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                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, DC 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 December 31, 1997
 
[_]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
   EXCHANGE ACT OF 1934
  For the transition period from                 to
 
COMMISSION FILE NUMBER 000-28294
 
                             SILICON GAMING, INC.
            (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
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                 CALIFORNIA                                      77-0357939
        (State or other jurisdiction                          (I.R.S. Employer
      of incorporation or organization)                     Identification No.)
</TABLE>
 
                   2800 W. BAYSHORE ROAD PALO ALTO, CA 94303
              (Address of principal executive offices) (Zip Code)
 
                                 650-842-9000
             (Registrant's telephone number, including area code)
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
 
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               TITLE OF CLASS                  NAME OF EACH EXCHANGE ON WHICH REGISTERED
               --------------                  -----------------------------------------
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                    None                                         None
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          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 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]
 
  Aggregate market value of the registrant's Common Stock held by non-
affiliates as of February 28, 1998: $96,364,181
 
Number of shares outstanding of the issuer's Common Stock, $.001 par value, as
of February 28, 1998: 13,649,198
 
                     DOCUMENTS INCORPORATED BY REFERENCE:
 
  Portions of the Registrant's 1997 Annual Report for the year ended December
31, 1997, are incorporated by reference into Parts II and IV of this Form 10-
K. Portions of the definitive Proxy Statement for the Registrant's Annual
Meeting of Shareholders to be held on May 26, 1998, are incorporated by
reference into Part III of this Form 10-K.
 
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                                    PART I
 
ITEM 1: BUSINESS
 
  Silicon Gaming, Inc. ("SGI" or the "Company") is engaged in the design,
development, production, marketing and sale of what it believes will be the
next generation of interactive slot machines for use in casinos and other
gaming establishments. The Company's first product, Odyssey(TM), combines an
advanced multimedia gaming platform with software-based games that the Company
believes will be more engaging and entertaining than other gaming devices
currently available and will, as a result, generate increased gaming revenue
per device ("win per machine") for the casino operator.
 
  Odyssey features high resolution video presented across the full surface of
a large touchscreen display. The games feature high quality animation, video
clips, digital sound and a level of visual appeal and interactivity that the
Company believes is unattainable by the current generation of slot machines.
The Company is attempting to maximize the entertainment value offered on the
video screen by providing multiple levels of achievement within certain games
so that, through successful play over a period of time, a player may advance
to a bonusing sequence and win additional jackpots. SGI believes that, by
utilizing these features, its products will encourage longer and more frequent
periods of play by existing slot machine customers and attract new gaming
customers who are seeking greater entertainment value than that offered by the
current generation of slot machines. The Company has designed its machines
with a number of unique player features, such as play stoppage
entertainment(TM). In addition, Odyssey's modular components and Machine
Management System(TM) software provides easy-to-use diagnostics designed to
minimize player inconvenience and machine down-time.
 
  In January and February of 1997, the Company conducted regulatory field
trials of its product at Bally's Las Vegas. Based on the results of extensive
tests by the Nevada Gaming Lab and on the results of the field trial, Odyssey
was granted final product approval by the Nevada Gaming Commission on March
20, 1997, allowing the Company to commence commercial distribution of the
Odyssey. Having received product approval, the Company has, through December
31, 1997 installed 1,501 Odyssey machines at 72 properties throughout Nevada,
Missouri and Mississippi. Of these machines, 1,298 were converted to revenue
under one of the three pricing options offered by the Company. Sixty machines
remain installed on a trial basis and the casino operators are required to
purchase the machine outright, participate in SGI's revenue sharing plan or
return the machine to the Company within a defined trial period.
 
INDUSTRY BACKGROUND
 
  According to industry sources, casino gaming revenue in the United States in
1991, 1992, 1993, 1994 and 1995 was approximately $9.0 billion, $9.9 billion,
$12.6 billion, $14.0 billion and $18.0 billion respectively, and continued
growth was forecast for 1997 and 1998. Slot machines, video gaming machines
and similar devices are the dominant source of gaming revenue for casino
operators in most U.S. markets. Slot revenue as a percentage of total gaming
revenue in 1996 was 63% in Nevada and 69% in Atlantic City. Jurisdictions
where gaming has recently been legalized have reported similar statistics. For
example, in 1996, slot machines accounted for 72% of casino revenue in
Illinois and 67% in Missouri. In addition to constituting the largest portion
of gaming revenue, slot revenue is more profitable than table games for casino
operators, since slot machines require much lower labor costs.
 
  The Company believes that slot machines offer their owners an attractive
return on investment. In December 1997, the average "win per machine per day"
(defined as the average amount of money wagered on a machine less the average
jackpot payoffs) on the Las Vegas Strip was $92. A new slot machine from a
major manufacturer, equipped with player tracking and slot accounting
software, costs approximately $8,000. At this price, a new slot machine
earning the Las Vegas Strip average would recoup its purchase price in 87
days. While certain markets have lower average wins per day than the Las Vegas
Strip, many other markets, such as Atlantic City and Connecticut, often have
casinos with win per day figures over $300.
 
 
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  All casino games offer the same underlying proposition: the opportunity to
win money in varying amounts and with varying frequency, but with the
statistical certainty of losing money to the casino operator over an extended
period of time. With slot machines, the prospect of winning can be varied
across the spectrum from many small jackpots won frequently to one very large
jackpot won very rarely. Players' risk/reward appetites will determine what
type of machine they will want to play, and the nature of the payoffs can be
deduced from the "pay table," a chart that graphically shows how much can be
won based on various outcomes and various amounts of money wagered.
Notwithstanding the differences in jackpot frequency and size, however, all
slot machines retain a net amount of the money wagered through them over time.
This amount is referred to as the "hold" and is generally expressed as a
percentage of the amount of money wagered on a machine, which is called the
"handle." The handle in any given machine is preset by the manufacturer based
on specifications from the casino, subject to legal parameters in some
jurisdictions, and may differ from machine to machine on a casino floor.
 
  The U.S. gaming machine market is currently dominated by reel-based slot
machines, which were broadly introduced in the 1960s, when the free-spinning
reel was made possible by advances in electro-mechanical circuitry. The free-
spinning reel enabled manufacturers to create different versions of the same
product by varying such things as the number of reels, the number of stops on
each reel and the number and variety of payoff combinations. The 1980s saw the
introduction of virtual reel "stepper" technology which allowed for a greater
number of stops, or outcomes, on a reel, enabling casino operators to offer
larger jackpots due to the lower likelihood of their being hit. Another
significant development was the installation of electronic memory in machines,
allowing players to keep an "account" of credits on the machine consisting of
the initial amount inserted plus winnings minus losses. Since the player did
not have to reinsert coins for every pull of the handle, the number of pulls
per hour was increased significantly, and players tended to rewager much of
the amounts won, raising the total win per machine. Except for the addition of
features such as bill acceptors and player tracking systems, the technology
employed by slot machines in the 1970s and 1980s still predominates in
current-generation machines.
 
  In the 1980s, hardware and software advances allowed for application of
video graphics to gaming devices. Using these techniques, International Game
Technology, Inc. ("IGT") was the first company to introduce video poker. Video
poker offers slot players two important advantages. First, the game is
interactive, since the player has to decide which cards to hold or discard
during the hand. This feature allows the outcome to be influenced somewhat by
the player, an attribute unavailable on reel-based machines. Second, the use
of a video screen allows machine manufacturers to develop more interesting and
attractive graphics than are available on reel-based slot machines. Recently,
Bally Gaming expanded the capabilities of video-based devices when it
introduced GameMaker, a popular video-based machine which offers the player a
choice of up to twelve different games on a single machine. The Company
believes that the popularity of video poker and multi-game machines suggests
that customers may be receptive to a more complex and interactive slot
experience.
 
  In the late 1980s, a category of slot machine games called "progressives"
was introduced and became very popular. The progressive configuration
generally consists of traditional reel-based machines linked together by a
computer network that allows them to share a common jackpot which is usually
much larger than the jackpot that a single, unlinked machine could support.
Progressive jackpots are usually several million dollars, and have
occasionally exceeded $10 million. Progressives may be linked locally within a
bank of a few machines, across an entire casino, or across an entire state.
IGT is the dominant competitor in the progressives market.
 
  Growth in demand for slot machines has historically been driven by the
opening of new casinos, including casinos in jurisdictions where gaming has
recently been legalized. However, in recent years, the rate at which new
jurisdictions have legalized gaming has fallen significantly; therefore, the
Company believes that demand based on new openings will be largely limited to
new projects in existing markets. Several new projects are under construction
or have been announced in Las Vegas, Atlantic City, on the Gulf Coast and in
the Midwest.
 
  While the physical useful life of a slot machine can be up to a decade or
more, casino operators have tended to replace machines on a cycle closer to
every five years. Also, the development of certain new features which
 
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offer the prospect of significantly increased slot earnings, such as the
advent of bill acceptors in the 1990s, can encourage operators to replace
machines even more rapidly.
 
STRATEGY
 
  Although the gaming industry has enjoyed significant growth over the past
decade, the Company believes that most of the investment over this period has
been made in assets such as large hotels and themed attractions, and that
comparatively little has been invested in further developing the actual casino
games which, in the aggregate, account for a majority of the average casino's
revenue and profits. SGI's strategy is to tap what it believes is an
underexploited segment of the gaming market by developing what it believes
will be the next generation of interactive slot machines and on implementing
its strategy of providing a gaming platform that offers slot machine players a
more entertaining and engaging experience than is available from current
gaming machines. The Company believes that its machines will encourage casino
patrons to play more frequently and for longer periods of time and will also
attract new gaming customers, particularly younger patrons who typically are
not attracted to current generation slot machines. The Company believes that,
as a result, its machines will outperform most existing machines in win per
machine and thus motivate casino operators to supplement or replace existing
slot machines with SGI products.
 
  Because of the importance of slot win to casino operators and the high
returns available from an investment in slot machines, the Company believes
that casino operators are willing to try new slot machine products that offer
the prospect of higher win per machine per day. At the same time, operators
are motivated to remove any machines that are performing significantly below
expectations. SGI believes that its machines will generate win per machine per
day that will exceed that of the average installed machine and, therefore, it
believes that it will be able to penetrate the market, generate orders for its
machines and maintain a share of casino floor space. However, the tastes and
playing styles of slot players are difficult to predict with certainty, and
there can be no assurance that SGI's machines will, in the long run,
outperform competing machines in win per machine per day.
 
  The Company believes that new slot machine sales in the replacement category
will surpass sales for new installations in the near future, due to the
slowing in demand from new casino projects, and because the large number of
machines installed during the high-growth period of the early 1990s will soon
be reaching their normal replacement time.
 
  The market for slot machines outside of North America is relatively small,
with the exception of Australia, and is generally difficult to forecast. In
addition, international markets have often served as an outlet for used
machines. While SGI intends to take advantage of certain opportunities in
international markets, it intends to pursue these markets only after
successfully establishing its market position in North America.
 
  SGI's initial sales of Odyssey include the hardware platform bundled with a
suite of six games, play stoppage entertainment and the Machine Management
System. SGI sells Odyssey at a significant premium to most current slot
machines based on its belief that Odyssey will generate greater win per unit.
The Company offers Odyssey to casino operators and other potential purchasers
using two alternative purchase programs, consisting of either (i) the sale of
the hardware unit bundled with a single game or a suite of games and other
software for a fixed price, or (ii) the sale of the hardware unit alone
combined with a renewable one-year software license, including access to the
entire Odyssey game library for the term of the license.
 
  In order to support the initial rollout of Odyssey and promote more rapid
expansion, the Company also has developed a unique revenue sharing plan as an
alternative to the two purchase pricing options. Under this plan, the casino
operator is not required to make an upfront capital investment and does not
take ownership of the machines; rather, in exchange for placing the machines
on the floor, the casino operator agrees to share with the Company the
aggregate win generated by the machines. Under this plan, 20% of the aggregate
win goes to the Company, subject to a predetermined minimum.
 
