<PAGE>

                                                                   EXHIBIT 13.1

SELECTED CONSOLIDATED FINANCIAL DATA
------------------------------------

<TABLE>
<CAPTION>
                                  Period from                                                                      Cumulative from
                             inception (July 27,                                                                 Inception (July 27,
(In thousands, except per       1993) through       Year Ended         Nine Months Ended          Year Ended         1993) through
 share amounts)                 March 31, 1994    March 31, 1995    December 31, 1995/(1)/    December 31, 1996    December 31, 1996

------------------------------------------------------------------------------------------------------------------------------------

<S>                             <C>              <C>                <C>                       <C>                  <C>
Statement of Operations Data:
Loss from operations             $140            $1,851             $ 4,059                   $   14,533            $20,583
Net loss                          140             1,866               3,974                       13,634             19,614
Net loss per share/(2)/                                               (0.48)                       (1.36)
</TABLE> 


<TABLE> 
<CAPTION> 
                                                            March 31                                     December 31
                                                 -----------------------------------------------------------------------------------

(In thousands)                                     1994                     1995                1995/(1)/             1996
------------------------------------------------------------------------------------------------------------------------------------

<S>                                                <C>                <C>                       <C>                  <C>
Balance Sheet Data:
Cash and equivalents                              $  36                   $   241           $    2,399               $25,583
Short-term investments                               --                        --                   --                 9,683
Working capital                                    (169)                   (1,253)               2,027                34,203
Total assets                                         67                       486                3,486                39,646
Long-term debt                                       --                        --                  272                   778
Redeemable Convertible Preferred Stock               --                       967                8,496                 6,455
Total shareholders' equity (deficiency)            (138)                   (2,003)              (5,946)               30,061

</TABLE>

/(1)/ Effective April 1, 1995, the Company changed its fiscal year end from 
      March 31 to December 31.

/(2)/ See Note 1 of Notes to Consolidated Financial Statements for an 
      explanation of the method used to determine the number of shares used in
      the computation of net loss per share.
 

                                       26
<PAGE>
 
         MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION 
                           AND RESULTS OF OPERATIONS

                             SILICON GAMING, INC. 
                         (A DEVELOPMENT STAGE COMPANY)

OVERVIEW

THIS DISCUSSION INCLUDES A NUMBER OF FORWARD-LOOKING STATEMENTS WHICH REFLECT
THE COMPANY'S CURRENT VIEWS WITH RESPECT TO FUTURE EVENTS AND FINANCIAL
PERFORMANCE. THESE FORWARD-LOOKING STATEMENTS ARE SUBJECT TO CERTAIN RISKS AND
UNCERTAINTIES, INCLUDING THOSE REFERRED TO IN THE RISK FACTORS SECTION BELOW AND
ELSEWHERE HEREIN AND CONTAINED IN THE COMPANY'S PREVIOUSLY FILED FORM 10 AND
FORM S-1 REGISTRATION STATEMENTS, THAT COULD CAUSE ACTUAL RESULTS TO DIFFER
MATERIALLY FROM HISTORICAL RESULTS OR THOSE ANTICIPATED. IN THIS DISCUSSION, THE
WORDS "ANTICIPATES," "BELIEVES," "EXPECTS," "INTENDS," "FUTURE" AND SIMILAR
EXPRESSIONS IDENTIFY FORWARD-LOOKING STATEMENTS. READERS ARE CAUTIONED NOT TO
PLACE UNDUE RELIANCE ON THESE FORWARD-LOOKING STATEMENTS, WHICH SPEAK ONLY AS OF
THE DATE HEREOF.

The following discussion should be read in conjunction with the audited
consolidated financial statements and notes thereto included in this Annual
Report.

The Company was incorporated on July 27, 1993 to design, develop, manufacture
and distribute interactive gaming devices that implement advanced multimedia
technologies using state-of-the-art, off-the-shelf components. Since its
formation, the Company has been in the development stage, and its principal
activities have consisted of assembling a technical, marketing and executive
staff, developing its gaming platform, raising capital, and initiating
applications for regulatory approvals in Nevada and other jurisdictions to
manufacture and distribute its gaming devices. To date, the Company has
generated no sales or other revenue and has had negative operating cash flows.

The Company's first commercial product was approved for product field testing in
Nevada in December 1996. Following the completion of field testing, the product
was approved for sale to licensed casinos in Nevada by the Nevada Gaming
Commission on March 20, 1997. Accordingly, the Company is now commencing the
next phase in its transition to making commercial sales of its product.
Consistent with industry practice, the Company's product will first be installed
on a trial basis on casino floors for a period of 45 days before a sales
decision is made by the customer. In the fourth quarter of 1996, the Company
commenced manufacture of commercial units and, in 1997, the Company intends to
transition from the development stage to commercial distribution of its product.
The Company plans to limit the number of machines it sells in 1997, however, in
order to carefully monitor reactions to its platform, game software and product
support features. In 1998, the Company expects to broadly market and sell its
product; thus, the Company believes that 1998 will be the first year in which a
reasonable assessment can be made of its product's commercial potential. Future
revenue, profits, and cash flows will depend on market acceptance of the
Company's product, the ability of such product to generate higher revenue for
casinos as compared to competitive products and the technical performance of the
Company's product. The Company's success will also depend on, among other
factors, the Company's ability to attract, retain and motivate qualified
personnel and meet all the initial and ongoing licensing requirements in key
jurisdictions.

Effective April 1, 1995, the Company changed its fiscal year end from March 31
to December 31. Accordingly, the period ended December 31, 1995 is a nine-month
period.

RESULTS OF OPERATIONS

The Company is in the development stage and has not generated any revenue to
date. As of December 31, 1996, the Company had net losses since inception of
$19,614,000. To date, the Company has focused its resources on product
development, including system hardware and software, game concept development
and software coding, hiring additional marketing and administrative staff,
ramping up its marketing activities and starting up the manufacturing
operations. In addition to increasing expenditures in research and development,
the Company will need to incur significant expenses and other costs associated
with the commencement of manufacturing operations and building sales, support
and

                                      27
<PAGE>
 
administrative infrastructure. During 1996, units were manufactured primarily
for testing and engineering, game development, licensing approval and regulatory
field trials. In the fourth quarter of 1996, the Company commenced
manufacture of units for commercial distribution, although volume shipments are
not expected to commence until the second quarter of 1997. The Company did not
generate any product sales or any revenue from other sources in 1996. The
Company's plan for 1997 is to limit the number of machines it sells so that it
can collect feedback from casino operators and gaming patrons before commencing
a full roll-out of its product. Accordingly, the Company expects only limited
revenue in 1997 and expects to incur substantial losses and negative operating
cash flows at least through the second quarter of 1998.

Amounts for the year ended March 31, 1995, the nine-month period ended December
31, 1995, and the year ended December 31, 1996 may not be comparable due to the
Company's change in fiscal year-end. The Company believes that operating
expenses will increase in the future as it continues to develop its product and
emerges from the development stage to begin commercial operations, including
manufacturing, marketing and sales. Accordingly, the Company expects that future
results will differ materially from, and may not be comparable to, prior
periods.


