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                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                    FORM 10-K

         /X/  ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES
                              EXCHANGE ACT OF 1934


                 FOR THE FISCAL YEAR           COMMISSION FILE
                 ENDED MARCH 31, 1998          NUMBER 0-21510

                     SANCTUARY WOODS MULTIMEDIA CORPORATION
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

        DELAWARE                                       75-2444109
 (State of incorporation)                (I.R.S. Employer Identification Number)

                           1250 45TH STREET, SUITE 350
                        EMERYVILLE, CALIFORNIA 94608-2924
                                 (510) 594-3200
              (Address of principal executive offices and zip code)

         Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.001
                                   par value

         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 the past 90 days. Yes    No X
                                                                      ---   ---

         Check if there is no disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is contained in this form, and no disclosure will be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. / /

         Registrant's revenues for its most recent fiscal year: $2,010,000.

         The aggregate market value of the voting stock held by non-affiliates
computed by reference to the average bid and asked prices of such stock, was
$208,662 as of September 21, 1998.

         The number of shares outstanding of each of issuer's classes of common
equity, as of September 21, 1998, was 5,193,303 shares of Common Stock, $0.001
par value.

         Documents Incorporated by Reference: None

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                                     PART I

ITEM 1.  DESCRIPTION OF BUSINESS.

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

         THIS FORM 10-K OF SANCTUARY WOODS MULTIMEDIA CORPORATION ("SANCTUARY
WOODS" OR THE "COMPANY") CONTAINS FORWARD-LOOKING STATEMENTS THAT ARE SUBJECT TO
RISKS AND UNCERTAINTIES. STATEMENTS INDICATING THAT THE COMPANY "BELIEVES,"
"EXPECTS," "ANTICIPATES" OR "ESTIMATES" ARE FORWARD-LOOKING AS ARE ALL OTHER
STATEMENTS REGARDING FUTURE FINANCIAL RESULTS, MARKET CONDITIONS, PRODUCT
OFFERINGS OR OTHER EVENTS THAT HAVE NOT YET OCCURRED. THERE ARE MANY IMPORTANT
FACTORS THAT COULD CAUSE ACTUAL RESULTS OR EVENTS TO DIFFER MATERIALLY AND/OR
ADVERSELY FROM THOSE ANTICIPATED BY THE FORWARD-LOOKING STATEMENTS CONTAINED IN
THIS FORM 10-K. SUCH FACTORS INCLUDE BUT ARE NOT LIMITED TO, THE RATE OF GROWTH
OF THE CONSUMER MARKET FOR EDUCATIONAL SOFTWARE, MARKET ACCEPTANCE OF THE
COMPANY'S PRODUCTS OR THOSE OF ITS COMPETITORS, THE TIMING OF NEW PRODUCT
INTRODUCTIONS, EXPENSES RELATING TO THE DEVELOPMENT AND PROMOTION OF NEW PRODUCT
INTRODUCTIONS, CHANGES IN PRICING POLICIES BY THE COMPANY OR ITS COMPETITORS,
PROJECTED AND ACTUAL CHANGES IN PLATFORMS AND TECHNOLOGIES, TIMELY AND
SUCCESSFUL ADAPTATION TO SUCH PLATFORMS OR TECHNOLOGIES, THE ACCURACY OF
FORECASTS OF CONSUMER DEMAND, PRODUCT RETURNS, MARKET SEASONALITY, THE TIMING OF
ORDERS FROM MAJOR CUSTOMERS AND ORDER CANCELLATIONS, CHANGES OR DISRUPTIONS IN
THE CONSUMER SOFTWARE DISTRIBUTION CHANNELS, LIMITATIONS ON THE ABILITY OF THE
COMPANY TO ACHIEVE PROFITABILITY OR OBTAIN FINANCING SUFFICIENT TO ALLOW THE
COMPANY TO REMAIN IN BUSINESS, AS WELL AS THOSE FACTORS LISTED UNDER RISK
FACTORS ELSEWHERE HEREIN. ACTUAL EVENTS OR THE ACTUAL FUTURE RESULTS OF THE
COMPANY MAY DIFFER MATERIALLY FROM ANY FORWARD-LOOKING STATEMENT DUE TO SUCH
RISKS AND UNCERTAINTIES. OTHER FACTORS, UNCERTAINTIES AND ASSUMPTIONS NOT
SPECIFICALLY IDENTIFIED OR DISCLOSED BY THE COMPANY WERE ALSO INVOLVED IN THE
DERIVATION OF THESE FORWARD LOOKING STATEMENTS AND THE FAILURE OF SUCH OTHER
ASSUMPTIONS TO BE REALIZED MAY ALSO CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY
FROM THOSE PROJECTED. THE COMPANY ASSUMES NO OBLIGATION TO UPDATE THESE
FORWARD-LOOKING STATEMENTS TO REFLECT ACTUAL RESULTS OR CHANGES IN FACTORS OR
ASSUMPTIONS AFFECTING SUCH FORWARD-LOOKING STATEMENTS.

INTRODUCTION

         During the last few years the Company has been through a period of 
dramatic restructuring and repositioning. The Company has had operating 
losses and net losses in each of its last five fiscal years and has suffered 
operating losses in each of its last nine quarters. In the three years ended 
March 31, 1998, March 31, 1997 and December 31, 1995, the Company reported 
operating losses of $15.8 million, $4.1 million and $18.7 million, 
respectively, and net losses in each of these years of $16.6 million, $3.7 
million and $18.7 million, respectively. There can be no assurances that the 
Company will cease to incur losses in the foreseeable future, if ever. 
Continued losses have and will continue to result in liquidity and cash flow 
problems which have and will inhibit the Company's ability to develop new 
products. The Company funded its working capital requirements and capital 
expenditures during fiscal 1998 through the issuance of senior secured 
convertible promissory notes to a significant stockholder. Further sustained 
losses will necessitate the infusion of additional capital. The Company may 
seek to raise additional capital through future additional financings that if 
raised through the issuance of equity securities, will reduce the percentage 
ownership of the stockholders of the Company. Existing stockholders may 
experience additional dilution, and securities issued in conjunction with new 
financings may have rights, preferences and privileges senior to those of 
holders of the Company's Common Stock. There can be no assurance, however, 
that additional financing will be available when needed, if at all, or on 
favorable terms. The failure to obtain additional financing would have a 
material adverse affect on the Company and may force the Company to seek 
protection of a

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bankruptcy court. See "Management's Discussion and Analysis of Financial 
Condition and Results of Operations - Liquidity and Capital Resources."

         The primary business of the Company is to develop, publish and market
interactive multimedia educational software content (programs) on CD-ROM for the
K-12 school and home consumer markets. The Company's products integrate digital
graphics, text, sound, animation and video and take advantage of the major
advances in PC technology. The Company's products are primarily developed for
the personal computer with sound capabilities and a CD-ROM drive. The Company
believes that, as more powerful personal computers become less costly and more
widely available to consumers and classrooms, demand for multimedia CD-ROM
products and content will grow.

         More importantly, the Company is making the transition to delivering
innovative and educationally sound content over the Internet for children,
parents and teachers. The Company is providing a "kid safe" environment online
for children's activities. These environments focus on communication, creativity
and developing specific skill sets. For example, leveraging its long term
relationship with the National Football League, the Company has developed the
NFL's successful Internet site for kids, "Play Football!" which achieves
millions of page views per month and targets the demographic of 8 to 14 year old
boys engaged in football activities. As a result, the Company is positioning
itself to take advantage of the growth in the teenage population going online
over the next five years by providing content and activities that are conducive
to this growing demographic.

         The Internet provides another key platform for distribution of its
products. Accordingly, the Company has begun to develop specific content for the
Internet leveraging its considerable skill set in developing award winning
nonviolent, fun and educational media content. In addition, the Company is
partnering with online distributors to provide the foundation for broad based
online distribution to over 900 outlets for the Company's existing CD-ROM
product line. The Company is also exploring other technologies to enable it to
sell its products directly through download and encryption technologies as the
bandwidth capabilities expand making the process more commercially viable. The
Company furthermore believes that broadband platforms will become increasingly
attractive to the marketplace. Broadband, which can generally be described as a
digital communications medium that allows for high bandwidth throughput, may
take form in a number of delivery systems including cable, fiber optics, and
satellite. In anticipation of this, the Company has formed and continues to form
alliances with partners involved in developing and distributing content
appropriate for broadband systems.

         The Company's products are available for Macintosh, Windows and Windows
95 platforms and all major Internet browsers.

CD-ROM PRODUCTS

         The Company's CD-ROM products are organized into three families: 
sports learning, animated learning and early learning. Sports learning uses 
sports themes to help kids develop their reading and math skills. These 
products are sold under the Company's "Head Coach" brand name use 
professional team logos, statistics, and player likenesses through licenses 
obtained from NFL Properties, NFL Players and Major League Baseball. In the 
future, the Company intends to offer additional products under the Head Coach 
brand through other sports franchise affiliations.

         The products acquired in the merger with Theatrix Interactive comprise
the Company's animated learning line. This line is lead by award winning titles,
including the "Hollywood" series and the "Head" series, among many other titles
that have been developed with leading educators in specific curriculum areas.


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         Finally, the Company's early learning line of products use animation
and a curriculum-based approach to help develop important learning skills.

         The Sanctuary Woods brand of products also contains some of the
Company's older titles including those purchased from Magic Quest in 1994.

SPORTS LEARNING PRODUCTS

         NFL MATH. This product allows kids ages 8 to 12 to guide their favorite
NFL-TM- team down the field by answering math questions that cover 24 different
math skills including basic computation, fractions and decimals, charts and word
problems. It features 3D photo-realistic animation, real teams, real players,
statistics, and workshops.

         NFL-TM- READING. This product allows kids ages 8 to 12 to practice
reading comprehension, spelling and vocabulary skills by teaming up with the
pros. Kid's read more than 1,800 articles packed with interesting facts about
NFL teams and players. With multi-player, multi-level capabilities, kids of
different ages can compete against one another on a level playing field.

         MAJOR LEAGUE-TM- MATH. This product allows kids ages 8 to 12 to guide
their favorite Major League Baseball-TM- team around the bases by answering math
questions that cover 22 different math skills such as basic computation,
percentages, prime numbers, geometric shapes and structures, powers and square
roots, volume and area. It features 3D photo-realistic animation, real teams,
statistics, and workshops.

         MAJOR LEAGUE-TM- READING. Kids can read more than 1,500 articles packed
with interesting facts about Major League teams and players and field 2,500
reading, spelling and vocabulary questions. With multi-player, multi-level
capabilities, kids of different ages can compete against one another on a level
playing field with 3D photo-realistic animation.

ANIMATED LEARNING PRODUCTS

         HOLLYWOOD. Using innovative text-to-speech synthesis technology,
children ages 9 and up write movies using a cast of characters, backgrounds,
actions, and sound effects contained in the program. The characters literally
speak the written script out loud as they follow the stage directions that the
young writers give them. Kids can stretch their imaginations to the limit as
they practice creative writing, organizational, and cooperative learning skills.

         HOLLYWOOD HIGH. In the second program in the series, children have
access to all of the information from Hollywood in addition to a new set of
characters, settings, sound effects, and actions. Advanced features include the
ability to "teach" characters how to say complex or foreign words using a custom
pronunciation dictionary, as well as the capability to switch between several
scenes within a single show.

         MATH HEADS. This fast-paced math games challenges children ages 10 to
14 to sharpen their mathematical estimation skills. Kids navigate using a remote
control; each channel contains a different game show with wacky characters
acting as hosts. Skills covered include decimals, percentages, mental
calculation, estimation, rounding, number patterns, geometry, multiplication,
and division.

         WORD HEADS. This program uses the same type of highly interactive
game-show setting to teach children the ins and outs of the English language.
Kids ages 10 to 14 build their own Heads characters and


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surf the channels on Heads TV to practice idioms, metaphors, parts of speech, 
roots, creative writing, and effective word choice skills.

         STRATEGY HEADS. Designed to improve strategic and analytical thinking
skills for 10 to 14 year olds, this program is filled with thousands of
brainteasers, puzzles, and mazes. Different channels provide different
challenges. Innovative problems involve geometric transformations, spatial
relationships, deductive reasoning, strategy planning and implementation,
logical analysis, and navigation.

         BIG SCIENCE COMICS. This program is a more advanced science adventure
for 8 to 12 year-olds. It teaches important scientific principles such as
density, work, force, elasticity, projectile motion, and mass, using common
household items. Kids keep notes as they solve the various puzzles, thus
becoming familiar with the Scientific Method.

         JUILLIARD-TM- MUSIC ADVENTURE. Juilliard developed the content for this
program for children ages 9 and up. Non-traditional musical notation is combined
with a musical encyclopedia to help children solve a variety of puzzles in an
animated medieval castle setting. Three levels allow kids to practice the
concepts with the puzzles and engage in free musical composition. Juilliard
Music Adventure is one of a few music theory programs that do not require the
use of a MIDI Keyboard.

EARLY LEARNING PRODUCTS

         FRANKLIN LEARNS MATH. This pre-school program for kids ages 4 to 7
combines education and entertainment with the popular book character "Franklin"
developed by Kids Can Press Ltd. The program uses endearing characters and
animation, and a curriculum-based approach to teach important learning skills,
including pattern and number recognition, telling time, counting, addition, and
subtraction.

         FRANKLIN'S ACTIVITY CENTER. This fun-filled program for kids ages 4 to
9 finds Franklin the Turtle in his room on a rainy day. There are 11 fun things
to do including jigsaw puzzles, matching games, card playing, and coloring.
There are even costumes in which to dress Franklin and greeting cards to create
and print out.

         FRANKLIN'S READING WORLD. This pre-reading program for kids ages 4 to
7, combines education and entertainment. This program uses endearing characters,
animation and a curriculum-based approach to teach important language skills
including reading comprehension, vocabulary and spelling. Words are always
spoken aloud and shown on the screen simultaneously, so children not only hear
but see words and their parts.

         BUILD-A-BOOK WITH ROBERTO. Developed in connection with C-TREC (the
Children's Television Resource and Education Center), this ground-breaking
program for children ages 3 to 7 focuses on social development issues. Children
create an interactive storybook about Roberto the Hippo trying to join in a game
with his friends. Other activities include an offline coloring book, emotion
masks and puppets, dance-alongs and sing-alongs, and a sizable Parent Module
that covers the different approaches to social learning.

BACK LIST CD-ROM PRODUCTS

         The Company also continues to sell many of its older award winning
titles. These titles are no longer sold into the consumer retail channel, but
are distributed as teacher's editions and "site-licenses" to schools


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and teachers throughout the United States and Canada. These titles include 
SITTING ON THE FARM, THE CAT CAME BACK, ADDISON-WESLEY'S REAL WORLD MATH, BIT 
BOT'S MATH VOYAGE and HOW DO YOU SPELL ADVENTURE.

         SNOOTZ MATH TREK. Children ages 7 to 10 join the Snootz from outer
space on a math discovery adventure. Activities are designed to teach important
concepts basic to math, such as navigation, order of operations, patterns, data
collection, process of elimination, and other similar concepts. The program
includes suggestions for a large number of offline activities that build on
topics covered in the program.

         BUMPTZ SCIENCE CARNIVAL. Children ages 6 to 10 explore the world of
science as they navigate the Great Galaxies amusement park to help the Bumptz
family repair their spaceship. Creative tools including the Bubblearium,
Magnet-O-Whirl, and Photon-O-Tron, contain hundreds of puzzles that address
buoyancy, light properties, and magnetic forces.

         MATH ACE GRAND PRIX. Eight levels of game play allow kids ages 8 to 16
practice math concepts essential to their grade level. Topics covered range from
basic addition and subtraction up through basic calculus. Arcade-style graphics
provide set the stage for over 8,000 mathematical word and number problems. A
tutorial section provides extra information when kids are learning new concepts.

         WORD CITY GRAND PRIX. This program covers 7 essential language arts
skills, from alphabetization to parts of speech and allows kids, ages 7 to 14,
to enter and practice their own spelling words or create a custom dictionary.
With fast-paced arcade-style games and 3D-style graphics, learning becomes fun,
especially when kids get to drive in a Grand Prix race.

PRODUCT DEVELOPMENT

         The Company has an internal product development team of producers,
artists, programmers and engineers. Depending on the complexity of the CD-ROM
software program and the particular platform, the development time per software
program is typically 4 to 9 months.The development of Website enabling
technologies require approximately 4 to 6 months with a testing cycle. The
actual development of Websites requires a much shorter timeline given the
existence of core enabling game engines and other related Web technologies.

         During fiscal 1998, fiscal 1997 and fiscal 1996, respectively, the
Company spent $1,270,000, excluding the immediate charge for in-process R&D from
the Theatrix merger of $2,036,000,$1,395,000 and $4,496,000, respectively, on
product development.

         The Company's strategy is to develop curriculum-based educational
software using professional sports themes and popular cartoon characters. The
Company licenses the use of names, logos and other property of professional
sports teams, including football and baseball, from the NFL, Major League
Baseball and other sports associations. The Company also licenses the use of
popular cartoon characters, such as Franklin the Turtle, or develops them
jointly with others. The Company has an arrangement with the Juilliard
Conservatory to develop and publish products that teach children how to play and
understand music. In addition, the Company has an arrangement with the C-TREC,
The Children's Television Resource and Education Center to develop early
learning products based on cartoon characters of C-TREC; the first of which is
"Build a Book by Roberto" a socialization tool for young children.

         The Company's license agreements require it to pay advances and
royalties to the licensor. Royalty obligations for products licensed under these
agreements are primarily based on (i) a percentage of the Company's net revenues
for the product, (ii) a fixed amount per unit of sales, or (iii) a percentage of
net


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revenue less the licensor's contribution to the finished product. The Company 
is required to pay royalties within certain time periods and comply with 
various other requirements in its license agreements.

         The Company is currently in default under many of these license
agreements for the failure to pay royalties required. Kids Can Press LTD. has
terminated the license agreement relating to Franklin the Turtle due to the
Company's failure to pay royalties due under that license agreement. As a result
of the termination of the Kids Can Press LTD license agreement the Company will
lose the right to distribute its Franklin the Turtle products as of December 31,
1998. Although the Company intends to try to renew this license, there can be no
assurance that the Company will have the funds necessary to continue to license
Franklin and the Company could be prohibited from distributing Franklin the
Turtle-related products in the future. Moreover, the Company's failure to pay
royalties in connection with its other license agreements could result in the
termination of such license agreements, and potentially the loss of the right to
distribute certain of the Company's products. Termination of such license
agreements would materially adversely affect the Company's ability to sell
certain of its products, which would materially adversely affect the Company's
financial results.

DISTRIBUTION AND MARKETING

         The Company sells its products through educational dealers and
distributors. In addition, the Company also sells its products directly to
schools and consumers using its own in-house sales force. International sales
are derived from licensing agreements with foreign distributors.

         The Company targets its efforts in the following channels:

          (i)   EDUCATION. The Company sells its products directly to schools 
and teachers and indirectly through educational product dealers.

          (ii)  INTERNATIONAL. The Company has both exclusive and non-exclusive
republishing and distribution relationships in foreign territories.

          (iii) OEM. The Company has relationships with original equipment
manufacturers and software bundlers who bundle the Company's products with their
own hardware or third party software or other products.

          (iv)  DIRECT. The Company has developed and continues to develop its
own direct mail-order distribution system. Product sales are made direct to the
consumer via catalog, targeted mailings, telephone, fax, and through the
Internet.

          (v)   INTERNET. The Company has developed an infrastructure to sell
existing CD-ROM products through a commerce enabled capability and strategic
alliance with an Internet distributor direct to over 900 online stores.

         The Company continued to sell products through this fiscal year into
the consumer retail channel, curtailing such activities toward the end of the
1997 calendar year because of the cost and, moreover, the increased risk of
doing business in this channel. The Company continues to sell a limited amount
of product into the consumer retail channel. However, the Company attempts to
monitor and manage the volume of its sales to distributors and retailers in
order to avoid their overstocking of the Company's products and to limit product
returns and other concessions to distributors.