 
                                       4
<PAGE>
 
  In order to broaden distribution and accelerate market penetration, SGI
plans to introduce a single game strategy that it believes will enable it to
capture a significant portion of the casino floor. The Odyssey multigame
platform's flexibility enables casino operators to evaluate, analyze and
optimize game offerings for a particular customer base. As the next step in
the penetration of the casino floor, SGI intends to offer a lower-cost single-
game platform that will enable the operators to roll out and promote those
games which are most successful in their particular casinos. SGI believes that
players will ultimately identify with individual games and the single-game
platform will enable slot operators to leverage the brand identity of popular
games such that they are easily recognizable and accessible on the casino
floor. Additionally, SGI believes that the single-game strategy will enable it
to penetrate areas of the casino floor that are dedicated to a particular game
type such as stand-alone Keno.
 
SGI PARADIGM
 
  SGI believes that it has succeeded in improving on the standard slot machine
game in part due to its understanding of the slot machine market and the
casino patron, in particular. The Company believes it has identified an
underlying structure to the typical slot play session, consisting of four
distinct phases: initial attraction; initial play; extended play; and
completion. During each of these phases, certain factors determine whether the
player advances from one phase to the next. SGI has sought to understand these
four phases so that (1) it can maximize the likelihood that a slot customer
will play its machine, (2) once playing, the player will stay at the machine
for a long period of time, and (3) the player will return frequently to play
the same or similar SGI machines. When developing Odyssey and games played on
Odyssey, the Company has focused on the four phases of play in order to
deliver a full entertainment experience to the casino patron.
 
    Initial Attraction. The Company believes that the factors that determine
  whether a customer will initiate play include the machine's visual appeal,
  the payout structure, promotional graphics and other external attributes
  that convey the impression that the machine would be entertaining to play.
 
    Initial Play. Once play commences, the customer makes an initial decision
  about whether to continue. The Company believes that factors affecting this
  decision include whether the game meets the customer's entertainment
  expectations, conforms to his or her payout expectations, is easy to
  understand and play, and is relatively trouble-free.
 
    Extended Play. Extended play occurs when the player has become fully
  engaged in the entertainment experience provided by the game. Because
  extended play eliminates idle machine time, this phase is strongly desired
  by casino operators. Once the player commits to extended play, any
  interruption in play, such as a fill, malfunction or reset for change
  service, becomes an excuse to end the session.
 
    Completion. Completion is the final phase of the play session and can
  occur, for example, when the customer runs out of money, runs out of time,
  or achieves a targeted jackpot level. One of the Company's goals in
  designing its gaming platform is to increase the likelihood that the player
  will leave the completion phase with the desire to play the same machine at
  a later time based on a number of factors, including winnings and
  entertainment value.
 
PRODUCT
 
  The Company has developed a product that it believes represents the next
generation of interactive gaming devices for use in casinos and other gaming
establishments in the United States and worldwide. Odyssey utilizes multimedia
technologies to present casino games that it believes will be more engaging
and entertaining than other gaming devices currently available. The Company's
games feature high-resolution video presented across the full surface of a
large touchscreen display. The games feature high-quality animation, video
clips, digital sound and a level of game attractiveness and interaction that
the Company believes is unavailable from and unachievable by current-
generation slot machines. Unlike traditional "hardware-dominant" slot
machines, Odyssey runs games that are software based, allowing SGI and casino
operators to adapt their game offerings to
 
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evolving technologies and changing consumer tastes without structural change
to, or replacement of, the gaming platform.
 
  PLATFORM, HARDWARE AND OTHER PHYSICAL ATTRIBUTES
 
  SGI's gaming platform is designed to resemble a traditional slot machine in
many respects. The machine occupies the same footprint as a traditional slot
machine and is of roughly the same general size and shape, enabling casino
operators to replace traditional slot machines with SGI's machines without any
reconfiguration of the casino floor. The most distinctive attribute of the
product is its vertically-oriented, 26-inch-diagonal touchscreen video
monitor. A player's sense of interactivity is heightened by the ability to
make all the required decisions on the screen, within the game itself. For
players who are uncomfortable or unfamiliar with touchscreen devices, however,
all of the traditional slot machine controls have been included as well. Thus,
a player can control the game by using the touchscreen, by pushing a series of
buttons similar to those found on current slot or video poker machines, or by
pulling a handle as on traditional slot machines. Coin handling mechanisms,
bill acceptors, card readers and other devices related to cash deposit, credit
and win payout are similar to those used in current gaming machines. The
music, voice and other audible features of the Company's games are played on a
digital sound system.
 
  The principal electronic hardware used in SGI's gaming platform consists of
high-end multimedia and personal computer components. The central processing
unit is a 166-MHz Intel Pentium chip. This processor is accompanied by a
variety of video and auxiliary controllers, some of which have been developed
exclusively for use with the Company's product. To achieve high-level
multimedia performance from the system, the Company's machine uses 64
megabytes of random access memory. Storage for the audio and visual media
elements of the games, as well as the product software itself, is provided by
a 4 gigabyte hard disk drive. These components are connected internally by a
high-speed PCI bus. SGI's reliance on sophisticated full-motion video and
high-quality audio presentations requires the use of state-of-the-art
technology, and SGI expects to upgrade the performance of its platform
periodically as higher-performance components become available. SGI machines
are intended to be easily reconfigurable in the field through the replacement
of hardware components such as computer motherboards and video and auxiliary
controllers, allowing casino operators to upgrade hardware in a cost-effective
manner.
 
  SGI's gaming platform employs modular construction at almost every level,
facilitating upgrades and minimizing machine down-time. Such modularity
permits the rapid exchange of components for upgrades or to replace defective
parts. Using SGI's proprietary Machine Management System, casino personnel can
run a variety of diagnostic programs or review detailed performance data
directly from the gaming platform itself. In the case of a malfunctioning
component, a casino technician can quickly restore play simply by swapping out
the failed component with a new one. The modularity of SGI's platform will
also facilitate upgrades of hardware components such as card readers and bill
validators as new components become available. The Company believes that these
features may allow casino operators to reduce platform down-time and shorten
the time required to fix any malfunction, thereby increasing the time the
platform is available for play and reducing the risk that a player will elect
to terminate a gaming session as a result of play stoppage.
 
  The Company's gaming platform is assembled almost entirely from off-the-
shelf hardware, which the Company anticipates will reduce the chance of a
parts shortage and will enable the Company to continue to manufacture its
devices using state-of-the-art components as PC and multimedia technologies
advance. There can be no assurance, however, that the Company will continue to
enjoy a reliable supply of hardware components. Moreover, certain components
such as the touchscreen display and monitor are manufactured by single sources
and may be particularly susceptible to interruptions in supply. Although SGI
does develop proprietary components in order to meet certain specialized
requirements of its platform, the Company intends to primarily use
commercially available computer hardware components as a regular part of its
product development process.
 
 
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<PAGE>
 
  SGI's machines have been designed to accept future hardware upgrades that
will take advantage of networking capabilities. When networked, two or more
machines can be linked, facilitating activities such as group play,
tournaments and progressives. For example, a particular group of platforms can
be configured to announce to players that a tournament will begin at a
particular time and allow each player the option to participate. Similarly,
platforms can be configured so that when one machine hits a jackpot, a player
at another machine can win a bonus award; the two affected platforms can then
display a coordinated audio/video simulation of a coin flying out of one tray
and into the other. The Company believes that features of this kind will
promote interaction among players at adjacent platforms and thereby maintain
player interest for longer periods of time.
 
  SGI has incorporated numerous features into its gaming platform that are
designed both to attract the player and to maintain his or her interest over
an extended period of time. For example, SGI's gaming platform can be
programmed to allow for a free spin following a specified number of
unsuccessful attempts in order to ensure a minimum level of reward to the
player. Similarly, SGI's machines are capable of running promotional or
entertainment video programs during play stoppages such as those caused by a
hopper refill, malfunction or request for change. These features have been
designed to reduce the likelihood that a player will leave the machine during
a play stoppage event. These features may also provide an additional revenue
or promotional source to the operator by providing an advertising medium.
 
  To address the desire of slot machine operators to respond efficiently to
service calls that cause stoppages in play, SGI's slot machine incorporates
what SGI believes to be a significant improvement over the traditional
"candle" (the light on the top of a slot machine). SGI's multi-state candle
uses variable color and strobe rate displays to convey more information than a
simple call for help. Different colors signify different service calls, and
changes in strobe rate signify how long the customer has been waiting,
features that the Company believes will assist the casino floor staff in
prioritizing responses to customer needs.
 
GAMES AND OTHER SOFTWARE
 
  While SGI believes that the design of its machine and its hardware
components are important to its operation and its ability to foster initial
and extended play, it believes that the most important factor affecting the
success of its platform will be the games themselves and the software that
controls those games. The majority of the Company's development efforts to
date have been devoted to hardware, system software and game development, and
the Company expects that, in the future, game development will be its
principal development activity.
 
  Odyssey is a multi-game platform. The Company's initial release of Odyssey
included six separate game themes, play stoppage entertainment and the Machine
Management System. The Company intends to introduce at least ten to twelve new
games per year.
 
  The Company's games have been designed to present traditional casino games
with the benefit of video and audio enhancements that are afforded by the
Company's use of high-end multimedia hardware. While the underlying game may
consist of a traditional casino game such as poker, keno, blackjack or a reel-
based slot machine, the game itself is only one aspect of the entertainment
experience. Such games may be enhanced by an entertaining story and a rich
multimedia environment.
 
  The Company believes that the combination of its attractive machine, high-
level graphics and sound, bonusing features and the pursuit of an interesting
and entertaining story will make SGI's product outperform conventional slot
machines at each of the four phases of slot machine play--initial attraction,
initial play, extended play and completion.
 
    Initial Attraction. The Company believes that the physical appearance of
  its machines is more attractive than conventional machines and will entice
  customers to play. In addition to the physical attributes of its machines,
  the Company has included a suite of video images that run when the machine
  is not being
 
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  played. These include short, animated vignettes from the Company's games
  and "help" screens, as well as a menu page identifying all of the games
  available on that particular machine. Information regarding any game can be
  viewed through the push of a "Help" button. These merchandising segments
  feature the same quality of graphics, sound, video and animation that
  distinguish all of SGI's games.
 
    Initial Play. In the initial play period, SGI believes it is necessary to
  quickly engage the customer in the story line and to avoid any confusion,
  unfamiliarity or negative experiences which might cause the customer to
  discontinue play. For this reason, the Company's initial suite of games
  consisted of enhanced versions of traditional casino games, including reel-
  based slot games, so that the rules of the game will be well known. SGI
  presents these games using enhanced graphics and sound to enrich the play
  experience, without changing the fundamental characteristics or objective
  of the game. In addition, the machine offers traditional game controls for
  those players unfamiliar or uncomfortable with the touchscreen interface.
 
    Extended Play. The Company believes that the enhancements it has made to
  traditional casino games by the addition of high level graphics, sound,
  animation and storyline will encourage extended play, as well as more
  frequent play, and thereby generate greater win per machine than the
  unenhanced versions of these games available in conventional machines.
 
    A significant feature which the Company believes will contribute
  significantly to extended play is the introduction of advanced play levels
  in which a player, by virtue of having played a certain amount of time or
  achieved a certain number of jackpots at one level, gains access to a bonus
  sequence in which larger jackpots become available. For example, in Fort
  Knox, one of the Company's reel-based games, a 10-digit master combination
  to the main vault appears in the play field. At random time intervals
  during play, another digit on the main vault lock is matched. When the main
  vault is opened, a player may select from one of three vault drawers to
  receive an additional bonus.
 
    To facilitate extended play, the Company has developed a sophisticated
  on-line tutorial, help features and play stoppage entertainment. The
  tutorial and help features generally consist of video inserts designed to
  provide orientation, instruction and assistance before or during the game.
  In Fort Knox, for example, Seymour Bucks, the main security guard at Fort
  Knox, can appear if there is a call for change and provide assistance. If
  there is a machine play stoppage, a hopper fill requirement, or a jackpot
  requiring the player to be hand paid, Professor Jack Potts, the absent-
  minded slot genius, will explain the cause of the play stoppage and present
  trivia, other game information, video clips advertising the casino's
  amenities or upcoming promotions and tournaments, or other commercial
  material.
 
    Completion. The Company believes that the principal events that lead to
  completion of play include the player's running out of money, running out
  of time or achieving a targeted jackpot level. The Company believes that
  the unique features and entertainment value of its games will entice
  players to remain in the extended play phase for longer periods of time
  than are generally fostered by current generation slot machines. Moreover,
  the design of the Company's platform and games is intended to provide an
  entertainment experience that will encourage repeated play.
 