Research and Development
------------------------
Research and development ("R&D") expenses include payroll and related costs of
employees engaged in ongoing design and development activities, fees to outside
contractors, early prototype development expenses, overhead costs, equipment
depreciation and costs of supplies. To date, the Company has expensed all costs
associated with the research, design and development of its product. R&D
expenses were $1,539,000, $3,137,000 and $7,030,000 for the year ended March 31,
1995, the nine-month period ended December 31, 1995, and the year ended December
31, 1996, respectively. Increases over the periods have resulted from the
incremental hiring of personnel, increased usage of engineering consultants and
license fees and similar costs associated with the acquisition of outside
technologies. The Company believes that a significant level of R&D expense is
required due to the technical nature of the product and the elaborate
requirements of the game development process. Accordingly, the Company
anticipates devoting substantial resources, including additional personnel, to
R&D and that these costs will continue to increase in absolute dollars in future
periods.

Manufacturing Development
-------------------------
Manufacturing development expenses include payroll and related costs for
manufacturing personnel, overhead costs, reserves against inventory and
depreciation. In the fourth quarter of 1996, the Company completed initial
development of its manufacturing process and commenced commercial production.
Manufacturing development expenses were $2,458,000 for the year ended December
31, 1996. There were no manufacturing development expenses in prior
periods. Manufacturing expenses are expected to increase through 1997 as the
Company expands its manufacturing capacity and infrastructure to produce its
product in commercial quantities. Upon commencement of sales of its product,
manufacturing costs will be matched to the corresponding revenue or included in
inventory prior to product sale. Due to the significant resources required to
manufacture its product and the early stage of its manufacturing processes, the
Company believes the fixed costs associated with its manufacturing activities
will increase significantly in absolute dollars in future periods.

Selling, General and Administrative
-----------------------------------
Selling, general and administrative ("SG&A") expenses include payroll and
related costs for administrative and executive personnel and sales and marketing
personnel, overhead costs, legal and associated costs, costs associated with
obtaining corporate and product licenses in various jurisdictions and fees for
professional services. SG&A expenses were $312,000, $922,000 and $5,045,000 for
the year ended March 31, 1995, the nine-month period ended December 31, 1995,
and the year ended December 31, 1996, respectively. Increases over the periods
result from the incremental hiring of personnel and expenses associated with
applying for corporate and product licensing in various jurisdictions. SG&A
expenses are expected to increase substantially in absolute dollars as the
Company invests in sales and marketing activities to launch its product and in
administrative personnel to support its growing infrastructure and comply with
regulatory requirements.

                                       28
<PAGE>
 
Income Taxes
------------
The Company has not been required to pay income taxes due to its net operating
losses in each period since inception. As of December 31, 1996, the Company had
net operating loss carryforwards of approximately $18,600,000 for federal
purposes and $17,200,000 for state purposes. These loss carryforwards will
expire beginning in 2000, if not utilized. The Company also has R&D credit
carryforwards of approximately $490,000 for federal and state purposes as of
December 31, 1996, which expire beginning in 2010. A valuation allowance has
been recorded for these deferred tax assets as a result of uncertainties
regarding the realization of these assets due to the lack of earnings history of
the Company. Due to changes in ownership, as defined by Section 382 of the
Internal Revenue Code, that may have resulted from the sale of Series B and
Series C Redeemable Convertible Preferred Stock in private placements and the
sale of Common Stock in the Company's initial public offering, the annual
deductibility of a substantial portion of the federal net operating loss and tax
credit carryforwards may be limited. See Note 7 of Notes to Consolidated
Financial Statements.

LIQUIDITY AND CAPITAL RESOURCES

To date, the Company has financed its operations primarily through the issuance
of Common Stock in its initial public offering, private placements of Redeemable
Convertible Preferred Stock and loans from shareholders which were subsequently
converted to Redeemable Convertible Preferred Stock. In August 1996, the Company
completed its initial public offering, in which the Company received proceeds,
net of underwriting discounts and offering expenses, of $32,855,000. Through
December 31, 1996, the amounts raised in the private placements of Redeemable
Convertible Preferred Stock, net of issuance costs, totaled $22,943,000. As of
December 31, 1996, the Company had $35,266,000 of cash and cash equivalents and
short-term investments to fund operations.

The Company's operating activities used cash of $1,696,000, $3,731,000 and
$11,991,000 for the year ended March 31, 1995, the nine-month period ended
December 31, 1995 and the year ended December 31, 1996, respectively. Cash used
in operating activities primarily reflects net losses, partially offset by
depreciation and amortization and changes to working capital.

From inception through December 31, 1996, the Company acquired a total of
$3,930,000 in fixed assets, primarily computer equipment, of which $1.0 million
was financed under a capital lease.

In the future, the Company expects to significantly increase cash used in
operating activities in order to commence commercial production and distribution
of its product, enhance manufacturing capabilities, expand sales and support
operations, increase research and development activities and add administrative
infrastructure. The Company believes that its cash on hand will be sufficient to
meet its anticipated cash needs for working capital, capital expenditures and
business expansion. However, the Company may need to raise additional funds to
finance more rapid expansion, to develop its product, to respond to competitive
pressures or to acquire complementary products, businesses or technologies. No
assurance can be given that additional financing will be available or that, if
available, it will be available on terms acceptable to the Company or its
shareholders. If adequate funds are not available to satisfy either the short-
term or long-term capital requirements, the Company may be required to limit its
operations significantly. The Company's capital requirements will depend on many
factors, including, but not limited to, the rate at which the Company can
introduce its product, the market acceptance and competitive position of such
product, the response of competitors to the Company's product, and the ability
of the Company to satisfy the licensing requirements in various jurisdictions
applicable to the Company, its product, and in some jurisdictions, its officers,
directors, employees or principal shareholders.

                                      29
<PAGE>
 
RISK FACTORS

SINGLE PRODUCT; RISK OF TECHNICAL ERRORS; UNCERTAIN MARKET ACCEPTANCE. The
Company's success will depend on the success of a single product. There can be
no assurance that a substantial technical difficulty with, or an undetected
error in, the Company's software or hardware will not arise, possibly resulting
in unanticipated costs, production delays, temporary revocation of existing
product licenses or delays in future product licensing.