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         The rate of product returns or price protection could increase if 
general mass merchant retailers become an increasing percentage of the 
Company's business or other changes occur in the Company's distribution 
channels. Recent trends in the distribution of software to mass merchandisers 
may put pressure on the Company's margins and adversely affect the Company's 
financial results. In addition, the Company is still negotiating with several 
major consumer retail distributors regarding the return of the Company's 
products from the consumer retail channel. Subsequently, going forward, the 
Company has decided to focus its efforts on sales directly to educational 
dealers and distributors with tighter controls on return policies. Industry 
standards in the education channel allow for moderation in this area. Because 
of the changes in return policies for the majority of the educational dealers 
and distributors, the Company has reduced its reserves for returns. The 
Company is investigating partnerships for retail sales with the larger 
players in the marketplace that can afford the aggressive return policies and 
standards. Such a partnership will result in a smaller percentage of sales 
revenue reserved for returns with a significant reduction in risk.

         The Company uses reasonable efforts to assess the creditworthiness of
its customers before orders are fulfilled or shipped. If the Company's
assessment of the creditworthiness of its customers receiving products on credit
proves incorrect, the Company could be required to significantly increase bad
debt reserves. There can be no assurance that such write-offs will not occur in
the future or that the amounts written off will not have a material adverse
effect on the Company's business, results of operations and financial condition.
The Company has experienced in the past, and continues to experience,
significant delays in the collection of certain of its accounts receivable. The
existence of overstock circumstances at distributor and retailer warehouses, or
the lack of significant new product releases, may cause delays in collecting
amounts otherwise owed to the Company by distributors or retailers.

         The Company generates brand awareness and demand for its products
through public relations activities, advertising, product reviews, in-store
promotions and national and local trade shows. In addition, the Company devotes
resources and attention to the packaging of its products, which it considers a
major marketing tool. The Company also employs certain full-time technical and
customer support personnel to assist customers in the use of the Company's
products. The Company has substantially cut-back on all of these efforts
recently due to its cash shortfall.

COMPETITION IN THE EDUCATIONAL SOFTWARE MARKET

         The educational software industry is competitive. Among many key
factors affecting the competitiveness of educational software are product design
and content, ease of operation, brand name recognition, access to distribution
channels and retail shelf space, quality and reliability, price and quality of
support service. The Company competes against a large number of other companies
of varying sizes and resources including, Cendant, Inc., The Learning Company,
Inc., the Disney Co., and Headbone, Interactive. In the last several years there
has been a significant consolidation of software publishers. While the Company
believes that its products compete favorably in terms of design and content,
ease of operation, and quality, many of the Company's competitors have
substantially greater financial, technical and marketing resources than the
Company. These companies may also have greater access to established
distribution channels and a larger development budget. The Company lowered its
price levels in 1997 to compete more effectively in a marketplace where prices
have reduced rapidly over the past year. While the Company has made an effort to
improve its competitive position, there can be no assurance that it will be
successful in this regard. The Company may take further price reductions in the
future, as may be warranted by market conditions, product life cycle and sales
levels.


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MANUFACTURING

         The Company contracts with third party vendors for mass production,
packaging and order fulfillment services of its CD-ROM products.

         To the extent that data is supplied from distributors and retailers,
the Company monitors its inventory levels and channel sell-through information
to avoid accumulating excess inventory. Product returns from distributors and
retailers can cause the Company to maintain excess inventory. The Company has
greatly reduced its inventory levels and continues to maintain them through
focused sales strategies, liquidation, and destruction of certain unsalable
inventories.

PROPRIETARY RIGHTS

         The Company regards software that it develops or licenses as
proprietary and relies on a combination of trade secret, trademark and copyright
laws, license agreements and confidentiality agreements to protect its rights in
its products. The Company has one patent application for the scripting language
embedded within the "Hollywood" series. While the Company has developed core
enabling technologies and engines to build much of their existing product line,
including an intelligent 3-D language and scripting engine for development of
new and innovative children's products, much of the technology the Company
currently uses to develop products and websites is not proprietary. There can be
no assurance that the Company's competitors will not independently utilize
commercially available technologies to develop products that are substantially
equivalent or superior to the Company's.

         The Company has registered the trademarks "Sanctuary Woods,"
"Theatrix," "Theatrix Interactive," and the stylized "Theatrix" logo in the
United States for the promotion of goods and services, computer programming, and
the designing of computer programs. The Company has registered trademarks of
several of its front line titles and applications, including HOLLYWOOD HIGH, BIG
SCIENCE COMICS, MATH HEADS, and BUILD-A-BOOK WITH ROBERTO for use in the United
States for the promotion of goods and services, online activities, and for
educational purposes.

         Applications are on file with the U.S. Patent and Trademark Office for
the "Head Coach" brand and the "Get A Head" brand, as the Company uses and
intends to continue to use these titles for promotional purposes. Furthermore,
the Company is in the process of registering trademarks that are currently in
use for specific valuable characters and applications from JUILLIARD MUSIC
ADVENTURE and BUMPTZ SCIENCE CARNIVAL. The other program titles that the Company
has produced are allowed, and the Company intends to register the marks once
they are in used in connection with specific commercial goods and services.

         The Company owns registered trademarks for several of its titles and is
in the process of readying allowed marks of other titles and applications for
registration in the United States. However, existing trademark laws afford only
limited protection, and the laws of certain countries in which the Company's
products are or may be distributed do not protect applicable intellectual
property rights to the same extent as the laws of the United States or Canada.

         The Company believes that its products do not infringe on the
proprietary rights of any third party. However, as the number of software
products increases and their functionality overlaps, software developers may
become subject to infringement claims. In addition, the Company's products in
certain cases make use of the likenesses of individuals, which are licensed
where believed necessary by the Company. There can be no assurance that third
parties will not assert infringement claims against the Company with respect to
current or future products. In the event an infringement claim is asserted, the
Company may be faced with


                                     -9-
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costly litigation which it cannot currently afford to defend or it may enter 
into license arrangements with the party alleging infringement. There can be 
no assurance that any such licenses will be available to the Company on 
commercially reasonable terms.

EMPLOYEES

         As of September 21, 1998, the Company had 16 full-time employees, one
part-time employee and 2 independent contractors.

         The Company's future success depends in large part on the continued
service of its key technical and senior management personnel and on its ability
to attract, motivate and retain highly qualified employees. Competition for such
employees is intense, and the loss of key personnel could have a material
adverse effect upon the Company's current operations and on new product
development efforts. None of the Company's employees are represented by a
collective bargaining agreement nor has the Company experienced a work stoppage.

ITEM 2.  DESCRIPTION OF PROPERTIES

         The Company leases approximately 7,863 square feet of office space in
Emeryville, California where the Company maintains its principal executive
offices. The Emeryville facility is subject to a lease that expires December 16,
1999. The Company believes that its facilities provide suitable and adequate
production capacity.

ITEM 3. LEGAL PROCEEDINGS

         In September 1997, after the acquisition of Theatrix Interactive, the
Company engaged counsel to develop a program to restructure the Company's debt
and develop a program of voluntary liquidation of debt.

         At the same time, a significant stockholder (the "Stockholder") of 
the Company provided interim financing in the form of a promissory 
convertible debt instrument to facilitate in the restructuring of the Company 
going forward and allow it to continue operations. A debt reconciliation 
program was devised and a creditor's meeting held on November 4, 1997 to 
inform the creditors' of the Company's financial status and intent to settle 
outstanding liabilities.

         Because of the interim financing supplied, the Stockholder secured a
senior position for the assets of the Company and the program was developed to
protect not only the Stockholder's senior position but also that of another
first priority lien holder, Silicon Valley Bank ("SVB"). The Company is
obligated to SVB for its secured revolving line of credit. SVB asserts that it
is due approximately $392,000 under the line of credit, and the last partial
payment made to SVB by the Company was in January 1998.

         In December 1997, approximately 61 of the Company's trade creditors 
with claims for an aggregate of $491,000 entered into a settlement with the 
Company pursuant to which the Company agreed to pay $0.15 for every dollar it 
owed to the trade creditors in full and complete satisfaction of the 
Company's obligations to them. This resulted in a net gain for forgiveness of 
debt of $356,000 in fiscal 1998. Subject to available capital, the Company 
expects to continue its program of debt restructuring and voluntary 
liquidation of debt for many of the current liabilities which were 
outstanding at March 31, 1998 in the aggregate of $5,074,000.

                                     -10-
<PAGE>

         The Company was only able to reconcile a portion of the debt under this
program and as a result, is a party to various claims, threatened litigation and
judgements, as outlined below. It is possible that any of these claims could
cause the Company to become insolvent and seek bankruptcy protection. However,
for the most part, counsel and the Company have been able to continue to work
with the majority of the creditors as the Company continues to rebuild its
operations.

PENDING LITIGATION.

         The Company is a party to a legal claim for alleged failure to pay
invoices of Bowne of Los Angeles, Inc. Bowne filed a complaint in the Alameda
County Court on February 18, 1998 seeking approximately $75,000 from the Company
in this matter. A trial for this suit has been set for December 1998.

         The Company is a party to a legal claim for distribution, inventory in
the channel and marketing expenses brought by Navarre Corporation in the State
of Minnesota, County of Hennepin. Navarre is seeking damages in excess of
$450,000. The Company and Navarre reached a settlement and release agreement
that required the Company to pay the sum of $37,500 by August 15, 1998, which it
failed to do because of lack of funds. The Company believes that Navarre is
likely to go back to Minnesota Court to seek a judgement of up to $460,000.

THREATENED LITIGATION AND/OR ADVERSE judgementS.

         Threatened litigation and/or judgements against the Company fall 
broadly into the following categories. All of the below described judgement 
amounts have been accrued for in the Company's financial statements as of 
March 31, 1998.

         DISTRIBUTORS. Certain companies have been involved in the distribution
of the Company's products into the retail consumer channel. Because of economic
challenges, the Company no longer distributes into this channel and the
distributors listed below may bring claims against the Company for outstanding
inventory, marketing and promotional funds resulting from these activities in
prior years:

                  The Company was a party to a legal claim for an amount owed to
         a software distributor. The plaintiff obtained a judgement against the
         Company in July 1998 for a total of $59,200.33 in principal, interest
         and fees plus 10% interest per annum. Discussions are ongoing for
         settlement by counsel.

                  The Company has received notice of an action filed against it
         in June 1998 regarding distribution of the Company's products. The
         plaintiff is seeking approximately $56,648.23 plus 10% interest per
         annum, and obtained a default judgement in September 1998, but no
         damages were specified or awarded at that timed

                  The Company was a party to a legal claim for trade debt
         associated with the distribution of the Company's products. The
         plaintiff in the matter obtained a judgement in April 1998 for the
         amount of $51,833.94.

         EQUIPMENT LEASING COMPANIES. The Company had several major equipment
leases. Legal action has been taken by one company as follows:

                  The Company was a party to a legal claim of an alleged breach
         of an equipment lease. The lessor of the equipment obtained a judgement
         against the Company for approximately $26,294.19 in February 1998.


                                     -11-
<PAGE>

         SERVICE PROVIDERS. A variety of service providers that did not receive
settlement by the Company in December 1997 have taken action as follows:

                  The Company was a party to a legal claim for breach of
         contract with an employment placement agency. The plaintiff obtained a
         judgement against the Company for approximately $25,540 plus interest
         and attorneys' fees. The plaintiff has attempted to collect payment by
         levying on certain of the Company's bank accounts. Most, if not all, of
         the judgement remains outstanding.

                  The Company was a party to a legal claim for services
         provided. The plaintiff in the matter obtained judgement for $74,469.66
         plus interest 1997. The plaintiff has tried to levy various assets of
         the Company without success.

                  The Company was a party to a legal claim based on an alleged
         breach of a consulting agreement in 1997. The plaintiff in the matter
         obtained a default judgement in this matter for approximately $6,935
         plus interest of $1.89 per annum and subsequently levied against
         certain bank accounts of the Company in 1998. It is believed that a
         substantial portion of the default judgement may have been satisfied
         through such levies.

         PERSONNEL. The Company has a personnel dispute with the prior CEO and
CFO of Theatrix Interactive, Incorporated.

         The Company has been a party to a legal claim for severance payment and
vacation accrued. The plaintiffs have obtained judgements for a total of
$138,469.62 in January 1998. It is believed that attempts to levy the Company's
assets have been unsuccessful to date.

         In addition, there are a number of matters in which litigation has 
been threatened against the Company. The matters involve approximately 47 
parties for claims ranging from $258.84 to $600,000 and have been accrued for 
in the Company's financial statements.

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

         There were no matters submitted to a vote of security holders during
the fourth fiscal quarter of the fiscal year ended March 31, 1998.

                                     PART II

ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

         The Company's common stock was traded in the United States on the
Nasdaq National Market system until July 2, 1996 when it was delisted for
failing to maintain the minimum criteria for inclusion on such exchange. Since
that date, the Company's Common Stock has traded over-the-counter under the
symbol "SWMC." The following information was obtained in part from Nasdaq and in
part from Stocksite and reflects inter-dealer prices, without mark-up, mark-down
or commission and may not represent actual transactions.


                                     -12-
<PAGE>

                         OTC ELECTRONIC BULLETIN BOARD
<TABLE>
<CAPTION>
                                                                QUARTER ENDED
                                      ---------------- ---------------- ---------------- -------------
                                      June 30          September 30     December 31      March 31
                                      ---------------- ---------------- ---------------- -------------
<S>                                  <C>              <C>              <C>              <C>
FISCAL YEAR ENDED MARCH 31, 1998
                                      
High                                  3.12500          2.12500          0.37500          0.32000
Low                                   0.03125          0.18750          0.03125          0.0400
                                      
FISCAL YEAR ENDED MARCH 31,1997
                                      
High                                  1.56250          0.68000          0.55000          0.25000
Low                                   0.56250          .12500           0.14000          0.03125

</TABLE>

DIVIDEND POLICY


         The Company has not paid cash dividends and has no present plans to do
so. The Company has a negative covenant prohibiting dividends under the terms of
one of the Company's current loan agreements. There were approximately 444
shareholders of record on September 21, 1998, excluding stockholders whose stock
is held in nominee or street name by brokers.

RECENT SALES OF UNREGISTERED SECURITIES

         None.

ITEM 6. SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
                                                            Transition
                                                              Period
                           Year Ended       Year Ended         Ended         Year Ended      Year Ended       Year Ended
                           3/31/98(3)         3/31/97          3/31/96       12/31/95(1)    12/31/94(2)         12/31/93
<S>                      <C>              <C>              <C>            <C>              <C>             <C>
Revenues, net               $2,010,000      $4,749,000         $937,000     $10,981,000      $ 6,261,000      $1,425,000
Cost of sales                1,487,000       1,513,000          924,000      12,576,000        3,057,000         994,000
Gross margin
(deficit)                      523,000       3,236,000           13,000      (1,595,000)       3,204,000         431,000
Operating loss             (15,765,000)     (4,071,000)      (4,445,000)    (18,685,000)      (8,028,000)     (4,436,000)
Net loss                   (16,579,000)     (3,677,000)      (4,514,000)    (18,698,000)      (7,404,000)     (4,222,000)
Basic and diluted
loss per share                   (4.15)          (3.30)           (4.97)         (22.16)          (10.58)          (9.15)
Number of shares
used in computation          3,995,471       1,113,145          907,904         843,687          699,684         461,571
Working capital
(deficit)                  $(4,604,000)      $(966,000)     $(6,299,000)    $(2,315,000)     $ 6,364,000        $649,000
Total Assets                   691,000       2,286,000        4,594,000       6,599,000       12,849,000       4,239,000
Current liabilities          5,074,000       2,532,000        8,914,000       6,355,000        2,096,000         670,000
Long-term obligations          869,000       5,302,000          548,000         601,000          770,000         970,000
Shareholders' equity
(deficit)                   (5,252,000)     (5,548,000)      (4,868,000)       (357,000)       9,984,000       2,599,000
</TABLE>

(1)       See "Management Discussion and Analysis of Financial Condition and
          Results of Operations" for a discussion of significant and material
          1995 charges.


                                     -13-
<PAGE>

(2)       Reflects acquisition of Magic Quest, Inc., effective June 30, 1994,
          and resultant write-off of $1,035,000 of purchased in-process research
          and development.

(3)       Reflects acquisition of Theatrix, effective August 12, 1997, and 
          resultant write-off of $2,036,000 of purchased in-process research 
          and development.


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        OF OPERATIONS

OVERVIEW

         The Company is engaged in the development, publication and sale of
interactive multimedia educational software products for the home and education
markets.

         The Company sells its products in North America through educational
dealers and distributors as well as directly to schools. In addition, the
Company distributes products on a limited basis in the consumer retail channel.
International product sales occur through license agreements with foreign
distributors and re-publishers.

         During the last few years the Company has been through a period of
dramatic restructuring and repositioning. In fiscal 1997, management
discontinued the development of home entertainment products and narrowed the
Company's focus to the development of children's educational software products
and of youth oriented Web sites for the NFL and Major League Baseball on a
contract basis.

         In fiscal 1996 and 1997, the Company took various steps to restructure
its operations, including changing the Company's year-end from December 31 to
March 31. Personnel changes included the installation of new senior management
and a substantial reduction of headcount from 148 employees as of December 31,
1995 to 32 employees at March 31, 1997. Operational changes included the closing
of the Publisher Services division, the sale of the majority of the fixed assets
of the Entertainment division, and elimination of the Company's outstanding debt
at that time, and the cancellation of the performance shares in March 1997 (see
note 17 to the financial statements).

         During fiscal 1998, the Company changed its jurisdiction of
incorporation from British Columbia, Canada to Delaware, U.S.A., effected a
one-for-twenty share consolidation of its outstanding Common Stock, exchanged
$5,302,000 in outstanding convertible debentures for Series A Preferred Stock
and warrants and raised $2,157,000 in a rights offering.

         In August 1997, in an attempt to increase market share for its 
products, the Company acquired Theatrix Interactive, Inc., in exchange for 
3,089,203 shares of its Common Stock. The aggregate purchase price of 
Theatrix was $9,271,000. This included recognition of goodwill of $8,142,000 
and in-process research and development of $2,036,000 as well as the assets 
and liabilities of Theatrix, net of the transaction costs for the merger. The 
in-process research and development expenses were charged to income 
immediately in accordance with generally accepted accounting principles.

         In addition, the reliance on the retail distribution channel by both
companies resulted in major financial problems for the newly-formed entity. Many
of the Company's large distributors and consumer-channel retailers of both the
Company's and Theatrix' products returned excess inventory for credit. However,
in order to gain shelf space in the popular consumer retail channels the Company
had to continue to issue promotional credits based on the original orders placed
by its distributors, and some customer balances remain outstanding.


                                     -14-
<PAGE>

         By September 1997, the Company was under extreme financial and 
operational constraints. Extensive employee changes and the complicated 
merger of Sanctuary Woods' and Theatrix operating systems, as well as 
limited capital resources, prohibited the Company from paying its debts and 
operating expenses. During this period, Michelle Kraus, a software industry 
expert, became the Company's Chief Executive Officer.

         In September 1997, the Company retained counsel and adopted a formal 
plan of voluntary liquidation of debt. Under this plan, approximately 61 of 
the Company's trade creditors with claims for an aggregate of $491,000 
entered into a settlement with the Company pursuant to which the Company 
agreed to pay $0.15 for every dollar it owed to the trade creditors in full 
and complete satisfaction of the Company's obligations to them. This resulted 
in a net gain for forgiveness of debt of $356,000 in fiscal 1998. Subject to 
available capital, the Company expects to continue its program of debt 
restructuring and voluntary liquidation of debt for many of the current 
liabilities which were outstanding at March 31, 1998 in the aggregate of 
$5,074,000 (see Litigation section), but it is possible that the creditors 
could force the Company to initiate insolvency proceedings.

         As a result of the impairment to the capital of the business, goodwill
of $8,142,000 which was initially capitalized as a part of the purchase price of
Theatrix, was written off in fiscal 1998 and accounts for a significant portion
of the fiscal 1998 loss.

         In the third quarter of fiscal 1998, the Company continued to 
restructure its operations, and was able to secure $869,000 in debt financing 
from Dawson-Samberg Capital Management, Inc. ("DSCM"), a significant 
stockholder of the Company, in convertible promissory notes which include 
warrants to purchase 869,000 shares at an exercise price of $0.15 per share. 
Notwithstanding this one-time financing, the Company's capital situation 
remains unstable, and the Company has not paid its creditors on a timely 
basis.