  In addition to features that are designed to enhance the entertainment value
of SGI's machine and its ability to generate incremental revenue for the
casino, SGI's platform incorporates proprietary features that are designed to
overcome certain hurdles that may be involved in obtaining regulatory
licensing of a slot machine design, as well as to facilitate easy maintenance
and supervision by casino personnel. These features are as follows:
 
    Random Number Generator. At the core of every gaming machine is a random
  number generator that determines the outcome of every gaming proposition.
  To eliminate what the Company believes are some of the impediments to
  randomness that characterize random number generators, SGI engaged Dr.
  Evangelos A. Yfantis, a recognized authority in the field of random number
  algorithms, to develop a proprietary random number generator algorithm for
  the Company. The Company has filed a U.S. patent application with respect
  to its algorithm. See "Proprietary Rights and Licensing."
 
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    Software Authentication. A critical element of all gaming machines is an
  authentication mechanism to determine that the software being used is
  identical to the software that has been approved by regulatory authorities
  and is operating correctly. Traditional slot machines must be authenticated
  manually, a process usually performed only after a sizable jackpot award.
  This infrequency of checks offer greater opportunities to breach the
  security of traditional machines. The Company has developed a proprietary
  authentication process which leverages the advanced capabilities of the
  Company's machine to verify the integrity of a game each time it is
  selected for play. This process combines sophisticated authentication
  routines developed by RSA Data Security, Inc. with a proprietary
  methodology developed by the Company. The Company's authentication process
  provides continual checking of the machine's software for both accidental
  corruptions and intentional attempts to cheat the machine. Any detected
  anomalies will cause the machine to signal the loss of integrity
  immediately. The Company has filed for patent protection for certain
  aspects of its authentication methodology. See "Proprietary Rights and
  Licensing."
 
    Machine Management System. The Company's Machine Management System is
  designed to provide easy access to the configuration, accounting, and
  diagnostic capabilities of the machine. The Machine Management System's
  accounting functions are designed to provide a rapid, easy-to-interpret
  report of all key machine metering data, as well as detailed accounting and
  statistics, on a game-by-game basis. The Machine Management System uses the
  machine's touchscreen to make installation and setup of the machine easier
  than traditional slot machines. The diagnostic programs comprise a user-
  friendly maintenance and troubleshooting system that allows casino floor
  personnel to quickly and effectively assess the cause of a play stoppage or
  other malfunctions or to examine transaction history where the validity of
  a jackpot or other transaction must be verified. For example, if a player
  asserts that the machine has not given full credit for a jackpot or has not
  properly recorded a cash input, a floor manager, using the touchscreen and
  a key, can access comprehensive data to review transaction and event
  history. With this information, the floor manager can rapidly evaluate the
  merit of the player's claim and take appropriate action at the machine's
  location without having to consult back office records or review
  surveillance videotape.
 
PRODUCT DEVELOPMENT
 
  The Company's product development efforts, particularly its game development
efforts, will be critical to its success in the gaming market. Research and
development expenses have increased significantly since inception and are
expected to continue to increase in the future. During the nine-month period
ended December 31, 1995 and the years ended December 31, 1996 and 1997, the
Company's research and development expenses were $3,137,000, $7,030,000 and
$9,283,000, respectively. At December 31, 1997, 55 of the Company's 190 full-
time employees were engaged in research and development.
 
  Ideas for new games are derived from customer preferences as perceived by
the Company or ascertained through the Company's market research and direct
feedback from slot machine operators. The initial designs for the Company's
games are conceived by a design team, which outlines the appearance and
features of each game. A prototype is developed by a production team that
includes a producer, product manager, artists, computer graphics engineers and
entertainment software engineers. The game is then evaluated by SGI's
marketing and sales staff, after which it is modified into its final form. The
Company estimates that the development of a typical game takes approximately
five to eight months and costs approximately $500,000 to $700,000.
 
  SGI is continually seeking to develop a variety of specific games which
management believes will appeal to casino operators and their customers.
Currently, the Company is engaged in the development of games based on
traditional slot machine games such as animated reel slots, video poker and
keno. The Company is also in the process of creating slot machine versions of
popular casino games such as blackjack and roulette. These initial games are
intended to help customers look beyond the unfamiliar technology to
recognizable game types. In addition, the Company is developing a line of
Magic Windows type games. The proprietary Magic Windows game type introduces
decision making into a traditional reel-slot experience by allowing the player
to select from a number of available symbols.
 
 
                                       9
<PAGE>
 
  Completion of games under development is subject to various risks and
uncertainties. Such games may be subject to further creative decisions that
could alter the game implementation or marketing considerations that could
result in a shift of the Company's development focus to different types of
games altogether. Successful completion of any game will also be subject to
risks typically associated with the creative process, such as the risk that
the Company's creative team will be unable to achieve the desired results in
terms of the game's entertainment quality.
 
  Over time, SGI expects to introduce additional games that offer a wider
range of gaming experiences as players become more familiar with the
capabilities of advanced video gaming platforms. For example, the Company may
introduce games with sports attributes such as baseball, football or golf. The
Company also anticipates developing some of its games for progressive formats
in which the Company's machines would be networked to support a common jackpot
that is significantly larger than that which a stand-alone machine could
offer.
 
SALES AND MARKETING
 
  The ultimate success of SGI's gaming platform depends on its acceptance by
casino operators and casino patrons. The Company believes that, from the point
of view of casino operators, the attractiveness of any gaming platform depends
on win per machine, ease of upgrade, maintenance and game change and
information management. The Company believes that, from the casino patron's
perspective, the attractiveness of a platform is a function of entertainment
value. SGI's sales and marketing strategy is to generate product sales by
highlighting the advantages presented by its gaming platform to casino
operators, such as potential for increased win per machine; and by developing
processes focused on key operator values. SGI's marketing strategy also
targets casino players and will focus on developing brand recognition for
SGI's games, which the Company believes can be accomplished through the
development of proprietary games that deliver greater entertainment value for
the gaming dollar.
 
  SGI intends to position itself as a partner with casino operators in
establishing the next generation of wagering entertainment. The Company
recognizes the important role that casino operations personnel play in
establishing market acceptance for new machines and thus will target this
group with products, sample game platforms and training.
 
  Because SGI's games are software-based, SGI believes that there will be a
significant opportunity for game customization and the development of games
for the exclusive use of one or more casino customers. It is already
commonplace for casinos to ask that conventional slot machines be customized
with the casino's logo or theme. SGI believes that it can significantly exceed
this level of customization by inserting the casino's logo or theme directly
in the game, by presenting images of the casino's other games and amenities,
or by creating a new game entirely based on the casino's theme. The Company
intends to charge customers a fee for this work.
 
  THREE-PHASE PRODUCT INTRODUCTION
 
  The Company introduced its product and began its marketing and sales efforts
in a controlled and deliberate manner, following a three-phase program that
began in 1996 and is expected to be completed in 1998:
 
    1996: In the initial phase, the Company's primary objective was to
  complete development of Odyssey and to have it licensed and available for
  sale in one or more jurisdictions. The Company was approved by the Nevada
  Gaming Control Board to conduct a 60-day field trial of Odyssey in December
  1996. Final approval was granted in March 1997, allowing the Company to
  make its first customer shipment into Nevada.
 
    1997: The Company commenced installations of its product in certain Las
  Vegas casinos during the first quarter of 1997. The Company's plan was to
  limit the number of machines it sold in 1997 so that it could carefully
  monitor the reactions of gaming patrons and casino operators to its
  platform, game software
 
                                      10
<PAGE>
 
  and product support features. Based on the feedback obtained through this
  process, the Company periodically introduced modifications and enhancements
  to Odyssey's hardware and software components. Also during this period, the
  Company built its sales and support infrastructure in order to properly
  support customers when full rollout, planned for 1998, takes place.
 
    1998: In 1998, the Company expects to broadly market and sell its
  platform and software-based games. Because of the restraints imposed by its
  product introduction program, the Company currently believes that 1998 will
  be the first year in which a reasonable assessment of the commercial
  potential of its product can be made.
 
  The successful introduction of the Company's product is subject to
substantial risks and uncertainties, including the risk of technical or
manufacturing difficulties, the possibility that the SGI platform will not
receive the anticipated market acceptance and possible delays or hurdles
associated with licensing of the Company's product in various jurisdictions.
 
  The Company will be required to be licensed in each jurisdiction in which it
expects to sell product. As of December 31, 1997, the Company had filed
applications to sell its product in Nevada, New Jersey, Mississippi, Missouri,
Colorado, Indiana and Minnesota. To date, the Company has received both
corporate approval and approval to sell its product in Nevada, Missouri and
Mississippi and has also received corporate approval in Colorado. The Company
has also filed an application for approval of its gaming platform in New
Jersey and with Gaming Laboratories International, Inc., an independent
testing facility which grants product approval for many jurisdictions
worldwide. See "Gaming Regulation and Licensing."
 
  Although the Company plans to file applications in other jurisdictions,
there can be no assurance that the Company will be ready to file future
applications or that any licenses will be granted on a timely basis, or at
all.
 
  PRICING
 
  The Company offers its product to casino operators and other potential
purchasers using two alternative purchase programs, consisting either of (i)
the sale of the hardware unit bundled with a single game or a suite of games
and other software for a fixed price, or (ii) the sale of the hardware unit
alone combined with a renewable one-year software license, including access to
the entire Odyssey game library for the term of the license. Based on its
belief that Odyssey will generate substantially greater win per machine than
conventional slot machines and that casino operators attribute more weight to
win per machine than to the machine's purchase price, the Company plans to
offer the foregoing packages at prices that are substantially higher than the
prices of existing slot machines.
 
  In order to support the initial rollout of the Odyssey and promote more
rapid expansion, the Company has also developed a unique revenue sharing plan
as an alternative to the two purchase pricing options. Under this plan, the
casino operator is not required to make an upfront capital investment; rather,
in exchange for placing the machines on the floor, the casino operator agrees
to share with the Company the aggregate win generated by the machines. Under
this plan, 20% of the aggregate win goes to the Company, subject to a
predetermined minimum. The Company offers the casino operator a buyout option
at any point after the 90 day minimum evaluation period, something not
currently offered elsewhere in the industry. Under the buyout option, the
operator receives a credit towards the purchase of the hardware and must then
purchase its choice of software at list price. Because software-based gaming
machines represent a new development for the casino industry, potential
purchasers' preferences for any particular pricing mode have not been
determined. The Company plans to evaluate its pricing and sales methods from
time to time and to incorporate changes as appropriate. The Company believes
that licensing revenue from game software may eventually constitute a
substantial portion of its revenue.
 
 
                                      11
<PAGE>
 
COMPETITION
 
  The current slot machine market is highly competitive and is dominated by a
small number of manufacturers, some of whom have significantly greater
financial and other resources than the Company. The Company believes that the
principal competitive factors in this market are the appeal of the machine to
players, knowledge of customer requirements and player preferences, service,
support and training, distribution, name and product recognition and price.
IGT may be viewed as a dominant competitor in the slot machine market, with a
1997 market share estimated at 75%. Additional or potential competitors
include Alliance Gaming Corp., Anchor Gaming, WMS Industries Inc., Video
Lottery Consultants, Aristocrat Leisure Industries, Universal Distributing,
Sigma Games, Casino Data Systems, Acres Gaming Inc. and Innovative Gaming
Corporation of America. Companies in historically unrelated industries, such
as Sega, have technological resources that could offer them a competitive
advantage in developing multimedia-based gaming machines. There can be no
assurance that other companies in the video game or multimedia market will not
successfully enter the market for video slot machines. There also can be no
assurance that the manufacturers of traditional slot machines will not develop
products that offer superior performance or that achieve greater market
acceptance than, the Company's product. In general, the Company's existing
competitors, as well as many potential new competitors, have significantly
greater financial and technical resources than the Company, as well as more
established customer bases and distribution channels, any of which could
afford them a competitive advantage. If Odyssey displays a potential to
capture a significant share of the gaming machine market, the Company's
competitors can be expected to employ a variety of tactics to limit erosion of
their market shares, including price reductions, acceleration of technical
development or acquisition of new, competitive technologies. Any success the
Company might have may benefit existing competitors and induce new competitors
to enter the market. There can be no assurance that the Company will be a
successful competitor in the gaming machine industry.
 
