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                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                                    FORM 10-K
(Mark One)
[ X ]          ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                         SECURITIES EXCHANGE ACT OF 1934
                    For the fiscal year ended March 31, 1997

                                      OR

[   ]         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                         SECURITIES EXCHANGE ACT OF 1934
           For the transition period from ____________ to ____________
                         Commission file number: 0-21510

                     Sanctuary Woods Multimedia Corporation
             (Exact name of registrant as specified in its charter)


        Delaware                                   75-2444-09
        State or other jurisdiction of             (IRS Employer
        incorporation or organization              Identification No.)

        1825 South Grant Street
        San Mateo, California                      94402
        (Address of principal executive offices)   (Zip Code)

        Registrant's telephone number, including area code (415) 286-6000
        Securities registered pursuant to Section 12(b) of the Act: None
           Securities registered pursuant to Section 12(g) of the Act:
                          Common Stock, $.001 Par Value

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No[ ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and
will not 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. [x]

To the best of the Company's knowledge, the aggregate market value of the voting
shares held by non-affiliates of the registrant on June 27, 1997 (based on the
average over-the-counter bid and asked prices of such stock on such date) was
$4,471,327.

The number of shares of Common Stock of the registrant outstanding as of June
27, 1997, was 2,104,154.

                       DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant's Proxy Statement for its 1997 Stockholders' Meeting
("Proxy Statement") are incorporated by reference into Part I Item 4 and Part
III as set forth herein. Only such portions of the Proxy Statement as are
specifically incorporated by reference are made a part of this Annual Report on
Form 10-K.

Except where the context otherwise requires, as used herein, the term "Company"
means Sanctuary Woods Multimedia Corporation and its subsidiaries. In addition,
this Annual Report on Form 10-K includes trade names and marks of companies
other than the Company.


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                                     PART I

ITEM 1.  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
software market, 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, and changes or disruptions in the consumer software distribution
channels 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.

FISCAL YEAR

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 information presented herein to conform to the new
fiscal year end.

RECENT DEVELOPMENTS

Domestication into the State of Delaware. 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 adopt a Certificate of Incorporation and Bylaws under Delaware's
corporate legislation. The domestication became effective April 15, 1997.

Reverse Stock Split. On April 15, 1997, the Company's stockholders also 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 reverse stock
split.

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

Conversion of 8% Convertible Debentures into Series A Preferred Stock. In April
1997, the Company exchanged $5,302,000 in 8% convertible 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




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privileges on an "as converted" basis. The Series A Preferred stock
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 a share
of Series A Preferred Stock (currently $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 1,021,474 shares of the Company's common stock at an exercise price
of U.S. $3.00 per share and reduced the exercise price of 132,550 previously
issued warrants from $13.75 to $3.00 per share. 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 forego interest ($225,445 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 warrants have certain rights
to have these shares registered.

Proposed Acquisition of Theatrix Interactive, Inc. On June 4, 1997, the Company
signed a definitive agreement to acquire 100% of the outstanding shares of
Theatrix Interactive, Inc. (Theatrix). The Company proposes to issue 3,102,528
shares of the Company's common stock in consideration for all the shares of
Theatrix capital stock and outstanding options and warrants. Up to an additional
500,000 shares of the Company's common stock are issuable fifteen (15) 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 will
set aside 300,000 shares, under its 1996 Stock Option Plan, for issuance to
former Theatrix employees who become employees of Sanctuary Woods and will issue
a warrant to Kingdon Capital, a stockholder of Theatrix, to purchase 500,000
shares of common stock of the Company at $3.00 per share. Consummation of the
transaction is conditioned on the approval of the Theatrix stockholders and
certain regulatory approvals. The Company's management expects the transaction
to be consummated in the quarter ended September 30, 1997.

INTRODUCTION

The Company develops, publishes and markets interactive multimedia educational
software content (programs) for use in 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 multimedia-equipped personal
computers (MPC) which include sound capabilities and a CD-ROM drive (desktop
systems). The Company believes that as more powerful personal computers become
less costly and more widely available to consumers and classrooms, demand for
multimedia products and content will continue to grow. Another category of
systems is the "set-top" system, designed primarily for connection to the
consumer's television (i.e. Sony Playstation, Sega Saturn). The Company has
developed for such systems in the past but has no current plans to do so in the
future.

The Company presently develops products for the Macintosh, Windows and Windows
95 platforms and numerous browsers. By developing products for multiple
platforms, the Company expects to reduce the risk of dependence on any one
platform, while enabling it to build the development tools that will keep it
technologically responsive as new technologies emerge. However, the
proliferation of inexpensive PC based multimedia computers have given Windows
based products more than an 80% market share. In addition, CD-ROM capacity
allows developers to produce "hybrid disks" which place both MacIntosh and PC
platforms on a single CD-ROM.

In the last several years the internet has provided another platform for
distribution of multimedia programs. Accordingly, the Company has begun to
develop specific content for the internet. The Company also 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 band-width 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.



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CD-ROM. The Company's products are designed primarily for delivery on CD-ROM
because of the cost benefits available from the use of this medium as a mass
storage device, and the proliferation of this medium as the preferred consumer
platform. In addition, because the manufacturing technology is so well
developed, CD-ROMs can be purchased and replicated through numerous qualified
sources with short lead-times thereby reducing inventory risks. The Company
believes that the emergence of Digital Video Disk (DVD) technology will also
become a standard medium for the delivery of products in the future.

PRODUCTS

The Company's products are organized into families of like products under
differing brand names. The "Head Coach" brand of products uses sports themes to
help kids develop their reading and math skills. The Head Coach products
currently 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. The Franklin brand of products contain the popular storybook turtle
"Franklin." These programs use animation and a curriculum-based approach to help
develop important learning skills. The Sanctuary Woods brand of products
contains some of the Company's older titles including those purchased from Magic
Quest in 1994.

HEAD COACH(TM)

NFL(TM) 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 23 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 25 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 2,000 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.

FRANKLIN(TM)

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, 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.

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. The diskette version
of this product is sold under the name, Franklin's Reading Fun.



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SANCTUARY WOODS(TM)

Ripley's: How Do You Spell Adventure. This program for kids ages 9 to 14
combines an amazing adventure game with unusual and outlandish content from the
Ripleys Believe It or Not archives. There are adventures in a jungle, a Chinese
temple and a bat cave through which kids develop their skills in reading,
spelling and vocabulary.

Travelrama. This multi-player board game helps players of all ages sharpen
geography, math and social studies skills as they use the Rand McNally road map
to scour the country in search of monuments, national parks, historical
locations and points of interest while picking up picture postcards along the
way. Multiple levels allow kids of different ages to compete against the
computer or each other.

Math Ace Grand Prix. This products allows kids, ages 8 to 14, to build an
on-screen racetrack by answering more than 3,000 math questions in this
multi-level game while learning 11 essential math 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.

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 and teachers throughout the
United States and Canada. These titles include Sitting on the Farm, The Cat Came
Back, Earth Treks, Ecology Treks, Time Treks, and Addison-Wesley's Real World
Math.

PRODUCT DEVELOPMENT

During 1996, the Company developed products in three studio locations: Victoria,
British Columbia; Toronto, Ontario; and San Mateo, California. The Victoria
Studio produced the Company's entertainment products, while the Toronto and San
Mateo studios developed the kids' products. In May 1996, the Company sold the
studio in Victoria, British Columbia pursuant to management's decision to
discontinue the development of entertainment titles. The Company closed its
Toronto office in January 1997 to consolidate its operations in California.

The Company maintains an internal product development team consisting of
producers, artists, programmers and engineers. Depending on the complexity of
the titles and the target player platforms, the elapsed development time per
title is typically 4 to 9 months.

In 1995 and prior, the Company entered into development agreements with
third-parties to develop programs to be published under the Company's name. The
Company ceased outside development of titles in January 1996.

During fiscal 1997 and calendar 1995 and 1994 respectively, the Company spent
$1,395,671, $4,495,963, and $5,056,661 on research and development. Research and
development expenditures in 1994 included $1.0 million allocated to in-process
research and development in connection with the Company's purchase of Magic
Quest, that was charged to operations in the June 1994 calendar quarter.

In 1995 and 1994, the Company developed products using outside developers. Such
product development was often associated with a royalty to the third party
developer based upon sales of the product developed. Payments made to the
developer in advance of release of the product were reported as prepaid and
deferred royalties. When royalties were earned, such prepaid and deferred
royalties were expensed. Prepaid and deferred amounts were also expensed based
on management's estimation of future product sales. In the fourth quarter of
1995, the Company expensed substantially all prepaid and deferred royalties
related to entertainment products, due to a strategic 



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shift in the Company's focus to the children's home and education markets and a
net realizable value analysis of the recoverability of such prepaid and deferred
royalties. The Company currently has a prepaid and deferred royalty balance
corresponding to certain deferred royalty obligations related to education
products.