To achieve commercial success, the Company's gaming platform must be accepted
both by casino operators and by gaming patrons. Because acceptance of the
platform by casino operators will ultimately depend on win per machine, the
Company believes that its ultimate success will depend on player acceptance. The
Company has performed only limited market studies to support its belief that its
platform design will be perceived by slot players as an improvement in slot
machine design, and there can be no assurance that its gaming platform will be
accepted by casino patrons. Player preferences are highly subjective, vary
substantially among geographic and demographic markets and are subject to
unpredictable change. Because the Company's gaming platform contains features
not found on traditional slot machines, it may not appeal to the player for whom
familiarity and predictability are an important consideration. As a new and
relatively small entrant in a market dominated by larger companies, the Company
believes that its success will require that its gaming platform demonstrate
superior, as opposed to merely comparable, win per machine when compared to
traditional slot machines and other gaming platforms offered by more established
competitors. The Company also believes its product must have superior
performance since its price is expected to exceed that of its competitors'
products. Although several casinos have agreed to install and evaluate the
Company's gaming platform, any purchases of gaming platforms by such casinos, or
by others that may conduct similar evaluations in the future, will likely
require that the Company's machine outperform competing machines on the casino
floor. If the Company's gaming platform does not perform well in its initial
evaluations, the Company's business, financial condition and results of
operations will be materially and adversely affected, and investors will be
exposed to the risk of loss of at least a portion of their investment.

REGULATORY APPROVAL.  The Company will be required to obtain the necessary
licenses, approvals, findings of suitability and product approvals in all
jurisdictions in which it intends to distribute its product. The licensing and
approval processes can involve extensive investigation into the Company and its
officers, directors, employees, principal shareholders and product, and can
require significant expenditures of time and resources by the Company. The
Company and certain of its subsidiaries have been approved as manufacturers and
distributors of gaming devices in Nevada, Mississippi, Missouri and Colorado.
The Company has also applied for the requisite corporate and individual
approvals in New Jersey and intends to file for the requisite approvals in other
jurisdictions wherein its product can be legally sold. The Company's gaming
platform was approved for sale in Nevada on March 20, 1997. In addition, the
Company has submitted its product for testing in Mississippi and New Jersey and
with Gaming Laboratories International, Inc., an independent testing facility
located in Tom's River, New Jersey. There can be no assurance that the Company's
product will be approved in any additional jurisdiction other than Nevada. The
regulations relating to Company and product licensing are subject to change, and
other jurisdictions, including the federal government, may elect to regulate or
tax gaming activities. The Company cannot predict the nature of any such changes
or their impact on the Company.

Any beneficial holder of the Company's Common Stock may be subject to
investigation by any gaming authority in any jurisdiction in which the Company
does business if such authorities have reason to believe that such ownership may
be inconsistent with the gaming policies of that jurisdiction. Persons who
acquire beneficial ownership of more than certain designated percentages of the
Common Stock may be subject to certain reporting and qualification procedures.
In addition, changes in control of the Company and certain other corporate
transactions may not be effected without the prior approval of gaming
authorities in other jurisdictions in which the Company plans to do business.
Such provisions could adversely affect the marketability of the Company's Common
Stock or prevent certain corporate transactions, including mergers or other
business combinations.

                                       30
<PAGE>
 
In the future, the Company intends to store its game software and Machine
Management System/TM/ on a writeable internal hard disk drive that will enhance
data storage and facilitate upgrades to game software. Current technical
standards in Nevada and Colorado prohibit the storage of software affecting game
outcome in a medium that can be altered through the circuitry or programming of
the gaming device. Accordingly, implementation of a writeable internal disk
drive will require a modification to the applicable technical standard or any
similar regulations of any other jurisdictions where the Company intends to sell
its machine. Although the Company believes that the Nevada gaming authorities
may modify the technical standard in the near future in a manner that will
permit the implementation of the Company's current design, there can be no
assurance that such modification will occur in the near future or at all, or
that a similar modification will be made to the regulations of any other
jurisdiction. Moreover, any such modification will be subject to administrative
procedures in Nevada that allow for comment by certain parties currently
licensed under Nevada gaming regulations.  Thus, certain existing or potential
competitors of the Company will have the opportunity to object to modifications
to the technical standard that may be necessary to permit the Company to
implement a writeable hard disk design. There can be no assurance that such
objection will not affect the outcome of this administrative procedure in a
manner that would prevent the Company's implementation of its current platform
design. The Company has altered its product to comply with existing regulations
in Nevada by disabling the write feature of its hard drive in a manner that
could not be changed without violating the integrity of the machine. Although
this alternative limits the machine's ability to store substantial quantities of
game history data during play and the ease of software upgrades, the Company
does not believe that this alternative affects the actual play characteristics
of the Company's games or the operation of the Machine Management System./TM/

DEVELOPMENT STAGE COMPANY; EXPECTATION OF LOSSES; NEGATIVE CASH FLOWS.  The
Company was founded in July 1993 and, as a development stage company, has not
yet generated revenue from product sales or other sources. As of December 31,
1996, the Company had cumulative net losses since inception of $19,614,000, and
the Company expects to continue to incur substantial losses and negative
operating cash flows at least through mid-1998. There can be no assurance that
the Company will become profitable or cash flow positive at any time in the
future. The likelihood of the success of the Company must be considered in light
of the expenses, difficulties, complications and delays frequently encountered
in connection with the formation of a new business and the competitive and
regulatory environment in which the Company must operate. In particular, the
Company's operations to date have focused primarily on product development, and
the Company has little or no experience in the areas of manufacturing, sales,
product distribution or customer support. It is not possible to estimate future
operating expenses and revenue based upon historical operating performance.
Operating results will depend, in part, on matters over which the Company has no
control, including, without limitation, general economic conditions, gaming
regulations and taxes, the ability of the Company to obtain the licenses
necessary to conduct its business, competition, the actual number of orders for
its product and the availability of qualified personnel.

COMPETITION.  The gaming machine industry is characterized by intense
competition, which is based on, among other things, a device's ability to
generate win per machine through product appeal to players, knowledge of
customer requirements such as ease of use, ease of service, support and
training, distribution, name recognition and price. In recent years, the gaming
machine market has been dominated by International Game Technology ("IGT")
which, according to industry sources, captured approximately 75% of the market
in 1996. Because of its extensive market presence, distribution capacity, player
acceptance and financial, technological and other resources, IGT represents
formidable competition.  Several other companies, including Bally Gaming
International, Inc., are established in, or are seeking to enter, the gaming
machine business. Companies in historically unrelated industries, such as Sega
Enterprises LTD ("Sega"), have technological resources that could offer them a
competitive advantage in developing multimedia-based gaming machines. 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, which may allow them to move rapidly into the Company's market and
acquire significant market share. Increased competition could result in price
reductions, reduced operating margins and loss of market share, any of which

                                       31
<PAGE>
 
could materially and adversely affect the Company's business, operating results
or financial condition. Furthermore, 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.

MANAGEMENT OF GROWTH.  Execution of the Company's plan of operation will require
significant growth. The Company's current plans for growth will place a
significant strain on the Company's financial, managerial and other resources.
The Company's ability to manage its growth effectively will require it to
continue to improve its operational, financial and management information
systems and to attract, motivate and train key employees. If the Company's
executives are unable to manage growth effectively, the Company's business,
operating results and financial condition would be materially and adversely
affected.