         As a result of the Company's financial situation, the Company failed to
comply with its periodic reporting obligations under the Exchange Act. In July
1998 the Securities and Exchange Commission notified the Company that it must
correct its non-compliance with the periodic reporting obligations under the
Securities Exchange Act of 1934, as amended. Because of the Company's financial
condition, the Company had been unable to hire auditors and other professionals
necessary to prepare and file the requisite reports. The Company is currently
working to file the delinquent reports by mid October 1998. In order to
facilitate this reporting process, DCSM has agreed to lend to the Company, on a
secured note, certain amounts necessary to pay the costs of professionals and
other service organizations necessary to complete the reporting process.

         During this period the Company's accounting controls were adversely 
affected by the Company's difficult financial position, staff turnover and 
reductions, and the significant volume of returns and promotional credits 
from the retail distribution channel and related events. As a result, during 
the audit of the Company's financial statements for the fiscal year ended 
March 31, 1998, the Company's independent accountants, PricewaterhouseCoopers 
LLP, determined that the Company's existing accounting systems have certain 
material weaknesses, including deficiencies in its internal controls. 
PricewaterhouseCoopers LLP has informed management that a letter of material 
weakness in accounting internal controls will be issued to the Company. 
Management is aware of the accounting control issues and believes that with 
proper staffing the Company will be able to address this issue in the near 
future. However, there can be no assurance that the Company will be able to 
obtain additional financing and will be able to address its accounting 
control issues in the future.

                                     -15-
<PAGE>

RESULTS OF OPERATIONS

         Effective April 1, 1996, the Company changed its fiscal year from
December 31 to March 31. For comparison purposes, results for the year ended
March 31, 1997 are being compared with results for the year ended December 31,
1995. The Company has not recast the prior year's information presented herein
to conform to the new fiscal year end.

NET LOSS

         For the fiscal year ended March 31, 1998, the Company incurred a net
loss of $16,579,000 and an operating loss of $15,765,000. For the fiscal year
ended March 31, 1997, the Company incurred a net loss of $3,677,000 and an
operating loss of $4,071,000. The increases in net operating loss of $11,694,000
is primarily due to the following items:

<TABLE>
   <S>                                                        <C>
    Write-off of Goodwill                                      $ 8,142,000
    Charge for Theatrix In-Process Research and Development      2,036,000

    Lower Gross Margin due to lower Revenues                     1,866,000
    Increase in Provision for Unsalable Inventory                  397,000
    Gain on Forgiveness of debt, net                              (356,000)
                                                               -----------
    Total                                                      $12,085,000
                                                               -----------
                                                               -----------
</TABLE>

         For the fiscal year ended March 31, 1997, the Company incurred a net
loss of $3,677,000 and an operating loss of $4,071,000, which was an 
improvement over the twelve months ended December 31, 1995 of $15,021,000 and 
$14,614,000, respectively.

         The net loss for fiscal year 1997 included the following:

         - bad debt losses of $329,000 partly related to bankruptcy filings by
two of the Company's significant customers.

         - interest expense totaling $225,000 related to the September 1996
issuance of convertible debentures. Pursuant to the conversion of the debentures
into Series A Preferred Stock in April 1997 and the issuance of additional
warrants to purchase common stock, the debenture holders have forgiven the
accrued interest.

         - expenses of approximately $390,000 related to the Company's
domestication into the State of Delaware from British Columbia, Canada, a
reverse stock split, conversion of subordinated debentures and related SEC
filings (see recent developments) in April 1997.

         - expenses of approximately $420,000 related to facility consolidation
including operating expenses form the Victoria studio up to its sale in May 1996
and costs related to the closure of the Toronto studio.

          In the fourth quarter of 1995, the Company's management increased 
reserves for inventory and wrote off prepaid and deferred royalties and 
licenses and other intangibles for an aggregate of $11,004,000 (see note 18 
of the financial statements). This increase did not reoccur in 1997 and was 
the primary reason for the variance in operating and net income between 
fiscal years 1995 and 1997.

NET REVENUES

         Net Revenues in 1998 were $2,010,000, a decrease of 57.7% from the 
prior fiscal year's net revenues of $4,749,000. The reduction in revenues was 
primarily due to lower sales in connection with the Company's decision to 
focus on sales of educational software programs and shift out of the retail 
market as well as the volume of returns from retail distributors and 
promotional credits given by the Company resulting from, and which was 
exacerbated by, the collapse of the software market during this period. Sales 
to Company's customer Scholastic represented 10.3% of net revenues. Revenue 
from website

                                     -16-
<PAGE>

development and maintenance was not material in fiscal 1998 or 1997.

         Net revenues in fiscal 1997 included approximately $950,000 from the 
sale of publication rights to certain entertainment titles. Sales to two of 
the Company's customers, Eidos Interactive and Navarre Corporation, 
represented 18% and 16% of net revenues, respectively. Net revenues in fiscal 
1997 decreased substantially from net revenues of $10,981,000 in 1995 in part 
due to the fact that in fiscal 1997 the Company discontinued its 
entertainment product line, which accounted for 60% of net revenues in 1995.

         The Company intends to develop its internet Web site, WWW.THEATRIX.COM,
as an alternative distribution channel to increase sales. There is no assurance,
however, that the Company will be successful in developing its Web site as a
distribution channel, or that the Web site will generate significant sales. In
addition, retailers of the Company's products typically have a limited amount of
shelf space and promotional resources, and there is intense competition for high
quality and adequate levels of shelf space and promotional support from
retailers. Industry practice and competitive pressures generally require the
Company to accept returns of unsold product from wholesale distributors and
retailers. Alternatively, the Company may choose to reduce the price of
previously shipped products to encourage retailers to maintain the products on
the retailers' shelves. This competition has caused a downward pressure on the
prices of the Company's products and an adverse effect on the Company's gross
margins. The Company believes that competition for shelf space will become more
intense in the future and that the downward pressure on the Company's prices
will continue.

COST OF SALES

         Cost of sales in fiscal 1998 was $1,487,000 or 74.0% of net revenues 
as compared to $1,513,000 or 31.9% of net revenues in fiscal 1997. Actual 
cost of sales decreased in fiscal 1998 by $26,000 or 1.7% due primarily to 
lower revenues as a result of the Company's focus on its educational product 
lines and the retail channel returns and promotional credits.

         Gross margin in fiscal 1998 was $523,000 or 26.0% of net revenues as 
compared to $3,236,000 or 68.1% of net revenues in fiscal 1997, which was a 
decrease of $2,713,000. As a result of the lower revenues, the gross margin 
was negatively impacted by $1,866,000. Gross margin was also negatively 
affected by the increase in the provision for unsalable inventory as a result 
of the excessive units received from the retail channel returns and their 
related costs of freight and processing.

         Cost of sales in 1995 were $12,576,000. Cost of sales decreased in 
fiscal 1997 due in part to lower sales as a result of the Company's focus on 
its educational product lines. In addition, cost of sales were unusually high 
in 1995. In the fourth quarter of 1995 the Company experienced an unusually 
high rate of return for products sold primarily in the third quarter of 1995. 
As a result, the Company reserved $5.5 million for returns and price 
protection, took a charge of $4.3 million for unrecoverable royalty advances, 
and a charge of $1.0 million for obsolete, slow-moving, and non-salable 
inventory.

OPERATING EXPENSES

         RESEARCH AND DEVELOPMENT. Research and development expenses, 
exclusive of a one time charge in fiscal 1998 for the acquired Theatrix 
in-process research and development of $2,036,000, were $1,270,000 in fiscal 
1998 or 63.2% of net revenues as compared to $1,395,000 or 29.4% of net 
revenues in fiscal 1997. Although

                                     -17-
<PAGE>

research and development expenses in fiscal 1998 decreased in dollars by 
$125,000, research and development expenses increased as a percentage of 
revenues in fiscal 1998 as compared to fiscal 1997 primarily as a result of 
the significant decrease in net revenues in fiscal 1998 as compared to fiscal 
1997. In the last quarter of fiscal 1998, the Company ceased its development 
efforts on new products, which resulted in lower research and development 
expenses in fiscal 1998. As of fiscal year-end the Company had 7 people in 
its development staff working primarily on Web site activities and developing 
derivative products.

         Research and development expenses were $4,496,000, or 40.9% of net 
revenues in 1995. Research and development expenses decreased in fiscal 1997 
primarily due to a reduction in headcount and the sale of the Company's 
Victoria, British Columbia studio associated with the narrowing of the 
Company's focus solely on education products.

         MARKETING & SALES. Marketing and sales expenses were $2,863,000 in 
fiscal 1998 or 142.4% of net revenues as compared to $3,061,000 in fiscal 
1997, or 64.5% of revenues. The Company's sales and marketing expenses 
increased as a percentage of revenue primarily as a result of the increase in 
promotional and product credits that the Company was required to pay to its 
distributors in the retail channel. The Company took action to substantially 
reduce its marketing and sales expenses in fiscal 1998, and the majority of 
these reductions took effect during the latter half of fiscal 1998.

         Marketing and sales expenses were $8,264,000, or 75.2% of net 
revenues, in 1995. The reduction in marketing and sales expenses in 
fiscal 1997 both in actual expense and as a percentage of revenue was 
primarily due to the Company's lack of resources to fund advertising and 
promotional activities and reduced headcount associated with the narrowing of 
the Company's focus solely on educational products.

         ADMINISTRATION. Administrative expenses were $1,977,000, or 98.4% of 
net revenues, in fiscal 1998 as compared to $2,851,000, or 60.0% of net 
revenues in fiscal 1997, representing a decline in these expenses of $874,000 
or 30.7% due primarily to reduction of operating expenses related to the 
downsizing of the Company's operating structure.

         Administrative expenses were $4,330,000, or 39.4% of net revenues in 
1995. Although actual administrative expenses decreased in fiscal 1997 
primarily as a result of the Company's reduced headcount, administrative 
expenses as a percentage of net revenue increased primarily due to 
nonrecurring expenses incurred by the Company in connection with the 
Company's domestication into the State of Delaware and in connection with the 
bankruptcy of two of the Company's distributors.

         OTHER INCOME. Total Other Income was a loss in fiscal 1998 of 
$814,000 versus a gain of $394,000 in fiscal 1997. The principal change in 
these accounts was the gain in fiscal 1997 on the sale and disposal of assets 
of $800,000 as opposed to the loss in fiscal 1998 of $1,080,000, which was 
due principally to the cancellation of equipment leases and reductions of 
fixed assets in accordance with the headcount reductions within the period. 
Net Interest expense was lower by $311,000 between fiscal 1998 and 1997 due 
the conversion of the subordinate debentures into common stock.

         In addition, the Company realized a net gain from the forgiveness of
debt from its aggressive program of debt restructuring of $356,000 in fiscal
1998.

         Total Other Income was a gain in fiscal 1997 of $394,000 as opposed 
to a loss of $13,000 in 1995. The issuance in fiscal 1997 of debentures and 
their related interest expense of $401,000, offset by the net gain on the 
1997 sale of the Company's studio in Victoria, British Columbia, Canada, of 
$897,000, accounts for the primary difference between these periods.

LIQUIDITY AND CAPITAL RESOURCES


                                     -18-
<PAGE>

         The Company has had operating losses in each fiscal year since its
inception and as of March 31, 1998, had an accumulated deficit of $56,130,000
and total stockholders deficit of $5,252,000.

         Operating activities in fiscal 1998 used $3,438,000 in cash. The 
Company financed its operating activities through the issuance of $869,000 in 
debt and through the Rights Offering in April, 1997 in which the Company 
raised $2,157,000. At March 31, 1998, cash was $21,000.

         The Company has deferred development of new products and is
undercapitalized for its current operations. The Company believes it must
continue spending on the development and acquisition of new products, the
maintenance of adequate personnel, and on distribution, sales and marketing
efforts in order to operate its business. It appears that the Company's current
revenues are not sufficient to cover these expenditures and the Company will
likely experience ongoing losses and require additional capital infusions. The
Company is currently investigating its alternatives for its financial resources
as discussed below.

YEAR 2000 COMPLIANCE

         The Company believes that if the Company were to experience any Year 
2000 problems, they would occur as a result of problems associated with the 
Company's software products, problems arising with its internal information 
technology systems or problems experienced by its third party distributors' 
reporting systems. The Company's products consist of educational software 
programs that typically do not rely upon dates for their operation. 
Accordingly, the Company believes that its products are Year 2000 compliant. 
Finally, with respect to the Company's internal information technology 
systems, the Company relies primarily upon prepackaged shrinkwrap software 
products that the Company believes are either currently Year 2000 compliant 
or will be Year 2000 compliant in the near future. With respect to the 
Company's third-party distributors, the Company has not undertaken any 
assessment of whether these third-party distributors may be adversely 
affected by any Year 2000 problems. The Company currently does not believe 
that the distributors of its products will be materially adversely affected 
by the Year 2000.

         The Company could in the event of a Year 2000 problem with its 
vendors, suppliers or distributors utilize alternative sources of 
manufacturing, supply and/or distribution. The Company believes there are 
adequate alternative sources available within the software and other related 
industries.

         Should Year 2000 issues arise with the Company's internal 
information technology systems, the Company should be able to rely on the 
provision of third party software upgrades for accounting, operations and 
other related internal operational procedures. If such third party software 
upgrades are not available for the current internal systems, then the Company 
may incur the cost of switching vendors and replacing internal software 
systems with Year 2000 compliant vendors.

         Although the Company has not undertaken a comprehensive assessment 
of the potential risks and exposures of the Company which may occur as a 
result of the Year 2000 problem, the Company plans to begin more thoroughly 
and systematically assessing its exposure. As a result, the potential costs 
to address the Company's Year 2000 issues are unknown. However, the Company 
believes that such costs will not be material. There can be no assurance that 
the Company will have the resources to complete a satisfactory review of 
potential Year 2000 risks in the near future or at all in light of the 
Company's financial condition and level of staffing. Any Year 2000 compliance 
problem experienced by the Company, its strategic partners, its customers or 
the Internet infrastructure could result in a material adverse effect on the 
Company's future operating performance. See "Risk factors--Year 2000 
Compliance."

CURRENT STATUS AND MANAGEMENT'S PLANS; GOING CONCERN UNCERTAINTY

         CALENDAR 1996 OPERATIONS

         Beginning in 1996, the Company commenced the reorganization of its
operations. A major part of that reorganization involved ceasing publication of
new entertainment titles and eliminating the Publisher Services Division. Costs
incurred from reorganization, including severance, site closure and
consolidation, significantly contributed to the net loss in the three months
ended March 31, 1996. Additionally, there were charges taken against accounts
receivable and inventories. These charges (mostly for entertainment titles)
resulted from a review of product inventories in the distribution channel and
the price relief required to sell them through to the consumer and an evaluation
of the salability of inventories on hand. The amount of these expenses included
the following:

<TABLE>
<CAPTION>
<S>                                                                <C>

               Closure of Publisher Services Division              $  437,000
               Severance expenses                                     210,000
               Consolidation of facilities and related items          358,000
               Estimated sales returns and price protection           426,000
               Provision for inventory obsolescence                   250,000
                                                                   ----------
               Total                                               $1,681,000
                                                                   ----------
                                                                   ----------
</TABLE>

         Revenues and expenses for the fiscal year ended March 31, 1997 included
the following items related to entertainment operations and products:

<TABLE>
<CAPTION>
<S>                                                                   <C>
      Revenues -
      Sale of rights to certain entertainment products                 $580,000
                                                                       --------
                                                                       --------
      Expenses -
      Victoria studio operating expenses (studio sold in May 1996)     $250,000
      Consolidation of facilities and related items                      48,000
      Estimated sales returns and price protection                      150,000
      Provision for inventory obsolescence                              100,000
                                                                       --------
      Total                                                             548,000
                                                                       --------
                                                                       --------
      Other income - net gain on sale and disposal of assets           $875,000
                                                                       --------
                                                                       --------

</TABLE>

         1996 - 1997  MANAGEMENT ACTIONS

During 1996 and early fiscal 1997, the Company instituted measures to improve 
operations and cash flows. 

                                     -19-
<PAGE>

Specific items accomplished through June 20, 1997 included the following:

- Appointment of a new Chairperson, President and Chief Executive Officer, Vice
President of Marketing and Controller.

- Reduction of head count by approximately 70% from December 31, 1995 levels and
elimination of many part-time, temporary and contract positions.

- Ceasing publication of new entertainment titles.

- Closure of the Publisher Services Division.

- Sale of substantially all of the fixed assets of the Entertainment Division.
This included the sale of the studio in Victoria, British Columbia during May
1996 for $1,900,000, of which $500,000 was used to reduce bank borrowings. The
gain on the sale of the studio, included in other income in the fiscal year
ended March 31, 1997 totaled $897,000.

- Repayment of the Company's bank borrowings which reached a peak of $2,572,000
in January 1996.

- Termination of all software development projects through outside developers.

- Sale in June 1996 of certain entertainment product rights to one of its
licensors in consideration for a $430,000 reduction in royalty obligations. Such
sale was included as licensing revenue in the fiscal year ended March 31, 1997.
The transaction also encompassed the issuance of 8,750 shares of the Company's
common stock in consideration of an additional $120,000 reduction in royalty
obligations.

- Sale of other entertainment product rights (included in licensing revenue) for
$150,000 in the fiscal year ended March 31, 1997.

         1997 - 1998 MANAGEMENT ACTIONS

During fiscal 1997 and early fiscal 1998, the Company instituted measures to 
improve operations and cash flows. Specific items accomplished through 
September 30, 1998, included the following:

-    Acquisition of Theatrix Interactive in August, 1997 to increase the quality
     and volume of products in the Company's revenue pipeline.

-    Integration and consolidation of companies for better efficiencies and
     economies of scale with an overall reduction in operational expenditures,
     including the consolidation of facilities at the Company headquarters in
     Emeryville, CA; consolidation of manufacturing and warehouse facilities;
     reduction of marketing commitments and promotional expenditures; and the
     termination of lease agreements for the Company for other than its
     headquarters facility.

-    Development of Internet work with the National Football League (NFL) to
     begin the Company's work on the Internet for children and sports.

-    Restructuring of sales operations from more than 50% concentration on
     consumer retail sales to less than 20%, with more than 80% redirected
     toward the educational channel through catalogue sales.

                                     -20-
<PAGE>

-    Appointment of a new experienced software industry expert as the Chief
     Executive Officer and President in September 1997.

-    Establishment of a new management and operations team.

-    Development of a debt reduction program for the existing liabilities under
     the advice of counsel. Completion of this program requires additional
     capital or debt financing.

-    Settlement of a portion of the Company debt through a Creditor's Meeting
     held in November 21, 1997 paying vendors under this program $.15 on the
     dollar for their trade settlements, for an aggregate settlement of $491,000
     in prior trade debt.

-    Reduction of headcount from the combined entities of the Company and
     Theatrix by approximately 75% from the previous fiscal year.

-    Reduction of R & D expenditures, excluding the $2,036,000 write-down of R&D
     in process from the Theatrix merger, by $125,000 with a shift to more
     profitable Website development.

-    Termination of all software development projects through outside developers
     by December 31, 1997.

         The Company will need to raise significant additional working 
capital through debt or equity financing to sustain its operations and fund 
its fiscal March 31, 1999 operating plan and form strategic relationships 
that may enhance the Company's ability to develop, publish and distribute its 
products. No assurance can be given that additional financing will be 
available or that, if available, such financing will be obtainable on terms 
favorable to the Company.

         The accompanying consolidated financial statements have been prepared
on a going concern basis, which contemplates the realization of assets and
satisfaction of liabilities in the normal course of business. The matters
discussed above, among others, may indicate that the Company will be unable to
continue as a going concern for a reasonable period of time.

         The consolidated financial statements do not include any adjustments
relating to the recoverability and classification of recorded asset amounts or
the amounts and classification of liabilities that might be necessary should the
Company be unable to continue as a going concern. The Company's continuation as
a going concern is dependent upon its ability to generate sufficient cash flow
to meet its obligations on a timely basis, to obtain additional financing or
refinancing, and ultimately to attain successful operations. Management is
continuing its efforts to obtain additional funds so that the Company can meet
its obligations and sustain its operations. There can be no assurance that the
Company will be able to raise additional financing in this time frame on
commercially reasonable terms, or at all. If the Company is unsuccessful in
raising this capital, the Company may be required to cease operations and
declare bankruptcy. Under such circumstances, the Company's secured creditors
would have a first claim on all, or substantially all, of the Company's assets.

