTIVITIES
Distributions                                                             (3,638,578)     (4,047,918)
Repayment of note payable                                                         --      (1,622,223)
                                                                         -----------     -----------
Net cash used in financing activities                                     (3,638,578)     (5,670,141)
                                                                         -----------     -----------
Net (decrease) increase in cash and cash equivalents                        (205,074)        676,045
Cash and cash equivalents at beginning of period                             480,692         152,084
                                                                         -----------     -----------
Cash and cash equivalents at end of period                               $   275,618     $   828,129
                                                                         -----------     -----------
                                                                         -----------     -----------
RECONCILIATION OF NET INCOME TO NET CASH
USED IN OPERATING ACTIVITIES
Net income                                                               $ 3,180,781     $ 7,164,143
                                                                         -----------     -----------
Adjustments to reconcile net income to net cash used in operating
  activities:
Gain on sale of investments in equity securities                          (3,621,513)     (7,370,532)
Termination of royalty rights                                                     --        (516,870)
Changes in:
  Other asset                                                                216,669              --
  Accrued expenses and other liabilities                                      (2,489)        (25,348)
  Royalties receivable                                                            --          13,942
  Accrued management fee                                                          --        (818,680)
                                                                         -----------     -----------
Total adjustments                                                         (3,407,333)     (8,717,488)
                                                                         -----------     -----------
Net cash used in operating activities                                    $  (226,552)    $(1,553,345)
                                                                         -----------     -----------
                                                                         -----------     -----------
----------------------------------------------------------------------------------------------------
SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING ACTIVITIES
1995
Exercised a warrant to acquire, on a net issuance basis, 171,635 shares of Interleaf, Inc. common
  stock.
----------------------------------------------------------------------------------------------------
                  The accompanying notes are an integral part of these statements
</TABLE>
                                       4
<PAGE>
                PRUTECH RESEARCH AND DEVELOPMENT PARTNERSHIP III
                            (a limited partnership)
                         NOTES TO FINANCIAL STATEMENTS
                               SEPTEMBER 30, 1996
                                  (unaudited)
 
A. General
 
   These financial statements have been prepared without audit. In the opinion
of management, the financial statements contain all adjustments (consisting of
only normal recurring adjustments) necessary to present fairly the financial
position of PruTech Research and Development Partnership III (the
``Partnership'') as of September 30, 1996, the results of its operations for the
nine and three months ended September 30, 1996 and 1995 and its cash flows for
the nine months ended September 30, 1996 and 1995. However, the operating
results for the interim periods may not be indicative of the results expected
for the full year.
 
   Certain information and footnote disclosures normally included in annual
financial statements prepared in accordance with generally accepted accounting
principles have been omitted. It is suggested that these financial statements be
read in conjunction with the financial statements and notes thereto included in
the Partnership's Annual Report on Form 10-K filed with the Securities and
Exchange Commission for the year ended December 31, 1995.
 
   Certain balances for prior periods have been reclassified to conform with
current financial statement presentation.
 
B. Royalties
 
   On April 1, 1990 the Partnership entered into a Technology Development
Investment Agreement with Kopin Corporation (``Kopin'') for the development of
LED technology. Pursuant to the Agreement, Kopin was obligated to pay to the
Partnership royalties on the sale of products containing the technology through
April 1, 1996, with a minimum royalty payment of $433,334 due April 1, 1996
(payable in cash or by the delivery of a promissory note). Kopin agreed to pay
cash for the minimum royalty because the Partnership also agreed to transfer to
Kopin its GaAs technology developed under an earlier contract. During the second
quarter of 1996, the Partnership received the $433,334 minimum royalty payment
of which $216,669 represented a reduction of its receivable from Kopin and
$216,665 was recorded as royalty income. As a result, the Partnership holds no
technology or royalty positions with Kopin and, therefore, no further royalties
will be received by the Partnership from Kopin.
 
C. Investments
 
   During the first quarter of 1996, the Partnership sold its remaining 75,000
shares of Forest Laboratories, Inc. common stock with a cost basis of $6,130
resulting in a gain of $3,594,350 and 4,334 shares of Kopin common stock with a
cost basis of $32,413 resulting in a gain of $27,163.
 
   Investments in marketable equity securities available-for-sale include the
following:
 
<TABLE>
<CAPTION>
                                  September 30, 1996                                         December 31, 1995
                -------------------------------------------------------    ------------------------------------------------------
                                       Gross unrealized     Carrying                              Gross unrealized     Carrying
                Shares    Cost basis        gains             value        Shares    Cost basis        gains            value
<S>             <C>       <C>          <C>                <C>              <C>       <C>          <C>                <C>
-----------------------------------------------------------------------    ---------------------------------------------
Creative
 BioMolecules,
  Inc.-Common
  Stock         724,282   $2,370,177      $2,790,332       $ 5,160,509     724,282   $2,370,177     $  2,699,797     $  5,069,974
Forest
 Laboratories,
  Inc.-
  Common Stock       --           --              --                --      75,000        6,130        3,387,620        3,393,750
Kopin
  Corporation-
  Common Stock  537,333    4,019,256       1,085,414         5,104,670     541,667    4,051,669        3,667,086        7,718,755
Somatix
  Therapy
  Corporation-
  Common Stock  500,000    1,500,000         656,250         2,156,250     500,000    1,500,000        1,500,000        3,000,000
                          ----------   ----------------   -------------              ----------   ----------------   ------------
                          $7,889,433      $4,531,996       $12,421,429               $7,927,976     $ 11,254,503     $ 19,182,479
                          ----------   ----------------   -------------              ----------   ----------------   ------------
                          ----------   ----------------   -------------              ----------   ----------------   ------------
</TABLE>
 