DEPENDENCE ON KEY PERSONNEL.  The operations of the Company depend a great
extent on the management efforts of its officers and other key personnel and on
the ability to attract new key personnel and retain existing key personnel.
Competition is intense for highly skilled product development employees in
particular. There can be no assurance that the Company will be successful in
attracting and retaining such personnel or that it can avoid increased costs in
order to do so. In addition, the Company's officers and key employees are not
bound by noncompetition agreements that extend beyond their employment at the
Company, and there can be no assurance that employees will not leave the Company
or compete against the Company. The Company's failure to attract additional
qualified employees or to retain the services of key personnel could have a
material adverse effect on the Company's operating results and financial
condition. The Company currently maintains a "key-man" life insurance policy in
the amount of $3 million on the life of Andrew S. Pascal, the Company's
Executive Vice President-Marketing and Game Development.

LIMITED PROTECTION OF INTELLECTUAL PROPERTY RIGHTS; RISK OF LITIGATION.  The
Company regards its product as proprietary and relies primarily on a combination
of trademark, copyright and trade secret laws and employee and third-party
nondisclosure agreements to protect its proprietary rights. Defense of
intellectual property rights can be difficult and costly, and there can be no
assurance that the company will be able effectively to protect its technology
from misappropriation by competitors. In addition, the protections offered by
trademark, copyright and trade secret laws would not prevent a competitor from
designing games having appearance and functionality that closely resemble the
company's games. At present, the company's principal proprietary technology
consists of its game authentication algorithm, which is designed to inhibit the
ability of any person to tamper with the game software resident in its product,
and its random number generator algorithm, which determines the outcome of each
gaming proposition. While the company believes that these algorithms are unique
at present, the algorithms are not patented, and there can be no assurance that
a competitor of the company will not succeed in developing an authentication
algorithm or a random number generator algorithm that performs as well as, or
better than, the company's. Although the company has applied for a U.S. patent
with respect to its authentication algorithm, there can be no assurance that
such patent will be issued or, if issued, that such patent will not be
successfully challenged in subsequent litigation.

As the number of software products in the industry increases and the
functionality of these products further overlaps, software developers and
publishers may increasingly become subject to infringement claims. The Company
may also become subject to infringement claims, with or without merit, that are
brought by competitors who are motivated by a desire to disrupt the Company's
business. Although the Company is not currently aware of any claim that it is
infringing upon any of its intellectual property rights, there can be no
assurance that the Company will not face claims, with or without merit, in the
future. Any such claims or litigation could be costly and could result in a
diversion of management's attention, which could have a material adverse effect
on the Company's business and financial condition. Any settlement of such claims
or adverse determinations in such litigation could also have a material adverse
effect on the Company's business, operating results and financial condition.

RAPIDLY CHANGING TECHNOLOGY.  The Company's product utilizes hardware components
that have been developed primarily for the personal computer and multimedia
industries. These industries are characterized by rapid technological change 

                                      32
<PAGE>
 
and product enhancements. The Company's ability to remain competitive and retain
any technological lead may depend in part upon its ability to continually
develop new slot machine games that take full advantage of the technological
possibilities of state-of-the-art hardware. Should any current or potential
competitor of the Company succeed in developing a competing software-based
gaming platform, such competitor could be in a position to outperform the
Company in its ability to exploit developments in microprocessor, video or other
multimedia technology. The emergence of a suite of slot machine games that is
superior to the Company's in any respect could substantially diminish the
Company's product sales and thereby have a material adverse effect on the
Company's operating results.

CAPITAL REQUIREMENTS.  The Company believes that its cash and equivalents and
short-term investments will be sufficient to fund its capital and operating
requirements. No assurance can be given, however, that the Company will not be
required to seek additional financing to fund its operations. In that event,
there can be no assurance that the Company will be able to obtain such
financing, or that, if it is able to obtain such financing, it will be able to
do so on satisfactory terms or on a timely basis. If additional funds are raised
through the issuance of equity, convertible debt or similar securities, the
percentage of ownership of the Company's shareholders will be reduced,
shareholders may experience additional dilution, and such securities may have
rights or preferences senior to those of the Common Stock. Moreover, if adequate
funds were not available to satisfy the Company's short-term or long-term
capital requirements, the Company would be required to limit its operations
significantly. The Company's capital requirements will depend on many factors,
including, but not limited to, the rate at which the Company can introduce its
product, the market acceptance and competitive position of such product, the
response of competitors to the product and the ability of the Company's
management and its product to satisfy the corporate licensing and product
licensing requirements in various jurisdictions.

LIMITED MANUFACTURING EXPERIENCE.  In order for the Company to be successful,
its product must be manufactured to meet high quality standards in commercial
quantities at competitive prices. Although the Company has produced small
quantities of prototype devices for testing, design, licensing and field testing
purposes, it has only recently attempted to manufacture its product for
commercial distribution. The transition to commercial manufacturing of the
Company's product, either by the Company or by a contract manufacturer, will
involve various risks and uncertainties including unforeseen costs or assembly
difficulties and the possibility that anticipated efficiencies or economies of
scale will fail to materialize as the Company begins manufacturing in greater
volumes. A failure by the Company to successfully manage this transition would
have a material adverse affect on the Company's business, operating results or
financial condition.

DEPENDENCE ON SINGLE-SOURCE SUPPLIERS.  The Company currently obtains a number
of its system's components from single-source suppliers. In particular, the
touchscreen and picture tube that comprise the video display are supplied by
MicroTouch Systems, Inc. and Philips Display Components Company, respectively.
The Company does not have long-term supply contracts with these suppliers but
rather obtains these components on a purchase order basis. Although the design
of these components is not unique or proprietary and the Company believes that
it could identify alternative sources of supply, if necessary, there can be no
assurance that the Company would be able to procure, substitute or produce such
components without a significant interruption in its assembly process in the
event that these single sources were unable to supply these components. The
failure or delay by any supplier to furnish the Company with any such components
would have a material adverse effect on the Company's business, financial
condition and results of operations.

SLOWING IN TREND TO LEGALIZE GAMING.  Growth in demand for slot machines
historically has been driven by the opening of new casinos, including casinos in
jurisdictions where gaming has recently been legalized. However, in recent
years, the legalization of gaming in new jurisdictions has been significantly
reduced; therefore, demand based on new openings will be largely limited to new
projects in existing markets. There can be no assurance that the slot machine
industry will sustain the rate of growth that was possible in the first half of
this decade.

NO DIVIDENDS.  The Company has not paid any cash dividends in the past and does
not expect to do so in the foreseeable future.