         MARCH 1996 FINANCING

         In February and March 1996, the Company privately placed for cash
$1,500,000 principal amount of 10% convertible notes. These notes included
$100,000 principal amount of notes sold to two of the 

                                     -21-
<PAGE>

Company's officers. In June 1996, all of the notes, plus accrued interest, 
were converted into 156,379 shares of common stock, the holders of which have 
certain registration rights. In connection with the issuance of the notes, 
warrants were issued to purchase 93,750 shares of common stock at an exercise 
price of $10.00 per share. In June 1996, certain of the convertible note 
holders exercised, for $750,000 in cash, warrants to purchase 75,000 shares 
of stock. The holders of these shares have certain registration rights.

         8% CONVERTIBLE DEBENTURES

         In September 1996, the Company privately placed for cash $5,302,000 in
8% convertible subordinated debentures due July 31, 1999. The debentures were
convertible into shares of the Company's common stock at the rate of one share
for each $11.00 of principal (482,000 shares) plus accrued interest. In
addition, the Company issued to each purchaser of the debentures a warrant to
purchase one share of common stock for each $40.00 invested or 132,550 shares.
Each warrant was exercisable at a price of $13.75 per share until September 1999
(see note 12 of the financial statements).

         CONVERTIBLE PROMISSORY NOTE FINANCING

         From October through December 1997, the Company engaged in a
convertible promissory financing from its largest shareholder, Dawson-Samberg
Capital Management. The monies were allocated to fund operations and repay debt
settlements under the Creditor's program of November 1997. For this series of
notes, the Company issued 868,858 warrants priced at 15 cents. A permit was
filed with the California Department of Corporations on October 29, 1997 for the
November notes forward allowing for the usage of a higher interest rate. The
subsequent notes were granted at 15% interest.

         In addition, DSCM has filed UCC-1s and has the senior position for 
repayment of debt in the Company.

         See note 11 of the financial statements for related party disclosure.

RISK FACTORS:

RISKS RELATED TO BUSINESS AND OPERATIONS OF SANCTUARY WOODS

         CONTINUED LOSSES; LIQUIDITY. In the three years ended March 31, 
1998, March 31, 1997 and December 31, 1995, the Company reported operating 
losses of $15.8 million, $4.1 million and $18.7 million, respectively, and 
net losses in each of these years of $16.6 million, $3.7 million and $18.7 
million, respectively. There can be no assurances that the Company will cease 
to incur losses in the foreseeable future, if ever. Continued losses have and 
will continue to result in liquidity and cash flow problems which have 
inhibited and will continue to inhibit the Company's ability to develop new 
products. The Company funded its working capital requirements and capital 
expenditures during fiscal 1998 through the issuance of senior secured 
convertible promissory notes to a significant stockholder. See Legal 
Proceedings and Certain Relationships and Related Transactions. Further 
sustained losses will necessitate the infusion of additional capital. The 
Company may seek to raise additional capital through future additional 
financings that if raised through the issuance of equity securities, will 
reduce the percentage ownership of the stockholders of the Company. Existing 
stockholders may experience additional dilution, and securities issued in 
conjunction with new financings may have rights, preferences and privileges 
senior to those of holders of the Company's Common Stock. There can be no 
assurance, however, that additional financing will be available when needed, 
if at all, or on favorable terms. The failure to obtain additional financing 
would have a material adverse affect on the Company and may force the Company 
to seek bankruptcy 

                                     -22-
<PAGE>

protection. See "Management's Discussion and Analysis of Financial Condition 
and Results of Operations - Liquidity and Capital Resources."

         FLUCTUATIONS IN OPERATING RESULTS; SEASONALITY. The Company has 
experienced, and expects to continue to experience, significant fluctuations 
in operating results due to a variety of factors, including the size and rate 
of growth of the consumer and educational software market, market acceptance 
of the Company's products and those of its competitors, development and 
promotional expenses relating to the introduction of new products or new 
versions of existing products, projected and actual changes in computing 
platforms, budgetary constraints of school districts and other education 
providers, the timing and success of product introductions, product returns, 
changes in pricing policies by the Company and its competitors, difficulty in 
securing retail shelf space for the Company's products, the accuracy of 
retailers' forecasts of consumer demand, the timing of orders from major 
customers, order cancellations, and delays in shipment. In addition, the 
Company's business has been in the past and is expected to continue to be 
subject to seasonal fluctuations as a result of the purchasing cycle of 
consumers, school districts, and dealers in educational products. In response 
to competitive pressures, the Company may take certain pricing or marketing 
actions that could materially adversely affect the Company's business, 
operating results and financial condition. The Company may be required to pay 
fees in advance to obtain licenses to intellectual properties from third 
parties. A significant portion of the Company's operating expenses are 
relatively fixed, and planned expenditures are based in part on sales 
forecasts. If net sales do not meet the Company's forecasts, the Company's 
business, operating results and financial condition could be materially 
adversely affected.

         POSSIBLE WRITE-OFFS FROM PRODUCT RETURNS, PRICE PROTECTION; BAD 
DEBTS; COLLECTIONS. The Company recognizes revenue from the sale of its 
products upon shipment to its distributors, retailers, and end users (net of 
an allowance for product returns and price protection), which is in 
accordance with industry practice. There can be no assurance that the 
Company's reserves will be adequate and if the Company's assessment of the 
creditworthiness of its customers receiving products on credit proves 
incorrect, the Company could be required to significantly increase the 
reserves previously established. In addition, the Company has experienced in 
the past, and continues to experience, significant delays in the collection 
of certain of its accounts receivable. Product returns or price protection 
concessions that exceed the Company's reserves, or the failure to collect 
accounts receivable in a timely manner 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.

         IMPACT OF REORGANIZATION OF OPERATIONS. The Company recently 
experienced a period of reorganization -- including moving its jurisdiction of
incorporation from British Columbia, Canada to Delaware, USA, effecting a 
one-for-twenty share consolidation, exchanging outstanding convertible 
debentures for equity and the cancelling of outstanding Performance Shares 
in consideration for Common Stock of the Company -- that has placed, and 
could continue to place a significant strain on the Company's financial, 
management, personnel, and other resources. These changes or other future 
steps to reorganize and reduce expenses could result in the delayed 
introduction of new products, which could have a material adverse effect on 
the Company's financial condition and results of operations.

         COMPETITION. The entertainment software industry is intensely 
competitive and market acceptance for any of the Company's products may be 
adversely affected by competitors introducing similar products with greater 
consumer demand. The Company competes against a large number of other 
companies of varying sizes and resources. Most of the Company's competitors 
have substantially greater financial, technical, and marketing resources, as 
well as greater name recognition and better access to consumers. Existing 
competitors and potential competitors, including large computer 

                                     -23-
<PAGE>

or software manufacturers, entertainment companies, diversified media 
companies, and book publishers may continue to broaden their product lines, 
and may enter or increase their focus on the CD-ROM school and home education 
markets, resulting in increased competition for the Company. Retailers of the 
Company's products typically have a limited amount of shelf space and 
promotional resources; consequently there is intense competition among 
consumer software producers for high quality and adequate levels of shelf 
space and promotional support from retailers. To the extent that the number 
of consumer software products and computer platforms increases, this 
competition for shelf space may intensify. Due to increased competition for 
limited shelf space, retailers and distributors are increasingly in a better 
position to negotiate favorable terms of sale, including price discounts and 
product return policies. Retailers often require software publishers to pay 
fees in exchange for preferred shelf space. There can be no assurance that 
retailers will continue to purchase the Company's products or provide them 
with adequate shelf space. Increased competition could result in loss of 
shelf space for, and reduction in sell-through of, the Company's products at 
retail stores and significant price competition, any of which could adversely 
affect the Company's business, operating results and financial condition. In 
addition, other types of retail outlets and methods of product distribution, 
such as on-line services, may become important in the future, and it may be 
important for the Company to gain access to these channels of distribution. 
There can be no assurance that the Company will gain such access or that the 
Company's access will be on terms favorable to the Company.

         DEPENDENCE ON KEY PERSONNEL; RETENTION OF EXISTING EMPLOYEES; HIRING 
OF NEW EMPLOYEES. The Company's success depends in large part on the 
continued service of its key creative, technical, marketing, sales and 
management personnel and its ability to continue to attract, motivate and 
retain highly qualified employees. Because of the multifaceted nature of 
interactive media, key personnel often require a unique combination of 
creative and technical talents. Such personnel are in short supply, and the 
competition for their services is intense. The process of recruiting key 
creative, technical and management personnel with the requisite combination 
of skills and other attributes necessary to execute the Company's strategy is 
often lengthy. The Company has entered into at-will employment agreements 
with its management and other personnel, who may generally terminate their 
employment at any time. The loss of the services of key personnel or the 
Company's failure to attract additional qualified employees could have a 
material adverse effect on the Company's results of operations and research 
and development efforts. In particular, the Company has recently reorganized 
its operations and has undergone a reduction in force among its employees. 
Such reduction in force, combined with the Company's disappointing operating 
performance, the price of the Company's stock, and the availability of 
substantial alternative employment for talented employees of the Company, may 
result in key employees and managers leaving the Company, which could 
materially adversely impact the Company's ability to develop and sell its 
products. The Company does not have key insurance covering any of its 
personnel.

         DEPENDENCE ON NEW PRODUCT DEVELOPMENT; PRODUCT DELAYS. The success 
of the Company depends on the continuous and timely introduction of 
successful new products. In general, consumer preferences for entertainment 
software products are difficult to predict and are often short-lived. The 
retail life of edutainment software programs has become shorter, and may now 
last only 4 to 12 months (or even less for unsuccessful products), while the 
Company typically requires 6 to 9 months or longer for the development of a 
new edutainment CD-ROM title. In addition, some of the Company's edutainment 
CD-ROM products are seasonal, especially the sports-based products. There can 
be no assurance that new products introduced by the Company will achieve any 
significant market acceptance or that, if such acceptance occurs, it will be 
sustained for any significant period. If the Company does not timely 
introduce new products, or if the Company does not correctly anticipate and 
respond to demand for its products in a timely manner, the Company's 
business, operating results and financial condition will be materially 
adversely affected.

                                     -24-
<PAGE>

         A significant delay in the introduction of, or the presence of a 
defect in, one or more products could have a material adverse affect on the 
Company's business, operating results and financial condition, particularly 
in view of the seasonality of the Company's business and certain of its 
products. Further, delays in a product introduction near the end of a fiscal 
quarter may materially adversely affect operating results for that quarter, 
as initial shipments of a product may move from one quarter to the next and 
may represent a substantial percentage of annual shipments of a product. The 
timing and success of software development is unpredictable due to the 
technological complexity of software products, inherent uncertainty in 
anticipating technological developments, the need for coordinated efforts of 
numerous creative and technical personnel and difficulties in identifying and 
eliminating errors prior to product release. In the past, the Company has 
experienced delays in the introduction of certain new products. There can be 
no assurance that new products will be introduced on schedule or at all or 
that they will achieve market acceptance or generate significant revenues.

         CHANGING PRODUCT PLATFORMS AND FORMATS. The Company's software 
products are intended for use on machines built by other manufacturers. The 
operating systems of machines currently being manufactured are characterized 
by several competing and incompatible formats, or "platforms", and new 
platforms will probably be introduced in the future. The Company must 
continually anticipate the emergence of, and adapt its products to, popular 
platforms for consumer software. When the Company chooses a platform for its 
products, it must commit substantial development time and investment in 
advance of shipments of such products. If the Company invests time developing 
products for a platform that does not achieve significant market penetration, 
the Company's planned revenues from those products will be adversely affected 
and it may not recover its development investment. If the Company does not 
choose to develop for a platform that achieves significant market success, 
the Company's revenues may also be adversely affected. The Company is 
currently developing products only for Windows and other PC-based 
environments, and Macintosh computers. The Company has terminated virtually 
all current development for other platforms, such as CDX, the Sony 
PlayStation and Sega. There can be no assurance that the Company has chosen 
to support platforms that will ultimately be successful.

         CHANGES IN TECHNOLOGY AND INDUSTRY STANDARDS. The edutainment 
software industry is continually undergoing rapid changes, including evolving 
industry standards and the introduction of new technologies, including audio 
and video enhancement technologies such as DVD, MMX and 3D graphic 
accelerators, and operating system upgrades. These evolving industry 
standards and new technologies can render the Company's existing products 
obsolete or unmarketable and may require the Company to expend substantial 
resources to develop products that incorporate technological changes and 
evolving industry standards. There can be no assurance that the Company will 
have the resources necessary to undertake such a development effort, or if 
such development effort is undertaken, that the Company will be successful in 
introducing new products that keep pace with technological changes or 
evolving industry standards, or satisfy evolving consumer preferences. 
Failure to do so would have a material adverse effect on the Company's 
business, operating results and financial condition.

         LIMITED PROTECTION OF INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS; 
RISK OF LITIGATION. The Company regards its software as proprietary and 
relies primarily on a combination of trademark, copyright and trade secret 
laws, and employee and third-party nondisclosure agreements and other methods 
to protect its proprietary rights. However, the Company does not have signed 
license agreements with its end-users and does not include in its products 
any mechanism to prevent or inhibit unauthorized copying. Unauthorized 
parties may copy the Company's products or reverse engineer or otherwise 
obtain and use information that the Company regards as proprietary. 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 materially adversely affected. Further, the laws of certain 
countries in which the Company's products are or may be 

                                     -25-
<PAGE>

distributed do not protect applicable intellectual property rights to the 
same extent as the laws of the United States. In addition, the Company holds 
no patents, and although the Company has developed and continues to develop 
certain proprietary software tools, the copyrights of which are owned by the 
Company, most of the technology used to develop the Company's products is not 
proprietary. There can be no assurance that the Company's competitors will 
not independently utilize existing technologies to develop products that are 
substantially equivalent or superior to the Company's. Also, as the number of 
software products in the industry increases and the functionality of these 
products further overlaps, software developers and publishers may 
increasingly become subject to infringement claims. There can be no assurance 
that third parties will not assert infringement claims against the Company in 
the future with respect to current or future products.

         As is common in the industry, from time to time the Company receives
notices from third parties claiming infringement of intellectual property or
other rights of such parties. The Company investigates these claims and responds
as it deems appropriate. There has been substantial litigation regarding
copyright, trademark and other intellectual property rights involving computer
software companies in general. The Company may also face suits as a result of
employment matters, publicity rights, governmental or regulatory investigations,
or due to claims of breach of the Company's obligations under various agreements
to publish or develop products, or for goods or services provided to the
Company. Adverse determinations in such claims or litigation could have a
material adverse effect on the Company's business, operating results and
financial condition. The Company may find it necessary or desirable in the
future to obtain licenses relating to one or more of its products or relating to
current or future technologies. There can be no assurance that the Company will
be able to obtain these licenses or other rights on commercially reasonable
terms or at all.

         RELATIONSHIPS WITH VENDORS. In the past the Company has experienced
difficulty in paying its vendors. If the Company experiences such difficulty in
the future, it may result in the loss of the availability of the services of
such vendors, which could hamper the Company's ability to manufacture and ship
products, and may ultimately result in the Company being sued for collection of
such amounts as may be owed to such vendors. If the Company is unable to produce
its products to fill orders, the Company's operating results and financial
condition could be materially adversely affected. In the event that suits by
vendors are filed against the Company, the Company may be required to incur
unanticipated legal expenses.

         MARKET FOR COMMON STOCK; STOCK PRICE VOLATILITY. The Company's Common
Stock has traded solely on the over-the-counter bulletin board since March 12,
1997, when the Company's shares were delisted from the Vancouver Stock Exchange
at the Company's request. Shares traded over-the-counter are subject to wide
fluctuations between bid and ask prices. In addition, the Company's Common Stock
is thinly traded. Based upon these factors and historical trends in the market
for other software company stocks, the Company anticipates that the trading
price of its Common Stock may be subject to wide fluctuations in response to
quarterly variations in operating results, changes in actual earnings or in
earnings estimates by analysts, announcements of technological developments by
the Company or its competitors, general market conditions or other events
largely outside the Company's control.

         IMPORTANCE OF INTERNATIONAL SALES. The development of products for
foreign markets requires substantial additional time, effort and expense because
of the large differences among countries' education requirements and cultures.
The Company expects that international sales will continue to represent a
significant percentage of net sales. International sales may be adversely
affected by the imposition of governmental controls, restrictions on export
technology, political instability, trade restrictions, changes in tariffs and
the difficulties associated with staffing and managing international operations,
lack of acceptance of localized products in foreign countries, longer accounts
receivable payment cycles, difficulties in collecting payment, reduced
protection for the Company's intellectual property rights and the burdens of

                                     -26-
<PAGE>

complying with a wide variety of foreign laws. In addition, international sales
may be adversely affected by the economic conditions in each country. There can
be no assurance that the Company will be able to maintain or increase
international market demand for the Company's products or that such factors will
not have a material adverse effect on the Company's future international revenue
and, consequently, the Company's business, operating results and financial
condition.

         The Company's international revenue is currently denominated in a
variety of foreign currencies and the Company does not currently engage in any
hedging activities. Although exposure to currency fluctuations to date has been
insignificant, there can be no assurance that fluctuations in the currency
exchange rates in the future will not have a material adverse effect on the
Company's business, operating results and financial condition.

         YEAR 2000 COMPLIANCE. Many currently installed computer systems and
software products are coded to accept only two-digit entries in the date code
field. Beginning in the year 2000, these date code fields will need to accept
four-digit entries to distinguish 21st century dates from 20th century dates. As
a result, computer systems and/or software used by many companies will need to
be upgraded to comply with such "Year 2000" requirements. Significant
uncertainty exists concerning the potential effects associated with compliance.
The Company has not undertaken a comprehensive assessment of the 
potential risks and exposures of the Company which may occur as a result of 
the Year 2000 problem, the Company plans to begin more thoroughly and 
systematically assessing its exposure. In light of the Company's financial 
condition and level of staffing, there can be no assurance that the Company 
will have the resources to complete a satisfactory review of potential Year 
2000 risks in the near future or at all. Any Year 2000 compliance problem 
experienced by the Company, its strategic partners, its customers or the 
Internet infrastructure could result in a material adverse effect on the 
Company's future operating performance.

ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

          Not Applicable.

ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA


                                      -27-
<PAGE>


                     SANCTUARY WOODS MULTIMEDIA CORPORATION
                          INDEX TO FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                              Page
                                                                              ----
<S>                                                                           <C>
Report of Independent Accountants - PricewaterhouseCoopers LLP.............    F-1

Independent Auditors' Report - Deloitte & Touche LLP.......................    F-2

Consolidated Balance Sheet:
     March 31, 1998 and 1997...............................................    F-4

Consolidated Statement of Operations:
     Years Ended March 31, 1998 and 1997, and December 31, 1995 and
     the Three Month Period Ended March 31, 1996...........................    F-5

Consolidated Statement of Stockholders' Deficit:
     Years Ended March 31, 1998 and 1997, and December 31, 1995 and
     the Three Month Period Ended March 31, 1996...........................    F-6

Consolidated Statement of Cash Flows:
     Years Ended March 31, 1998 and 1997, and December 31, 1995 and
     the Three Month Period Ended March 31, 1996...........................    F-7

Notes to Consolidated Financial Statements.................................    F-8

Consolidated Financial Statement Schedules:

Supplemental Schedule II - Valuation and Qualifying Accounts
     Years Ended March 31, 1998 and 1997, and December 31, 1995 and
     the Three Month Period Ended March 31, 1996...........................   F-23
</TABLE>

<PAGE>

                      REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors
  and Stockholders of Sanctuary Woods Multimedia Corporation

   In our opinion, the accompanying consolidated balance sheet and the 
related consolidated statements of operations, of stockholders' deficit and 
of cash flows present fairly, in all material respects, the financial 
position of Sanctuary Woods Multimedia Corporation and its subsidiaries at 
March 31, 1998 and the results of their operations and their cash flows for 
the year then ended, in conformity with generally accepted accounting 
principles. These financial statements are the responsibility of the 
Company's management; our responsibility is to express an opinion on these 
financial statements based on our audit. We conducted our audit of these 
statements in accordance with generally accepted auditing standards which 
require that we plan and perform the audit to obtain reasonable assurance 
about whether the financial statements are free of material misstatement. An 
audit includes examining, on a test basis, evidence supporting the amounts 
and disclosures in the financial statements, assessing the accounting 
principles used and significant estimates made by management, and evaluating 
the overall financial statement presentation. We believe that our audit 
provides a reasonable basis for the opinion expressed above.