PROPRIETARY RIGHTS AND LICENSES
 
  The Company's computer programs and technical know-how are both novel and
proprietary, and management believes that they can best be protected by use of
technical devices to protect the computer programs and by enforcement of
contracts and covenants not to compete with certain employees and others with
respect to the use of the Company's proprietary information and trade secrets.
The Company has registered copyrights with respect to various aspects of its
games, and has filed several U.S. patent applications for protection of
certain technology it has created or licensed. These patent applications cover
various aspects of the gaming machine hardware and software. Although the
company has received certain patents and trademarks with respect to its
intellectual property, no assurance can be given that the remaining pending
applications will be granted, nor can there be any assurance that the patents
will not be infringed or that others will not develop technology that does not
violate such patents.
 
  SGI has developed a proprietary method of authentication for disk drive-
based gaming machines, for which it has submitted a patent application. Since
modern gaming technology requires the handling and processing of large amounts
of on-line data, establishing a method for storing and retrieving data that
meets the approval requirements of the regulatory authorities in Nevada and
other jurisdictions while meeting adequate standards of internal performance
requires use of a comprehensive authentication system to assure both the
casino operator and requisite gaming authorities that the software is an exact
copy of what was generated by SGI and approved by such regulatory authorities.
 
  In addition, SGI owns exclusive rights to the algorithm for its random
number generator, the key component of the Company's gaming machine which
determines the outcome of each proposition. SGI's algorithm was developed by
Dr. Evangelos A. Yfantis, a professor of Computer Science at the University of
Nevada, Las Vegas.
 
  In developing its games, the Company relies on certain software that it
licenses from Duck Corporation ("Duck") on a nonexclusive basis. This license
may be terminated by Duck only in the event of a material breach of its terms
by the Company or in the event of a bankruptcy petition with respect to the
Company.
 
                                      12
<PAGE>
 
EMPLOYEES
 
  As of December 31, 1997, the Company had 190 full-time employees, including
55 in research and development. The Company also retains independent
contractors to provide certain services, primarily in connection with its
product development activities. The Company and its full-time employees are
not subject to any collective bargaining agreements and the Company believes
that its relations with its employees are good. From time to time the Company
has retained actors and/or "voice over" talent to perform in certain of the
Company's games and expects to continue this practice in the future. The
Company's future success depends in large part on its ability to attract and
retain management and other key personnel.
 
MANUFACTURING
 
  The Company's manufacturing process consists primarily of assembly of
components obtained from third-party suppliers and testing of software systems
and applications. In 1996, the Company established its manufacturing process
and commenced commercial production. During 1997 the Company moved its
manufacturing operations into a new facility in Mountain View, California. The
Company intends to continue investing significantly in leasehold improvements
and manufacturing equipment at its Mountain View location. The Company has
installed manufacturing lines with 5,000 unit per year capacity and intends to
incrementally increase its manufacturing capacity in accordance with perceived
demand. The Company believes that, once fully operational, its Mountain View
manufacturing facility will allow the Company to produce 25,000 units per
year. As of December 31, 1997, the Company had 39 full-time employees in
manufacturing.
 
GAMING REGULATION AND LICENSING
 
  General Regulation of Shareholders of Publicly Traded Corporations. In most
jurisdictions, any beneficial owner of the Company's Common Stock is subject
on a discretionary basis to being required to file applications with gaming
regulatory authorities, be investigated and found suitable or qualified as
such. In addition, shareholders whose holdings of Common Stock exceed certain
designated percentages are subject to certain reporting and qualification
requirements imposed by state and federal gaming regulators and, any
shareholder, if found to be unsuitable, may be required to immediately dispose
of its holdings of Common Stock.
 
  Nevada Regulatory Matters. The Company must obtain a registration, license,
approval or finding of suitability, and equipment approval in all
jurisdictions before it can offer gaming devices for sale to licensed gaming
operations within those jurisdictions. The licensing process usually involves
the licensing or approval of certain officers, directors, and shareholders of
the corporation, and approval of the specific product that the Company wants
to offer for sale. On June 19, 1996 the Nevada Commission registered SGI as a
publicly traded corporation and licensed Silicon Gaming-Nevada ("SGI-Nevada"),
a wholly-owned subsidiary of SGI, as a manufacturer, distributor and operator
of a slot machine route. The Company's initial public offering was also
approved by the Nevada Commission on June 19, 1996. On March 20, 1997, the
Nevada Commission granted final approval of the Company's product for sale to
licensed casinos in Nevada.
 
  The manufacture, sale and distribution of gaming devices for use or play in
Nevada or for distribution outside of Nevada, the manufacture and distribution
of associated equipment for use in Nevada, and the ownership and operation of
slot machine routes in Nevada are subject to: (i) the Nevada Gaming Control
Act and the regulations promulgated thereunder (collectively, "Nevada Act");
and (ii) various local ordinances and regulations. Such activities are subject
to the licensing and regulatory control of the Nevada Commission, the Nevada
Board, and various local, city and county regulatory agencies (collectively
referred to as the "Nevada Gaming Authorities").
 
  The laws, regulations and supervisory procedures of the Nevada Gaming
Authorities are based upon declarations of public policy which are concerned
with, among other things: (i) the prevention of unsavory or unsuitable persons
from having a direct or indirect involvement with gaming, or manufacturing or
distribution of gaming devices at any time or in any capacity; (ii) the strict
regulation of all persons, locations, practices,
 
                                      13
<PAGE>
 
associations and activities related to the operation of licensed gaming
establishments and the manufacture or distribution of gaming devices and
equipment; (iii) the establishment and maintenance of responsible accounting
practices and procedures; (iv) the maintenance of effective controls over the
financial practices of licensees, including the establishment of minimum
procedures for internal fiscal affairs and the safeguarding of assets and
revenue, providing reliable record keeping and requiring the filing of
periodic reports with the Nevada Gaming Authorities; (v) the prevention of
cheating and fraudulent practices; and (vi) the provision of a source of state
and local revenue through taxation and licensing fees. Change in such laws,
regulations and procedures could have an adverse effect on the Company's
operations.
 
  On June 19, 1996 the Company was registered by the Nevada Commission as a
publicly-traded corporation (a "Registered Corporation"), and SGI-Nevada was
approved as a manufacturer, distributor and operator of a slot machine route.
On March 20, 1997, the Nevada Commission granted final approval of the
Company's product. Such gaming approvals require the periodic payment of fees
and taxes and are not transferable. As a Registered Corporation, the Company
is required periodically to submit detailed financial and operating reports to
the Nevada Commission and furnish any other information which the Nevada
Commission may require. No person may become a shareholder of, or receive any
profit from SGI-Nevada without first obtaining licenses and approvals from the
Nevada Gaming Authorities. The Company and SGI-Nevada have applied for, and in
some cases received, the various registrations, approvals, permits and
licenses in order to engage in manufacturing, distribution and slot route
activities in Nevada.
 
  All gaming devices that are manufactured, sold or distributed for use or
play in Nevada, or for distribution outside of Nevada, must be manufactured by
licensed manufacturers and distributed or sold by licensed distributors. All
gaming devices manufactured for use or play in Nevada must be approved by the
Nevada Commission before distribution or exposure for play. The approval
process for gaming devices includes rigorous testing by the Nevada Board, a
field trial and a determination as to whether the gaming device meets strict
technical standards that are set forth in the regulations of the Nevada
Commission. Associated equipment must be administratively approved by the
Chairman of the Nevada Board before it is distributed for use in Nevada.
 
  The Nevada Gaming Authorities may investigate any individual who has a
material relationship to, or material involvement with, a Registered
Corporation or its subsidiaries in order to determine whether such individual
is suitable or should be licensed as a business associate of a gaming
licensee. Officers, directors and certain key employees of the Company and
SGI-Nevada are required to file applications with the Nevada Gaming
Authorities and may be required to be licensed or found suitable by the Nevada
Gaming Authorities. The Nevada Gaming Authorities may deny an application for
licensing for any cause which they deem reasonable. A finding of suitability
is comparable to licensing, and both require submission of detailed personal
and financial information followed by a thorough investigation. The applicant
for licensing or a finding of suitability must pay all the costs of the
investigation. Changes in licensed positions must be reported to the Nevada
Gaming Authorities and in addition to their authority to deny an application
for a finding of suitability or licensure, the Nevada Gaming Authorities have
jurisdiction to disapprove a change in a corporate position. On June 19, 1996
SGI's Chief Executive Officer, Chief Financial Officer, the required directors
and SGI-Nevada's sole officer and director were found suitable by the Nevada
Commission.
 
  If the Nevada Gaming Authorities were to find an officer, director or key
employee unsuitable for licensing or unsuitable to continue having a
relationship with SGI or SGI-Nevada, the Company would have to sever all
relationships with such person. In addition, the Nevada Commission may require
the Company or SGI-Nevada to terminate the employment of any person who
refuses to file appropriate applications. Determination of suitability or of
questions pertaining to licensing are not subject to judicial review in
Nevada.
 
  The Company and SGI-Nevada will be required to submit detailed financial and
operating reports to the Nevada Commission. Substantially all material loans,
leases, sales of securities and similar financing transactions by the Company
will be required to be reported to or approved by the Nevada Commission.
 
 
                                      14
<PAGE>
 
  If it were determined that the Nevada Act was violated by the Company or
SGI-Nevada, the registration and gaming licenses it holds could be limited,
conditioned, suspended or revoked, subject to compliance with certain
statutory and regulatory procedures. In addition, the Company, SGI-Nevada and
the persons involved could be subject to substantial fines for each separate
violation of the Nevada Act at the discretion of the Nevada Commission.
Limitation, conditioning or suspension of any gaming license could (and
revocation of any gaming license would) materially adversely affect the
Company's gaming operations.
 
  Any beneficial holder of a Registered Corporation's voting securities,
regardless of the number of shares owned, may be required to file an
application, be investigated, and have his suitability determined as a
beneficial holder of the Registered Corporation's voting securities if the
Nevada Commission has reason to believe that such ownership would otherwise be
inconsistent with the declared policies of the State of Nevada. The applicant
must pay all costs of investigation incurred by the Nevada Gaming Authorities
in conducting any such investigation.
 
  The Nevada Act requires any person who acquires beneficial ownership of more
than 5% of a Registered Corporation's voting securities to report the
acquisition to the Nevada Commission. The Nevada Act requires that beneficial
owners of more than 10% of a Registered Corporation's voting securities apply
to the Nevada Commission for a finding of suitability within thirty days after
the Chairman of the Nevada Board mails the written notice requiring such
filing. Under certain circumstances, an "institutional investor," as defined
in the Nevada Act, which acquires more than 10% but not more than 15%, of the
Registered Corporation's voting securities may apply to the Nevada Commission
for a waiver of such finding of suitability if such institutional investor
holds the voting securities for investment purposes only. An institutional
investor shall not be deemed to hold voting securities for investment purposes
unless the voting securities were acquired and are held in the ordinary course
of business as an institutional investor and not for the purpose of causing,
directly or indirectly, the election of a majority of the members of the board
of directors of the Registered Corporation, any change in the Registered
Corporation's corporate charter, bylaws, management, policies or operations of
the Registered Corporation, or any of its gaming affiliates, or any other
action which the Nevada Commission finds to be inconsistent with holding the
Registered Corporation's voting securities for investment purposes only.
Activities which are not deemed to be inconsistent with holding voting
securities for investment purposes only include: (i) voting on all matters
voted on by shareholders; (ii) making financial and other inquiries of
management of the type normally made by securities analysts for informational
purposes and not to cause a change in its management, policies or operations;
and (iii) such other activities as the Nevada Commission may determine to be
consistent with such investment intent. If the beneficial holder of voting
securities who must be found suitable is a corporation, partnership or trust,
it must submit detailed business and financial information including a list of
beneficial owners. The applicant is required to pay all costs of
investigation.
 