The Company from time to time may seek to expand its product lines and enhance
its market position by adding complementary products, technologies and
companies. Such expansion may take place through internal development, mergers
or acquisitions, licensing agreements, joint ventures, combinations with
strategic investors, or other similar arrangements.

LICENSING ARRANGEMENTS FOR INTERNAL PRODUCT DEVELOPMENT

The Company's product development strategy focuses on curriculum-based
educational content combined with major league sports themes and/or recognizable
licensed characters/products. The Company seeks opportunities to license the use
of recognizable characters and/or content libraries or to develop them jointly
with others. To date, the Company has entered into a number of such arrangements
including agreements with the NFL and Major League Baseball permitting the use
of their respective team names, logos, and other licensed properties. The
Company also has an agreement with Kids Can Press Ltd. to develop and publish
multiple titles based upon the "Franklin the Turtle" series of children's books.

The license agreements require the Company to pay certain 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
(ii) a fixed amount per unit of sales, or (iii) a percentage of net 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's failure to comply could
result in the termination of such license agreements, and potentially the loss
of the right to distribute the products licensed. Termination of such license
agreements could materially adversely affect the Company's ability to sell such
products, and could materially adversely affect the Company's financial results.

In 1993, the Company entered into a licensing agreement with Ripley
Entertainment, Inc. ("Ripley"), the publisher of "Ripley's Believe It or Not,"
for certain rights to use Ripley's existing archive materials to develop and
market interactive multimedia products on CD-ROM and certain other electronic
media. The Company released two titles under this license, The Riddle of Master
Lu and How Do You Spell Adventure? In June 1996, in exchange for a $550,000
reduction in outstanding royalty obligations and other concessions, the Company
sold the license back to Ripley along with the publishing rights to The Riddle
of Master Lu and the development plans to one other title for this series.

DISTRIBUTION AND MARKETING

The Company sells its products through distributors, computer superstores,
electronic stores, mass merchandisers, discount warehouse stores, office stores
and educational dealers using its own in-house sales force, outside sales
representative and contracted sales agents. In addition, the Company also sells
its products directly to schools and consumers. International sales are derived
from licensing agreements with foreign distributors.

The Company targets its efforts in the following channels:

(i) Consumer retail. Store accounts are supplied through a variety of software
distributors and direct to certain accounts in the United States and Canada.

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

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



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(iv) 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.

(v) 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.

During the fiscal year ended March 31, 1997, the Company had sales to two
customers, Eidos Interactive and Navarre Corporation, that represented 18% and
16% of total net sales, respectively. 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 sales. In 1994,
pursuant to a distribution agreement, the Company had sales to one customer
which represented 37% of total net sales.

Beginning in 1996, the Company began focusing its efforts on the development and
distribution of education titles for the education marketplace and began
allocating resources toward developing an educational sales strategy hiring an
educational sales staff and a VP of Education.

The Company also allocated resources to the development of its internet
web-site. The site located at www.ah-hah.com provides consumers with up-to-date
information on the Company and its products. In June 1997, the Company began
receiving customer orders at its web-site. The Company intends to devote
additional resources to increase the use of the web-site as an alternate
distribution channel. The Company has been and will continue to develop content
for the internet which plans to distribute on its own web site and others
through syndication.

There is intense competition for the limited shelf space and promotional
resources of software retailers and such competition is expected to increase as
the multimedia software market continues to develop. There can be no assurance
that the Company will be able to obtain shelf space for its products. As with
other companies in the industry, the Company has experienced difficulty in
maintaining its retail shelf presence as software titles have proliferated. The
Company has attempted to overcome this difficulty by maintaining strong
relationships with retail and wholesale buyers, and through a more targeted
approach to using its resources for channel marketing and promotions.
Nonetheless, there can be no assurance that the Company will be successful in
increasing or maintaining its shelf penetration or market share percentages.

Industry practice and competitive pressures generally require the Company to
accept returns of unsold product from wholesale distributors and retailers,
including product that is defective, shelf-worn or damaged. To mitigate exposure
to returns, the Company may choose to reduce the price of previously shipped
products to enable retailers to sell slow moving inventories. 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,
however, the Company's distributors are not required to provide the Company with
this information. The Company recognizes revenue (net of an allowance for
product returns and price protection) from the sale of its products upon
shipment to its distributors, even though such products may be returned to the
Company. At the time of product shipment, the Company establishes reserves which
estimate the potential for future product returns and price protection
concessions based on seasonal terms of sale, distributor and retailer
inventories of the Company's products, as well as other factors. Actual product
returns or price protection concessions that exceed the Company's reserves could
materially adversely affect the Company's business, operating results and
financial condition in the quarter in which the products are shipped and in
subsequent quarters, and could increase the magnitude of quarterly fluctuations
in the Company's operating and financial results. For example, in the fourth
quarter of 1995, the Company established reserves that were significantly higher
than historical levels due to slower than expected sell through of its products,
including products that were shipped and for which the Company recognized
revenue in the third quarter of 1995. As a result, in the fourth quarter of
1995, the Company recorded product return and price protection reserves of
$5,475,002, and reported negative net revenues. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations".



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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, it
may be difficult for the Company to estimate reserves accurately with respect to
newly introduced products or those products sold through new distribution
channels. The Company believes its success in the near term depends on the
successful introduction and market acceptance of its new products. If the
Company is not successful in introducing its new products, operating results
will be materially adversely affected.

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 substantial
resources and attention to the packaging of its products, which it considers a
major marketing tool. The Company also employs certain full-time technical
support personnel to assist customers in the use of the Company's products.

COMPETITION IN THE EDUCATIONAL SOFTWARE MARKET

The educational software industry is intensely competitive, and market
acceptance for any of the Company's software products may be adversely affected
by competitors introducing similar products with greater consumer appeal. The
Company's products compete not only with CD-ROM programs but also with diskette
and, to some extent, cartridge-based video game products. As discussed above,
increased competition could result in loss of shelf space for, and reduction in
sell-through of, the Company's products at retail stores in addition to putting
significant downward pressure on pricing. Increased competition can also create
difficulty in attracting and maintaining key employees. Any of these events
could adversely affect the Company's operating results.

The Company competes against a large number of other companies of varying sizes
and resources including, among others, CUC International Inc., The Learning
Company Inc., Disney Co., Broderbund Software Inc., Creative Wonders Inc. and GT
Interactive Software Corp. Currently, the Company's competitors fall into three
general categories, (i) companies already producing computer games or other home
entertainment software, (ii) divisions of major corporations established to
pursue what is referred to as "the new media market," and (iii) small private
companies and even start-up companies whose names are not well-known but whose
founders or key personnel are recognized talents within the industry. In
addition, there has been significant consolidation of software publishers, with
large companies acquiring certain independent publishers, such as SoftKey's
acquisition of The Learning Company, and CUC International's acquisitions of
Sierra Online and Davidson & Associates. Many of the Company's competitors have
substantially greater financial, technical and marketing resources than the
Company. Such consolidation may further increase these competitors' resources.
Strong financial resources provide access to established distribution channels
and support a strong development budget. The Company is actively pursuing
strategies in order to increase its financial resources and market strength,
including strategic relationships, raising of additional capital, and mergers
and/or acquisitions. There can be no assurance, however, that the Company will
be successful in consummating any such relationships or activities, or that if
consummated, such relationships or activities will be successful.



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Among many key factors affecting the competitiveness of multimedia 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 believes that its products compete
favorably in terms of design and content, ease of operation, quality, and
reliability and less favorably in terms of access to distribution and retail
shelf space, price, and support service. The Company lowered its price levels in
1996 to compete more effectively, and in February 1996 terminated a relationship
with a third party that was providing the Company with support services. 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.

MANUFACTURING

The Company contracts with a variety of third party vendors, primarily IPC
Communications located in San Jose, California, for the mass production,
packaging and order fulfillment services relating to its CD-ROM products. The
CD-ROM industry uses many of the same production facilities as the music CD
industry, and benefits from similar economies of scale. During 1997 and 1995,
the Company also utilized Softworld Services of Milpitas, California and
Certified Media, Inc. of San Jose, California for its manufacturing. Although
IPC Communications currently performs most of the Company's manufacturing
operations, the Company believes that it could enter into similar arrangements
with a number of other qualified suppliers without material expense or delay,
and may do so in the future. To date, the Company has not experienced any
material difficulties or delays in obtaining suppliers for the manufacture and
assembly of its products. Normal production runs take less than two weeks,
allowing the Company to maintain minimal backlogs.