   The accompanying consolidated financial statements have been prepared 
assuming that the Company will continue as a going concern. As discussed in 
Note 2 to the consolidated financial statements, the Company has suffered 
recurring losses from operations and has a net capital deficiency that raises 
substantial doubt about its ability to continue as a going concern. 
Management's plans in regard to these matters are also described in Note 2. 
The consolidated financial statements do not include any adjustments that 
might result from the outcome of this uncertainty.

PRICEWATERHOUSECOOPERS LLP

San Jose, California
September 21, 1998


                                      F-1
<PAGE>

                          INDEPENDENT AUDITORS' REPORT

To the Board of Directors and Stockholders of
  Sanctuary Woods Multimedia Corporation:

   We have audited the accompanying consolidated balance sheets of Sanctuary 
Woods Multimedia Corporation as of March 31, 1997, and the related 
consolidated statements of operations, stockholders' deficit, and cash flows 
for the year ended March 31, 1997, the three-month period ended March 31, 
1996 and the year ended December 31, 1995. Our audits also included the 
consolidated financial statement schedule for the year ended March 31, 1997, 
the three-month period ended March 31, 1996 and the year ended December 31, 
1995 appearing on page F-23. These consolidated financial statements and the 
consolidated financial statement schedule are the responsibility of the 
Company's management. Our responsibility is to express an opinion on these 
consolidated financial statements and the consolidated financial statement 
schedule based on our audits.

   We conducted our audits in accordance with generally accepted auditing 
standards. Those standards require that we plan and perform the audit to 
obtain reasonable assurance whether the financial statements are free of 
material misstatement. An audit includes examining, on a test basis, evidence 
supporting the amounts and disclosures in the financial statements. An audit 
also includes assessing the accounting principles used and significant 
estimates made by management, as well as evaluating the overall financial 
statement presentation. We believe that our audits provide a reasonable basis 
for our opinion.

   In our opinion, the consolidated financial statements referred to above 
present fairly, in all material respects, the financial position of the 
Company as of March 31, 1997, and the results of its operations and its cash 
flows for the year ended March 31, 1997, the three-month period ended March 
31, 1996 and the year ended December 31, 1995 in conformity with generally 
accepted accounting principles. Also, in our opinion, the consolidated 
financial statement schedule referred to above, when considered in relation 
to the basic consolidated financial statements taken as a whole, presents 
fairly, in all material respects, the information set forth therein.

   The accompanying consolidated financial statements have been prepared 
assuming that the Company will continue as a going concern. As discussed in 
Note 2 to the consolidated financial statements, the Company has experienced 
recurring losses from operations, has generated negative cash flows from 
operations and has negative working capital and a stockholders' deficit at 
March 31, 1997. These matters raise substantial doubt about the Company's 
ability to continue as a going concern. Management's plans concerning these 
matters are also described in Note 2. The consolidated financial statements 
do not include any adjustments that might result from the outcome of this 
uncertainty.


                                      F-2
<PAGE>


DELOITTE & TOUCHE LLP

San Francisco, California
June 20, 1997


                                      F-3
<PAGE>

                      SANCTUARY WOODS MULTIMEDIA CORPORATION
                            CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                                MARCH 31,
                                                                    -------------------------------
                                                                         1998              1997
                                                                    ------------       ------------
<S>                                                                 <C>                <C>
ASSETS
Current assets:

  Cash                                                              $     21,000       $    102,000
  Accounts receivable, net                                               190,000            275,000
  Inventories                                                            259,000            656,000
  Prepaid royalties                                                            -            198,000
  Prepaid expenses                                                             -            244,000
  Prepaid offering expenses                                                    -             91,000
                                                                    ------------       ------------
    Total current assets                                                 470,000          1,566,000

Property and equipment, net                                              207,000            462,000
Deferred warrant expense and other                                        14,000            258,000
                                                                    ------------       ------------
    Total assets                                                    $    691,000       $  2,286,000
                                                                    ------------       ------------
LIABILITIES AND STOCKHOLDERS' DEFICIT
Current liabilities:
  Accounts payable                                                  $  2,155,000       $  1,343,000
  Accrued expenses                                                     1,411,000            579,000
  Accrued interest                                                        84,000            225,000
  Royalty obligations                                                    532,000            371,000
  Capital lease obligations                                              500,000             14,000
  Line of credit                                                         392,000                  -
                                                                    ------------       ------------
    Total current liabilities                                          5,074,000          2,532,000

Convertible notes payable                                                869,000                  -
8% convertible subordinated debentures                                         -          5,302,000
                                                                    ------------       ------------
    Total liabilities                                                  5,943,000          7,834,000
                                                                    ------------       ------------
Commitments and contingencies (Notes 1 and 16)

Stockholders' deficit:
  Preferred stock, authorized 5,000,000 shares; $0.001 par value;
    Series A issued and outstanding 99,993 and nil shares
    at March 31, 1998 and 1997, respectively                                   -                  -
  Common stock, authorized 50,000,000 shares; $0.001 par value;
    issued and outstanding 5,193,303 and 1,171,582 shares
    at March 31, 1998 and 1997, respectively                               5,000              1,000
  Additional paid-in capital                                          51,625,000         34,754,000
  Accumulated deficit                                                (56,130,000)       (39,551,000)
  Accumulated translation adjustments                                   (752,000)          (752,000)
                                                                    ------------       ------------
    Total stockholders' deficit                                       (5,252,000)        (5,548,000)
                                                                    ------------       ------------
    Total liabilities and stockholders' deficit                     $    691,000       $  2,286,000
                                                                    ------------       ------------
                                                                    ------------       ------------
</TABLE>

                 See notes to consolidated financial statements.


                                      F-4
<PAGE>

                    SANCTUARY WOODS MULTIMEDIA CORPORATION
                    CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
                                                                              THREE MONTHS
                                                 YEAR ENDED MARCH 31,             ENDED         YEAR ENDED
                                            -----------------------------       MARCH 31,      DECEMBER 31,
                                                1998             1997             1996             1995
                                            ------------      -----------      -----------     ------------
<S>                                         <C>               <C>              <C>             <C>
Net revenues                                $  2,010,000      $ 4,749,000      $   937,000     $ 10,981,000

Cost of revenues                               1,487,000        1,513,000          924,000       12,576,000
                                            ------------      -----------      -----------     ------------

Gross margin (deficit)                           523,000        3,236,000           13,000       (1,595,000)

Operating expenses:
   Research and development                    3,306,000        1,395,000        1,261,000        4,496,000
   Marketing and sales                         2,863,000        3,061,000        1,790,000        8,264,000
   General and administration                  1,977,000        2,851,000        1,407,000        4,330,000
   Write-off of goodwill                       8,142,000                -                -                -
                                            ------------      -----------      -----------     ------------
        Total operating expenses              16,288,000        7,307,000        4,458,000       17,090,000
                                            ------------      -----------      -----------     ------------
Operating loss                               (15,765,000)      (4,071,000)      (4,445,000)     (18,685,000)

Other income (expense):
   Gain on forgiveness of debt, net              356,000                -                -                -
   Foreign exchange loss                               -           (5,000)               -           (4,000)
   Interest expense, net                         (90,000)        (401,000)         (69,000)          (9,000)
   Net gain (loss) on sale and disposal
      of assets                               (1,080,000)         800,000                -                -
                                            ------------      -----------      -----------     ------------
        Total other income (expense)            (814,000)         394,000          (69,000)         (13,000)
                                            ------------      -----------      -----------     ------------

Net loss                                    $(16,579,000)     $(3,677,000)     $(4,514,000)    $(18,698,000)
                                            ------------      -----------      -----------     ------------
                                            ------------      -----------      -----------     ------------

Basic and diluted loss per share            $      (4.15)     $     (3.30)     $     (4.97)    $     (22.16)
                                            ------------      -----------      -----------     ------------
                                            ------------      -----------      -----------     ------------
Shares used in computation of
   basic and diluted loss per share            3,995,471        1,113,145          907,904          843,687
                                            ------------      -----------      -----------     ------------
                                            ------------      -----------      -----------     ------------
</TABLE>

                See notes to consolidated financial statements.


                                      F-5
<PAGE>

                    SANCTUARY WOODS MULTIMEDIA CORPORATION
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' DEFICIT

<TABLE>
<CAPTION>
                                                      PREFERRED STOCK          COMMON STOCK         ADDITIONAL
                                                    ------------------     --------------------       PAID-IN        ACCUMULATED
                                                    SHARES     AMOUNT       SHARES       AMOUNT       CAPITAL          DEFICIT
                                                    ------     -------     ---------     ------     -----------     ------------
<S>                                                 <C>        <C>         <C>           <C>        <C>             <C>
Balances, December 31, 1994                                                  979,513     $1,000     $23,395,000     $(12,662,000)
Exercise of warrants                                                             400          -          23,000                - 
Exercise of stock options                                                     27,766          -       1,034,000                - 
Shares issued for cash                                                       100,000          -       7,169,000                - 
Stock option compensation                                                          -          -         132,000                - 
Foreign currency translation
   adjustments                                                                     -          -               -                - 
Net loss                                                                           -          -               -      (18,698,000)
                                                    ------     -------     ---------     ------     -----------     ------------

Balances, December 31, 1995                                                1,107,679      1,000      31,753,000      (31,360,000)
Exercise of stock options, net of
   issuance costs                                                                250          -          (3,000)               - 
Stock option compensation                                                          -          -          12,000                - 
Foreign currency translation
   adjustments                                                                     -          -               -                - 
Net loss                                                                           -          -               -       (4,514,000)
                                                    ------     -------     ---------     ------     -----------     ------------

Balances, March 31, 1996                                                   1,107,929      1,000      31,762,000      (35,874,000)
Exercise of warrants                                                          75,000          -         750,000                - 
Conversion of notes payable                                                  156,379          -       1,563,000                - 
Conversion of accounts payable
   and royalty obligations                                                    22,750          -         316,000                - 
Cancellation of performance shares
   in exchange for shares of common
   stock, net                                                               (190,476)         -          (1,000)               - 
Stock option and warrant compensation                                              -          -         364,000                - 
Foreign currency translation
   adjustments                                                                     -          -               -                - 
Net loss                                                                           -          -               -       (3,677,000)
                                                    ------     -------     ---------     ------     -----------     ------------

Balances, March 31, 1997                                                   1,171,582      1,000      34,754,000      (39,551,000)
Issuance of common stock from
   rights offering, net of issuance costs                                    932,518      1,000       2,156,000                - 
Conversion of notes payable                         99,993     $     -             -          -       5,302,000                - 
Issuance of common stock for
   Theatrix acquisition                                                    3,089,203      3,000       8,545,000                - 
Warrants issued for Theatrix
   acquisition                                                                     -          -         868,000                - 
Foreign currency transaction 
   adjustments                                           -           -             -          -               -                - 
Net loss                                                 -           -             -          -               -      (16,579,000)
                                                    ------     -------     ---------     ------     -----------     ------------
Balances, March 31, 1998                            99,993     $     -     5,193,303     $5,000     $51,625,000     $(56,130,000)
                                                    ------     -------     ---------     ------     -----------     ------------
                                                    ------     -------     ---------     ------     -----------     ------------

<CAPTION>
                                                    ACCUMULATED
                                                    TRANSLATION
                                                    ADJUSTMENTS        TOTAL
                                                    -----------    ------------
<S>                                                 <C>            <C>
Balances, December 31, 1994                         $(751,000)     $  9,983,000
Exercise of warrants                                        -            23,000
Exercise of stock options                                   -         1,034,000
Shares issued for cash                                      -         7,169,000
Stock option compensation                                   -           132,000
Foreign currency translation 
   adjustments                                         (1,000)           (1,000)
Net loss                                                    -       (18,698,000)
                                                    ---------      ------------

Balances, December 31, 1995                          (752,000)         (358,000)
Exercise of stock options, net of
   issuance costs                                           -            (3,000)
Stock option compensation                                   -            12,000
Foreign currency translation
   adjustments                                         (6,000)           (6,000)
Net loss                                                    -        (4,514,000)
                                                    ---------      ------------

Balances, March 31, 1996                             (758,000)       (4,869,000)
Exercise of warrants                                        -           750,000
Conversion of notes payable                                 -         1,563,000
Conversion of accounts payable 
   and royalty obligations                                  -           316,000
Cancellation of performance shares
   in exchange for shares of common
   stock, net                                               -            (1,000)
Stock option and warrant compensation                       -           364,000
Foreign currency translation 
   adjustments                                          6,000             6,000
Net loss                                                    -        (3,677,000)
                                                    ---------      ------------

Balances, March 31, 1997                             (752,000)       (5,548,000)
Issuance of common stock from
   rights offering, net of issuance costs                   -         2,157,000
Conversion of notes payable                                 -         5,302,000
Issuance of common stock for 
   Theatrix acquisition                                     -         8,548,000
Warrants issued for Theatrix 
   acquisition                                              -           868,000
Net loss                                                    -       (16,579,000)
                                                    ---------      ------------
Balances, March 31, 1998                            $(752,000)     $ (5,252,000)
                                                    ---------      ------------
                                                    ---------      ------------
</TABLE>

                See notes to consolidated financial statements.


                                      F-6
<PAGE>

                       SANCTUARY WOODS MULTIMEDIA CORPORATION
                       CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                                                  THREE MONTHS
                                                                     YEAR ENDED MARCH 31,            ENDED           YEAR ENDED 
                                                              -------------------------------      MARCH 31,         DECEMBER 31,
                                                                   1998              1997             1996               1995
                                                              -------------      ------------     ------------      -------------
<S>                                                           <C>                 <C>              <C>               <C>
Cash flows from operating activities:
  Net loss                                                     $(16,579,000)      $(3,677,000)      $(4,514,000)     $(18,698,000)
  Depreciation and amortization                                     180,000           361,000           211,000         1,710,000
  Stock options and warrant compensation                                  -           143,000            13,000           132,000
  Sale of intellectual property rights
     in consideration for a reduction
     in royalty obligations                                               -          (430,000)                -                 -
  Net loss (gain) on sale and disposal of assets                  1,080,000          (800,000)                -                 -
  Consolidation of facilities and other items                             -                 -           402,000                 -
  Write off of research and development purchased                 2,036,000                 -                 -                 -
  Write off of goodwill                                           8,142,000                 -                 -                 -
  Gain on forgiveness of debt, net                                 (356,000)                -                 -                 -
  Provision for inventories                                         453,000                 -                 -                 -
  Changes in assets and liabilities, net of assets 
     and liabilities acquired:
     Accounts receivable                                            300,000           525,000           508,000         1,610,000 
     Inventories                                                    119,000           728,000           593,000        (1,277,000)
     Prepaid royalties, expenses and other                          960,000          (237,000)          451,000         2,651,000 
     Accounts payable and accrued expenses                          227,000        (2,208,000)          439,000         2,148,000 
                                                               ------------       -----------       -----------      ------------ 
       Net cash used in operating activities                     (3,438,000)       (5,595,000)       (1,897,000)      (11,724,000)
                                                               ------------       -----------       -----------      ------------ 
Cash flows from investing activities:
  Proceeds from sale of assets                                            -         1,921,000                 -                 -
  Purchases of property and equipment                               (49,000)          (31,000)          (79,000)         (958,000)
  Cash acquired in acquisition                                      455,000                 -                 -                 -
                                                               ------------       -----------       -----------      ------------ 
       Net cash provided by (used in) investing activities          406,000         1,890,000           (79,000)         (958,000)
                                                               ------------       -----------       -----------      ------------ 
Cash flows from financing activities:
  Proceeds from issuance of notes, debentures and warrants          869,000         5,302,000         1,556,000                 -
  Proceeds from exercise of warrants                                      -           750,000                 -                 -
  Common stock issued, net of issue costs                         2,157,000                 -            (3,000)        8,225,000
  Net (repayments) borrowings on bank debt                          (75,000)       (2,227,000)          426,000         1,800,000
  Repayments on long-term debt                                            -           (29,000)                -                 -
                                                               ------------       -----------       -----------      ------------ 
       Net cash provided by financing activities                  2,951,000         3,796,000         1,979,000        10,025,000
                                                               ------------       -----------       -----------      ------------ 
Effect of exchange rate changes on cash                                   -             3,000            (6,000)           (1,000)

Net increase (decrease) in cash                                     (81,000)           94,000            (3,000)       (2,658,000)

Cash, beginning of period                                           102,000             8,000            11,000         2,669,000
                                                               ------------       -----------       -----------      ------------ 
Cash, end of period                                            $     21,000       $   102,000       $     8,000      $     11,000
                                                               ------------       -----------       -----------      ------------ 
                                                               ------------       -----------       -----------      ------------ 
Supplemental disclosures of cash flow information: 
   Cash paid during the period for:
     Interest                                                  $          -       $    92,000       $    58,000      $     74,000
     Income taxes                                                         -             6,000                 -             2,000

Supplemental disclosures of non-cash financing and 
  investing activities:
     Conversion of notes payable into common stock                        -         1,563,000                 -                 -
     Reduction in royalty obligations in exchange 
       for issuance of common stock and sale of 
       intellectual property rights                                       -           550,000                 -                 -
     Conversion of account payable into common stock                      -           195,000                 -                 -
     Capital lease obligations                                            -                 -                 -            50,000
     Issuance of common stock and warrants for acquisition        9,416,000                 -                 -                 -
     Conversion of debentures into preferred stock                5,302,000
</TABLE>

               See notes to consolidated financial statements.


                                      F-7
<PAGE>

                   SANCTUARY WOODS MULTIMEDIA CORPORATION
                 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 -- NATURE OF OPERATIONS AND CHANGE IN FISCAL YEAR-END:

       Sanctuary Woods Multimedia Corporation and its subsidiaries (the 
"Company") develop, publish and market interactive multimedia educational 
software products for use in the K-12 school and home consumer markets. Sales 
are made directly to schools, educational dealers and distributors, hardware 
manufacturers and bundlers (OEM), and international distributors, and the 
Company's products are sold directly over the Internet. Revenue is also 
generated from licensing and other activities related to the Company's 
products and intellectual properties. Prior to 1996, the Company published 
interactive entertainment products and provided interactive multimedia 
services to trade and textbook publishers.

       The Company changed its reporting and tax fiscal year to March 31 from
December 31 effective April 1, 1996. Accordingly, the accompanying consolidated
financial statements include the Company's fiscal years ended December 31, 1995,
the three month transition period ended March 31, 1996 and the fiscal years
ended March 31, 1997 and 1998.

       On April 15, 1997, the Company's stockholders approved a special
resolution authorizing the Company to change its jurisdiction of incorporation
from British Columbia, Canada to the state of Delaware and the adoption by the
Company of a Certificate of Incorporation and Bylaws under Delaware's corporate
legislation. The domestication became effective April 16, 1997. In addition, the
Company's stockholders approved a one-for-twenty share consolidation of the
Company's common stock and an increase in the number of the Company's authorized
shares of common stock to 50,000,000. All references in the accompanying
consolidated financial statements to share information, per share amounts, stock
option data and market prices of the Company's common stock have been restated
to reflect such stock consolidation.

       In August 1997, the Company acquired 100% of the outstanding shares of
Theatrix Interactive, Inc. ("Theatrix"). The Company issued 3,089,203 shares of
the Company's common stock in consideration (see Note 8).

       On November 4, 1997, Sanctuary Woods and Theatrix proposed a plan of 
settlement (the "Proposed Settlement") to all their general unsecured 
creditors (the "Creditors"). The Proposed Settlement excluded a 
first-priority secured claim of $525,000 due under an arrangement with a 
bank. In addition, the Proposed Settlement excluded $500,000 in amounts due 
under software license agreements and $90,000 of amounts due to software 
fulfillment houses as the licensing and fulfillment houses are necessary to 
the continued operations of Sanctuary Woods and Theatrix. The Proposed 
Settlement provided that (1) the Creditors owed less than $50,000, receive a 
payment of fifteen percent of the aggregate claim on or before December 27, 
1997 or seventeen percent of the aggregate claim on or before March 20, 1998 
and (2) the Creditors owed more than $50,000, receive seventeen percent of 
aggregate claims by March 20, 1998. Sanctuary Woods and Theatrix met with the 
Creditors on November 21, 1997 and requested that the Creditors vote on the 
Proposed Settlement by December 5, 1997. In December 1997, the Creditors who 
elected to receive a payment of fifteen percent of the aggregate claims 
totaling $491,000 were paid an amount totaling $74,000. No other amounts have 
been paid under the Proposed Settlement. All outstanding trade claims have 
been included in these financial statements at their face value.