  Any person who fails or refuses to apply for a finding of suitability or a
license within thirty days after being ordered to do so by the Nevada
Commission or the Chairman of the Nevada Board, may be found unsuitable. The
same restrictions apply to a record owner if the record owner, after request,
fails to identify the beneficial owner. Any shareholder found unsuitable and
who holds, directly or indirectly, any beneficial ownership of the Common
Stock beyond such period of time as may be prescribed by the Nevada Commission
may be guilty of a criminal offense. The Company will be subject to
disciplinary action if, after it receives notice that a person is unsuitable
to be a shareholder or to have any other relationship with the Company or SGI-
Nevada, the Company (i) pays that person any dividend or interest upon voting
securities of the Company, (ii) allows that person to exercise, directly or
indirectly, any voting right conferred through securities held by that person,
(iii) pays remuneration in any form to that person for services rendered or
otherwise, or (iv) fails to pursue all lawful efforts to require such
unsuitable person to relinquish his voting securities including, if necessary,
the immediate purchase of said voting securities for cash at fair market
value.
 
  The Nevada Commission may, in its discretion, require the holder of any debt
security of a Registered Corporation to file applications, be investigated and
be found suitable to own the debt security of a Registered Corporation. If the
Nevada Commission determines that a person is unsuitable to own such security,
then pursuant to the Nevada Act, the Registered Corporation can be sanctioned,
including the loss of its approvals, if
 
                                      15
<PAGE>
 
without the prior approval of the Nevada Commission, it: (i) pays to the
unsuitable person any dividend, interest, or any distribution whatsoever; (ii)
recognizes any voting right by such unsuitable person in connection with such
securities; (iii) pays the unsuitable person remuneration in any form; or (iv)
makes any payment to the unsuitable person by way of principal, redemption,
conversion, exchange, liquidation, or similar transaction.
 
  The Company will be required to maintain a current stock ledger in Nevada
which may be examined by the Nevada Gaming Authorities at any time. If any
securities are held in trust by an agent or by a nominee, the record holder
may be required to disclose the identity of the beneficial owner to the Nevada
Gaming Authorities. A failure to make such disclosure may be grounds for
finding the record holder unsuitable. The Company will also be required to
render maximum assistance in determining the identity of the beneficial owner.
The Nevada Commission has the power to require the stock certificates of the
Company to bear a legend indicating that the securities are subject to the
Nevada Act. However, the Nevada Commission has not imposed such a requirement
on the Company to date, but it is unknown whether the Nevada Commission will
impose such a requirement on the Company in the future.
 
  As a Registered Corporation, the Company may not make a public offering of
its securities, such as an IPO, without the prior approval of the Nevada
Commission if the securities or proceeds therefrom are intended to be used to
construct, acquire or finance gaming facilities in Nevada, or to retire or
extend obligations incurred for such purposes. Approval of a public offering,
if given, does not constitute a finding, recommendation or approval by the
Nevada Commission or the Nevada Board as to the accuracy or adequacy of the
Offering Memorandum or the investment merits of the securities offered. Any
representation to the contrary is unlawful.
 
  Changes in control of a Registered Corporation through merger,
consolidation, stock or asset acquisitions, management or consulting
agreements, or any act or conduct by a person whereby he obtains control, may
not occur without the prior approval of the Nevada Commission. Entities
seeking to acquire control of a Registered Corporation must satisfy the Nevada
Board and the Nevada Commission in a variety of stringent standards prior to
assuming control of such Registered Corporation. The Nevada Commission may
also require controlling shareholders, officers, directors and other persons
having a material relationship or involvement with the entity proposing to
acquire control, to be investigated and licensed as part of the approval
process relating to the transaction.
 
  The Nevada legislature has declared that some corporate acquisitions opposed
by management, repurchases of voting securities and corporate defense tactics
affecting Nevada corporate gaming licensees, and Registered Corporations that
are affiliated with those operations, may be injurious to stable and
productive corporate gaming. The Nevada Commission has established a
regulatory scheme to ameliorate the potentially adverse effects of these
business practices upon Nevada's gaming industry and to further Nevada's
policy to: (i) assure the financial stability of corporate gaming licensees
and their affiliates; (ii) preserve the beneficial aspects of conducting
business in the corporate form; and (iii) promote a neutral environment for
the orderly governance of corporate affairs. Approvals are, in certain
circumstances, required from the Nevada Commission before the Registered
Corporation can make exceptional repurchases of voting securities above the
current market price thereof and before a corporate acquisition opposed by
management can be consummated. The Nevada Act also requires prior approval of
a plan of recapitalization proposed by the Registered Corporation's Board of
Directors in response to a tender offer made directly to the Registered
Corporation's shareholders for the purposes of acquiring control of the
Registered Corporation.
 
  License fees and taxes, computed in various ways depending on the type of
gaming or activity involved, are payable to the State of Nevada and to the
counties and cities in which gaming operations are to be conducted. Depending
upon the particular fee or tax involved, these fees and taxes are payable
either monthly, quarterly or annually and are based upon either: (i) a
percentage of the gross revenue received; or (ii) the number of gaming devices
operated. Annual fees are also payable to the State of Nevada for renewal of
licenses as a manufacturer, distributor and operator of a slot machine route.
 
 
                                      16
<PAGE>
 
  Any person who is licensed, required to be licensed, registered, required to
be registered, or is under common control with such persons (collectively,
"Licensees"), and who proposes to become involved in a gaming venture outside
of Nevada, is required to deposit with the Nevada Board, and thereafter
maintain, a revolving fund in the amount of $10,000 to pay the expenses of
investigation by the Nevada Board of their participation in such foreign
gaming. The revolving fund is subject to increase or decrease in the
discretion of the Nevada Commission. Thereafter, Licensees are required to
comply with certain reporting requirements imposed by the Nevada Act.
Licensees are also subject to disciplinary action by the Nevada Commission if
they knowingly violate any laws of the foreign jurisdiction pertaining to the
foreign gaming operation, fail to conduct the foreign gaming operation in
accordance with the standards of honesty and integrity required of Nevada
gaming operations, engage in activities that are harmful to the state of
Nevada or its ability to collect gaming taxes and fees, or employ a person in
the foreign operation who has been denied a license or finding of suitability
in Nevada on the ground of personal unsuitability.
 
  In the future, SGI intends to seek the necessary registrations, licenses,
approvals, and findings of suitability for the Company, its product and its
personnel in other jurisdictions throughout the world. However, there can be
no assurances that such registrations, licenses, approvals or findings of
suitability will be obtained. Many other jurisdictions in which the Company
wishes to do business require various licenses, permits, and approvals in
connection with the manufacture and/or distribution of gaming devices,
typically involving restrictions similar in most respects to those of Nevada.
 
  Missouri Regulatory Matters. Gaming was originally authorized in the state
of Missouri in November 1992. On April 29, 1993, new legislation (the
"Missouri Act") was enacted which replaced the 1992 legislation. In January
1994 the Missouri Supreme Court handed down a decision which held that the
operation of certain games of chance such as traditional slot machines was
prohibited by the constitution of the state of Missouri. On November 8, 1994,
the people of Missouri voted in favor of an amendment to the Missouri
constitution to allow slot machine gaming in the state. The Missouri Act
provides for the licensing and regulation of excursion gambling boat
operations on the Mississippi and Missouri Rivers in the state of Missouri and
the licensing and regulation of persons who distribute gaming equipment and
supplies to gaming licensees. An excursion gambling boat is a boat, ferry or
other floating facility on which gaming is allowed. The Missouri Act limits
the loss per individual on each excursion to $500, but does not otherwise
limit the amount which may be wagered on any bet or the amount of space in the
vessel which may be utilized for gaming.
 
  The Missouri Act is to be implemented and enforced by a five-member Missouri
Commission. The Missouri Commission is empowered to issue such number of
riverboat gaming licenses as it determines to be appropriate. A gaming license
cannot be granted to any gaming operator unless the voters in such operator's
"home dock" city or county have authorized gaming activities on gaming
riverboats.
 
  On September 1, 1993, the Missouri Commission adopted rules and regulations
(the "Missouri Regulations") governing the licensing, operation and
administration of riverboat gaming in the state of Missouri and the form of
application for such licensure. The Missouri Regulations generally provide for
four types of licenses--a Class A owner's license; a Class B operator's
license; a supplier's license; and an occupational license. In addition, the
Missouri Regulations remain subject to amendment and interpretation, and may
further limit or otherwise adversely affect the Company and its Missouri
gaming operations.
 
  Directors and certain officers and key persons of the Company and Silicon
Gaming-Missouri ("SGI-Missouri"), a wholly-owned subsidiary of SGI, must file
personal disclosure forms with the gaming license application and must be
found suitable by the Missouri Commission. Further, the Missouri Regulations
require that all employees of SGI-Missouri who are involved in gaming
operations and who are employed on the licensed premises must file
applications for and receive Missouri gaming occupational licenses. The
Missouri regulations require disclosure by the Company and SGI-Missouri of any
person or entity holding any direct or indirect ownership interest in SGI-
Missouri. SGI-Missouri is also required to disclose the names of the holders
of all of the Company's and SGI-Missouri's debt including a description of the
nature and terms of such debt. The Missouri Commission may, in its sole
discretion, request additional information with respect to such holders.
 
                                      17
<PAGE>
 
Missouri suppliers' gaming licenses must be renewed annually for a fee of
$5,000 or such greater amount as may be determined by the Commission. On
November 8, 1996, SGI-Missouri was granted a temporary supplier's license by
the Missouri Commission.
 
  Under Missouri law, gaming licenses are not transferable, and under the
Missouri Regulations the transfer of (i) any ownership interest in a privately
held business entity or (ii) a 5% or greater interest in a publicly traded
company directly or indirectly holding a Missouri gaming license is prohibited
without the approval of the Missouri Commission. Further, without the prior
approval of the Missouri Commission, the Missouri Regulations prohibit
withdrawals of capital, loans, advances or distribution of any assets in
excess of 5% of accumulated earnings by a license holder to anyone with an
ownership interest in the license holder.
 
  The Missouri Regulations specifically provide that any action of the
Missouri Commission shall not indicate or suggest that the Missouri Commission
has considered or passed in any way on the marketability of the applicant or
licensee's securities, or on any other matter, other than the applicant or
licensee's suitability for licensure under Missouri law. A Missouri gaming
license holder can be disciplined in Missouri for gaming-related acts
occurring in another jurisdiction which result in disciplinary action in the
other jurisdiction.
 
  The Missouri Commission has broad powers to require additional disclosure by
an applicant during the processing of a gaming application, to deny gaming
licensure and to administratively fine or suspend or revoke a gaming license
for failure to comply with or for violation of the Missouri Act or Missouri
Regulations.
 
  Colorado Regulatory Matters. The State of Colorado created the Division of
Gaming (the "Division") within the Department of Revenue to license,
implement, regulate and supervise the conduct of limited gaming. The Director
of the Division, under the supervision of a five-member Colorado Commission,
has been granted broad power to ensure compliance with the Colorado
Regulations. The Director may inspect, without notice, impound or remove any
gaming device. He may examine and copy any licensee's records, may investigate
the background and conduct of licensees and their employees, and may bring
disciplinary actions against licensees and their employees. He also may
conduct detailed background investigations of persons who loan money to the
Company.
 
  The Colorado Commission is empowered to issue five types of gaming and
gaming-related licenses. The failure or inability of the Company or Silicon
Gaming-Colorado, Inc. (the "Colorado subsidiary"), or others associated with
the Company or the Colorado subsidiary, to obtain or maintain necessary gaming
licenses will have a material adverse affect on the operations of the Company.
All persons employed by the Company and the Colorado subsidiary and involved,
directly or indirectly, in gaming operations in Colorado also are required to
obtain a Colorado gaming license. All licenses must be renewed annually. On
January 24, 1997, the Company's wholly-owned subsidiary, Silicon Gaming-
Colorado, Inc., was granted a manufacturer and distributor license by the
Colorado Limited Gaming Commission and the Company was found suitable to be an
associated person of a licensee.
 
  In addition, pursuant to the Colorado Regulations, no manufacturer or
distributor of slot machines may have an interest in any casino operator,
allow any of its officers to have such an interest, employ any person if such
person is employed by a casino operator, or allow any casino operator or
person with a substantial interest therein to have an interest in a
manufacturer's or distributor's business. The Commission has ruled that a
person does not have a "substantial interest" if it directly or indirectly has
less than a five percent (5%) interest in such voting securities of a
licensee. Some Division Staff informally have interpreted the Regulations to
prohibit a casino operator from having any interest in a slot machine
manufacturer or distributor.
 