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 experienced an
unusually high level of product returns in the three month periods ended March
31 and June 30, 1996, and thus maintained higher than normal inventory levels.
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 no patents and much 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.

The Company has registered the trademark "Sanctuary Woods" and "Head Coach" in
the United States for the promotion of goods and services and computer
programming and the designing of computer programs, has registered certain
others of its trademarks in the United States, and has filed applications for
trademark registration for certain of its marks in a number of foreign
countries. The Company has also filed trademark applications in the United
States for various other trademarks, including its trees logo.

The Company owns copyrights in its various titles and has various applications
on file for U.S. registrations of its copyrights on certain products. However,
existing copyright 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 



                                       9
<PAGE>   10

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 costly litigation 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.

PUBLISHER SERVICES DIVISION

In May 1996, the Company closed its Dallas studio and ceased operating its
publisher services business. The closure of this facility was completed on May
15, 1996.

EMPLOYEES

As of June 20, 1997, Sanctuary Woods had approximately 35 full-time employees.
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 the services 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 is represented by a
collective bargaining agreement nor has the Company experienced a work stoppage.

ITEM 2.  PROPERTIES

The Company leases approximately 7,500 square feet of office space in San Mateo,
California where the Company maintains its principal executive offices. The San
Mateo facility is subject to a lease which expires June 30, 1999. The Company
believes that its facilities provide suitable and adequate production capacity.

ITEM 3.  LEGAL PROCEEDINGS

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.

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

There were no matters submitted to a vote of security holders during the year
ended March 31, 1997.



                                       10
<PAGE>   11

                                     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 Company's Common Stock was traded in Canada on the Vancouver Stock Exchange
until March 1997 when it was delisted at the Company's request in connection
with the Company's domestication to the state of Delaware.

The following tables set forth, for the periods indicated, closing prices for
the Company's Common Stock as reported by the Vancouver Stock Exchange, the
Nasdaq National Market and the OTC Bulletin Boards. The prices have been
adjusted to reflect the one-for-twenty share consolidation effected by the
Company on April 15, 1997.

                            VANCOUVER STOCK EXCHANGE

<TABLE>
<CAPTION>
FISCAL 1997                      HIGH            LOW
<S>                         <C>             <C>   
June 1996                   CDN  $42.00     CDN  $16.00
September 1996              CDN  $19.60     CDN   $9.80
December 1996               CDN  $16.00     CDN   $4.40
March 1997                  CDN   $5.80     CDN   $4.20

FISCAL 1996
June 1995                   CDN $150.00     CDN  $60.00
September 1995              CDN $205.00     CDN $125.00
December 1995               CDN $175.00     CDN  $60.00
March 1996                  CDN $ 85.00     CDN  $11.40
</TABLE>

                    NASDAQ NATIONAL MARKET/SMALL CAP SYSTEMS

<TABLE>
<CAPTION>
FISCAL 1997                            HIGH           LOW
<S>                                 <C>           <C>   
June 1996                             $31.25        $12.50

FISCAL 1996
June 1995                            $107.50        $45.00
September 1995                       $157.50        $87.50
December 1995                        $140.00        $40.00
March 1996                            $65.00         $7.50
</TABLE>

                          OTC ELECTRONIC BULLETIN BOARD

<TABLE>
<CAPTION>
FISCAL 1997                            HIGH           LOW
<S>                                   <C>            <C>  
September 1996                        $15.00         $2.50
December 1996                         $12.50         $1.25
March 1997                            $15.00         $0.63
</TABLE>



                                       11
<PAGE>   12

The Company has not paid cash dividends and has no present plans to do so. There
were approximately 300 stockholders of record on June 15, 1997, excluding
stockholders whose stock is held in nominee or street name by brokers.


                                  EXCHANGE RATE INFORMATION

Since June 1, 1970, the Government of Canada has permitted a floating exchange
rate to determine the value of the Canadian dollar against the U.S. dollar. The
high and low exchange rates, the average rates (average of the exchange rate on
the last day of each month during the period) and the end of the period rates
for United States dollars, expressed in Canadian dollars, for the years ended
December 31, 1993 through 1996, based on the New York buying rate for cable
transfers payable in Canadian dollars as certified for customs purposes by the
Federal Reserve Bank of New York, were as follows:

                           CDN DOLLARS PER U.S. $1.00

<TABLE>
<CAPTION>
                                 1996         1995         1994
<S>                           <C>          <C>          <C>     
End of Period                 $ 1.3696     $ 1.3652     $ 1.4028
Average                       $ 1.3653     $ 1.3725     $ 1.3657
High                          $ 1.3860     $ 1.4235     $ 1.4074
Low                           $ 1.3306     $ 1.3282     $ 1.3102
</TABLE>

At March 31, 1997, the Company had either sold or terminated all of its assets
and operations in Canada.


ITEM 6.  SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
                                   TRANSITION
                                     PERIOD
                       YEAR ENDED     ENDED     YEAR ENDED    YEAR ENDED    YEAR ENDED    YEAR ENDED
                        3/31/97      3/31/96    12/31/95(1)   12/31/94 (2)   12/31/93      12/31/92
<S>                    <C>         <C>         <C>           <C>           <C>            <C>     
Sales                  $ 4,749,351    $937,612 $10,981,097    $6,261,226   $ 1,424,971     $527,265
Cost of sales            1,512,871     924,210  12,575,831     3,057,368       994,153      303,083
Gross margin
(deficit)                3,236,480      13,402  (1,594,734)    3,203,858       430,818      224,182
Operating loss         (4,071,238) (4,445,340) (18,684,569)  (8,027,801)   (4,436,009)    (625,756)
Net loss               (3,677,011) (4,514,171) (18,698,441)  (7,404,436)   (4,221,569)    (586,392)
Net loss per share          (3.30)      (4.97)     (22.16)       (10.58)        (9.15)       (1.79)
Number of shares used
  in computation         1,113,145     907,904     843,687       699,684      461,571      326,762
Working capital
(deficit)                (966,479) (6,299,113) $(2,314,531)  $ 6,363,968     $ 649,247    $ 981,644
Total assets             2,286,799   4,593,861   6,598,634    12,849,414     4,238,990    1,945,122

Current liabilities      2,532,745   8,914,312   6,354,655     2,095,651       669,675       99,671
Long-term obligations    5,302,000     547,781     601,359       770,000       970,000       55,232
Shareholders' equity
  (deficit)            (5,547,946) (4,868,232)   (357,380)     9,983,763     2,599,315    1,790,219
</TABLE>



                                       12
<PAGE>   13

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

(2)   Reflects acquisition of Magic Quest, Inc., effective June 30, 1994, and
      resultant write-off of $1,034,958 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.

In 1996, management discontinued the development of home entertainment products
and narrowed the Company's focus to the development and publication of
educational software products for the children's home and education markets, and
in fiscal 1996 released six new educational products: Major League Math(TM),
Franklin Learns Math(TM), How do you Spell Adventure?(TM), NFL(TM) Math and
NFL(TM) Reading and Major League Math(TM) Second Edition.

The Company also took various steps to restructure its operations, including
changing the Company's year end to March 31, installing new senior management,
substantially reducing head count from 148 employees at December 31, 1995 to 32
employees at March 31, 1997, closing the Company's Publisher Services division,
selling substantially all of the fixed assets of the Entertainment division and
eliminating the Company's outstanding debt. In addition, in April 1997, 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 $5.3 million in outstanding convertible
debentures for Series A Preferred Stock and warrants, cancelled the performance
shares and raised $2.2 million in a rights offering.

The Company sells its products in North America through distributors as well as
directly to schools and retailers, such as computer superstores, electronic
stores, mass merchandisers, discount warehouse stores and office stores, and
internationally through licensing arrangements with foreign distributors.

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 information presented herein to conform to the new
fiscal year end.

NET LOSS

For the fiscal year ended March 31, 1997, the Company incurred a net loss of
$3,677,011 and an operating loss of $4,071,238. This included a net gain of
$897,000 from the sale of the Company's studio in Victoria, British Columbia.
The net loss for the year included the following:

-   bad debt losses of $329,360 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.



                                       13
<PAGE>   14

-   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 from the Victoria studio up to its sale in May
    1996 and costs related to the closure of the Toronto studio.

NET REVENUES

Net revenues in 1997 were $4.7 million including 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 1997 decreased
substantially from net revenues of $11.0 million in 1995 and $6.3 million in
1994, in part due to the fact that in 1996 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.ah-hah.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 1997 were $1.5 million or 31% of net revenues as compared to
$12.6 million in 1995 and $3.1 million in 1994. Cost of sales decreased in 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 were $1.4 million in
1997 or 29% of net revenue as compared to $4.5 million in 1995 and $5.1 million
in 1994. Research and development expenses decreased in 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 $3.1 million in 1997 or 63%
of net revenue as compared to $8.3 million in 1995 and $3.7 million in 1994. The
reduction in marketing and sales expenses in 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 education products.