NOTE 2 -- GOING CONCERN UNCERTAINTY:

       The Company incurred net losses of $16,579,000, $3,677,000, $4,514,000
and $18,698,000 in the fiscal years ended March 31, 1998, 1997, the three months
ended March 31, 1996 and the year ended December 31, 1995, respectively. Net
cash used by operating activities was $3,438,000, $5,595,000, $1,897,000 and
$11,724,000 in the same periods, respectively. At 


                                 F-8
<PAGE>

                   SANCTUARY WOODS MULTIMEDIA CORPORATION
                 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                (CONTINUED)

March 31, 1998 working capital deficit was $4,604,000 and stockholders' 
deficit was $5,252,000.

CURRENT STATUS AND MANAGEMENT'S PLANS

       Management believes that the Company will need to raise significant
working capital through additional debt or equity financing to sustain its
operations and fund its fiscal March 31, 1999 operating plan.

       The Company plans to pursue various sources of additional funding 
including, but not limited to, debt, equity and strategic investors. The 
Company is also actively exploring strategic relationships that may enhance 
the Company's ability to develop, publish and distribute its products, as 
well as augment the business with Internet website development for the 
growing adolescent population. No assurance can be given that additional 
financing will be available or that, if available, such financing will be 
obtainable on terms favorable to the Company.

GOING CONCERN UNCERTAINTY

       The accompanying consolidated financial statements have been prepared on
the going concern basis, which contemplates the realization of assets and
satisfaction of liabilities in the normal course of business. The matters
discussed above, among others, may indicate that the Company will be unable to
continue as a going concern for a reasonable period of time.

       The consolidated financial statements do not include any adjustments
relating to the recoverability and classification of recorded asset amounts or
the amounts and classification of liabilities that might be necessary should the
Company be unable to continue as a going concern. The Company's continuation as
a going concern is dependent upon its ability to generate sufficient cash flow
to meet its obligations on a timely basis, to obtain additional financing or
refinancing, and ultimately to attain successful operations. Management is
continuing its efforts to obtain additional funds so that the Company can meet
its obligations and sustain its operations.

NOTE 3 -- SIGNIFICANT ACCOUNTING POLICIES:

       BASIS OF PRESENTATION. In April 1997, the Company reincorporated from
Canada into Delaware. The consolidated financial statements have been prepared
in accordance with generally accepted accounting principles of the United States
of America (U.S. GAAP).

       Consolidation. The consolidated financial statements include the 
accounts of Sanctuary Woods Multimedia Corporation and its wholly-owned 
subsidiaries, Theatrix Interactive, Inc., Magic Quest Inc. and Sanctuary 
Woods Multimedia Inc. All intercompany balances and transactions are 
eliminated in consolidation.

       Foreign Currency Translation. The consolidated financial statements are
stated in U.S. dollars. Assets and liabilities of foreign operations that have a
different functional currency are translated into their U.S. dollar equivalents
based on the rate of exchange as of the balance sheet dates. Revenue and expense
accounts are translated based on average rates of exchange during the period.
Gains or losses resulting from foreign currency translation are reported as a
separate component of stockholders' equity. Foreign currency transaction gains
and losses are included in the statements of operations. As of March 31, 1998,
the Company had no foreign accounts or operations.

       Use of Estimates. The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make


                               F-9
<PAGE>

                   SANCTUARY WOODS MULTIMEDIA CORPORATION
                 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                (CONTINUED)

estimates and assumptions that affect the reported amount of assets and
liabilities, the disclosure of contingent assets and liabilities at the date of
the financial statements, and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.

       Inventories consist of finished goods and raw materials and are stated at
the lower of cost (first-in, first-out) or market (net realizable value). The
Company estimates the net realizable value of inventories based on anticipated
future revenues. It is reasonably possible that such estimates of anticipated
future revenues could be significantly reduced from time to time due to
competitive products and pricing pressures. In the event that inventory cannot
be sold above its estimated net realizable value, the Company could incur
significant additional write-offs.

       Prepaid and Deferred Royalties represent prepayments made and current
guaranteed minimum payments to be made under licensing and development
agreements. Prepaid and deferred royalties are expensed as cost of goods sold
based on actual net product sales and are classified as current or noncurrent
based upon estimated product sales within the next year. Management estimates
the future value of prepaid and deferred royalties quarterly and any amounts
that management deems unlikely to be recouped through anticipated product sales
are charged to cost of goods sold.

       Royalty Obligations represent guaranteed minimum royalty payments to be
made pursuant to contractual license agreements. Generally, royalties are
calculated based on a percentage of sales ranging from 5% to 35%. Royalty
expense was $371,000, $147,000 for the fiscal years ended March 31, 1998 and
1997, respectively, $94,000 in the three months ended March 31, 1996 and
$7,233,000 for the year ended December 31, 1995. The 1995 royalty expense
includes write-offs of prepaid and deferred royalties totaling $4,261,000.

       Property and Equipment are recorded at cost and depreciation is provided
using the declining balance method over the following useful lives:

                 Computer equipment                 3 years
                 Computer software                  3 years
                 Furniture and equipment            5 years

       Leasehold improvements are amortized using the straight-line method over
the term of the lease.

       Technology Amortization represents the amortization of the cost of
technology acquired through the 1994 acquisition of Magic Quest Inc. and relates
to products for which technological feasibility had been established.
Amortization of the deferred development expenditures commenced in 1994 upon
release of such products and is included in cost of sales. Amounts were
amortized using the straight-line method and were fully amortized as of December
31, 1995.

       Research and Development Expenses. Software development costs incurred
prior to achieving technological feasibility are treated as research and
development expenses and are expensed as incurred. All software development
costs incurred by the Company have been expensed.

       The establishment of technological feasibility and the ongoing assessment
of recoverability of capitalized software development costs requires
considerable judgement by management with respect to certain factors affecting
the Company's products, including, but not limited to, anticipated future 


                                     F-10
<PAGE>

                   SANCTUARY WOODS MULTIMEDIA CORPORATION
                 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                (CONTINUED)

gross revenues, estimated economic life and changes in software and hardware 
technologies. Amounts that could have been capitalized after consideration of 
the above factors were immaterial and, therefore, no costs have been 
capitalized.

       Licenses and Other Intangible Assets. The Company capitalizes costs
relating to the acquisition of licenses, copyrights and trademarks. These costs
are capitalized until the related products are available for sale, at which time
they are amortized against income using the straight-line method over
management's estimate of the economic lives of the underlying assets, generally
one to two years. The Company regularly reviews the recoverability of intangible
assets based on estimated undiscounted future cash flows from operating
activities compared with the carrying values of the intangible assets. In the
fourth quarter of 1995, such estimates of the economic lives were significantly
reduced and $235,000 of licenses and other intangible assets were written-off.
In the second quarter of 1998, the Company wrote off goodwill of $8,142,000 (see
Note 8).

       Fair Value of Financial Instruments. Certain of the Company's 
financial instruments are comprised of cash and accounts receivable. The 
carrying amounts of these instruments approximate their fair value. The 
Company's financial instruments also include a line of credit which is in 
default (see Note 9). The Company's other financial instruments include 
accounts payable, accrued expenses capital lease obligations and convertible 
notes payable. Due to the Company's financial conditions the fair value of 
these instruments are not determinable.

       Revenue Recognition. The Company recognizes revenue in accordance with
the American Institute of Certified Public Accountants' Statement of Position
91-1 on Software Revenue Recognition ("SOP 91-1"). Revenue from product sales is
recognized when products are shipped if no significant vendor obligation remains
and collection of the resulting receivable is probable. The Company provides
estimated reserves for future returns and price protection. It is reasonably
possible that actual future returns and price protection allowances could exceed
such estimates. As a result, the Company's reserves could be significantly
increased in the near term.

       Certain revenue from sales and licensing agreements is recognized when
the Company fulfills its obligations under the related agreements. These include
the Company's delivery of software and associated documentation to the licensee
in reproducible form. Royalty income from subsequent product sales during the
licensing period is recorded in the period the products are sold by the
licensee.

       In October 1997 and March 1998, the American Institute of Certified
Public Accountants issued Statements of Position No. 97-2, "Software Revenue
Recognition," ("SOP 97-2) and No. 98-4, "Deferral of the Effective Date of the
Provisions of SOP 97-2, "Software Revenue Recognition" ("SOP 98-4"), which the
Company is currently required to adopt for transactions entered into in the
fiscal year beginning April 1, 1998. SOP 97-2 and SOP 98-4 provide guidance on
recognizing revenue on software transactions and supersedes previous guidance
provided by SOP 91-1. The Company believes that the adoption of SOP 97-2 and SOP
98-4 will not have a significant impact on its current licensing or revenue
recognition practices. However, should the Company amend its existing licensing
practice, the Company's revenue recognition practices may be subject to change
to comply with the accounting guidance provided by SOP 97-2 and SOP 98-4.

       Income taxes are recorded using the asset and liability approach as
defined by Statement of Financial Accounting Standards No. 109, "Accounting for
Income Taxes."

       In fiscal 1998, the Company adopted Statement of Financial Accounting 
Standards No. 128, "Earnings Per Share" (SFAS 128). All earnings per share 
data for prior periods have been restated to conform with SFAS 128.

       SFAS 128 requires a dual presentation of basic and diluted loss per 
share. Basic earnings per share excludes dilution and is computed by dividing 
net income (loss) available to common stockholders (numerator) by the 
weighted average number of common shares

                                    F-11
<PAGE>

                   SANCTUARY WOODS MULTIMEDIA CORPORATION
                 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                (CONTINUED)

outstanding (denominator) during a period. Diluted earnings per share reflects
the potential dilution that could occur if securities or other contracts to
issue common stock were exercised or converted into common stock during a
period.

       Stock-based Compensation. The Company accounts for stock based awards to
employees using the intrinsic value method in accordance with APB No. 25,
"Accounting For Stock Issued To Employees." As allowed under the provisions of
Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123"), the Company provides pro forma disclosures (see Note
13) of net income (loss) and earnings (loss) per share as if the accounting
provisions of SFAS 123 had been adopted.

       Recent Accounting Pronouncements. In February 1997, the FASB issued
Statement of Financial Accounting Standards No. 129, "Disclosure of Information
about Capital Structure" ("SFAS 129"). SFAS 129 requires disclosure of certain
information related to the Company's capital structure and is not anticipated to
have a material impact on the Company's financial position or results of
operations.

       In June 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 130, "Reporting Comprehensive Income"
("SFAS 130"). This statement is effective for the Company's fiscal year ending
March 31, 1999. The statement establishes presentation and disclosure
requirements for reporting comprehensive income. Comprehensive income includes
charges or credits to equity that are not the result of transactions with
owners. The Company expects there to be no material impact on the Company's
financial position and results of operations as a result of the adoption of this
new accounting standard.

       In June 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 131, "Disclosures About Segments of an
Enterprise and Related Information" ("SFAS 131"). The statement requires the
Company to report certain information about operating segments in annual
financial statements. It also establishes standards for related disclosures
about products and services, geographic areas and major customers. The Company
will adopt SFAS 131 beginning in fiscal year 1999 and does not expect such
adoption to have a material effect on the consolidated financial statement
disclosures.

       In March 1998, the American Institute of Certified Public Accountants
issued Statement of Position No. 98-1, "Software for Internal Use" ("SOP 98-1")
which provides guidance on accounting for the cost of computer software
developed or obtained for internal use. SOP 98-1 is effective for the Company's
fiscal year ending March 31, 2000. The Company does not expect that the adoption
of SOP 98-1 will have a material effect on the Company's financial position or
results of operations.

       Reclassifications.  Certain prior year amounts have been reclassified 
to conform with the current year presentation.

NOTE 4 -- ACCOUNTS RECEIVABLE:

       The Company allows customers to exchange and/or return products. In order
to promote sell-through and limit product returns, the Company also provides
"price protection" on slow moving products. In addition, the Company's products
are sold with a ninety-day warranty against defects. The Company has recorded
reserves for sales returns and allowances and price protection based on
historical experience and management's current estimates of potential returns
and allowances and necessary price protection.


                                       F-12
<PAGE>

                   SANCTUARY WOODS MULTIMEDIA CORPORATION
                 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                (CONTINUED)

       Accounts receivable consisted of:
<TABLE>
<CAPTION>
                                                     MARCH 31,
                                        ----------------------------------
                                             1998                1997
                                        ------------          ------------
<S>                                     <C>                   <C>
Accounts receivable                     $   821,000           $ 1,210,000
                                                              
Less allowances for:                                          
  Doubtful accounts                        (502,000)             (123,000)
  Sales returns and allowances             (129,000)             (812,000)
                                        ------------          ------------
Accounts receivable, net                $   190,000           $   275,000
                                        ------------          ------------
                                        ------------          ------------
</TABLE>

       As a result of reduced fourth quarter 1995 sales and significantly
increased requests for returns in the three months ended March 31, 1996, the
Company provided $5,475,000 for returns and price protection during the fourth
quarter of 1995. These reserves related primarily to products sold during the
third quarter of 1995.

NOTE 5 -- INVENTORIES:

       Inventories consisted of:
<TABLE>
<CAPTION>
                                                                MARCH 31,
                                                      -----------------------------
                                                          1998              1997
                                                      ----------          ---------
<S>                                                   <C>                 <C>
Finished goods                                        $ 325,000           $ 489,000
Raw materials (packaging)                               389,000             339,000
                                                      ---------           ---------
                                                        714,000             828,000
Less allowance for obsolete, slow moving and                              
   non-salable inventories                             (455,000)           (172,000)
                                                      ---------           ---------
Inventories, net                                      $ 259,000           $ 656,000
                                                      ---------           ---------
                                                      ---------           ---------
</TABLE>

       Inventory write downs were $453,000 and $150,000 for the years ended
March 31, 1998 and 1997, respectively, $250,000 for the three months ended March
31, 1996, and $1,083,000 for the year ended December 31, 1995.

NOTE 6 -- PROPERTY AND EQUIPMENT:

       Property and equipment consisted of:


                                      F-13
<PAGE>

                   SANCTUARY WOODS MULTIMEDIA CORPORATION
                 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                (CONTINUED)
<TABLE>
<CAPTION>
                                                   MARCH 31,
                                       ---------------------------------
                                           1998                  1997
                                       -----------           -----------
<S>                                    <C>                   <C>
Computer equipment                     $   604,000           $   695,000
Computer software                           99,000                99,000
Furniture and equipment                    120,000               147,000
Leasehold improvements                      31,000                66,000
                                       -----------           -----------
                                           854,000             1,007,000
Less accumulated depreciation             (647,000)             (545,000)
                                       -----------           -----------
Property and equipment, net            $   207,000           $   462,000
                                       -----------           -----------
                                       -----------           -----------

</TABLE>

       In May 1996 the Company sold its Victoria, British Columbia studio. At
March 31, 1996, net property and equipment included approximately $1,000,000
related to such operations.

NOTE 7 -- ACCRUED EXPENSES:

       Accrued expenses consisted of:
<TABLE>
<CAPTION>
                                             MARCH 31,
                                   ------------------------------
                                      1998                1997
                                   ----------          ----------
<S>                                <C>                 <C>
Professional fees                  $  721,000          $  150,000
Other accrued liabilities             690,000             429,000
                                   ----------          ----------
                                   $1,411,000          $  579,000
                                   ----------          ----------
                                   ----------          ----------
</TABLE>

NOTE 8 -- THEATRIX ACQUISITION:

       On August 12, 1997, the Company acquired 100% of the outstanding shares
of Theatrix Interactive, Inc. ("Theatrix"). The acquisition was accounted for as
a purchase. The Company issued 3,089,203 shares of the Company's common stock in
consideration for all the shares of Theatrix capital stock. Up to an additional
500,000 shares of the Company's common stock are issuable one year and three
months after the effective date of the merger if certain revenue goals are met
with respect to products acquired from Theatrix. In addition, Sanctuary Woods
set aside 300,000 shares, pursuant to its 1996 Stock Option Plan, for issuance
to former Theatrix employees who became employees of Sanctuary Woods and issued
a warrant to Kingdom Capital, a shareholder of Theatrix, to purchase 500,000
Sanctuary Woods common shares at $3.00 per share. Management ascribed a value of
$726,000 to the warrant. In exchange for services provided, an investment banker
received cash and a warrant to purchase 100,000 shares of Sanctuary Woods common
stock at $3.00 per share. Management ascribed a value of $142,000 to the
warrant. In addition, the Company recorded a charge of $2,036,000 to write-off
in-process research and development acquired in the transaction.

       The net assets acquired and liabilities assumed in the acquisition of
Theatrix are as follows:

                                 F-14
<PAGE>

                   SANCTUARY WOODS MULTIMEDIA CORPORATION
                 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                (CONTINUED)
<TABLE>

<S>                                                  <C>
Assets:
   Current assets                                    $    894,000
   Property and equipment                                 956,000
   Other assets, including goodwill                    10,312,000
                                                     ------------
                                                       12,162,000

Liabilities:
   Current liabilities                                 (2,746,000)
                                                     -------------
Net assets acquired and liabilities assumed          $  9,416,000
                                                     -------------
                                                     -------------
</TABLE>

       The results of operations of Theatrix are included in the consolidated
financial statements of the Company since the date of acquisition. The unaudited
pro forma combined condensed results of operations of the Company and Theatrix
for the years ended March 31, 1998 and 1997, assuming the acquisition had taken
place on April 1 of each year, after giving effect to certain pro forma
adjustments, is as follows:

<TABLE>
<CAPTION>

                                              YEAR ENDED MARCH 31,
                                          ---------------------------
                                              1998           1997
                                          ------------   ------------
<S>                                       <C>            <C>
Net revenues                              $  2,172,000   $  6,612,000
                                          ------------   ------------
Net loss                                  $(19,322,000)  $(17,100,000)
                                          ------------   ------------
Basic and diluted loss per share          $      (3.75)  $      (4.06)
                                          ------------   ------------
                                          ------------   ------------
</TABLE>

       The pro forma combined condensed results of operations is provided for
information purposes only and does not purport to be indicative of the future
results or financial position of the Company or what the results of operations
or financial position would have been had the acquisition been effective on the
dates indicated. This information should be read in conjunction with these
audited consolidated financial statements.

       Subsequent to the acquisition, in the second quarter of fiscal year 1998
the Company determined that the goodwill recorded in the transaction was
impaired and recorded a charge of $8,142,000 to write-off the goodwill. The
goodwill was to be amortized over three years. Management determined that the
goodwill was impaired and recorded the charge after management developed the
plan of settlement with the Company's general unsecured Creditors (see Note 1).

NOTE 9 -- LINE OF CREDIT:

       The Company's line of credit allowed for borrowings up to $750,000.
Borrowings are payable in 36 monthly installments of principal and interest.
Interest accrues on the outstanding balance at the bank's prime rate (6.5% at
March 31, 1998) plus 1.5% per annum. Borrowings are secured by substantially all
of the Company's assets and the agreement requires that the Company comply with
certain financial covenants. At March 31, 1998, the Company was not in
compliance with certain of these covenants and, accordingly, the outstanding

                                  F-15
<PAGE>

                   SANCTUARY WOODS MULTIMEDIA CORPORATION
                 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                (CONTINUED)

balance as of March 31, 1998 was classified as a current liability in the
balance sheet and the Company does not have access to the unused line of credit.

NOTE 10 -- CAPITAL LEASE OBLIGATIONS:

       At March 31, 1998, the Company was not in compliance with certain
covenants of its capital lease agreements. Accordingly, the outstanding balance
as of March 31, 1998 was classified as a current liability in the balance sheet.

NOTE 11 -- CONVERTIBLE NOTES PAYABLE:

       In November 1997, the Company executed a note purchase agreement with its
principal stockholder for borrowings of up to $3,000,000. The notes bear
interest at 15% per annum. The notes mature on varying dates from November of
2000 through January of 2001. At maturity, the note holder may elect to i)
convert the outstanding principal and unpaid accrued interest to shares of
common stock at a rate of $0.20 per share of common stock; ii) demand payment in
cash of any outstanding balance, or iii) extend the maturity date. Interest is
payable every six months in the form of cash or shares of common stock at the
conversion rate described above at the option of the note holder. The Company
will incur a 15% prepayment penalty of the outstanding principal amount and the
note holder can elect the payment in the form of cash or shares of common stock
at the conversion rate described above.

       In addition, the Company issued a warrant to the note holder for one
share of the Company's common stock for each dollar loaned to the Company. The
exercise price for each warrant is $0.15. Management ascribed a nominal value to
the warrants using a fair value method. As such, no amounts were recorded in the
consolidated financial statements to reflect the issuance of the warrants. At
March 31, 1998, the Company had issued 869,000 warrants associated with the
convertible notes payable.