  Under the Colorado Regulations, any person or entity having any direct or
indirect interest in a gaming licensee or an applicant for a gaming license,
including, but not limited to, the Company and shareholders of the Company,
may be required to supply the Colorado Commission with substantial
information, including, but not limited to, background information, source of
funding information, a sworn statement that such person or entity is not
holding his interest for any other party, and fingerprints. Such information,
investigation and licensing as
 
                                      18
<PAGE>
 
an "associated person" automatically will be required of all persons (other
than certain institutional investors discussed below) which directly or
indirectly own ten percent (10%) or more of a direct or indirect legal,
beneficial or voting interest in the Colorado subsidiary, through their
ownership in the Company. Such persons must report their interest and file
appropriate applications within 45 days after acquiring such interest. Persons
directly or indirectly having a five percent (5%) or more interest (but less
than 10%) in the Colorado Subsidiary, through their ownership in the Company,
must report their interest to the Colorado Commission within ten (10) days
after acquiring such interest and may be required to provide additional
information and to be found suitable. If certain institutional investors
provide certain information to the Colorado Commission, such investors, at the
Colorado Commission's discretion, may be permitted to own up to 14.99% of the
Colorado Subsidiary, through their ownership in the Company, before being
required to be found suitable. All licensing and investigation fees will have
to be paid for by the person in question. The associated person investigation
fee currently is $48.00 per hour.
 
  The Colorado Commission also has the right to request information from any
person directly or indirectly interested in, or employed by, a licensee, and
to investigate the moral character, honesty, integrity, prior activities,
criminal record, reputation, habits and associations of (i) all persons
licensed pursuant to the Colorado Limited Gaming Act, (ii) all officers,
directors and shareholders of a licensed privately held corporation, (iii) all
officers, directors and shareholders holding either a five percent (5%) or
greater interest or a controlling interest in a licensed publicly traded
corporation, (iv) all general partners and all limited partners of a licensed
partnership, (v) all persons who have a relationship similar to that of an
officer, director or shareholder of a corporation (such as members and
managers of a limited liability company), (vi) all persons supplying financing
or loaning money to any licensee connected with the establishment or operation
of limited gaming, including those acquiring the Notes, and (vii) all persons
having a contract, lease or ongoing financial or business arrangement with any
licensee, where such contract, lease or arrangement relates to limited gaming
operations, equipment, devices or premises.
 
  In addition, under the Colorado Regulations, every person who is a party to
a "gaming contract" with an applicant for a license, or with a licensee, upon
the request of the Colorado Commission or the Director, promptly must provide
to the Colorado Commission or Director all information which may be requested
concerning financial history, financial holdings, real and personal property
ownership, interests in other companies, criminal history, personal history
and associations, character, reputation in the community, and all other
information which might be relevant to a determination whether a person would
be suitable to be licensed by the Colorado Commission. Failure to provide all
information requested constitutes sufficient grounds for the Director or the
Colorado Commission to require a licensee or applicant to terminate its
"gaming contract" (as defined below) with any person who failed to provide the
information requested. In addition, the Director or the Colorado Commission
may require changes in "gaming contracts" before an application is approved or
participation in the contract is allowed. A "gaming contract" is defined as an
agreement in which a person does business with or on the premises of a
licensed entity.
 
  An application for licensure or suitability may be denied for any cause
deemed reasonable by the Colorado Commission or the Director, as appropriate.
Specifically, the Colorado Commission and the Director must deny a license to
any applicant who (i) fails to prove by clear and convincing evidence that the
applicant is qualified, (ii) fails to provide information and documentation
requested; (iii) fails to reveal any fact material to qualification, or
supplies information which is untrue and misleading as to a material fact
pertaining to qualification; (iv) has been, or has any director, officer,
general partner, shareholder, limited partner or other person who has a
financial or equity interest in the applicant who has been, convicted of
certain crimes, including the service of a sentence upon conviction of a
felony in a correctional facility, city or county jail, or community
correctional facility or under the state board of parole or any probation
department within ten years prior to the date of the application, gambling-
related offenses, theft by deception or crimes involving fraud or
misrepresentation, is under current prosecution for such crimes (during the
pendency of which license determination may be deferred), is a career offender
or a member or associate of a career offender cartel, or is a
 
                                      19
<PAGE>
 
professional gambler; or (v) has refused to cooperate with any state or
federal body investigating organized crime, official corruption or gaming
offenses.
 
  If the Colorado Commission determines that a person or entity is unsuitable
to own interests in the Company, then the Company or the Colorado Subsidiary
may be sanctioned, which may include the loss by the Company or the Colorado
Subsidiary of their respective approvals and licenses.
 
  The Colorado Commission determines that a person or entity is unsuitable to
own interests in the Company, then the Company or the Colorado Subsidiary may
be sanctioned, which may include the loss by the Company or the Colorado
Subsidiary of their respective approvals and licenses.
 
  In addition, the Colorado Regulations prohibit a licensee or affiliated
company thereof, such as the Company, from paying dividends, interest or other
remuneration to any unsuitable person, or recognizing the exercise of any
voting rights by any unsuitable person. Further, the Company may repurchase
the shares of anyone found unsuitable at the lesser of the cash equivalent to
the original investment in the Company or the current market price. Further,
the regulations require anyone with a material involvement with a licensee,
including a director or officer of a holding company, such as the Company, to
file for a finding of suitability if required by the Colorado Commission.
 
  In addition to its authority to deny an application for a license or
suitability, the Colorado Commission has jurisdiction to disapprove a change
in corporate position of a licensee and may have such authority with respect
to any entity which is required to be found suitable by the Colorado
Commission. The Colorado Commission has the power to require the Company and
the Colorado Subsidiary to suspend or dismiss managers, officers, directors
and other key employees or sever relationships with other persons who refuse
to file appropriate applications or whom the authorities find unsuitable to
act in such capacities, and may have such power with respect to any entity
which is required to be found suitable.
 
  A person or entity may not sell, lease, purchase, convey or acquire a
controlling interest in the Company without the prior approval of the Colorado
Commission. The Company may not sell any interest in the Colorado Subsidiary
without the prior approval of the Colorado Commission.
 
  Limited gaming facilities in Colorado must not exceed certain gaming square
footage limits as a total of each floor and the full building. Casinos in
Colorado may operate only between 8:00 a.m. and 2:00 a.m., and may permit only
individuals 21 years or older to gamble in casino. The law permits slot
machines, blackjack and poker, with a maximum single bet of $5.00. Casinos may
not provide credit to their gaming patrons.
 
  The Colorado Constitution permits a gaming tax of up to 40% on adjusted
gross gaming proceeds. The Colorado Commission has set a gaming tax rate of 2%
on adjusted gross gaming proceeds of up to and including $2 million, 4% over
$2 million and including $4 million, 14% over $4 million up to and including
$5 million and 18% on adjusted gross gaming proceeds over $5 million up to and
including $10 million and 20% in excess of $10 million. The Colorado
Commission also has imposed an annual device fee of $100 per gaming device.
The Colorado Commission may revise the gaming tax rate and device fee from
time to time. Central City Black Hawk and Cripple Creek each have imposed
annual device fees of approximately $1,000 per gaming device and may revise
the same from time to time.
 
  Colorado has certain unique regulatory laws which, if adversely interpreted
or not modified, may limit or adversely affect the ability of the Company to
enter in, or compete within, the Colorado market. First, as noted, gaming in
Colorado constitutionally is limited to slot machines, blackjack and poker.
Although no manufacturer or distributor has attempted to distribute the
Company's type of interactive game, it should be included within the
definition of "slot machine." In preliminary discussions, Division personnel
have stated that the device likely is a "slot machine," although neither the
division nor the Commission have formally ruled on the issue and will not do
so until the product is submitted to the Division for approval.
 
 
                                      20
<PAGE>
 
  Second, Colorado constitutionally limits the maximum single bet to $5.00.
Colorado statutes define a bet to be an amount placed as a wager in a game of
chance. If the Company's product permits multiple rounds of betting at $5.00
per round, it would be unclear whether Colorado would permit such betting. If
Colorado does not permit multiple round bets in excess of $5.00, then the
Company would need to adjust its machines to limit the total bets to $5.00,
including all rounds.
 
  Third, Commission Regulations define the requirements of slot machines,
including limitations on the ability to alter the slot machine's program and
the internal requirements of the slot machine itself. The Company's proposed
machines do not comply with existing Regulations. Although the Company intends
to seek a change in the Commission's Regulations, there can be no assurance
that such changes will be made. If the Regulations are not changed, then the
Company will need to modify its machines to conform to Colorado requirements.
Even as so modified, the Company's machines must be approved by the Division
as meeting existing Regulations and there is no assurance that the Company
will receive such approval or will receive such approval in a timely basis.
 
  New Jersey Regulatory Matters. Casino gaming in New Jersey, including the
manufacture, distribution and operation of gaming devices, is subject to
strict regulation by the New Jersey Casino Control Commission (the "New Jersey
Commission") pursuant to the New Jersey Casino Control Act and the regulations
of the New Jersey Commission promulgated thereunder (collectively, the "New
Jersey Act"). The New Jersey Commission is authorized to decide all
applications for licensure or other approvals and to promulgate regulations.
The New Jersey Act also established the New Jersey Division of Gaming
Enforcement (the "New Jersey Division"), which is responsible for
investigating all applications for licensure or approval and for prosecuting
violations of the New Jersey Act.
 
  Under the New Jersey Act, a company must be licensed as a gaming related
casino service industry ("CSI") in order to manufacture or distribute gaming
devices to New Jersey casinos. In January of 1997, the applications of the
Company and its wholly-owned subsidiary, Silicon Gaming-New Jersey, Inc.
("SGI-NJ"), for CSI licensure were deemed complete and accepted for filling by
the New Jersey Commission. These applications consisted of extensive
disclosure forms by the Company, SGI-NJ, and certain of their officers,
directors, principal employees and security holders.
 
  The New Jersey Commission has broad discretion regarding the issuance,
renewal, suspension or revocation of CSI licenses. In order to obtain a CSI
license, the Company and SGI-NJ must demonstrate to the New Jersey Commission
by clear and convincing evidence that they, any five percent or greater
security holders, certain officers, directors, and principal employees, and
anyone else whom the New Jersey Commission deems appropriate in its
discretion, possess good character, honesty and integrity, and financial
stability, integrity and responsibility. If a person who is required to be
found qualified is found disqualified by the New Jersey Commission, the
license applications may be denied.
 
  With respect to security holders, the New Jersey Commission may waive the
qualification requirement for "institutional investors," as defined in the New
Jersey Act, of the Company in the absence of a prima facie showing by the
Director of the New Jersey Division that there is any cause to believe that
the institutional investor may be unqualified, if the institutional investor
holds less than ten percent of the outstanding securities, provided the
securities were acquired for investment purposes only and the holder has no
intention of influencing the affairs of the Company, other than voting its
securities. The New Jersey Act defines an "institutional investor" as (i) any
retirement fund administered by a public agency for the exclusive benefit of
federal, state or local public employees, (ii) an investment company
registered under the Investment Company Act of 1940, (iii) a collective
investment trust organized by banks under Part Nine of the Rules of the
Comptroller of the Currency, (iv) a closed end investment trust, (v) a
chartered or licensed life insurance company or property and casualty
insurance company, (vi) banking or other licensed or chartered lending
institutions, (vii) an investment advisor registered under the Investment
Advisors Act of 1940, or (viii) such other persons as the New Jersey
Commission may determine for reasons consistent with the policies of the New
Jersey Act.
 
 
                                      21
<PAGE>
 
  The applications of the Company and SGI-NJ will be investigated by the New
Jersey Division. During the course of the investigation, the Company and SGI-
NJ are required to provide additional information to the New Jersey Division.
At the conclusion of its investigation, the New Jersey Division will file a
report with the New Jersey Commission stating its position on the license
applications. After receipt of the report of the New Jersey Division, the New
Jersey Commission will hold a public hearing on the license applications. No
assurances can be given as to the timing of the completion of the
investigation by the New Jersey Division and the public hearing by the New
Jersey Commission on the license applications or that the licenses will be
obtained.
 