Administration. Administrative expenses were $2.5 million in 1997 or 53% of net
revenue as compared to $3.5 million in 1995 and $1.9 million in 1994. Although
actual administrative expenses decreased in 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



                                       14
<PAGE>   15

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.

Depreciation. Depreciation expenses were $354,823 in 1997 or 7% of net revenue
as compared to $852,211 in 1995 and $529,636 in 1994 . Depreciation expenses
decreased in 1997 primarily due to the Company's sale of its studio in Victoria,
British Columbia.


LIQUIDITY AND CAPITAL RESOURCES

The Company has had operating losses in each fiscal year since its inception and
as of March 31, 1997, had an accumulated deficit of $39.5 million and total
stockholders deficit of $5.5 million.

Operating activities in 1997 used $5.6 million in cash. The Company financed its
operating activities through the issuance of $5.3 million in convertible debt,
the receipt of $750,000 from the issuance of Common Stock on exercise of
warrants and the receipt of $1.9 million from the sale of the Company's studio
in Victoria, British Columbia. At March 31, 1997, cash was $101,932. On April
11, 1997, however, the Company closed a rights offering of its Common Stock in
which it raised $2.2 million.

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. If
the Company's revenues are not sufficient to cover these expenditures, the
Company will likely experience ongoing losses and require additional capital
infusions.

In connection with the proposed acquisition of Theatrix Interactive, Inc., the
Company expects that its working capital requirements will substantially
increase. As a result, management believes that the Company's existing cash
resources, cash flows from operations and the cash resources acquired from
Theatrix will fund continuing operations only through August 31, 1997.

Current Status and Management's Plans

At June 20, 1997, the Company had cash of $930,000. Management believes that 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, 1998
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 various business combinations (see note 2 regarding proposed
acquisition of Theatrix) and 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.

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.



                                       15
<PAGE>   16

ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not applicable.

RISK FACTORS

RISKS RELATED TO BUSINESS AND OPERATIONS OF SANCTUARY WOODS

Continued Losses; Liquidity. The Company had operating losses and net losses in
each fiscal year since its inception and has suffered operating losses in each
of its last five quarters. In the three years ended March 31, 1997, December 31,
1995, and December 31, 1994, the Company reported operating losses of $4.1
million, $18.7 million and $8.0 million, respectively, and net losses in each of
these years of $3.7 million, $18.7 million and $7.4 million, respectively. The
losses were primarily due to low sales volumes and with respect to fiscal year
ended 1997 to expenses incurred by the Company in connection with steps taken by
Sanctuary Woods to reorganize or consolidate its operations, 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 cancellation of outstanding
Performance Shares in consideration for Common Stock of the Company. Losses were
also due to the write-off of certain significant assets as a result of the
Company's lack of capital resources and its reassessment of the future
salability of certain products. There is no assurance that the Company will
become profitable in the near future or at all.

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 



                                       16
<PAGE>   17

debentures for equity and the cancellation 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 edutainment 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 may continue to
broaden their product lines and potential competitors, including large computer
or software manufacturers, entertainment companies, diversified media companies,
and book publishers, 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, and 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 levels of 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 person 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 edutainment 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 



                                       17
<PAGE>   18

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.

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 to be played 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 products
on that platform. If the Company invests in a platform that does not achieve
significant market penetration, the Company's planned revenues from those
products will be adversely affect 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 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 the platforms that ultimately will 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 will 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
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 



                                       18
<PAGE>   19

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.

Relationship 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
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




                                       19
<PAGE>   20

exchange rates in the future will not have a material adverse effect on the
Company's business, operating results and financial condition.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                                      INDEX

<TABLE>
<CAPTION>
                                                                                   Page
<S>                                                                                <C>
Independent Auditors' Report - Deloitte & Touche LLP                                21

Independent Auditors' Report - Deloitte & Touche                                    22

Consolidated Balance Sheets:
    March 31, 1997 and 1996                                                         23

Consolidated Statements of Operations:
    Years Ended March 31, 1997, December 31, 1995 and 1994
    and the Three Month Period Ended March 31, 1996                                 24

Consolidated Statements of Stockholders' Equity:
    Years Ended March 31, 1997, December 31, 1995 and 1994
    and the Three Month Period Ended March 31, 1996                                 25

Consolidated Statements of Cash Flows:
    Years Ended March 31, 1997, December 31, 1995 and 1994
    and the Three Month Period Ended March 31, 1996                                 26

Notes to Consolidated Financial Statements                                          27

Consolidated Financial Statement Schedules

Supplemental Schedule II - Valuation and Qualifying Accounts 
    Years Ended March 31, 1997, December 31, 1995 and 1994
    and the Three Month Period Ended March 31, 1996                                 38
</TABLE>


                                       20

<PAGE>   21

                          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 1996, and the related
consolidated statements of operations, stockholders' equity (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 38. 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 accompanying consolidated financial statements present
fairly, in all material respects, the financial position of the Company as of
March 31, 1997 and 1996, 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 3 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 3. The consolidated financial statements do not include any adjustments
that might result from the outcome of this uncertainty.

DELOITTE & TOUCHE LLP

San Francisco, California
June 20, 1997



                                       21
<PAGE>   22

                          INDEPENDENT AUDITORS' REPORT

To the Shareholders of
Sanctuary Woods Multimedia Corporation

We have audited the consolidated statements of operations, stockholders' equity
and cash flows of Sanctuary Woods Multimedia Corporation and its subsidiaries
(the "Company") for the year ended December 31, 1994. Our audit also included
the 1994 consolidated financial statement schedule appearing on page 38. These
consolidated financial statements and the 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 1994 consolidated
financial statement schedule based on our audit.

We conducted our audit in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform an audit
to obtain reasonable assurance whether the financial statements are free of
material misstatement. An audit included 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 audit provides a reasonable basis for our
opinion.

In our opinion, such consolidated financial statements present fairly, in all
material respects, the results of operations of the Company and its cash flows
for the year ended December 31, 1994 in accordance with accounting principles
generally accepted in the United States. Also, in our opinion, the 1994
consolidated financial statement schedule, 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.

Effective July 1, 1994, the Company changed its functional currency to United
States dollars from Canadian dollars and effective November 1, 1994, the Company
changes its reporting currency to United States dollars from Canadian dollars.

DELOITTE & TOUCHE

Chartered Accountants
Vancouver, British Columbia, Canada
February 23, 1995 (except for the second paragraph of Note 2 and the first
        paragraph of Note 13 which are as of April 15, 1997, and the second
        paragraph of Note 8 which is as of September 20, 1995)



                                       22
<PAGE>   23

SANCTUARY WOODS MULTIMEDIA CORPORATION
CONSOLIDATED BALANCE SHEETS


<TABLE>
<CAPTION>
                                                    MARCH 31,       MARCH 31,
                                                      1997             1996
<S>                                               <C>                <C>   
ASSETS

CURRENT ASSETS:
  Cash                                                 $101,932           $8,455
  Accounts receivable                                   275,335          800,701
  Inventories                                           656,415        1,384,840
  Prepaid royalties                                     197,941          127,000
  Prepaid expenses                                      244,136          294,203
  Prepaid offering expenses                              90,507
                                                    -----------      -----------
          Total current assets                        1,566,266        2,615,199

PROPERTY AND EQUIPMENT                                  462,348        1,834,266
PREPAID ROYALTY OBLIGATIONS                                   -          134,000
DEFERRED WARRANT EXPENSE & OTHER                        258,185           10,396
                                                    -----------      -----------
TOTAL ASSETS                                        $ 2,286,799      $ 4,593,861
                                                    ===========      ===========

LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)

CURRENT LIABILITIES:
  Accounts payable                                   $1,343,214      $ 3,087,886
  Accrued expenses                                      579,297        1,388,359
  Accrued  interest                                     225,443            7,000
  Royalty obligations                                   371,043          611,905
  Current portion of capital lease obligations           13,748           28,715
  Bank debt                                                            2,226,781
  Notes payable                                                        1,563,666
                                                    -----------      -----------

           Total current liabilities                  2,532,745        8,914,312

8% CONVERTIBLE SUBORDINATED DEBENTURES                5,302,000
LONG-TERM ROYALTY OBLIGATIONS                                            534,000
CAPITAL LEASE OBLIGATIONS                                                 13,781
                                                    -----------      -----------
           Total liabilities                          7,834,745        9,462,093
                                                    -----------      -----------

COMMITMENTS AND CONTINGENCIES

STOCKHOLDERS' EQUITY (DEFICIT):
   Preferred Stock, authorized  5,000,000, no
   par value none issued or outstanding
   Common Stock, authorized 50,000,000 shares,
   no par value, issued and outstanding, 
   1,171,582 shares and 1,107,929 shares             34,755,092       31,763,839
   Accumulated deficit                              (39,551,124)     (35,874,113)
   Accumulated translation adjustments                 (751,914)        (757,958)
                                                    -----------      -----------

           Total stockholders' equity (deficit)     (5,547,946)      (4,868,232)
                                                    -----------      -----------

 TOTAL LIABILITIES AND STOCKHOLDERS' 
    EQUITY (DEFICIT)                                $ 2,286,799      $ 4,593,861
                                                    ===========      ===========
</TABLE>


See notes to consolidated financial statements.