                                      33
<PAGE>
 
                             SILICON GAMING, INC. 
                         (A DEVELOPMENT STAGE COMPANY)

                          CONSOLIDATED BALANCE SHEETS



<TABLE>
<CAPTION>
                                                             December 31,
(In thousands, except share                        -----------------------------
 and per share amounts)                                 1995             1996
--------------------------------------------------------------------------------
<S>                                                <C>                <C> 
ASSETS:

Current Assets:
 Cash and equivalents                              $     2,399         $ 25,583
 Short-term investments                                      -            9,683
 Inventory                                                   -              477
 Prepaids and other                                        292              812
                                                   ----------------------------
  Total current assets                                   2,691           36,555
Property and Equipment, Net                                734            3,046
Other Assets, Net                                           61               45
                                                   ----------------------------
Total                                              $     3,486         $ 39,646
                                                   ============================
 
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIENCY):

Current Liabilities:
 Accounts payable                                  $       370         $  1,158
 Accrued liabilities                                       239              987
 Current portion of capital lease obligations               55              207
                                                   ----------------------------
  Total current liabilities                                664            2,352
Deferred Rent                                                -              133
Capital Lease Obligations                                  272              645
Commitments (Note 4)
Redeemable Convertible Preferred Stock
  6,884,473 shares authorized at December 31, 
    1996; Shares outstanding: December 31, 1995
    --8,534,997; December 31, 1996--6,384,473            8,496            6,455
                                                   ----------------------------
Shareholders' Equity (Deficiency)
 Common Stock, $.001 par value; 50,000,000 shares 
   authorized; Shares outstanding: December 31, 
   1995--2,737,989; December 31, 1996--10,608,105          109           49,873
 Notes receivable from shareholders                        (75)            (221)
 Unrealized gain on investments                              -               23
 Deficit accumulated during the development stage       (5,980)         (19,614)
                                                   ----------------------------
  Total shareholders' equity (deficiency)               (5,946)          30,061
                                                   ----------------------------
Total                                              $     3,486         $ 39,646
                                                   ============================
</TABLE> 

See notes to consolidated financial statements.
 

                                       34
<PAGE>
 
                             SILICON GAMING, INC. 
                         (A DEVELOPMENT STAGE COMPANY)

                     CONSOLIDATED STATEMENT OF OPERATIONS
<TABLE> 
<CAPTION> 
                                                                                                   Cumulative from
                                                                                                 Inception (July 27,
(In thousands, except per            Year Ended      Nine Months Ended         Year Ended           1993) through
 share amounts)                    March 31, 1995   December 31, 1995      December 31, 1996      December 31, 1996
--------------------------------------------------------------------------------------------------------------------
<S>                                <C>              <C>                <C>                <C> 
Operating Expenses:
 Research and development            $   1,539         $  3,137                 $  7,030               $ 11,785
 Manufacturing development                  -                -                     2,458                  2,458
 Selling, general and
  administrative                          312              922                     5,045                  6,340
                                     ------------------------------------------------------------------------------
  Loss from operations                  1,851            4,059                    14,533                 20,583
 Interest income                           (7)             (85)                   (1,016)                (1,108)
 Interest expense                          22                -                        84                    106
 Loss on disposal of fixed asset            -                -                        33                     33
                                     ------------------------------------------------------------------------------
Net Loss                             $  1,866         $  3,974                  $ 13,634               $ 19,614
                                     ==============================================================================
Net Loss Per Share                                       ($0.48)          ($1.36)
                                     ==============================================================================
Shares Used In Computation                                8,292           10,021
                                     ==============================================================================

</TABLE> 
See notes to consolidated financial statements.

                                       35
<PAGE>
 
                             SILICON GAMING, INC. 
                         (A DEVELOPMENT STAGE COMPANY)

         CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DEFICIENCY)
        PERIOD FROM INCEPTION (JULY 27, 1993) THROUGH DECEMBER 31, 1996

<TABLE> 
<CAPTION>                                                                           Unrealized   Deficit
                                                                     Notes           Gain on   Accumulated
                                          Common Stock             Receivable       Available-  During the
(In thousands, except share        ----------------------------       from          for-sale   Development
 and per share amounts)            Shares           Amount         Shareholders     Securities    Stage      Total
----------------------------------------------------------------------------------------------------------------------
<S>                                <C>               <C>            <C>              <C>         <C>          <C>  
September 1993-Sale of Common
 Stock to founders at $.001
 per share                          2,000,000         $      3       $       (1)                               $      2
Net loss                                                                                          $   (140)        (140)
                                    ------------------------------------------------------------------------------------
Balances, March 31, 1994            2,000,000         $      3               (1)           -          (140)        (138)
Collection of notes
 receivable                                                                   1                                       1
Net loss                                                                                            (1,866)      (1,866)
                                    -----------------------------------------------------------------------------------
Balances, March 31, 1995            2,000,000                3                -            -        (2,006)      (2,003)
Options exercised during the
 year for cash and notes
 receivable                           716,222               77              (75)                                      2
Common Stock and warrants
 issued to employees and vendors
 for services at $.18 per share       21,767                 4                                                        4
Warrants issued to vendors                                  25                                                       25
Net loss                                                                                            (3,974)      (3,974)
                                    -----------------------------------------------------------------------------------   
Balances, December 31, 1995         2,737,989              109              (75)           -        (5,980)      (5,946)
Options exercised for cash
 and notes receivable                 870,979              155             (152)                                      3
Collection of notes
 receivable                                                                   1                                       1
Repurchase of Common Stock
 and cancellation of notes
 receivable                           (39,780)              (5)               5                                       -   
Common Stock issued to
 vendors for services at $1.04
  per share                            10,568               11                                                       11
Conversion of Redeemable
 Preferred Stock in conjunction 
 with initial public offering       3,528,349           16,748                                                   16,748
Common Stock issued pursuant
 to initial public offering 
 in July 1996 at $10.50 per 
 share, net of costs  of $3,895     3,500,000           32,855                                                   32,855
Unrealized gain on investments                                            $  23                                      23
Net loss                                                                                           (13,634)     (13,634)
                                   ------------------------------------------------------------------------------------
Balances, December 31, 1996        10,608,105        $ 49,873             $  (221)   $    23      $(19,614)    $ 30,061
                                   ==================================================================================== 
</TABLE> 
 
See notes to consolidated financial statements.
 

                                       36
<PAGE>
 
                             SILICON GAMING, INC. 
                         (A DEVELOPMENT STAGE COMPANY)

                     CONSOLIDATED STATEMENT OF CASH FLOWS


<TABLE> 
<CAPTION> 
                                                                                                 Cumulative from
                                                                                               Inception (July 27,
                               Year Ended         Nine Months Ended         Year Ended           1993) through
(In thousands)                March 31, 1995      December 31, 1995      December 31, 1996      December 31, 1996
------------------------------------------------------------------------------------------------------------------
<S>                               <C>               <C>                    <C>                      <C>                             

Cash Flows from Operating
 Activities:            
  Net loss                        $ (1,866)         $ (3,974)               $(13,634)               $(19,614)
  Reconciliation to net cash
   used in operating
   activities:                          
  Depreciation and
   amortization                         47               136                     668                     852           
  Deferred rent                          -                 -                     133                     133  
  Common and Preferred Stock
   issued for services                   -                 4                     261                     265
  Accrued interest exchanged
   for Preferred Stock                   -                10                       -                      10
  Loss on sale of property               -                 -                      33                      33
  Changes in assets and
   liabilities: 
    Inventory                            -                 -                    (477)                   (477)
    Prepaids and other                 (28)             (264)                   (520)                   (812)
    Other assets, net                   (2)              (30)                      9                     (28)
    Accounts payable                    21               296                     788                   1,158
    Accrued liabilities                132                91                     748                     987
                                ----------------------------------------------------------------------------
      Net cash used in
       operating activities         (1,696)           (3,731)                (11,991)                (17,493)
                                ----------------------------------------------------------------------------