NOTE 12 -- CONVERTIBLE SUBORDINATED DEBENTURES:

       In September 1996, the Company privately placed for cash $5,302,000 in 8%
convertible subordinated debentures due July 31, 1999. The debentures were
convertible into shares of the Company's common stock at the rate of one share
for each $11.00 of principal (482,000 shares) plus accrued interest. In
addition, the Company issued to each purchaser of the debentures a warrant to
purchase one share of common stock for each $40.00 invested or 132,550 shares.
Each warrant was exercisable at a price of $13.75 per share until September
1999.

       In April 1997, the Company exchanged all of these 8% convertible
subordinated debentures for 99,993 shares of the Company's Series A Preferred
Stock. The Series A Preferred Stock has an aggregate liquidation preference of
$5,302,000 and is convertible into common stock at a rate of $2.40 per share
(2,209,167 shares) and has voting privileges on an "as converted" basis. The
Series A Preferred automatically converts into common stock on July 1, 1999 or
upon the occurrence of either (i) the Company's obtaining equity financing of
not less than $2,000,000 at a price not less than $4.40 per share or (ii) the
closing price of the Company's common stock having been 250% of the conversion
price of Series A Preferred Stock ($6.00) for any 21 trading days in any
consecutive 40 day trading period.

       In addition, the Company issued to the debenture holders warrants to
purchase an additional 1,154,024 shares of the Company's common stock at an
exercise price of U.S. $3.00 per share.

                                 F-16
<PAGE>

                   SANCTUARY WOODS MULTIMEDIA CORPORATION
                 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                (CONTINUED)

The warrants must be exercised if the closing price of the Company's common 
stock equals or exceeds 300% of the exercise price ($9.00) for any 21 trading 
days in any consecutive 40 day trading period. In consideration for the 
exchange, the Debenture Holders agreed to retroactively forgo interest 
($225,000 at March 31, 1997, which was payable in common stock) on the 
Convertible Debentures. The holders of common stock issued upon conversion of 
preferred stock or exercise of the warrants have certain rights to have these 
shares registered. Management ascribed a value of $1,143,000 to the warrants 
using a fair value method and such amount is included in the value of 
preferred stock and additional paid in capital.

NOTE 13 -- COMMON STOCK, OPTIONS AND WARRANTS:

       COMMON STOCK. In April 1997, the Company completed a stock rights
offering in which it issued approximately 932,500 shares at $2.40 per share and
received gross proceeds of $2,238,000.

       STOCK OPTIONS. Stock options for employees, officers, independent
contractors and directors are granted by the Board of Directors.

       Prior to August 1995, options were granted at a discount of 10-15% to
fair market value. Under the provisions of APB 25, the Company recognized as
compensation cost an amount equal to the difference between the fair market
value of the stock and the exercise price of the option at the date of grant or
repricing. The related cost was amortized to expense over the option vesting
period. Compensation expense was $12,000 for the three months ended March 31,
1996 and $133,000 for the year ended, December 31, 1995. No compensation expense
was recorded in fiscal years 1998 and 1997.

       In August 1995, the Company adopted a fixed option plan allowing the
Company to grant options for up to 98,500 shares of common stock. Under the
plan, all options have been granted at an exercise price of each option equal to
the market price of the Company's stock on the date of grant. The options
generally vest over a three-year period and expire five years from the date of
grant. In November 1996, the stockholders approved an amendment to the Plan to
increase the number of options available for grant to 200,000.

       On May 31, 1996, the Company repriced 41,338 options (originally granted
at a weighted average exercise prices of $27.50 to $122.50) to $17.50 per share,
which was the fair market value as of that date.

       In April 1997, the Company's stockholders ratified a fixed option plan
(1996 Stock Option Plan) allowing the Company to grant options for up to 400,000
shares of common stock. Under the plan, the Company intends that the exercise
price of each option shall equal the market price of the Company's stock on the
date of grant. The options generally vest over a three-year period and expire
ten years from the date of grant.

       Option activity is summarized as follows:

                                   F-17
<PAGE>

                       SANCTUARY WOODS MULTIMEDIA CORPORATION
                     NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (CONTINUED)
<TABLE>
<CAPTION>
                                                        OUTSTANDING OPTIONS
                                                      ------------------------
                                                                      WEIGHTED
                                                                      AVERAGE
                                                      NUMBER OF       PRICE PER
                                                       SHARES           SHARE
                                                      ---------       ---------
<S>                                                   <C>             <C>
Outstanding at December 31, 1994                        87,122         $40.87
Granted (at a weighted fair value of $59.98)            82,025          93.73
Exercised                                              (27,766)         37.21
Canceled                                               (14,239)         45.34
                                                       -------         ------

Outstanding at December 31, 1995                       127,142          75.13
Granted (at a weighted fair value of $9.10)             20,200          20.07
Exercised                                                 (250)         38.24
Canceled                                               (42,743)         92.83
                                                       -------         ------

Outstanding at March 31, 1996                          104,349          57.56
Granted (at a weighted fair value of $7.84)             93,638          17.33
Canceled                                              (127,287)         43.65
                                                       -------         ------

Outstanding at March 31, 1997                           70,700          29.20
Granted (at a weighted fair value of $2.31)            151,950           2.95
Exchanged for options of Theatrix                       10,750           5.26
Canceled                                               (93,442)         17.54
                                                       -------         ------

Outstanding at March 31, 1998                          139,958           5.52
                                                       -------         ------
                                                       -------         ------
</TABLE>

<TABLE>
<CAPTION>
                                                          MARCH 31,
                                      -------------------------------------------------      DECEMBER 31,
                                          1998               1997              1996              1995
                                      ------------       ------------      ------------      ------------
<S>                                       <C>              <C>              <C>                <C>
Options exercisable at year end            133,705          48,385            49,553             40,991
</TABLE>

       The following table summarizes information about fixed stock options
outstanding at March 31, 1998:


                                     F-18
<PAGE>

                       SANCTUARY WOODS MULTIMEDIA CORPORATION
                     NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (CONTINUED)

<TABLE>
<CAPTION>
                                     OUTSTANDING                            EXERCISABLE
                      -----------------------------------------      -------------------------
                                        WEIGHTED
                         NUMBER          AVERAGE       WEIGHTED         NUMBER         WEIGHTED
                       OUTSTANDING      REMAINING       AVERAGE      EXERCISABLE       AVERAGE
     RANGE OF         AT MARCH 31,        LIFE         EXERCISE      AT MARCH 31,      EXERCISE
 EXERCISE PRICES          1998          (IN YEARS)       PRICE           1998           PRICE
 ---------------      ------------      ---------      --------      ------------      --------
     <C>                  <C>               <C>         <C>              <C>            <C>
      $2.38-2.40           100,084           2.29        $ 2.40           100,084        $ 2.40
       3.81-4.00            12,824           8.69          3.99             9,623          3.99
           10.00               250           3.44         10.00                83         10.00
           17.50            25,400           2.88         17.50            22,515         17.50
           24.00             1,400           1.83         24.00             1,400         24.00
                           -------                                        -------

                           139,958                                        133,705
                           -------                                        -------
                           -------                                        -------
</TABLE>

       The Company applies APB No. 25 in accounting for its stock options. Had
compensation cost been recognized under the fair value method, the Company's net
loss and loss per share would have been changed to the pro forma amounts
indicated below:

<TABLE>
<CAPTION>
                                                                         THREE MONTHS
                                                                             ENDED           YEAR ENDED
                                         YEAR ENDED MARCH 31,              MARCH 31,        DECEMBER 31,
                                    ------------------------------       -------------      ------------
                                         1998              1997               1996              1995
                                    ------------       -----------        -----------       ------------
<S>                                <C>                <C>                <C>               <C>
Net loss
   As reported                      $(16,579,000)      $(3,677,000)       $(4,514,000)      $(18,698,000)
   Pro forma                         (16,790,000)       (4,240,000)        (4,836,000)       (19,287,000)
                                    ------------       -----------        -----------       ------------

Net loss per share
   As reported                      $      (4.15)      $    (3.30)        $     (4.97)      $     (22.16)
   Pro forma                               (4.20)           (3.81)              (5.40)            (24.00)
                                    ------------       -----------        -----------       ------------
                                    ------------       -----------        -----------       ------------
</TABLE>

       The fair value of each option grant was estimated on the date of grant
using the Black-Scholes option pricing model with the following weighted-average
assumptions:

<TABLE>
<CAPTION>
                                                             THREE MONTHS
                                                                 ENDED       YEAR ENDED
                                     YEAR ENDED MARCH 31,      MARCH 31,     DECEMBER 31,
                                     --------------------    ------------    ------------
                                     1998            1997        1996            1995
                                     ----            ----        ----            ----
<S>                                 <C>             <C>         <C>             <C>
Dividend yield                          0%              0%          0%              0%
Volatility                            100%             80%         98%             89%
Risk free interest rate              5.89%           5.25%       5.75%           5.31%
Expected term - years                5.00            4.00        4.72            4.72

</TABLE>


                                     F-19
<PAGE>

                    SANCTUARY WOODS MULTIMEDIA CORPORATION
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (CONTINUED)

       STOCK WARRANTS. Warrants to purchase 2,858,000 shares of common stock at
$0.15 to $117.88 per share were outstanding at March 31, 1998 (see Notes 8, 11
and 12).

NOTE 14 -- INCOME TAXES:

       Deferred income taxes, which result from temporary differences in the
recognition of revenue and expense for tax and financial reporting purposes,
relate approximately to:

<TABLE>
<CAPTION>

                                                  MARCH 31,
                                        -----------------------------
                                            1998            1997
                                        ------------   --------------
<S>                                     <C>            <C>
Deferred tax assets:
 Reserves and accruals                  $    422,000    $    784,000
 Deferred development expenditures                 -         321,000
 Depreciation and amortization                (8,000)        (84,000)
 Operating loss carryforwards             18,233,000      14,000,000
 Tax credits                                 535,000         220,000
 Valuation allowance                     (19,182,000)    (15,241,000)
                                        ------------   --------------
 Deferred tax assets, net               $          -    $          -
                                        ------------   --------------
                                        ------------   --------------
</TABLE>

       The Company has recorded a 100% valuation allowance against the deferred
tax assets reflecting the uncertainty of their future realization.

       At March 31, 1998, the Company had approximately $49,042,000 and
$25,543,000 of net operating loss carryforwards to reduce future taxable income
for federal and state purposes, respectively. If not utilized, these
carryforwards expire beginning in the year 2000. Under the Tax Reform Act of
1986, the amounts of and benefits from net operating loss carryforwards that can
be carried forward may be limited in certain circumstances, but not limited to,
a cumulative stock ownership change of more than 50% over a three-year period,
as defined.

NOTE 15 -- CONCENTRATION OF CREDIT RISK:

       Financial instruments that potentially subject the Company to significant
concentrations of credit risk consist principally of accounts receivable. The
Company's accounts receivable are primarily derived from revenues to
distributors and resellers located in the United States. The Company performs
ongoing credit evaluations of its customers financial condition and maintains an
allowance for uncollectible accounts receivable based upon the expected
collectibility of all accounts.

       During the fiscal year ended March 31, 1998, the Company had one customer
that represented 10% of total net revenues. During the fiscal year ended March
31, 1997, the Company had sales to two customers that represented 18% and 16% of
total net revenues. During the three months ended March 31, 1996, the Company
had sales to two customers that represented 22% and 16% of total net sales.
During the year ended December 31, 1995, the Company had sales to two customers
that represented 16% and 11% of total net revenues. Export sales to various
countries were approximately $553,000 for the year ended March 31, 1998.


                                     F-20
<PAGE>

                    SANCTUARY WOODS MULTIMEDIA CORPORATION
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (CONTINUED)

NOTE 16 -- COMMITMENTS AND CONTINGENCIES:

       The Company has recorded liabilities in the consolidated financial
statements for judgements against the Company arising from employee severance
and vendor liabilities (see Note 1). The Company is a party to various claims,
litigation and threatened litigation in the normal course of operations.
Management believes, based upon the advice of counsel, that the ultimate
resolution of such matters will not have a material adverse effect on the
Company's financial statements taken as a whole.

       Operating Lease Obligations. The Company leases its facilities under a
noncancelable operating lease agreement. The future minimum annual lease
payments are as follows:

<TABLE>
<CAPTION>
FISCAL YEAR ENDING MARCH 31,
---------------------------------------------------------
<S>                                             <C>
  1999                                          $171,000
  2000                                           128,000
                                                --------

                                                $299,000
                                                --------

</TABLE>

       Rent expense under operating leases totaled $201,000 and $258,000 in the
years ended March 31, 1998 and 1997 respectively, $134,000 in the three months
ended March 31, 1996, $495,000 in the year ended December 31, 1995.

       Benefit Plans. In August 1996, the Company established a 401(k)
retirement savings plan for its employees. Each participant may elect to
contribute a percentage of his or her salary to the plan, subject to IRS
limitations. The Company, at its discretion, may make contributions to the plan.
There were no such contributions made in the fiscal years ended March 31, 1998
and 1997.

NOTE 17 -- CANCELLATION OF PERFORMANCE SHARES:

       In October 1991, in connection with the sale of 90,000 common shares to
the Company's founders and principal stockholders, the Company issued 200,000
common "performance" shares (the "Performance Shares") at CDN $0.20 per share to
certain of these individuals. In July 1996, a total of 60,000 of these shares
were sold and transferred to certain members of current management at their then
estimated fair market value of $.60 per performance share.

       In March 1997, all of the Performance Shareholders surrendered their
shares for cancellation. In exchange, the Company issued these holders 9,524
shares of common stock and warrants to purchase 30,009 shares of common stock at
$3.20 per share through March 31, 1998 and $3.40 per share thereafter until
March 6, 1999.  Pursuant to the transaction, the Company recorded an expense of
$12,000.


                                     F-21
<PAGE>

                    SANCTUARY WOODS MULTIMEDIA CORPORATION
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (CONTINUED)

NOTE 18 -- FOURTH QUARTER ADJUSTMENTS:

       The Company's net loss for the following periods have included certain
significant adjustments recorded in the fourth quarter related to the matters
described as follows:

<TABLE>
<CAPTION>

                                                              DECEMBER 31,
                                                                  1995
                                                            ----------------
<S>                                                         <C>

Estimated sales returns and price protection                $      5,475,000
Write-off of unrecoverable prepaid and deferred royalties          4,261,000
Provision for inventory obsolescence                               1,033,000
Write off of licenses and other intangibles                          235,000
                                                            ----------------

                                                            $     11,004,000
                                                            ----------------
                                                            ----------------
</TABLE>


                                    F-22
<PAGE>

                        SANCTUARY WOODS MULTIMEDIA CORPORATION
                   SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS

<TABLE>
<CAPTION>
                                          BALANCE AT                                                               BALANCE AT
                                           BEGINNING        CHARGED TO        WRITE-OFFS/                            END OF
                                           OF PERIOD          EXPENSE           RETURNS            OTHER             PERIOD
                                        ----------------  ----------------   ---------------   ---------------   ----------------
<S>                                     <C>               <C>                <C>               <C>               <C>
Year ended March 31, 1998      
Allowance for doubtful accounts            $   123,000    $   547,000          $  (168,000)     $      -           $   502,000
Sales returns and allowances                   812,000        345,000           (1,028,000)            -               129,000
Inventory obsolesence                          172,000        583,000             (300,000)            -               455,000
                               
Year ended March 31, 1997                  $   207,000    $   329,000          $  (413,000)     $      -           $   123,000
Allowance for doubtful accounts              3,806,000      1,973,000           (4,967,000)            -               812,000
Sales returns and allowances                 1,450,000        150,000           (1,428,000)            -               172,000
Inventory obsolesence          
                               
Three months ended March 31, 1996
Allowance for doubtful accounts            $   200,000    $    16,000          $    (9,000)     $      -           $   207,000
Sales returns and allowances                 5,428,000        623,000           (2,246,000)            -             3,805,000
Inventory obsolesence                        1,518,000        250,000             (318,000)            -             1,450,000
                               
Year ended December 31, 1995   
Allowance for doubtful accounts            $   217,000    $   119,000          $  (136,000)     $      -           $   200,000
Sales returns and allowances                   414,000      8,168,000           (3,396,000)      242,000 (A)         5,428,000
Inventory obsolesence                          299,000      1,083,000             (132,000)      268,000 (A)         1,518,000

</TABLE>

(a)  Consolidation of reserve accounts


                                             F-23
<PAGE>

ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURE.

         As of October 16, 1997, the Company had not paid Deloitte & Touche 
LLP amounts due in connection with Deloitte & Touche LLP's audit of the 
Company's financial statements for the year ended March 31, 1997. On October 
16, 1997, Deloitte & Touche LLP ceased to serve as the Company's independent 
accountants, as fully detailed in a Current Report on Form 8-K dated October 
16, 1997 which the Company filed with the Commission.

         Deloitte & Touche LLP's report, dated April 12, 1996 disclaimed an
opinion on the consolidated financial statements of the Registrant as of and for
the year ended December 31, 1995 because of the possible material effects of the
uncertainty about the Registrant's ability to continue as a going concern.
Deloitte & Touche LLP's updated report, dated October 11, 1996, on the
consolidated financial statements of the Registrant as of and for the year ended
December 31, 1995, expressed a different opinion from the above-mentioned prior
report and such October 11, 1996 report on the December 31, 1995, March 31, 1996
and June 30, 1996 consolidated financial statements did not include an adverse
opinion or disclaimer of opinion and was not qualified or modified as to
uncertainty, audit scope or accounting principle. Deloitte & Touche LLP's
report, dated June 20, 1997 on the consolidated financial statements of the
Registrant as of and for the fiscal periods ended March 31, 1997, March 31, 1996
and December 31, 1996 included an explanatory paragraph referring to substantial
doubt about the Registrant's ability to continue as a going concern. The
Registrant's Board of Directors participated in and approved the decision to
cease the relationship with Deloitte & Touche LLP. In connection with its audits
for the two most recent fiscal years and through October 16, 1997, there have
been no disagreements with Deloitte & Touche LLP on any matter of accounting
principles or practices, financial statement disclosure, or auditing scope or
procedure, which disagreements if not resolved to the satisfaction of Deloitte &
Touche LLP would have caused them to make reference thereto in their report on
the financial statements for such years. During the two most recent fiscal years
and through October 16, 1997, there have been no reportable events, as defined
in Regulation S-K Item 304(a)(1)(v).

         Deloitte & Touche LLP furnished the Registrant with a letter addressed
to the SEC stating that it agrees with the above statements. A copy of the
letter was filed as Exhibit 16 to the Form 8-K dated October 16, 1997 filed by
the Registrant.

         In connection with the preparation of the audited financial 
statements for the acquisition of Theatrix Interactive, Inc. and for fiscal 
1998, the Company determined that it would be in the best interests of the 
Company and its stockholders to retain the national accounting firm of 
PricewaterhouseCoopers LLP to serve as its independent accountants. This 
change was more time consuming than the Company initially anticipated and was 
not completed until August 10, 1998. Concurrent with the filing of this 
report on Form 10-K, the Company has filed a Current Report on Form 8-K with 
the Commission to announce the change in accountants, as is required by the 
rules and regulations of the Commission.

         During the Company's two most recent fiscal years and the subsequent 
interim period prior to engaging PricewaterhouseCoopers, the Company has not 
consulted PricewaterhouseCoopers with respect to any of the matters described 
in Regulation S-K Item 304(a)(2)(i) or (ii) except for the following:

         The Company consulted with PricewaterhouseCoopers in the fall of 
1997 regarding the SEC reporting requirements associated with the Company's 
acquisition of Theatrix Interactive, Inc.  PricewaterhouseCoopers engaged in 
discussions with Company management regarding the Form 8-K reporting and 
filing requirements and the accounting requirements for acquisitions in 
accordance with APB No. 16.

                               PART III

ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CONTROL PERSONS; COMPLIANCE WITH 
         SECTION 16(A) OF THE EXCHANGE ACT.

DIRECTORS AND EXECUTIVE OFFICERS

         The directors and executive officers of Sanctuary Woods and their
respective ages and positions with the Company are set forth in the following
table.