                                       23
<PAGE>   24

SANCTUARY WOODS MULTIMEDIA CORPORATION
CONSOLIDATED  STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
                                                            THREE MONTHS
                                              YEAR ENDED        ENDED         YEAR ENDED      YEAR ENDED
                                               MARCH 31,       MARCH 31,      DECEMBER 31,    DECEMBER 31,
                                                 1997            1996            1995            1994
                                            --------------- --------------- --------------- ---------------
<S>                                            <C>                <C>          <C>              <C>       
SALES:
  Consumer titles                              $ 2,698,535        $592,985     $ 8,733,313      $5,299,507
  Licensing revenue                              2,050,816         338,820       1,678,240         472,416
  Publisher services                                                 5,807         569,544         489,303
                                            --------------- --------------- --------------- ---------------

           Total sales                           4,749,351         937,612      10,981,097       6,261,226
                                            --------------- --------------- --------------- ---------------

COST OF SALES:
  Consumer titles                                1,512,871         759,288      11,413,590       2,401,565
  Technology amortization                                                          532,305         338,737
  Publisher services                                               164,922         629,936         317,066
                                            --------------- --------------- --------------- ---------------

           Total cost of sales                   1,512,871         924,210      12,575,831       3,057,368
                                            --------------- --------------- --------------- ---------------

GROSS MARGIN (DEFICIT)                           3,236,480          13,402      (1,594,734)      3,203,858
                                            --------------- --------------- --------------- ---------------

OPERATING EXPENSES:
  Research and development                       1,395,671       1,261,391       4,495,963       5,056,661
  Marketing and sales                            3,061,491       1,789,866       8,263,739       3,722,789
  Administration                                 2,495,733       1,196,553       3,477,922       1,922,573
  Depreciation                                     354,823         210,932         852,211         529,636
                                            --------------- --------------- --------------- ---------------

           Total operating expenses              7,307,718       4,458,742      17,089,835      11,231,659
                                            --------------- --------------- --------------- ---------------

OPERATING LOSS                                  (4,071,238)     (4,445,340)    (18,684,569)     (8,027,801)
                                            --------------- --------------- --------------- ---------------

OTHER INCOME (EXPENSE):
  Foreign exchange gain (loss)                      (5,095)           (203)         (4,307)        378,951
  Interest income (expense), net                  (401,169)        (68,628)         (9,565)        244,414
  Net gain on sale and disposal of assets          800,491
                                            --------------- --------------- --------------- ---------------

           Total other income (expense)            394,227         (68,831)        (13,872)        623,365
                                            --------------- --------------- --------------- ---------------

NET LOSS                                      $ (3,677,011)    $(4,514,171)   $(18,698,441)    $(7,404,436)
                                            =============== =============== =============== ===============

NET LOSS PER SHARE                                  ($3.30)         ($4.97)        ($22.16)        ($10.58)

SHARES USED IN COMPUTATION                       1,113,145         907,904         843,687         699,684
</TABLE>

See notes to consolidated financial statements.




                                       24
<PAGE>   25

SANCTUARY WOODS MULTIMEDIA CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)



<TABLE>
<CAPTION>
                                                 Common Stock                     Accumulated
                                           ------------------------  Accumulated  Translation
                                             Shares       Amount       Deficit    Adjustments     Total
                                           ------------------------------------------------------------------
<S>                                        <C>          <C>         <C>           <C>            <C>        
Balances, December 31, 1993                    710,804   $8,184,672 $ (5,257,065) $ (328,292)    $ 2,599,315
Exercise of warrants                             8,208      436,671                                  436,671
Exercise of stock options                       22,688      685,007                                  685,007
Shares issued for cash                         132,500   11,933,809                               11,933,809
Shares issued on acquisition of subsidiary     105,313    1,838,791                                1,838,791
Stock option compensation                                   317,305                                  317,305
Foreign currency translation adjustments                                            (422,699)       (422,699)
Net loss                                                              (7,404,436)                 (7,404,436)
                                           ------------------------------------------------------------------
Balances, December 31, 1994                    979,513   23,396,255  (12,661,501)   (750,991)      9,983,763
Exercise of warrants                               400       22,905                                   22,905
Exercise of stock options                       27,766    1,033,617                                1,033,617
Shares issued for cash                         100,000    7,168,868                                7,168,868
Stock option compensation                                   132,543                                  132,543
Foreign currency translation adjustments                                                (635)           (635)
Net loss                                                             (18,698,441)                (18,698,441)
                                           ------------------------------------------------------------------
Balances, December 31, 1995                  1,107,679   31,754,188  (31,359,942)   (751,626)       (357,380)
Exercise of stock options, net of
  issuance costs                                   250       (2,730)                                  (2,730)
Stock option compensation                                    12,381                                   12,381
Foreign currency translation adjustments                                              (6,332)         (6,332)
Net loss                                                              (4,514,171)                 (4,514,171)
                                           ------------------------------------------------------------------
Balances, March 31, 1996                     1,107,929   31,763,839  (35,874,113)   (757,958)     (4,868,232)
Exercise of warrants                            75,000      750,000                                  750,000
Conversion of notes payable                    156,379    1,562,501                                1,562,501
Conversion of accounts payable and 
  royalty obligations                           22,750      316,312                                  316,312
Cancellation of performance shares in
  exchange for shares of common stock, net    (190,476)        (841)                                    (841)
Stock option and warrant compensation                       363,281                                  363,281
Foreign currency translation adjustments                                               6,044           6,044
Net loss                                                              (3,677,011)                 (3,677,011)
                                           ------------------------------------------------------------------
Balances, March 31, 1997                     1,171,582 $ 34,755,092 $(39,551,124)  $(751,914)    $(5,547,946)
                                           ==================================================================
</TABLE>


See notes to consolidated financial statements.



                                       25
<PAGE>   26

SANCTUARY WOODS MULTIMEDIA CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS


<TABLE>
<CAPTION>
                                                                     THREE MONTHS
                                                      YEAR ENDED         ENDED        YEAR ENDED      YEAR ENDED
                                                      MARCH 31,        MARCH 31,     DECEMBER 31,    DECEMBER 31,
                                                         1997            1996            1995            1994
                                                    ---------------  --------------  --------------  -------------
<S>                                                   <C>            <C>             <C>              <C>         
CASH FLOWS FROM OPERATING ACTIVITIES:

   Net loss                                            $(3,677,011)    $(4,514,171)   $(18,698,441)   $(7,404,436)
    Depreciation and amortization                          360,719         211,457       1,709,552        975,859
    Stock option and warrant compensation                  143,878          12,381         132,543        317,305
    Sale of intellectual property
      rights in consideration for a
      reduction in royalty obligations                    (429,688)
    Net gain on sale and disposal of assets               (800,491)
    Consolidation of facilities and other items                            401,658
    Write off of research and development
      purchased                                                                                         1,034,958

   Changes in assets and liabilities:
    Accounts receivable                                    525,366         507,902       1,609,655     (2,780,750)
    Inventories                                            728,425         593,018     (1,277,633)       (649,537)
    Prepaid royalties, expenses and other                (237,466)         450,997       2,651,411     (1,921,539)
    Accounts payable and accrued expenses              (2,208,297)         439,100       2,148,494      1,518,611
                                                    ---------------  --------------  --------------  -------------

           Net cash used in operating activities       (5,594,565)      (1,897,658)    (11,724,419)    (8,909,529)
                                                    ---------------  --------------  --------------  -------------

CASH FLOWS FROM INVESTING ACTIVITIES:
  Proceeds from sale of assets                           1,919,500
  Purchases of property and equipment                      (30,951)        (79,267)       (958,283)    (1,817,911)
                                                    ---------------  --------------  --------------  -------------

           Net cash provided (used) in investing 
               activities                                1,888,549         (79,267)       (958,283)    (1,817,911)
                                                    ---------------  --------------  --------------  -------------

CASH FLOWS FROM FINANCING ACTIVITIES:

  Proceeds from issuance of notes, debentures and
     warrants                                            5,302,000       1,556,177
  Proceeds from exercise of warrants                       750,000
  Common stock issued - net of issue costs                                  (2,730)      8,225,390     13,055,487
  Net (repayments) borrowings on bank debt              (2,226,781)        426,781       1,800,000
  Repayments on long-term debt                             (28,748)                                       (76,032)
                                                    ---------------  --------------  --------------  -------------
           Net cash provided in financing activities     3,796,471       1,980,228      10,025,390     12,979,455
                                                    ---------------  --------------  --------------  -------------

EFFECT OF EXCHANGE RATE CHANGES ON CASH                      3,022          (6,332)           (635)      (363,294)
                                                    ---------------  --------------  --------------  -------------

NET INCREASE (DECREASE) IN CASH                             93,477          (3,029)     (2,657,947)     1,888,721

CASH, BEGINNING OF PERIOD                                    8,455          11,484       2,669,431        780,710
                                                    ---------------  --------------  --------------  -------------

CASH, END OF PERIOD                                       $101,932          $8,455         $11,484     $2,669,431
                                                    ===============  ==============  ==============  =============

SUPPLEMENTAL DISCLOSURES OF CASH FLOW  INFORMATION:
 Cash paid during the period for:
    Interest                                               $91,833         $57,985         $73,972         $2,237
    Income taxes                                             5,984                           1,600
Supplemental disclosures of non-cash 
 financing and investing activities:
   Conversion of notes payable into common stock         1,562,501
   Reduction in royalty obligations in exchange
      for issuance of common stock and sale of 
      intellectual property rights                         549,688
   Conversion of account payable into common stock         195,000
   Capital lease obligations                                                               $49,985
   Issuance of common stock on acquisition of
      Magic Quest                                                                                      $1,838,791
</TABLE>

See notes to consolidated financial statements.



                                       26
<PAGE>   27

SANCTUARY WOODS MULTIMEDIA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


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. Products are
     sold primarily through distributors into retail outlets. Sales are also
     made directly to schools, hardware manufacturers and bundlers (OEM), and to
     international distributors. 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, 1994 and 1995, the three month transition period ended March
     31, 1996 and the fiscal year ended March 31, 1997.

2.   SUBSEQUENT EVENTS

     Domestication into the State of Delaware. 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.

     Reverse Stock Split. On April 15, 1997, 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.

     Rights Offering. 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 $2,238,024.

     Conversion of 8% Convertible Debentures into Series A Preferred Stock. In
     April 1997, the Company exchanged $5,302,000 in 8% convertible debentures
     (see Note 3) 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 1,021,474 shares of the Company's common stock at an
     exercise price of U.S. $3.00 per share and reduced the exercise price of
     132,550 previously issued warrants from $13.75 to $3.00 per share. 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
     ($225,445 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 warrants have certain rights to have
     these shares registered.



                                       27
<PAGE>   28

     Proposed Acquisition of Theatrix Interactive, Inc. On June 4, 1997, the
     Company signed a definitive agreement to acquire 100% of the outstanding
     shares of Theatrix Interactive, Inc. (Theatrix). The Company will issue
     3,102,528 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 after the effective date of
     the merger if certain revenue goals are met with respect to products
     acquired from Theatrix. In addition, Sanctuary Woods will set aside 300,000
     shares, pursuant to the its 1996 Stock Option Plan, for issuance to former
     Theatrix employees who become employees of Sanctuary Woods and isssue a
     warrant to Kingdon Capital, a shareholder of Theatrix, Inc. to purchase
     500,000 Sanctuary Woods common shares at $3.00 per share. Consummation of
     the transaction is conditioned on the approval of the Theatrix stockholders
     and certain regulatory approvals. The Company's management expects the
     transaction to be consummated in the quarter ended September 30, 1997.

3.   GOING CONCERN UNCERTAINTY

     The Company incurred net losses of $3,677,011, $4,514,171 and $18,698,441
     in the fiscal year ended March 31, 1997, the three months ended March 31,
     1996 and the year ended December 31, 1995, respectively. Net cash used by
     operating activities was $5,594,565, $1,897,658 and $11,724,419 in the same
     periods respectively. At March 31, 1997 working capital deficit was
     $966,479 and stockholder's deficit was $5,547,946.

     Calendar 1995 Operations

     Sales in the fourth quarter 1995 were significantly below expectations and
     the Company experienced significantly higher than expected returns. In
     light of its operating and financial situation in the fourth quarter of
     1995, the Company accelerated write-offs of certain prepaid and deferred
     royalties and made additional provisions for returns, price protection and
     inventory obsolescence.

     The Company's 1995 net loss included certain significant adjustments
     recorded in the fourth quarter related to these matters as follows:

<TABLE>
<S>                                                             <C>         
     Estimated sales returns and price protection               $  5,475,002
     Write-offs of unrecoverable prepaid and deferred              4,260,532
     royalties
     Provision for inventory obsolesence                           1,033,389
     Write-offs of licenses and other intangibles                    235,000
                                                                ------------
     Total                                                      $ 11,003,923
                                                                ============
</TABLE>

     Calendar 1996 Operations

     Beginning in 1996, the Company commenced 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>
               <S>                                                 <C>       
               Closure of Publisher Services Division              $  437,000
               Severance expenses                                     210,000
               Consolidation of facilites and related items           358,000
               Estimated sales returns and price protection           426,000
               Provision for inventory obsolescence                   250,000
                                                                   ----------
               Total                                               $1,681,000
                                                                   ==========
</TABLE>



                                       28
<PAGE>   29

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

<TABLE>
<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 facilites and related items                       47,500
      Estimated sales returns and price protection                      150,000
      Provision for inventory obsolescence                              100,000
                                                                       --------
      Total                                                             547,500
                                                                       ========
      Other income - net gain on sale and disposal of assets           $875,161
                                                                       ========
</TABLE>

     1996 - 1997  Management Actions

     During 1996 and early 1997, the Company instituted measures to improve
     operations and cash flows. 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
          $897,260.

     -    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 $429,688 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.



                                       29
<PAGE>   30

     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 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.

     Bank Line of Credit

     In March 1997 the Company paid in full all amounts due under a bank line of
     credit which expired April 3, 1997. The outstanding loan balance was
     $2,226,781 at March 31, 1996.

     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 subsequent events in note 2).

     Current Status and Management's Plans

     At June 20, 1997, the Company had cash of $930,000. 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, 1998 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 various business combinations (see note
     2 regarding proposed acquisition of Theatrix, Inc.) and 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.

     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.

4.   SIGNIFICANT ACCOUNTING POLICIES

     BASIS OF PRESENTATION - The consolidated financial statements have been
     prepared in accordance with generally accepted accounting principles of the
     United States of America (U.S. GAAP).



                                       30
<PAGE>   31

     a.   Consolidation - The consolidated financial statements include the
          accounts of Sanctuary Woods Multimedia Corporation (a Canadian
          corporation, reincorporated into the State of Delaware in April 1997)
          and its wholly-owned subsidiaries, Magic Quest Inc. (California,
          U.S.A.) and Sanctuary Woods Multimedia Inc. (Nevada, U.S.A.). All
          intercompany balances and transactions are eliminated in
          consolidation.

     b.   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, 1997, the Company had no significant foreign accounts or
          operations.

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

     d.   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.

     e.   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 $147,218 for the fiscal year ended
          March 31, 1997, $94,340 in the three months ended March 31, 1996 and
          $7,233,046 and $330,185 in the years ended December 31, 1995 and 1994
          respectively. The 1995 royalty expense includes write-offs of prepaid
          and deferred royalties totalling $4,260,532 (see Note 3).

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

<TABLE>
            <S>                                               <C>    
            Computer equipment                                3 years
            Computer software                                 3 years
            Furniture and equipment                           5 years
</TABLE>

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

     g.   Technology Amortization represents the amortization of the cost of
          technology acquired through the 1994 acquistion 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 



                                       31
<PAGE>   32

          sales. Amounts were amortized using the straight-line method and were
          fully amortized as of December 31, 1995. In addition, $1,034,958 of
          the Magic Quest purchase price was allocated to in process research
          and development and charged to operations in 1994.

     h.   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 judgment by management with respect to certain
          factors affecting the Company's products, including, but not limited
          to, anticipated future 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.

     i.   Licenses and Other Intangibles - 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. In the fourth
          quarter of 1995, such estimates of the economic lives were
          significantly reduced and $235,000 of licenses and other intangibles
          were written-off.

     j.   Revenue Recognition - Revenue from product sales is recognized when
          products are shipped. 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. Revenue from
          publisher services was recognized when earned.