Cash Flows from Investing
 Activities:
  Acquisition of property             (231)             (659)                 (3,013)                 (3,930)
   and equipment
  Proceeds from sale of assets           -                 -                       7                       7
  Purchases of short-term
   investments                           -                 -                 (14,310)                (14,310)
  Sales and maturities of
   short-term investments                -                 -                   4,650                   4,650
                                ----------------------------------------------------------------------------
      Net cash used in
       investing activities            (231)            (659)                (12,666)                (13,583)
                                ----------------------------------------------------------------------------

Cash Flows from Financing
 Activities:
  Sale of Common Stock,
   net of notes receivable                -                2                  32,858                  32,862
  Sale of Redeemable
   Convertible Preferred
   Stock, net of issuance costs         967            5,457                  14,457                  20,881
  Collection of notes receivable          1               12                       1                      14
  Proceeds from notes payable
   to shareholders                    1,300              750                       -                   2,186
  Payment on notes payable to
   shareholders                        (136)               -                       -                    (136)
  Proceeds from
   sale/leaseback of property
   and equipment                          -              333                     667                   1,000
  Repayment of capital lease
   obligation                             -               (6)                   (142)                   (148)
                                ----------------------------------------------------------------------------
      Net cash provided by
       financing activities           2,132            6,548                  47,841                  56,659
                                ----------------------------------------------------------------------------
Net Increase in Cash and
 Equivalents                            205            2,158                  23,184                  25,583
Cash and Equivalents: 
 Beginning of period                     36              241                   2,399                       -
                                ----------------------------------------------------------------------------
 End of period                    $     241         $  2,399                $ 25,583                $ 25,583
                                ============================================================================
Supplementary Disclosure of
 Cash Flow Information:
 Cash paid during the period
  for interest                    $       1         $     11                $     70                $     82
                                ============================================================================
Noncash Investing and
 Financing Activities:
  Issuance of Common and
   Preferred Stock for notes
   receivable                     $      25         $     75                $    152                $    252
                                ============================================================================
  Cancellation of stock and
   related note receivable       $        -         $     12                $      5                $     17
                                ============================================================================
  Conversion of note payable
   to shareholder to 
   Preferred Stock               $        -         $  2,050                $      -                $  2,050
                                ============================================================================
  Issuance of common warrants    $        -         $     25                $      -                $     25
                                ============================================================================
  Conversion of Preferred Stock
   to Common Stock on initial       
   public offering               $        -         $      -                $ 16,748                $ 16,748
                                ============================================================================
</TABLE>

See notes to consolidated financial statements.

                                       37
<PAGE>
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


1. BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES


BUSINESS--Silicon Gaming, Inc. (the Company) was incorporated on July 27, 1993
to develop and market innovative gaming devices through the use of advanced
multimedia and interactive technologies.

In May 1996, the Board of Directors of the Company approved a two-for-three
reverse split of the outstanding shares of Common Stock which was approved by
shareholders and effected in July 1996. All share and per share amounts in these
financial statements have been adjusted to reflect this split.

As of December 31, 1996, the Company was a development stage company. Successful
completion of the Company's development program and, ultimately, the attainment
of profitable operations is dependent upon future events, including obtaining
regulatory approval of its products and achieving a level of sales adequate to
support the Company's cost structure.

FISCAL YEAR END--Effective April 1, 1995, the Company changed its fiscal year
end to December 31 from March 31. Accordingly, the period ended December 31,
1995 is a nine-month period.

Selected financial information for the nine-month periods ended December 31,
1995 and 1996 are as follows :

<TABLE>
<CAPTION>
                                                  Nine Months ended December 31,
                                                --------------------------------
                                                      1995              1996
(In thousands, except per share amounts)                             (unaudited)
--------------------------------------------------------------------------------
<S>                                                   <C>               <C>
Research and development expense                      $ 3,137           $ 5,465
Manufacturing development expense                           -             2,458
Selling, general and administrative expense               922             4,273
Other expense (income)--net                               (85)             (898)
                                                      -------------------------
 Net loss                                             $ 3,974           $11,298
                                                      =========================
 Net loss per share                                    ($0.48)           ($1.09)
 Shares used in computation                             8,292            10,361
</TABLE>

CONSOLIDATION--The consolidated financial statements include the Company and its
wholly-owned subsidiaries (formed in February 1996) after elimination of
intercompany accounts and transactions.

ESTIMATES--The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amount of expenses during the reporting period.
Actual results could differ from those estimates.

CASH EQUIVALENTS--The Company considers all highly liquid debt instruments
purchased with an original maturity of three months or less to be cash
equivalents.

SHORT-TERM INVESTMENTS--Short-term investments represent debt securities which
are stated at fair value. The difference between amortized cost (cost adjusted
for amortization of premiums and accretion of discounts which are recognized
as adjustments to interest income) and fair value representing the unrealized
holding gains and losses are recorded as a separate component of shareholders'
equity until realized. While the Company's intent is to hold debt securities to
maturity, they are classified as available-for-sale securities because the sale
of such securities may be required prior to maturity. Any gains or losses on
the sale of debt securities are determined on a specific identification
basis.Inventories--Inventories consist of raw materials and work-in-process and
are stated at the lower of cost or market on a first-in, first-out basis.

                                      38
<PAGE>
 
PROPERTY AND EQUIPMENT--Property and equipment are stated at cost. Depreciation
and amortization are computed using the straight-line method over estimated
useful lives of three to ten years.

RESEARCH AND DEVELOPMENT EXPENSES--Research and development expenses are charged
to operations as incurred. In connection with the Company's product development
efforts, it develops software applications which are integral to the operation
of the product. The costs to develop such software have not been capitalized as
the Company believes its current software development process is essentially
completed concurrent with the establishment of technological feasibility and/or
development of the related hardware.

INCOME TAXES--The Company accounts for income taxes in accordance with Statement
of Financial Accounting Standards No. 109, "Accounting for Income Taxes," which
requires an asset and liability approach for financial reporting of income
taxes.

STOCK-BASED COMPENSATION--The Company accounts for stock-based awards to
employees using the intrinsic value method in accordance with APB No. 25,
Accounting for Stock Issued to Employees.

NET LOSS PER SHARE--Net loss per share is based on the weighted average number
of common shares outstanding subsequent to the Company's initial public offering
in 1996. Common share equivalents including stock options, warrants and
redeemable convertible preferred stock have been excluded, as their effect would
be antidilutive. Pursuant to rules of the Securities and Exchange Commission
Staff, all common and common equivalent shares issued by the Company at a price
less than the initial public offering price during the 12 months preceding the
offering date (using the treasury stock method until shares are issued) have
been included in the calculation of common and common equivalent shares
outstanding for all periods presented prior to the July 1996 initial public
offering.