                                    -28-
<PAGE>

<TABLE>
<CAPTION>
             Name               Age                 Position
     ------------------------  -----  -----------------------------------------------
     <S>                        <C>   <C>
     Michelle P. Kraus, Ph.D.   40    Chief Executive Officer, President and Director
     Marylyn Rosenblum          52    Chairman of the Board of Directors
     Erik W. Jansen             39    Director
     Lawrence Lenihan           33    Director

</TABLE>

MICHELLE P. KRAUS. Michelle Kraus has served as a member of the Company's Board
of Directors, Chief Executive Officer and President since September 1997. From
1995 to 1996, Dr. Kraus was the founder, chief executive officer and president
of MagicMaker, Inc., the first next-generation interactive digital media studio.
From 1988 to 1995, Dr. Kraus served as an executive consultant and raised
financing, advised management on strategy, repositioning and direction, managed
turnarounds, and built management teams for a diverse portfolio of clients
including Claris Corporation, Compaq Computers, and Quarterdeck Corporation. Dr.
Kraus earned a B.A. from Douglass College, Rutgers University, an M.A. from the
University of Michigan and a Ph.D. from Carnegie-Mellon University.

MARYLYN ROSENBLUM. Marylyn Rosenblum has served as a member and chairman of the
Company's Board of Directors since July, 1997. Ms. Rosenblum served as Acting
President and Chief Executive Officer from July 1997 until September 1997 and
Acting Executive Vice President, Sales from November 1996 until December 1997.
From September 1995 to April 1996, she was Vice-President of Education Sales and
Marketing at Softkey International (The Learning Company), a software company.
From June 1992 to September 1995, she was Vice-President of Education Sales and
Marketing at Broderbund Software, a software company.

ERIK W. JANSEN. Erik Jansen has served as a member of the Company's Board of
Directors since April 1997. Mr. Jansen has served as Vice President of
Dawson-Samberg Capital Management, Inc., an investment management firm, since
July 1998. From May 1997 until June 1998, Mr. Jansen served as Chief Operating
Officer and a member of Digital Media Capital, LLC, a private venture capital
firm. From February 1994 to July 1996, he was President of Digital Media Group,
Inc., a private venture capital firm. From March 1993 to February 1994, he was
Senior Vice President of S.N. Phelps & Co., a merchant and investment banking
company. From September 1986 to February 1993, he was Managing Director of
Martek & Associates, a Management Consulting firm. Mr. Jansen graduated from
Netherlands School of Business with a degree in International Business and
earned a Masters in Business Administration from Southern Methodist University.

LAWRENCE D. LENIHAN, JR. Mr. Lenihan has served as a member of the Company's
Board of Directors since April 1997. Since October 1996, he has been a Principal
at Dawson-Samberg Capital Management, Inc., an investment management firm. From
August 1993 to October 1996, Mr. Lenihan was a principal at Broadview
Associates, an investment banking firm. From July 1987 to June 1993 he held a
variety of positions at International Business Machines, Inc. He is a member of
the Board of Directors of Memotek Communications. Mr. Lenihan graduated from
Duke University with a degree in Electrical Engineering and earned a Masters in
Business Administration from Wharton School, University of Pennsylvania.


                                     -29-
<PAGE>

BOARD OF DIRECTORS COMMITTEES AND OTHER INFORMATION

         All directors hold office until the next annual meeting of shareholders
and until their successors have been duly elected and qualified. Officers are
elected by and serve at the discretion of the Board of Directors. There are no
family relationships among the directors or officers of the Company.

         The Board of Directors currently has an Audit Committee and a
Compensation Committee. The Audit Committee oversees the actions taken by the
Company's independent auditors and reviews the Company's internal financial and
accounting controls and policies. The Compensation Committee is responsible for
determining salaries, incentives and other forms of compensation for officers,
employees and consultants of the Company and administers the Company's incentive
compensation and benefit plans.

DIRECTOR COMPENSATION

         Directors of the Company do not receive cash for services they provide
as directors. From time to time, certain directors who are not employees of the
Company have served as consultants to the Company for which they have been paid
customary fees based on the value of the services rendered and/or received
grants of options to purchase shares of the Company's Common Stock. The Company
does not provide additional compensation for committee participation or special
assignments of the Board of Directors.

COMPLIANCE WITH SECTION 16(a) OF THE SECURITIES EXCHANGE ACT OF 1934

         Section 16(a) of the Securities Exchange Act of 1934 requires the
Company's officers and Directors, and persons who own more than ten percent of a
registered class of the Company's equity securities, to file reports of
ownership on Form 3 and changes in ownership on Form 4 or 5 with the Securities
and Exchange Commission (the "SEC") and the National Association of Securities
Dealers, Inc. Such officers, Directors and ten-percent stockholders are also
required by SEC rules to furnish the Company with copies of all forms that they
file pursuant to Section 16(a). Based solely on its review of the copies of such
forms received by it, or written representations from certain reporting persons
that no other reports were required for such persons, the Company believes that
all Section 16(a) filing requirements applicable to its officers, Directors and
ten-percent stockholders were complied with in a timely fashion, except for Erik
Jansen, who filed a late Form 3 after the Company failed to file a Form 3 on his
behalf in a timely manner.

ITEM 11. EXECUTIVE COMPENSATION

SUMMARY COMPENSATION

         The following table sets forth the information, on an accrual basis,
with respect to the compensation of Michelle Kraus, the Chief Executive Officer
of the Company, for the three fiscal years ended March 31, 1998.

<TABLE>
<CAPTION>
                                  YEAR ENDED      SALARY/OTHER      NO. OF SECURITIES
         NAME AND POSITION         MARCH 31,      COMPENSATION     UNDERLYING OPTIONS
-----------------------------     -------------  --------------   --------------------
<S>                               <C>            <C>              <C>
Michelle P. Kraus,                   1998           $  65,000             --(3)
President and Chief                  1997                --               --
Executive Officer (1)                1995(2)             --               --

</TABLE>

(1)      Dr. Kraus joined the Company in September, 1997.
(2)      The fiscal year end was December 31, 1995.


                                             -30-
<PAGE>

(3)      Dr. Kraus received the right to receive a grant of an option for 75,000
         shares of Common Stock pursuant to an employment agreement executed as
         of September, 1997. However, the Board of Directors of the Company did
         not formally grant this option to Dr. Kraus until September, 1998.

         The total annual salary and bonus for any other executive officer did
not exceed $100,000 for the fiscal year ended March 31, 1998.

STOCK OPTION GRANTS

         No grants of stock options were made to executive officers and
directors during the fiscal year ended March 31, 1998.

STOCK OPTIONS EXERCISED DURING FISCAL YEAR

         No stock options or stock appreciation rights were exercised by any
executive officers or directors of the Company during the fiscal year ending
March 31, 1998.

OPTION VALUES

         No unexercised options were held by executive officers as of March 31,
1998.

LTIP AWARDS DURING FISCAL YEAR

         No long term incentive plan awards were made to any executive officers
or directors of the Company during the fiscal year ending March 31, 1998.

EMPLOYMENT CONTRACTS

         In September 1997, the Company entered into an employment agreement
with Dr. Kraus. After expiration of the initial term of the Agreement in
September 1998, Dr. Kraus' employment became at-will, pursuant to the Agreement.
Dr. Kraus will receive a base salary per year of $150,000 per year, plus
additional bonuses at the discretion of the Board of Directors. The Agreement
also provides that Dr. Kraus has a further bonus program based upon the exit
strategy of the Company. Under the terms of the Agreement, the Company agrees to
pay to Dr. Kraus a one-time, lump sum bonus (the "Sales Bonus") upon the
occurrence of a Sales Event. Executive shall be entitled to receive the Sales
Bonus if the Company enters into a definitive agreement covering the applicable
Sales Event (i) during the Employment Term, or (ii) within ninety (90) days
following the termination or expiration of the Employment Term. The amount of
the Sales Bonus will range from $150,000 to as much as $300,000 plus 10% of the
Sale Proceeds in excess of $6,000,000, depending on the amount of total Sales
Proceeds from a Sales Event. In addition, Dr. Kraus received the right to
receive an option for 75,000 shares of the Company's Common Stock, which option
may be exercised by Dr. Kraus for up to a year after the termination of her
employment with the Company. The Company's Board of Directors granted this
option to Dr. Kraus in September, 1998.

LIMITATIONS ON LIABILITY AND INDEMNIFICATION MATTERS

         The Company's Restated Certificate of Incorporation provides that the
Company shall indemnify its directors and officers to the fullest extent
permitted by Delaware law, including circumstances in which indemnification is
otherwise discretionary under Delaware law. The Company has entered into
indemnification agreements with its officers and directors containing provisions
which will in some respects be broader than the specific indemnification
provisions contained in the Delaware General Corporations 


                                 -31-
<PAGE>

Law. The indemnification agreements require the Company, among other things, 
to indemnify such officers and directors against certain liabilities that may 
arise by reason of their status or service as directors or officers (other 
than liabilities arising from willful misconduct of a culpable nature) and to 
advance their expenses incurred as a result of any proceeding against them as 
to which they could be indemnified.

         At present, there is no pending material litigation or proceeding
involving a director or officer of the Company where indemnification will be
required or permitted. The Company is not aware of any threatened material
litigation or proceeding which may result in a claim for such indemnification.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         The following table sets forth certain information with respect to the
beneficial ownership of the Company's Common Stock as of September 30, 1998 for
(i) each entity or group that is known by the Company to beneficially own five
percent or more of the outstanding Common Stock of the Company, (ii) each
director, (iii) each executive officer and (iv) the Company's directors and
officers as a group. Except pursuant to applicable community property laws or as
indicated in the footnotes to this table, to the Company's knowledge, each
shareholder identified in the table possesses voting and investment power with
respect to all shares of Common Stock shown as beneficially owned by such
shareholder.

<TABLE>
<CAPTION>

                     NAME AND ADDRESS                          Common        PERCENT
                   OF BENEFICIAL OWNER                         Stock(1)      OF CLASS
----------------------------------------------------------   -----------    ----------
<S>                                                          <C>            <C>

Dawson-Samberg Capital Management, Inc.(2)
   354 Pequot Avenue                                           8,313,106       63.5%
   Southport, CT 06490

Kingdon Capital(3)
   152 West 57th Street                                        2,198,149       38.6%
   New York, NY 10019  

The Travelers Indemnity Company(4)
   388 Greenwich Street, 36th Floor                              638,138       11.5%
   New York, NY  10013

NEC USA, Inc.(5)
   8 Corporate Center Drive                                      583,562       11.2%
   Melville, NY 11757-3148 

Michelle P. Kraus(6)                                             150,000        2.8%

Marylyn Rosenblum(7)                                              75,000        1.4%

Erik W. Jansen(8)                                                   --           --

Lawrence D. Lenihan, Jr.(8)                                         --           --

All directors and executive officers as a group (4 persons)      225,000        4.2%

</TABLE>

*    Less than 1%.

(1)  Beneficial ownership is determined in accordance with the rules and
     regulation of the U.S. Securities and Exchange Commission and generally
     includes voting or investment power with respect to 


                                       -32-
<PAGE>

     securities. The percentage of beneficial ownership is based on 5,193,303 
     shares of Common Stock outstanding as of September 30, 1998 and unless 
     otherwise indicated excludes conversion of the outstanding Series A 
     Preferred Stock. Options to purchase shares of Common Stock which are 
     currently exercisable or will become exercisable within 60 days of 
     September 30, 1998 are deemed to be outstanding for purposes of 
     computing the percentage of the shares held by an individual but are not 
     outstanding for purposes of computing the percentage of any other 
     person. Except as indicated otherwise in the footnotes below, and 
     subject to community property laws where applicable, the persons named 
     in the table above have sole voting and investment power with respect to 
     all shares of Common Stock shown as beneficially owned by them.

(2)  Includes 208,334 shares of Common Stock held by Pequot Partners Fund, L.P.
     ("PPF") and 208,334 shares of Common Stock held by Pequot International
     Fund, Inc. ("PIF"). Also includes (i) 37,721 shares of Series A Preferred
     Stock (convertible into 833,319 shares of Common Stock), warrants to
     purchase 942,755 shares of the Company's Common Stock, and convertible debt
     in the principal amount of $434,429 which may be converted into 2,172,145
     shares of Common Stock held by PPF and (ii) 37,721 shares of Series A
     Preferred Stock (convertible into 833,319 shares of Common Stock), warrants
     to purchase 942,755 shares of the Company's Common Stock, and convertible
     debt in the principal amount of $434,429 which may be converted into
     2,172,145 shares of Common Stock held by PIF.

(3)  Includes 254,722, 424,537 and 1,018,890 shares of Common Stock held
     respectively by Kingdon Associates, Kingdon Partners and M. Kingdon
     Offshore N.V. Also includes a warrant to purchase 500,000 shares of Common
     Stock held by Kingdon Capital.

(4)  Neither The Travelers Indemnity Company or any of its affiliates has
     assumed or has any responsibility for the management, business or
     operations of the Company or for the statements contained in this Proxy
     Statement (other than the limited information regarding the stock ownership
     of such entities under the caption "Principal Stockholders"). Includes
     10,373 shares of Series A Preferred Stock (convertible into 229,157 shares
     of Common Stock) and warrants to purchase 139,786 shares of Common Stock
     and.

(5)  Includes 58,356 shares of Common Stock held in escrow in connection with
     the Company's acquisition of Theatrix Interactive, Inc.

(6)  Represents options for Common Stock.

(7)  Represents an option for Common Stock.

(8)  Mr. Jansen and Mr. Lenihan are a Vice President and a Principal,
     respectively, at Dawson-Samberg Capital Management, Inc. and, therefore,
     may be deemed to beneficially own the shares held by Pequot Partners Fund,
     L.P. and Pequot International Fund, Inc. Mr. Jansen and Mr. Lenihan
     disclaim beneficial ownership of the shares held by Pequot partners Fund,
     L.P. and Pequot International Fund, Inc.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         In August, 1998 the Company issued secured promissory notes in the
amount of $40,000.00 and bearing interest at a rate of 10% per annum to each of
Pequot Partners Fund, L.P. and Pequot International Fund, Inc. (collectively,
the "Lenders"), each of which are affiliates of Dawson-Samberg Capital


                                       -33-
<PAGE>

Management, Inc., a significant stockholder of the Company. At September 30,
1998 the Company was in default in payment of $64,000 of accrued interest under
the promissory notes.

         In November, 1997 the Company entered into a Note Purchase Agreement
(the "Purchase Agreement") with the Lenders. In connection with the Agreement,
the Company issued to the Lenders an aggregate of $868,858 in secured promissory
notes bearing interest at 15% per annum and which may be converted into Common
Stock of the Company at the option of each Lender at a conversion rate of $0.20
per share. In addition, the Company issued to the Lenders warrants for an
aggregate of 868,858 shares of the Company's Common Stock at a conversion price
of $0.15 per share.

         In October, 1997 the Company issued promissory notes bearing interest
at 10% per annum in the aggregate amount of $250,000 to the Lenders. The
principal amounts and all interest accrued under these notes were rolled-over as
secured promissory notes issued pursuant to the Note Purchase Agreement.

ITEM 14.  EXHIBITS AND REPORTS ON FORM 8-K

(a)      EXHIBITS

<TABLE>
<CAPTION>

         EXHIBIT
         NUMBER                           DESCRIPTION
         <S>        <C>
          2.1       Certificate of Domestication (Incorporated by reference to
                    Exhibit 2.1 to Registrant's Form 8-B filed May 2, 1997).

          3.1       Certificate of Incorporation (Incorporated by reference to
                    Exhibit 3.1 to Registrant's Form 8-B filed May 2, 1997).

          3.2       Amended and Restated Certificate of Incorporation
                    (Incorporated by reference to Exhibit 3.2 to Registrant's
                    Form 8-B filed May 2, 1997).

          3.3       Bylaws (Incorporated by reference to Exhibit 3.3 to
                    Registrant's Form 8-B filed May 2, 1997).

          4.1       Specimen Common Stock Certificate (Incorporated by reference
                    to Exhibit 4.1 to Registrant's Form 8-B filed May 2, 1997).

         10.13      Form of Warrant to Purchase Common Stock issued by the
                    Company to the placement agent in connection with the July
                    1995 private placement (Incorporated herein by reference to
                    Exhibit 7.5 of Registrant's Report on Form 8-K dated
                    February 14, 1995).

         10.18      Amendment to Loan Agreement between Sanctuary Woods
                    Multimedia, Inc. and a bank, dated April 2, 1996 and related
                    warrant (Incorporated herein by reference to Exhibit 10.18
                    of Registrant's Report on Form 10-K/A-1 filed April 15,
                    1996).

         10.20      Warrant granted in connection with Second Amendment to Loan
                    Agreement between the Registrant and Imperial Bank
                    (Incorporated herein by reference to Exhibit 10.20 of
                    Registrant's Report on Form 10-Q filed June 19, 1996).

         10.21      Agreement with Strategic Marketing Partners dated May 13,
                    1996 (Incorporated herein by reference to Exhibit 10.21 of
                    Registrant's Report on Form 10-Q filed June 19, 1996).


                                       -34-
<PAGE>

         <S>        <C>
         10.23      Amendment 1 to License Agreement between Ripley
                    Entertainment and the Registrant (effective August 1, 1996)
                    (Incorporated herein by reference to Exhibit 10.23 of
                    Registrant's Report on Form 10-Q filed August 14, 1996).

         10.25      Form of Indemnification Agreement Executed by Registrant and
                    its officers and directors (Incorporated by reference to
                    Exhibit 3.3 to Registrant's Form 8-B filed on May 2, 1997).

         10.28      Form of Warrant to Purchase Common Stock issued by the
                    Company to the holders of Series A Preferred Stock.
                    (Incorporated herein by reference to Exhibit 10.28 of
                    Registrant's Report on Form 10-K filed June 30, 1997).

         10.28A     Form of Warrant to Purchase Common Stock issued by the
                    Company to the holders of Series A Preferred Stock
                    (Incorporated herein by reference to Exhibit 10.28A of
                    Registrant's Report on Form 10-K filed June 30, 1997).

         10.29      Form of Warrant to Purchase Common Stock issued by the
                    Company to certain individuals and employees pursuant to the
                    cancellation of their performance shares (Incorporated
                    herein by reference to Exhibit 10.29 of Registrant's Report
                    on Form 10-K filed June 30, 1997).

         10.30      Note Purchase Agreement dated as of November 20, 1997 by and
                    between the Registrant and each of Pequot Partners Fund,
                    L.P. and Pequot International Fund, Inc., with forms of
                    Secured Convertible Promissory Note and Warrant for Common
                    Stock attached.

         10.31      Securities Exchange Agreement dated as of April 10, 1997 by
                    and between the Registrant and the Individuals listed on the
                    Schedule of Purchasers contained therein.

         10.32      Employment Agreement dated as of September 15, 1997 by and
                    between the Registrant and Michelle Kraus.

         10.33      Lease dated November 14, 1994 by and between Fordham
                    Properties Inc. and the Registrant.

         10.34      Registrant's 1996 Stock Option Plan, as amended.

         21.1       List of Subsidiaries.

         23.1       Consent of PricewaterhouseCoopers LLP.

         23.2       Consent of Deloitte & Touche LLP.

         27.1       Financial Data Schedule.
</TABLE>

(b)      REPORTS ON FORM 8-K

         No reports were filed during the fourth quarter of the year ended March
31, 1998.


                                       -35-
<PAGE>

                                   SIGNATURES

         In accordance with Section 13 or 15(d) of the Exchange Act, the
registrant has duly caused this Annual Report on Form 10-K to be signed on
October 2, 1998, on its behalf by the undersigned, thereunto duly authorized.

                                       SANCTUARY WOODS MULTIMEDIA CORPORATION

                                       By /s/ Michelle Kraus
                                          ----------------------------------
                                            Michelle Kraus
                                            Director, President and
                                            Chief Executive Officer

         In accordance with the Exchange Act, this report has been signed below
by the following persons on behalf of the registrant and in the capacities and
on the date indicated.

<TABLE>
<CAPTION>
Signature:                                                     Date:
<S>                                                            <C>

/s/ Michelle Kraus                                             October 2, 1998
------------------------------------------------------
Director, President and CEO
(principal executive and financial officer)

/s/ Marylyn Rosenblum                                          October 2, 1998
------------------------------------------------------
Chairman and Director

/s/ Lawrence Lenihan                                           October 2, 1998
------------------------------------------------------
Director            

/s/ Erik Jansen                                                October 2, 1998
------------------------------------------------------
Director       
</TABLE>