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

     l.   Net income (loss) per share. Primary earnings per share equals net
          income (loss) divided by the weighted average number of shares
          outstanding after giving effect to dilutive stock options and
          warrants. Fully diluted earnings per share is not presented because
          such amounts would be anti-dilutive.

     m.   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.

          The Black-Scholes model used by the Company to calculate option values
          pursuant to SFAS No. 123, as well as other currently accepted option
          valuation models, was developed to estimate the fair value of freely
          tradable, fully transferable options without vesting restrictions,
          which significantly differ from the Company's stock option awards.
          These models also incorporate highly subjective assumptions, including
          future stock price volatility and expected time until exercise, which
          greatly affect the calculated values. Under the Black-Scholes pricing
          model, stocks with high volatility provide option holders with a
          greater economic "upside" potential and, accordingly, result in a high
          option valuation. Thus management believes that the Black-Scholes
          model does not necessarily provide a reliable single measure of the
          fair value of the Company's option awards.



                                       32
<PAGE>   33

          As allowed under the provisions of SFAS No. 123, the Company provides
          proforma disclosures (see Note 9) of net income (loss) and earnings
          (loss) per share as if the accounting provisions of SFAS No. 123 had
          been adopted.

     n.   New accounting standards. In February 1997, The Financial Accounting
          Standards Board issued Financial Accounting Standards No. 128,
          "Earnings per Share" (SFAS 128). The Company is required to adopt SFAS
          128 in the December 31, 1997 quarter and will at that time restate
          earnings per share (EPS) data for prior periods to conform with SFAS
          128. Earlier application is not permitted.

          SFAS 128 replaces current EPS reporting requirements and requires a
          dual presentation of basic and diluted EPS. Basic EPS excludes
          dilution and is computed by dividing net income (loss) available to
          common shareholders by the weighted average of common shares
          outstanding for the period. Diluted EPS reflects the potential
          dilution that could occur if securities or other contracts to issue
          common stock were exercised or converted into common stock.

          If SFAS 128 had been in effect during the fiscal year ended March 31,
          1997, basic and diluted would not have been significantly different
          than EPS currently reported for the periods.

5.   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.

     Accounts receivable consisted of:

<TABLE>
<CAPTION>
                                         March 31, 1997     March 31, 1996
                                         --------------     --------------
<S>                                        <C>              <C>        
        Accounts receivable                $ 1,210,365      $ 4,814,104

        Less allowances for:
          Doubtful accounts                   (123,424)        (207,352)
          Sales returns and allowances        (811,606)      (3,806,051)
                                           -----------      -----------
        Accounts receivable - net          $   275,335      $   800,701
                                           ===========      ===========
</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 $5,475,002 for returns and price protection during the
     fourth quarter of 1995. These reserves related primarily to products sold
     during the third quarter of 1995 (see Note 3).



                                       33
<PAGE>   34

6.   INVENTORIES

     Inventories consisted of:

<TABLE>
<CAPTION>
                                         March 31, 1997    March 31, 1996
                                         --------------    --------------
<S>                                        <C>              <C>        
        Finished goods                     $   488,824      $ 1,967,558
        Raw materials                          339,491          866,957
                                           -----------      -----------
                                               828,315        2,834,515
        Less allowance for obsolete,
        slow-moving and non-salable
        inventories                           (171,900)      (1,449,675)
                                           -----------      -----------
        Inventories, net                   $   656,415      $ 1,384,840
                                           ===========      ===========
</TABLE>

     Inventory write-downs were $250,000 for the three months ended March 31,
     1996, and $150,000, $1,083,389 and $298,723 for the years ended March 31,
     1997 and December 31, 1995 and 1994 respectively.

7.   PROPERTY AND EQUIPMENT

     Property and equipment consisted of:

<TABLE>
<CAPTION>
                                         March 31, 1997   March 31, 1996
                                         --------------   --------------
<S>                                      <C>              <C>        
        Computer equipment                 $   695,459      $ 2,318,965
        Computer software                       98,612          477,188
        Furniture and equipment                146,455          504,287
        Leasehold improvements                  66,346          243,659
                                           -----------      -----------
            Total                            1,006,872        3,544,099
        Less accumulated depreciation         (544,524)      (1,709,833)
                                           -----------      -----------
        Property and equipment, net        $   462,348      $ 1,834,266
                                           ===========      ===========
</TABLE>

     As discussed in Note 3, 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.

8.   COMMON STOCK, OPTIONS AND WARRANTS

     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 $12,381 for the three
     months ended March 31, 1996 and $0, $132,543 and $317,305 for the years
     ended March 31, 1997, December 31, 1995 and 1994, respectively.

     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.

     Option activity is summarized as follows:



                                       34
<PAGE>   35

<TABLE>
<CAPTION>
                                                          OUTSTANDING OPTIONS
                                                      ---------------------------
                                                                    WEIGHTED AVG.
                                                         NUMBER       PRICE PER
                                                        OF SHARES       SHARE
<S>                                                    <C>          <C>       
      Outstanding at December 31, 1993                     61,051    $    36.61
      Granted (at a weighted fair value of $24.38)         54,800         46.19
      Exercised                                           (22,688)        29.94
      Canceled                                             (6,041)        80.70
                                                       ----------
      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
                                                       ==========

      Shares available for grant at March 31, 1997        129,300
                                                       ==========
</TABLE>

     The following table summarizes information about fixed stock options
     outstanding at March 31, 1997:

<TABLE>
<CAPTION>
                                      Outstanding                                Exercisable
                     -------------------------------------------------- ------------------------------
                                          Weighted       Weighted                          Weighted
                         Number           Average         Average           Number          Average
     Range of        Outstanding at      Remaining       Exercise       Exercisable at     Exercise
  Exercise Prices    March 31, 1997   Life (in years)      Price        March 31, 1997       Price
  ---------------    --------------   ---------------    ---------      --------------     ---------
<S>                  <C>              <C>               <C>             <C>                <C>    
$  10.00 - $10.60          1,500           4.38          $ 10.20               125         $ 10.60
   17.50 -  17.50         54,700           3.90            17.50            33,760           17.50
   38.10 - 115.00         14,500           2.36            75.29            14,500           75.29
                          ------                                            ------
$ 10.00  -$115.00         70,700                                            48,385
                          ======                                            ======
</TABLE>

     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 shareholders ratified a fixed option plan
     (1996 Stock Option Plan) allowing the Company to grant options for up to
     400,000 additional 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.

     STOCK WARRANTS - Warrants to purchase 264,831 shares of common stock at
     $3.20 to $102.50 per share were outstanding at March 31, 1997 (see notes 2,
     3, and 13).



                                       35
<PAGE>   36

9.   SFAS NO. 123 PRO FORMA DISCLOSURES

     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>
                                            Year Ended         Three Months          Year Ended
                                          March 31, 1997      March 31, 1996     December 31, 1995
                                          --------------      --------------     -----------------
       <S>                 <C>            <C>                 <C>                <C>
       Net loss            As reported     $(3,677,011)        $(4,514,171)        $(18,698,441)
                           Pro forma        (4,240,297)         (4,836,135)         (19,286,849)
       Net loss per share  As reported        $(3.30)             $(4.97)             $(22.16)
                           Pro forma           (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 (multiple award approach) with
     the following weighted-average assumptions:

<TABLE>
<CAPTION>
                               Year Ended       Three Months        Year Ended
                             March 31, 1997    March 31, 1996    December 31, 1995
                             --------------    --------------    -----------------
      <S>                    <C>               <C>               <C>
      Dividend yield               0%                0%                 0%
      Volatility                   80%               98%                89%
      Risk free interest rate     5.25%             5.75%              5.31%
      Expected term - yrs         4.00              4.72               4.72
</TABLE>

10.  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, 1997    March 31, 1996
                                         --------------    --------------
<S>                                      <C>               <C>         
        Reserves and accruals             $    784,000      $  2,327,000
        Deferred development
        expenditures                           321,000           321,000
        Depreciation and amortization          (84,000)          (84,000)
        Operating loss carryforwards        14,000,000        11,530,000
        Tax credits                            220,000           239,000
        Valuation allowance                (15,241,000)      (14,333,000)
                                          ------------      ------------
        Net deferred taxes                $          0      $          0
                                          ============      ============
</TABLE>

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

     At March 31, 1997 the Company had approximately $16,800,000, $17,500,000,
     and $9,000,000 of net operating loss carryforwards to reduce future taxable
     income for foreign, federal and state purposes, respectively. If not
     utilized, these carryforwards expire beginning in the year 2000.



                                       36
<PAGE>   37

11.  MAJOR CUSTOMERS

     During the fiscal year ended March 31, 1997, the Company had sales to two
     customers that represented 18% and 16% of total net sales. 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 sales. In 1994, pursuant to a distribution agreement, the
     Company had sales to one customer which represented 37% of total net sales.