2. SHORT-TERM INVESTMENTS

Short-term investments consist of the following debt securities as of December
31, 1996:

<TABLE>
<CAPTION>
                                                                       Unrealized   Unrealized
                                                   Amortized   Market    Holding      Holding
(In thousands)                                        Cost     Value      Gains        Losses
----------------------------------------------------------------------------------------------
<S>                                                 <C>       <C>         <C>           <C>
Available-for-sale corporate debt securities         $ 9,660   $ 9,683      $  28        $  5
                                                    =========================================
</TABLE>

Realized gains or losses on sales of available-for-sale securities for the year
ended December 31, 1996 were not significant. The cost of securities sold is
based on the specific identification method. Fair values are based on quoted
market prices obtained from independent brokers. Available-for-sale investments
have been classified as current assets as all maturities are within one year.

 
3. BALANCE SHEET COMPONENTS

Inventory consists of:
                                                              December 31,
                                                       ------------------------
(In thousands)                                            1995           1996
--------------------------------------------------------------------------------
Raw materials                                           $   -          $ 307
Work in progress                                        $   -            170
                                                        ------------------------
                                                        $   -          $ 477
                                                        ========================

                                      39
<PAGE>
 
Property and equipment consists of:

                                                          December 31,
                                                        ---------------
(In thousands)                                           1995      1996
-----------------------------------------------------------------------
Furniture and fixtures and office equipment             $ 136    $  485
Computer equipment                                        781     2,450
Manufacturing equipment                                     -       581
Leasehold improvements                                      -       156
Construction in progress                                    -       172
                                                        ---------------
                                                          917     3,844
Accumulated depreciation and amortization                (183)     (798)
                                                        ---------------
                                                        $ 734    $3,046
                                                        ===============
Accrued liabilities consists of:
                                                          December 31,
                                                        ---------------
(In thousands)                                           1995      1996
-----------------------------------------------------------------------
Accrued compensation benefits                           $  97    $  642
Other accrued liabilities                                 142       345
                                                        ---------------
                                                        $ 239    $  987
                                                        ===============

4. LEASES


In October 1995, the Company obtained a lease line of credit to acquire up to
$1,000,000 of equipment under capital leases with a term of 48 months. The
Company granted the leasing company a warrant to purchase 40,936 shares of
Common Stock at a price of $1.71 per share; such warrant expires in the year
2002 and may be net-exercised by the holder. The estimated fair value of the
warrant, $25,000, has been recorded as a deferred financing cost in other
assets, and is being amortized over the term of the related leases. In December
1995 and during 1996, the Company entered into sale/leaseback arrangements under
this lease line for equipment with an original cost of $333,000 and $667,000,
respectively; no gains or losses were recorded on these transactions.

In September 1995, the Company entered into a facility lease agreement which
expires in 2006 and requires the Company to incur at least $175,000 for net
leasehold improvements in the first three years of occupancy, which the Company
completed in 1996.

Future minimum operating and capital lease commitments at December 31, 1996 are
as follows:

                                      Operating
(In thousands)                          Leases   Capital Leases
---------------------------------------------------------------
1997                                    $  391           $  283
1998                                       299              336
1999                                       422              327
2000                                       445               56
2001                                       465                -
Thereafter                               2,110                -
                                        -----------------------
Total minimum lease payments            $4,132            1,002
                                        ======          
Amount representing interest                               (150)
                                                         ------
Present value of lease payments                             852
Current portion                                            (207)
                                                         ------
Long-term portion                                        $  645
                                                         ======

Total rent expense (including prorated common area maintenance charges and
utilities) for the year ended March 31, 1995, the nine-month period ended
December 31, 1995 and the year ended December 31, 1996 was $49,000, $58,000 and
$469,000, respectively.

                                       40
<PAGE>
 
5. REDEEMABLE CONVERTIBLE PREFERRED STOCK

At December 31, 1996, the Company had 1,998,332 shares of Series A1 and
4,386,141 shares of Series B1 Nonvoting Redeemable Convertible Preferred Stock
outstanding. Information concerning Redeemable Convertible Preferred Stock
transactions follows:

<TABLE>
<CAPTION>
                                                                                Amount, net
                                                                    Shares        of Notes
(In thousands, except share and per share amounts)                Outstanding    receivable
--------------------------------------------------------------------------------------------
<S>                                                              <C>              <C>
Series A:
 Issued May 1994 at $.75 per share for cash                        1,299,998       $    967
 Issued October 1994 at $.75 for notes                                50,000              -
 Cancellation of shares and note in June 1995                        (16,667)             -
 Collection of notes receivable                                            -             12
 Conversion of notes payable at $.75 per share in June 1995        1,666,666          1,250
 Conversion of Series A to Series A1 in April 1996                (1,998,332)        (1,489)
 Conversion to 667,777 shares of Common Stock                     (1,001,665)          (740)
 
Series A1:
 Conversion of Series A to Series A1 in April 1996                 1,998,332          1,489
 
Series B:
 Issued August 1995 at $1.14 per share for cash and
  accrued interest                                                 5,535,000          6,267
 Conversion of Series B to Series B1 in April 1996                (4,386,141)        (4,966)
 Conversion to 765,906 shares of Common Stock                     (1,148,859)        (1,301)
 
Series B1:
 Conversion of Series B to Series B1 in April 1996                 4,386,141          4,966
 
Series C:
 Issued March 1996 at $5.00 per share for cash                     1,600,000          7,500
 Issued April and May 1996 at $5.00 per share for
  cash and services                                                1,542,000          6,960
 Conversion to 2,094,666 shares of Common Stock                   (3,142,000)       (14,460)
                                                                  -------------------------
Total Balance, December 31, 1996                                   6,384,473       $  6,455
                                                                  =========================
</TABLE> 

Concurrent with the Company's initial public offering, the authorized number of
Preferred Shares was reduced to 6,884,473, including 500,000 shares not
designated to a specific series. The rights, preferences and privileges of these
500,000 additional shares of Redeemable Convertible Preferred Stock are subject
to the determination of the Board of Directors.

Significant terms of the Series A1 and B1 Redeemable Convertible Preferred Stock
are as follows:

Each share is convertible into .6667 shares of Common Stock (subject to
adjustment for anti-dilution) at the election of the holder upon at least 75
days notice to the Company.

Shares have no voting rights except as required by law.

At any time after August 2000, the holders of a majority of the then outstanding
shares of Redeemable Convertible Preferred Stock may require the Company to
redeem for cash the Preferred Shares outstanding over a three-year period at a
per-share purchase price equal to the original issue price (subject to certain
anti-dilution adjustments) plus all declared but unpaid dividends on such
shares. The Company shall redeem the shares of Redeemable Convertible Preferred
Stock ratably from the Preferred Shareholders of record on that date.

                                       41
<PAGE>
 
Dividends may be declared at the discretion of the Board of Directors and are
noncumulative. To the extent declared, dividends of $.075 per share for Series
A1 and $.114 per share for Series B1 must be paid prior to any dividends on
Common Stock. No dividends have been declared through December 31, 1996.