   The gross unrealized gains would be allocated 90% to the Unitholders and 10%
to R&D Funding Corp (the ``General Partner'') if realized at September 30, 1996;
however, there is no assurance that the Partnership would receive these amounts
in the event of the sale of its position in these securities.
 
                                       5
<PAGE>
 
D. Related Parties
 
   The General Partner and its affiliates perform certain services for the
Partnership (for which they are reimbursed through the management fee) which
include, but are not limited to: accounting and financial management; registrar,
transfer and assignment functions; asset management; investor communications and
other administrative services. The Partnership also reimburses an affiliate of
the General Partner for printing services. The management fee and printing costs
were:
 
<TABLE>
<CAPTION>
                              Nine months ended       Three months ended
                                September 30,            September 30,
                            ---------------------    ---------------------
                              1996         1995        1996         1995
<S>                         <C>          <C>         <C>          <C>
--------------------------------------------------------------------------
Management fee              $614,010     $614,010    $204,670     $204,670
Printing                       8,957       13,665       3,032        7,336
                            --------     --------    --------     --------
                            $622,967     $627,675    $207,702     $212,006
                            --------     --------    --------     --------
                            --------     --------    --------     --------
</TABLE>
 
   Printing costs payable to an affiliate of the General Partner (which are
included in accrued expenses and other liabilities) as of September 30, 1996 and
December 31, 1995 were $5,886 and $16,464, respectively.
 
   Prudential Securities Incorporated, an affiliate of R&D Funding Corp, owned
724 units in the Partnership at September 30, 1996.
 
   The Partnership maintains an account with the Prudential Institutional
Liquidity Portfolio Fund, an affiliate of R&D Funding Corp, for investment of
its available cash in short-term instruments pursuant to the guidelines
established by the Partnership Agreement.
 
   The Partnership has engaged in research and development co-investment
projects with PruTech Research and Development Partnership, PruTech Research and
Development Partnership II and PruTech Project Development Partnership
(collectively, the ``PruTech R&D Partnerships''), for which R&D Funding Corp
serves as the general partner. The allocation of the co-investment projects'
profits or losses among the PruTech R&D Partnerships is consistent with the
costs incurred to fund the research and development projects.
 
E. Contingencies
 
   On April 15, 1994 a multiparty petition captioned Mack et al. v. Prudential
Securities Incorporated et al. (Cause No. 94-17695) was filed in the 80th
Judicial District Court of Harris County, Texas, purportedly on behalf of
investors in the Partnership against the Partnership, the General Partner,
Prudential Securities Incorporated, The Prudential Insurance Company of America
and a number of other defendants. The petition alleges common law fraud and
fraud in the inducement and negligent misrepresentation in connection with the
offering of the Partnership units; negligence and breach of fiduciary duty in
connection with the operation of the Partnership; civil conspiracy; and
violations of the Federal Securities Act of 1933 (sections 11 and 12), and of
the Texas Securities and Deceptive Trade Practices statutes. The suit seeks,
among other things, compensatory and punitive damages, costs and attorneys'
fees. The ultimate outcome of this litigation as well as the impact on the
Partnership cannot presently be determined.
 
   The General Partner, Prudential Securities Incorporated and the Partnership
believe they have meritorious defenses to the complaint and intend to vigorously
defend themselves against this action.
 
                                       6
<PAGE>
                PRUTECH RESEARCH AND DEVELOPMENT PARTNERSHIP III
                            (a limited partnership)
      ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
                           AND RESULTS OF OPERATIONS
 
Liquidity and Capital Resources
 
   As of September 30, 1996, the Partnership had approximately $276,000 of cash
and cash equivalents which is a decrease of approximately $205,000 as compared
to December 31, 1995. The decrease in cash and cash equivalents is principally
attributed to net cash used in operating activities. Additionally, the
Partnership sold certain equity securities and distributed the resulting sales
proceeds as further discussed below.
 
   As of September 30, 1996, the Partnership had approximately $7.9 million
invested in equity securities with an aggregate market value which exceeded its
cost. Certain of these investments are in development stage companies which are
more speculative and higher in risk than other equity investments. Additionally,
the realization of this market value is further impacted by certain sale
restrictions and market volume capacity. The amount to be distributed by the
Partnership in future quarters will be based on the extent to which the market
value of its investments can be realized and, to a lesser extent, from the
revenue stream from royalties and interest income. Except for royalty income
from Kopin Corporation (``Kopin'') in 1996 as further discussed below, the
Partnership's royalty positions did not generate royalty income for the
Partnership during the nine months ended September 30, 1996 and 1995.
 