  In its discretion, the New Jersey Commission may permit the Company and SGI-
NJ to transact business with New Jersey casinos prior to their licensure. In
order to do so, the Company and SGI-NJ must continue to have complete
applications for CSI licensure on file with the New Jersey Commission,
petition the New Jersey Commission for permission for each transaction,
demonstrate that good cause exists for granting the petition and the New
Jersey Division must not object to the petition.
 
  The fee for a CSI license is a minimum of $5,000 and a maximum of $15,000,
with the actual cost depending upon the amount of time spent by the New Jersey
Commission and New Jersey Division in investigating an processing the
applications, plus the out of pocket expenses of the New Jersey Commission and
New Jersey Division.
 
  A CSI license is issued for an initial period of two years and, upon proper
application and satisfaction of the same standards applicable to the initial
issuance of a CSI license, is renewable for four year periods. The New Jersey
Commission may impose conditions on the issuance of a license. In addition,
the New Jersey Commission has the authority to impose fines or suspend or
revoke a license for violations of the New Jersey Act, including the failure
to satisfy the licensure requirements.
 
  In addition, gaming devices manufactured or distributed by the Company or
SGI-NJ must be approved by the New Jersey Commission based on, at a minimum,
their quality, design, integrity, fairness, honesty and suitability in order
to be used in New Jersey casinos. The approval process includes the submission
of a model of the gaming device and relevant documentation to the New Jersey
Division for testing, examination and analysis. Only a licensed CSI or an
applicant for CSI licensure can submit a gaming device for approval. All costs
of such testing, examination and analysis are borne by the Company. Prior to
deciding to approve a particular model of gaming device, the New Jersey
Commission may require a test of up to 60 days of the gaming device in a
licensed casino. During the test period, the manufacturer or distributor of
the gaming device shall not be entitled to receive revenue of any kind
whatsoever. Once a gaming device is approved by the New Jersey Commission, all
gaming devices of that model placed in operation in licensed casinos shall
operate in conformity with the model approved by the New Jersey Commission.
Any changes in the design, function or operation of an approved gaming device
are subject to prior approval by the New Jersey Commission, after testing by
the New Jersey Division. In March of 1997, Odyssey was submitted to the New
Jersey Division and New Jersey Commission for testing and approval. No
assurances can be given as to the timing of the testing process or that
Odyssey will be approved.
 
  Mississippi Regulatory Matters. The manufacture, sale and distribution of
gaming devices for use or play in Mississippi are subject to the Mississippi
Gaming Control Act and the regulations promulgated thereunder (collectively,
the "Mississippi Act"). Such activities are subject to the licensing and
regulatory control of the Mississippi Gaming Commission (the "Mississippi
Commission") and the Mississippi State Tax Commission (collectively referred
to as the "Mississippi Gaming Authorities"). Although not identical, the
Mississippi Act is similar to the Nevada Gaming Control Act and regulations
promulgated thereunder.
 
  On June 20, 1996 the Company was registered by the Mississippi Commission as
a publicly traded corporation (a "Registered Corporation") and the holding
company of Silicon Gaming-Mississippi, Inc. (the "Mississippi Subsidiary").
Also on June 20, 1996 the Mississippi Subsidiary was licensed as a
manufacturer and distributor. SGI and the Mississippi Subsidiary are required
to periodically submit detailed financial and operating reports to the
Mississippi Commission and furnish any other information which the Mississippi
 
                                      22
<PAGE>
 
Commission may require. The Company and the Mississippi Subsidiary have
received the various registrations, approvals, permits and licenses in order
to engage in manufacturing, distribution and gaming activities as presently
conducted in Mississippi. Such licenses, registrations and approvals are not
transferable, are initially issued for a two-year period and must be renewed
periodically thereafter.
 
  Similar to Nevada, the Mississippi Commission may investigate and find
suitable any individual who has a material relationship to, or material
involvement with, the Company or the Mississippi Subsidiary, including record
or beneficial holders of any of the voting securities of the Company, holders
of debt obligations, and officers, directors and employees of the Company and
the Mississippi Subsidiary. The Company and the Mississippi Subsidiary are
required to maintain a current stock ledger in Mississippi which may be
examined by the Mississippi Commission at any time. The Company believes that
all required findings of suitability currently required have been applied for
or obtained. Any application for a finding of suitability must pay all
investigative fees and costs of the Mississippi Commission in connection with
such an investigation.
 
  The Mississippi Act requires any person who acquires beneficial ownership of
more than 5% of a Registered Corporation's voting securities to report the
acquisition to the Mississippi Commission and such person may be required to
be found suitable. The Mississippi Act requires that beneficial owners of more
than 10% of a Registered Corporation's voting securities apply to the
Mississippi Commission for a finding of suitability. The Mississippi
Commission has generally exercised its discretion to require a finding of
suitability of any beneficial owner of more than 5% of a Registered
Corporation's Common Stock. Under certain circumstances, an "institutional
investor," as defined by Mississippi Commission policy, which acquires more
than 5%, but not more than 10%, of the Registered Corporation's voting
securities may apply to the Mississippi Commission for a waiver of such
finding of suitability if such institutional investor holds the voting
securities for investment purposes only.
 
  The Company may not make a public offering of its securities without the
approval of the Mississippi Commission if the securities or proceeds therefrom
are intended to be used to construct, acquire or finance gaming facilities in
Mississippi, or to retire or extend obligations incurred for such purposes.
 
  If it were determined that the Mississippi Act was violated by the
Mississippi Subsidiary, the licenses it holds could be limited, condition,
suspended or revoked, subject to compliance with certain statutory and
regulatory procedures, which action, if taken, could materially adversely
affect the Company's manufacturing and distribution.
 
  Federal Regulation. The Federal Gambling Devices Act of 1962 (the "Federal
Act") makes it unlawful, in general, for a person to manufacture, deliver, or
receive gaming machines, gaming machine type devices and component across
state lines or to operate gaming machines unless that person has first
registered with the Attorney General of the United States. The Company is
required to register and renew its registration annually. The Company has
complied with such registration requirements. In addition, various record
keeping equipment identification requirements are imposed by the Federal Act.
Violation of the Federal Act may result in seizure and forfeiture of the
equipment, as well as other penalties.
 
  Native American Gaming. Gaming on Native American lands, including the terms
and conditions under which gaming equipment can be sold or leased to Native
American tribes, is or may be subject to regulation under the laws of the
tribes, the laws of the host state, the Indian Gaming Regulatory Act or 1988
("IGRA"), which is administered by the National Indian Gaming Commission (the
"NIGC") and the Security of the U.S. Department of the Interior (the
"Secretary"), and also may be subject to the provisions of certain statutes
relating to contracts with Native American tribes, which are administered by
the Secretary. As a precondition to gaming involving gaming machines, IGRA
requires that the tribe and the state have entered into a written agreement (a
"tribal-state compact") that specifically authorizes such gaming, and that has
been approved by the Secretary, with notice of such approval published in the
Federal Registrar. Tribal-state compacts vary from state to state. Many
require that equipment suppliers meet ongoing registration and licensing
requirements of the state and/or the tribe and some impose background check
requirements on the officers, directors, and
 
                                      23
<PAGE>
 
shareholders of gaming equipment supplies. Under IGRA, tribes are required to
regulate all commercial gaming under ordinances approved by the NIGC. Such
ordinances may impose standards and technical requirements on gaming hardware
and software, and may impose registration, licensing and background check
requirements to gaming equipment suppliers and their officers, directors, and
shareholders.
 
  Application of Future or Additional Regulatory Requirements. In the future,
the Company intends to seek the necessary registrations, licenses, approvals
and findings of suitability for the Company, its product and its personnel in
other U.S. and foreign jurisdictions in which the Company identifies
significant sales potential for its product. However, there can be no
assurance that such registrations, licenses, approvals or findings of
suitability will be obtained and will not be revoked, suspended or conditioned
or that the Company will be able to obtain the necessary approvals for its
future products as they are developed in a timely manner, or at all. If a
registration, license, approval or finding of suitability is required by a
regulatory authority and the Company fails to seek or does not receive the
necessary registration, license, approval or finding of suitability, the
Company may be prohibited from selling its product for use in the respective
jurisdiction or may be required to sell its product through other licensed
entities at a reduced profit to the Company.
 
ITEM 2: PROPERTIES
 
  The Company leases a 28,000 square foot facility in Palo Alto, California
for its development, marketing, sales and administrative personnel. The lease
expires in January 2006. The Company also leases a 29,000 square foot
manufacturing facility in Mountain View, California pursuant to a lease that
expires in February 2006. The Company leases a 27,000 square foot facility in
Las Vegas, Nevada that houses its sales and support organization and a 4,000
square foot facility in Reno, Nevada that houses a sales and support
organization.
 
  The Company believes that its existing manufacturing facility is adequate to
meet its production requirements through at least 1999.
 
ITEM 3: LEGAL PROCEEDINGS
 
  Inapplicable.
 
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
  Inapplicable.
 
EXECUTIVE OFFICERS
 
  The executive officers of the Company are as follows:
 
<TABLE>
<CAPTION>
                NAME                AGE                 POSITION
                ----                ---                 --------
 <C>                                <C> <S>
 Donald J. Massaro................   54 President, Chairman of the Board and
                                         Chief Executive Officer
 Andrew S. Pascal.................   32 Executive Vice President--Marketing and
                                         Game Development
 Thomas E. Carlson................   44 Vice President--Chief Financial Officer
 Karen M. Katz....................   32 Vice President--Sales and Support
 Paul D. Matthews.................   33 Vice President--Corporate Development
                                         and Government Affairs
 H. Paul Kurth....................   61 Vice President--Operations
</TABLE>
 
  Donald J. Massaro has served as President and Chief Executive Officer since
June 1995. In addition, Mr. Massaro has served as a director of the Company
since May 1995 and as Chairman of the Board since October 1996. Mr. Massaro
has over 20 years of general management experience and has been a director
and/or chairman of the board of directors for a number of public and private
Silicon Valley based technology companies. Prior to
 
                                      24
<PAGE>
 
joining SGI, Mr. Massaro was Executive Vice President and General Manager of
Worldwide Sales and Marketing for Conner Peripherals Inc. ("Conner"), a disk
drive manufacturer, from July 1994 to May 1995. From January 1991 to June
1994, Mr. Massaro was Chief Executive Officer of Sjoberg Industries
("Sjoberg"), and Inversion Development Corporation ("Inversion"),
manufacturers of environmental products. Prior thereto, he served as President
and Chief Executive Officer of Metaphor Computer Systems ("Metaphor"), a
company he co-founded in 1982 to develop and manufacture client-server based
management information systems. Mr. Massaro's other prior experience includes
positions as Corporate Vice President and President of Xerox Corporation's
Office Products Division and President and Chief Executive Officer of Shugart
Associates, a computer peripherals company he co-founded in 1972.
 
  Andrew S. Pascal has served as Executive Vice President--Marketing and Game
Development since October 1994. He has over 10 years of gaming industry
experience with an emphasis in slot marketing, slot merchandising and slot
operations. He joined SGI in October 1994 from Mirage Resorts, Incorporated,
where he had worked from June 1985 to October 1994, most recently as Director
of Slot Operations and Marketing at The Mirage Hotel and Casino, managing a
division consisting of 350 employees and annual revenue in excess of $110
million. Mr. Pascal also served on The Mirage's eight-member Operating
Committee, which set operating policy and established the strategic direction
for The Mirage and its 7,300 employees, from September 1992 to October 1994.
Prior to the opening of The Mirage Hotel and Casino, Mr. Pascal served as the
Director of Slot Marketing for the Golden Nugget Casino-Hotel.
 
  Thomas E. Carlson joined SGI in May 1995 from Conner, where from November
1994 to February 1995 he held the position of Worldwide Research and
Development and Launch Manufacturing Controller. From January 1991 to October
1994 he was Chief Financial Officer of Sjoberg and continued in that position
with Inversion. From 1984 to 1990 Mr. Carlson held various positions at
Metaphor, including Director of Financial Planning and Corporate Controller.
 