12.  COMMITMENTS AND CONTINGENCIES

      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.

      Lease Obligations - The Company leases its facilities and certain
      equipment under noncancellable operating lease agreements. The future
      minimum annual lease payments are as follows:

<TABLE>
<CAPTION>
             Fiscal year ending March 31,:
               <S>                                             <C>      
               1998                                            $ 343,836
               1999                                              246,039
               2000                                               43,426
                                                                  ------
                 Total                                         $ 633,301
                                                               =========
</TABLE>

     Rent expense under operating leases totalled $134,188 in the three months
     ended March 31, 1996 and $258,565, $494,711 and $360,500 in the years ended
     March 31, 1997 and December 31, 1995 and 1994, respectively.

     The Company also leases certain equipment under a capital lease. Current
     lease payments due during the fiscal year ending March 31, 1998 total
     $13,781.

     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 year ended March 31, 1997.

13.  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.




                                       37
<PAGE>   38

SANCTUARY WOODS MULTIMEDIA CORPORATION
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS

<TABLE>
<CAPTION>
                                        Balance at       Charged                                            Balance at
                                        Beginning          To           Write-offs/                            End
                                        of Period        Expense          Returns             Other          Of Period
                                      ------------     ------------     ------------       -----------     ------------
<S>                                   <C>              <C>              <C>                <C>             <C>         
YEAR ENDED  MARCH 31, 1997
Allowance For Doubtful Accounts       $    207,352     $    329,360     $   (413,288)                      $    123,424
Sales Returns & Allowances               3,806,051        1,972,658       (4,967,103)                           811,606
Inventory Obsolescence                   1,449,675          150,000       (1,427,775)                           171,900

THREE MONTHS ENDED MARCH 31, 1996
Allowance For Doubtful Accounts       $    200,000     $     16,071     $     (8,719)                      $    207,352
Sales Returns & Allowances               5,428,236          623,385       (2,245,570)                         3,806,051
Inventory Obsolescence                   1,518,000          250,000         (318,325)                         1,449,675

YEAR ENDED DECEMBER 31, 1995
Allowance For Doubtful Accounts       $    217,000     $    118,968     $   (135,968)                      $    200,000
Sales Returns & Allowances                 414,275        8,168,460       (3,396,414)      $(a)241,915        5,428,236
Inventory Obsolescence                     298,723        1,083,389         (132,255)       (a)268,143        1,518,000

YEAR ENDED DECEMBER 31, 1994
Allowance For Doubtful Accounts       $     65,000     $    203,035     $    (88,517)      $ (a)37,482     $    217,000
Sales Returns & Allowances                 242,018          459,814         (330,270)        (a)42,713          414,275
Inventory Obsolescence                           0          298,723                0                            298,723
</TABLE>

--------
(a) Consolidation of reserve accounts



                                       38
<PAGE>   39
                                    PART III


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


Not applicable.

ITEMS 10 THROUGH 13 INCLUSIVE

These items have been omitted in accordance with instructions to Form 10-K
Annual Report. With respect to the Company's 1997 Annual Meeting of
Stockholders, the registrant will file with the Securities and Exchange
Commission a definitive proxy statement pursuant to Regulation 14A no later than
120 days after the end of the fiscal year covered by this report.


                                     PART IV


ITEM 14.  EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, AND REPORTS ON FORM 8-K

(a)   (1)  Financial Statements

           Attached to this Report at pages 21 through 37:

           Independent Auditors' Report - Deloitte & Touche LLP

           Independent Auditors' Report - Deloitte & Touche

           Consolidated Balance Sheets:
               March 31, 1997 and 1996

           Consolidated Statements of Operations:
               Years Ended March 31, 1997, December 31, 1995 and 1994
               and the Three Month Period Ended March 31, 1996

           Consolidated Statements of Stockholders' Equity:
               Years Ended March 31, 1997, December 31, 1995 and 1994
               and the Three Month Period Ended March 31, 1996

           Consolidated Statements of Cash Flows:
               Years Ended March 31, 1997, December 31, 1995 and 1994
               and the Three Month Period Ended March 31, 1996

           Notes to Consolidated Financial Statements

(a)   (2)  Consolidated Financial Statement Schedules

           Supplemental Schedule II - Valuation of Qualifying Accounts, Years
           Ended March 31, 1997, December 31, 1995, and 1994 and three month
           transition period ended March 31, 1996.

                                       39


<PAGE>   40
(a)   (3)  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).

10.9      Sub-Lease dated November 23, 1994 between the Registrant and Heublein,
          Inc., for premises located at 1825 South Grant Street, San Mateo,
          California 94402 (Incorporated herein by reference to Exhibit 10.36 
          to Registrant's Report on Form 10-K filed March 31, 1995).

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).

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).

</TABLE>


                                       40

<PAGE>   41

<TABLE>
<S>       <C>
10.26     Agreement and Plan of Reorganization among Registrant, Teacher
          Acquisition Corporation and Theatrix Interactive, Incorporated dated
          June 4, 1997.

10.27     Republishing and Distribution Agreement between Sanctuary Woods 
          Multimedia, Inc. a wholly-owned subsidiary of Registrant and Virgin
          Sound and Vision, Inc. dated June 12, 1997 (PORTIONS OMITTED -
          CONFIDENTIAL TREATMENT REQUESTED).

10.28     Form of Warrant to Purchase Common Stock issued by the Company to the
          holders of Series A Preferred Stock. 

10.28A    Form of Warrant to Purchase Common Stock issued by the Company to the
          holders of Series A Preferred Stock.

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.

21.1      List of Subsidiaries.

23.1      Consent of Deloitte & Touche LLP.

23.2      Consent of Deloitte & Touche, Chartered Accountants (Canada).

27.0      Financial Data Schedule.

(b)       Reports on Form 8-K: none
</TABLE>



                                       41
<PAGE>   42

                                   SIGNATURES

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

                     SANCTUARY WOODS MULTIMEDIA CORPORATION

                           By: /s/ CHARLOTTE J. WALKER
                               Charlotte J. Walker

                      President and Chief Executive Officer

Dated:  June 30, 1997

KNOW ALL WOMEN AND MEN BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Charlotte J. Walker and Peter C. Nichter,
jointly and severally, hers or his attorneys-in-fact, and each with power of
substitution, for him or her in any and all capacities, to sign any amendments
to this Report on Form 10-K, and to file the same, with exhibits thereto and
other documents in connection therewith, with the Securities and Exchange
Commission, hereby ratifying and confirming all that each of said
attorneys-in-fact, or her or his substitute or substitutes, may do or cause to
be done by virtue thereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this Report
has been signed below by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated.

<TABLE>
<CAPTION>
    SIGNATURE                        TITLE                                      DATE         
<S>                               <C>                                       <C>              
/s/ CHARLOTTE J. WALKER          Chairman of the Board                      June 30, 1997 
Charlotte Walker                 President and Chief Executive Officer                       
                                    (Principal Executive Officer)                            
                                                                                             
/s/ PETER C. NICHTER             Director, Finance and Operations           June 30, 1997   
Peter C. Nichter                   (Principal Financial and Accounting                       
                                   Officer)                                                  
                                                                                             
/s/ N. JOHN CAMPBELL             Director                                   June 30, 1997  
N. John Campbell                                                                             
                                                                                             
/s/ LAWRENCE LENIHAN             Director                                   June 30, 1997 
Lawrence Lenihan                                                                             
                                                                                             
/s/ ERIK JANSEN                  Director                                   June 30, 1997 
Erik Jansen
</TABLE>


                                      S-1

<PAGE>   43
                               LIST OF ATTACHED EXHIBITS


<TABLE>
<S>       <C>
10.26     Agreement and Plan of Reorganization among Registrant, Teacher
          Acquisition Corporation and Theatrix Interactive, Incorporated dated
          June 4, 1996.

10.27     Republishing and Distribution Agreement between Sanctuary Woods
          Multimedia, Inc. a wholly-owned subsidiary of Registrant and 
          Virgin Sound and Vision, Inc. dated June 12, 1997 (PORTIONS OMITTED -
          CONFIDENTIAL TREATMENT REQUESTED)

10.28     Form of Warrant to Purchase Common Stock issued by the Company to the
          holders of Series A Preferred Stock.

10.28A    Form of Warrant to Purchase Common Stock issued by the Company to the
          holders of Series A Preferred Stock.

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.

21.1      List of Subsidiaries.

23.1      Consent of Deloitte & Touche LLP.

23.2      Consent of Deloitte & Touche, Chartered Accountants (Canada).

27.0      Financial Data Schedule.

                                       42

</TABLE>