   In January 1996, the Partnership sold its remaining 75,000 shares of Forest
Laboratories, Inc. (``Forest'') common stock for approximately $3,600,000. The
proceeds from the sale were used to pay the January 1996 distribution discussed
below. The Partnership has retained its royalty position with Forest.
 
   Also, during the first quarter of 1996, the Partnership sold 4,334 shares of
Kopin common stock for approximately $60,000.
 
   On April 1, 1990 the Partnership entered into a Technology Development
Investment Agreement with Kopin for the development of LED technology. Pursuant
to the Agreement, Kopin was obligated to pay to the Partnership royalties on the
sale of products containing the technology through April 1, 1996, with a minimum
royalty payment of $433,334 due April 1, 1996 (payable in cash or by the
delivery of a promissory note). Kopin agreed to pay cash for the minimum royalty
because the Partnership also agreed to transfer to Kopin its GaAs technology
developed under an earlier contract. During the second quarter of 1996, the
Partnership received the $433,334 minimum royalty payment of which $216,669
represented a reduction of its receivable from Kopin and $216,665 was recorded
as royalty income. As a result of the above, the Partnership holds no technology
or royalty positions with Kopin and, therefore, no further royalties will be
received by the Partnership from Kopin.
 
   In January 1996, the Partnership paid a distribution of approximately
$3,639,000. Unitholders received a total of approximately $3,275,000 ($80 per
unit) and the General Partner received the remainder.
 
Results of Operations
 
   The Partnership's net income decreased by approximately $3,983,000 and
$3,092,000 for the nine and three months ended September 30, 1996 as compared to
the same periods in 1995. These decreases were primarily due to a decrease in
gains on the sale of investments in equity securities and income from the
termination of royalty rights recorded in 1995.
 
   During the first quarter of 1996, gains totalling approximately $3,622,000
were recorded on the sale of common stock of Forest and Kopin as discussed above
as compared to a gain of approximately $4,256,000 on the sale of 88,000 shares
of Forest common stock during the first quarter of 1995. Additionally, during
the third quarter of 1995, the Partnership sold 60,410 shares of Forest common
stock and 25,000 shares of Interleaf, Inc. common stock resulting in gains of
approximately $2,864,000 and $250,000, respectively.
 
   In March 1995, the Partnership and the MacNeal-Schwendler Corporation
(``MNS'') agreed to terminate the Partnership's contractual rights with respect
to MNS software and to transfer the technology relating to the software to MNS
in exchange for approximately $517,000. No further royalty payments will be
received by the Partnership from MNS as a result of this agreement.
 
                                       7
<PAGE>
 
   General and administrative expenses decreased by approximately $65,000 and
$35,000 for the nine and three months ended September 30, 1996 as compared to
the same periods in 1995. These decreases were primarily due to professional
costs incurred from the use of consultants in 1995 relating to a royalty dispute
with Interleaf, Inc.
 
   Interest expense was eliminated following the repayment of a Partnership note
and related interest payable during February 1995. Interest expense recorded in
1995 through February was approximately $18,000.
 
                                       8
<PAGE>
 
                           PART II. OTHER INFORMATION
 
Item 1. Legal Proceedings--This information is incorporated by reference to Note
        E to the financial statements filed herewith in Item 1 of Part I of the
        Registrant's Quarterly Report.
 
Item 2. Changes in Securities--None
 
Item 3. Defaults Upon Senior Securities--None
 
Item 4. Submission of Matters to a Vote of Security Holders--None
 
Item 5. Other Information--None
 
Item 6. Exhibits and Reports on Form 8-K
 
        (a) Exhibits--
 
            PruTech Research and Development Partnership III Agreement of
            Limited Partnership (incorporated by reference to Exhibit 3.1
            included with Registrant's Form S-1 Registration Statement, File No.
            33-6091, filed on June 3, 1986)
 
            First Amendment to the Agreement of Limited Partnership of PruTech
            Research and Development Partnership III (incorporated by reference
            to Exhibit 3 included with Registrant's Annual Report on Form 10-K
            filed March 28, 1992)
 
            Financial Data Schedule (filed herewith)
 
            (b) Reports on Form 8-K--None
 
                                       9
<PAGE>
                                   SIGNATURES
 
   Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
 
PruTech Research and Development Partnership III
 
By: R&D Funding Corp
    A Delaware corporation, General Partner
     By: /s/ Michael S. Hasley                    Date: November 13, 1996
     ----------------------------------------
     Michael S. Hasley
     President for the Registrant

By: R&D Funding Corp
    A Delaware corporation, General Partner
     By: /s/ Steven Carlino                       Date: November 13, 1996
     ----------------------------------------
     Steven Carlino
     Vice President and Chief Accounting
     Officer for the Registrant
                                       10