  Karen M. Katz joined SGI in July 1995 from Conner, where from August 1994 to
July 1995 she held the position of Director of Strategic Programs and was
responsible for developing and implementing the programs and systems for
managing its $2.5 billion disk drive and tape drive businesses. Prior to her
promotion to Director of Strategic Programs, from July 1993 to July 1994 Ms.
Katz served as Conner's Director of Corporate Sales and was responsible for
the global sales management of the Sun Microsystems, Inc. and Digital
Equipment Corporation accounts. Prior to joining Conner in October 1991, Ms.
Katz was a member of the technical staff at AT&T Bell Laboratories.
 
  Paul D. Mathews joined SGI in November 1995 from Casino Data Systems, a
designer and manufacturer of casino management information systems and gaming
devices, where from March 1995 to November 1995 he was Director of Regulatory
Compliance responsible for corporate and product licensing in all gaming
jurisdictions. Prior to joining Casino Data Systems, Mr. Mathews spent five
years with the Nevada State Gaming Control Board in the Corporate Securities
and Investigation Divisions.
 
  H. Paul Kurth joined SGI in November 1995 from Edge Diagnostic Systems, a
manufacturer of computerized automotive diagnostic systems, where he was the
founder and Vice President of Operations responsible for product design,
fabrication and manufacturing from January 1988 to June 1994. Prior to
founding Edge Diagnostic Systems, Mr. Kurth founded Vertex Peripherals, a
manufacturer of high-performance, high-capacity disk drives.
 
                                      25
<PAGE>
 
                                    PART II
 
  Portions of the information required by Part III of Form 10-K are
incorporated by reference to portions of the Company's 1997 Annual Report.
Except for the information specifically incorporated by reference, the
Company's 1997 Annual Report is not be deemed filed as part of this Report.
 
ITEM 5: MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
 
  The information under "Stock Price History" set forth in the 1997 Annual
Report is incorporated herein by reference.
 
ITEM 6: SELECTED FINANCIAL DATA
 
  The information under "Selected Consolidated Financial Data" set forth in
the 1997 Annual Report is incorporated herein by reference.
 
ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
 
  The information under "Management's Discussion and Analysis of Financial
Condition and Results of Operations" set forth in the 1997 Annual Report is
incorporated herein by reference.
 
ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
  The information contained the 1997 Annual Report under the captions
"Consolidated Balance Sheets," "Consolidated Statements of Operations,"
"Consolidated Statements of Shareholders' Equity (Deficiency)," "Consolidated
Statements of Cash Flows," "Notes to Consolidated Financial Statements" and
"Independent Auditors' Report" is incorporated herein by reference.
 
ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
 
  In November 1995, the Company engaged Deloitte & Touche LLP ("Deloitte") as
its independent auditor and dismissed its former auditor, Coopers & Lybrand
L.L.P. ("Coopers"). The decision to change auditors was approved by the
Company's Board of Directors. Since the Company's inception, there has been no
auditors' report on the Company's financial statements containing an adverse
opinion or disclaimer of opinion or that was qualified or modified as to
uncertainty, audit scope or accounting principles. During such period, there
were no disagreements with Coopers on any matter of accounting principle or
practice, financial statement disclosure or auditing scope or procedure, which
disagreements, if not resolved to Coopers' satisfaction, would have caused it
to make reference to the subject matter of the disagreements in connection
with its report. Further, during this period, there were no events of the type
required to be reported pursuant to Item 304(a)(1)(v) of Regulation S-K.
During the period from inception through November 1, 1995, the Company did not
consult Deloitte on items that involved either the Company's accounting
principles or the form of its audit opinion.
 
                                      26
<PAGE>
 
                                   PART III
 
  Portions of the information required by Part III of Form 10-K are
incorporated by reference to portions of the Company's definitive Proxy
Statement to be filed with the Commission in connection with the 1997 Annual
Meeting of Shareholders (the "Proxy Statement"), which the Company intends to
file not less than 120 days after the end of the fiscal year covered by this
Report.
 
ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
  The information set forth in the Proxy Statement under the captions
"Proposal One--Election of Directors-Nominees" and "Section 16(a) Beneficial
Ownership Reporting Compliance" in the Company's Proxy Statement to be filed
in connection with its 1998 Annual Meeting of Shareholders (the "Proxy
Statement") and the information set forth in Part I of this Report under the
caption "Executive Officers" is incorporated herein by reference.
 
ITEM 11: EXECUTIVE COMPENSATION
 
  The information set forth in the Proxy Statement under the caption
"Executive Compensation" is incorporated herein by reference.
 
ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
  The information set forth in the Proxy Statement under the caption "Security
Ownership of Certain Beneficial Owners and Management" is incorporated herein
by reference.
 
ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
  The information set forth in the Proxy Statement under the caption "Certain
Relationships and Related Transactions" is incorporated herein by reference.
 
                                      27
<PAGE>
 
                                    PART IV
 
ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
 
  (A) THE FOLLOWING DOCUMENTS ARE FILED AS PART OF THIS FORM 10-K:
 
    (1) Consolidated Financial Statements. The following consolidated
  financial statements and related notes, together with the report thereon of
  Deloitte & Touche LLP, independent public accountants, are incorporated
  herein by reference from the 1997 Annual Report.
 
<TABLE>
<CAPTION>
                                                                   ANNUAL REPORT
                                                                    PAGE NUMBER
                                                                   -------------
     <S>                                                           <C>
     Consolidated Balance Sheets at December 31, 1997 and 1996...        12
     Consolidated Statements of Operations for the years ended
      December 31, 1997 and 1996 and the nine-month period ended
      December 31, 1995..........................................        13
     Consolidated Statements of Shareholders' Equity (Deficiency)
      for the period from April 1, 1995 through December 31,
      1997.......................................................        14
     Consolidated Statements of Cash Flows for the years ended
      December 31, 1997 and 1996 and the nine-month period ended
      December 31, 1995..........................................        16
     Notes to Consolidated Financial Statements..................        17
     Independent Auditors' Report................................        28
</TABLE>
 
    (2) Financial Statement Schedules.
 
  Schedules have been omitted because they are not required or the information
required to be set forth therein is included in the Consolidated Financial
Statements or Notes to Consolidated Financial Statements.
 
    (3) Exhibits. The exhibits listed in the accompanying Exhibit Index are
  filed as part of, or incorporated by reference into, this Report.
 
  (B) REPORTS ON FORM 8-K:
 
  No reports on Form 8-K were filed during the quarter ended December 31,
1997.
 
                                      28
<PAGE>
 
                                  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, in the City of Palo Alto, County of Santa
Clara, State of California, on the 19 day of March, 1998.
 
                                          Silicon Gaming, Inc.
 
                                                   /s/ Donald J. Massaro
                                          By___________________________________
                                                     DONALD J. MASSARO
                                             PRESIDENT, CHAIRMAN OF THE BOARD
                                                         AND CHIEF
                                                     EXECUTIVE OFFICER
 
  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.
 
         SIGNATURES                      TITLE                      DATE
 
    /s/ Donald J. Massaro      President, Chairman of the      March 19, 1998
-----------------------------   Board and Chief Executive
      DONALD J. MASSARO         Officer (Principal
                                Executive Officer)
 
    /s/ Thomas E. Carlson      Vice President--Chief           March 19, 1998
-----------------------------   Financial Officer
      THOMAS E. CARLSON         (Principal Financial and
                                Accounting Officer)
 
     /s/ Robert M. Fell        Director                        March 19, 1998
-----------------------------
       ROBERT M. FELL
 
      /s/ William Hart         Director                        March 19, 1998
-----------------------------
        WILLIAM HART
 
     /s/ Kevin R. Harvey       Director                        March 19, 1998
-----------------------------
       KEVIN R. HARVEY
 
     /s/ David S. Morse        Director                        March 19, 1998
-----------------------------
       DAVID S. MORSE
 
    /s/ Joseph T. Piemont      Director                        March 19, 1998
-----------------------------
      JOSEPH T. PIEMONT
 
     /s/ Thomas J. Volpe       Director                        March 19, 1998
-----------------------------
       THOMAS J. VOLPE
 
 
                                      29
<PAGE>
 
                               INDEX TO EXHIBITS
 
<TABLE>
<CAPTION>
 EXHIBIT  DESCRIPTION
 -------  -----------
 <C>      <S>
  3.1(1)  Amended and Restated Articles of Incorporation of the Registrant.
  3.2(3)  Bylaws of the Registrant.
  4.1     Securities Purchase Agreement, dated as of September 30, 1997, by and
           between the Company and B III Capital Partners, L.P., a Delaware
           limited partnership
  4.2     Form of Senior Discount Notes due September 30, 2002
  4.3     Registration Rights Agreement dated September 30, 1997, by and
           between the Company and B III Capital Partners, L.P., a Delaware
           limited partnership
  4.4     Warrant Agreement including Form of Warrant dated September 30, 1997,
           by and between the Company and B III Capital Partners, L.P., a
           Delaware limited partnership
 10.1(3)  Amended and Restated 1994 Stock Option Plan, as amended.
 10.2(3)  Lease Agreement dated September 14, 1995, between the Registrant and
           Demmon Family Partnership.
 10.6(2)  Series C Preferred Stock Purchase Agreement dated as of March 21,
           1996, as amended May 29, 1996.
 10.7(3)  Second Amended and Restated Rights Agreement dated as of March 21,
           1996.
 10.8(2)  Master Equipment Lease Agreement dated October 6, 1995, between the
           Registrant and Lighthouse Capital Partners, L.P.
 10.10(3) Side Letter Agreement dated March 21, 1996, between the Registrant
           and the Interpublic Group of Companies, Inc.
 10.11(3) Side Letter Agreement dated March 21, 1996, between the Registrant
           and Station Casinos, Inc.
 10.15(3) OEM Master License Agreement dated April 17, 1996, between the
           Registrant and RSA Data Security, Inc.
 10.16(3) Agreement dated March 26, 1996, between the Registrant and MICROID
           Research.
 10.18(2) Employment Agreement dated May 25, 1995, by and between the
           Registrant and Donald J. Massaro.
 10.19(3) 1996 Employee Stock Purchase Plan.
 10.20(3) 1996 Outside Directors Stock Option Plan.
 10.21(2) Software License Agreement dated June 20, 1996 between the Registrant
           and Duck Corporation.
 10.22(4) Lease Agreement dated August 14, 1996, between the Registrant and
           Interactive Technologies, Inc.
 10.23(4) Lease Agreement dated January 1997, between the Registrant and The
           Prudential Insurance Company of America
 10.24(4) Lease Agreement dated January 23, 1997, between the Registrant and
           Johnny Ribeiro
 10.25(4) Lease Agreement dated January 23, 1997, between the Registrant and
           The Ribeiro Corporation
 10.26    Lease Agreement dated October 7, 1997 between the Registrant and
           Battle Born Development, LLC.
 10.27    1997 Nonstatutory Stock Option Plan
 10.28    See Exhibit 4.1
 10.29    See Exhibit 4.2
</TABLE>
 
                                       1
<PAGE>
 
<TABLE>
<CAPTION>
 EXHIBIT DESCRIPTION
 ------- -----------
 <C>     <S>
 10.30   See Exhibit 4.3
 10.31   See Exhibit 4.4
 11.1    Statement of Computation of Net Loss Per Share.
 12.1    Computation of Ratio of Earnings to Fixed Charges.
 13.1    Portions of 1997 Annual Report to Shareholders.
 16.1(3) Letter re change in certifying accountant.
 21.1    Subsidiaries of the registrant.
 23.1    Consent of Deloitte & Touche LLP.
 27      Financial Data Schedule.
</TABLE>
--------
(1) Incorporated by reference to Exhibit 3.3 to Registrant's Registration
    Statement on Form S-1 (No. 333-4793) which became effective on July 30,
    1996 (the "Form S-1"). (No. 0-28294) filed with the Commission on
    April 24, 1996 (the "Form 10").
(2) Incorporated by reference to identically numbered exhibit to the Form S-1.
(3) Incorporated by reference to identically numbered exhibit to Registrant's
    Registration Statement on Form 10 (No. 0-28294) filed with the Commission
    on April 24, 1996 (the "Form 10").
(4) Incorporated by reference to identically numbered exhibit to Registrant's
    Annual Report on Form 10-K for the year ended December 31, 1996.
 
                                       2