In the event of liquidation, dissolution or winding up of the Company, the
Preferred Shareholders shall receive the initial issue price per share plus all
declared but unpaid dividends. If the assets and funds to be distributed are
insufficient to permit full payment, then the funds shall be distributed on a
pro rata basis. Upon completion of this distribution, the holders of the Common
Stock will receive a pro rata distribution of any remaining assets of the
Company.

Holders of the Redeemable Convertible Preferred Stock have certain registration
rights.


6. COMMON STOCK

During 1996, the Board of Directors adopted, and the shareholders approved, an
amendment to the Articles of Incorporation to increase the number of authorized
shares of Common Stock to 50,000,000. At December 31, 1996, Common Stock was
reserved for issuance as follows:

-------------------------------------------------------------------------------
Conversion of outstanding Redeemable Convertible Preferred Stock      4,256,315
Issuable under stock purchase warrants                                  335,379
1994 Stock Option Plan                                                1,279,466
1996 Employee Stock Purchase Plan                                       300,000
1996 Outside Directors Stock Option Plan                                200,000
                                                                      ---------
                                                                      6,371,160
                                                                      =========
Common Stock Offering
---------------------
In August 1996, the Company completed an initial public offering of 3,500,000
shares of Common Stock at a price of $10.50 per share. Concurrent with the
initial public offering, all outstanding shares of Series A, B and C Redeemable
Convertible Preferred Stock were automatically converted into 3,528,349 shares
of Common Stock. The proceeds to the Company from the offering, net of
underwriting discounts and offering expenses, were $32,855,000.

Warrants
--------
During 1996 the Company issued warrants to certain financial advisors in
connection with its Series C Redeemable Convertible Preferred Stock financing.
These warrants are exercisable for 116,666 shares of Common Stock at an
exercise price of $7.50 per share. In connection with the initial public
offering, the Company issued 5-year warrants to purchase an aggregate of 177,777
shares of Common Stock to other financial advisors at an exercise price of
$12.60 per share. Warrants to purchase 40,936 shares of Common Stock at an
exercise price of $1.71 were issued to a leasing company in 1995 in connection
with a lease line of credit (See Note 4). All warrants expire in 2001.

Stock Option Plans
------------------
Under the 1994 Stock Option Plan (the "Option Plan"), the Company may grant
incentive or nonstatutory stock options up to 2,866,666 shares of Common Stock
to employees, directors and consultants at prices not less than fair
market value for incentive stock options and not less than 85% of fair market
value for nonstatutory stock options. These options generally expire five to ten
years from the date of grant. Options normally vest at a rate of 25% on the
first anniversary of the grant date and 1/48 per month thereafter and may be
exercised at any time, subject to the Company's right to repurchase unvested
shares at the original exercise price upon termination. During the nine months
ended December 31, 1995 and the year ended December 31, 1996, employees
exercised options in exchange for notes payable to the Company of $75,000 and
$152,000, respectively.

In 1996, the Board of Directors adopted the 1996 Outside Directors Stock Option
Plan (the "Directors Plan"). Under this plan, non-employee directors of the
Company are automatically granted initial options to purchase 15,000 shares of
Common Stock and additional options to purchase 5,000 shares of Common Stock in
each subsequent year that such person remains a director of the Company. Options
under the Directors Plan have an exercise price equal to fair market value at
the grant date, vest at a rate of 1/36 per month over three years and expire 10
years from the date of grant. The number of shares authorized under this plan is
200,000.

                                       42
<PAGE>
 
Option activity under the 1994 Option Plan and the Directors Plan is as follows:

                                                                   Weighted
                                                Number of           Average
                                                 Shares         Exercise Price
-------------------------------------------------------------------------------
Granted                                           406,667             $ 0.11
                                                ----------------------------
Outstanding, March 31, 1995                       406,667               0.11
Granted (weighted average fair value of $.04)   1,096,333               0.13
Exercised                                        (716,222)              0.11
Cancelled                                         (61,111)              0.11
                                                ----------------------------
Outstanding, December 31, 1995                    725,667               0.14
Granted (weighted average fair value of $2.59)  1,020,063               5.34
Exercised                                        (870,979)              0.18
Cancelled                                         (39,348)              2.22
                                                ----------------------------
Outstanding, December 31, 1996                    835,403             $ 6.35
                                                ============================

Additional information regarding options outstanding as of December 31, 1996,
is as follows:
<TABLE> 
<CAPTION> 
          
                                   Options Outstanding                               Options Exercisable
                            ----------------------------------       -------------------------------------------------
                                                   Weighted
                                                    Average
                               Number              Remaining           Weighted             Number         Weighted
                             Outstanding          Contractual          Average          Exercisable as      Average 
Range of Exercise Prices    as of 12/31/96         Life (yrs)        Exercise Price      of 12/31/96     Exercise Price
-----------------------------------------------------------------------------------------------------------------------
<S>                                <C>                    <C>                <C>              <C>                <C> 
$  0.105  -  $  0.165               33,666                8.33               $ 0.11             33,666           $ 0.11
$  1.500  -  $  1.500              233,994                9.30                 1.50            233,994             1.50
$  4.500  -  $  4.500              148,663                9.41                 4.50            148,663             4.50
$  7.500  -  $  7.500              107,997                9.54                 7.50            107,997             7.50
$  8.750  -  $ 11.625              247,833                8.01                10.13            247,833            10.13
$ 13.375  -  $ 16.625               63,250                9.92                15.13             63,250            15.13
-----------------------------------------------------------------------------------------------------------------------
$  0.105  -  $ 16.625              835,403                8.98               $ 6.35            835,403           $ 6.35
=======================================================================================================================
</TABLE>

At December 31, 1996, 540,908 and 140,000 shares were available for future
grants under the Option Plan and Directors Plan, respectively. At December 31,
1996, 966,471 shares exercised were subject to repurchase.

Employee Stock Purchase Plan
----------------------------
In 1996, the Board of Directors adopted the 1996 Employee Stock Purchase Plan
(the 'Purchase Plan'). Under the Purchase Plan, eligible employees are permitted
to purchase shares of Common Stock through salary withholding at a price equal
to 85% of the lower of the market value of the stock at the beginning of the 24-
month offering period or the end of each six-month purchase period, subject to
certain limitations. No shares have been issued under the Purchase Plan as of
December 31, 1996; 300,000 shares were reserved for future issuance.

Additional Stock Plan Information
---------------------------------
As discussed in Note 1, the Company continues to account for its stock-based
awards using the intrinsic value method in accordance with APB No. 25,
Accounting for Stock Issued to Employees, and its related interpretations.
Accordingly, no compensation expense has been recognized in the financial
statements for employee stock arrangements.

Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based
Compensation (SFAS 123), requires the disclosure of pro forma net income and
earnings per share had the Company adopted the fair value method as of the
beginning of fiscal 1995. Under SFAS 123, the fair value of stock-based awards
to employees is calculated through the use of the minimum value method for all
periods prior to the initial public offering, and subsequently through the use
of option pricing models, even though such models were developed to estimate the
fair value of freely tradable, fully transferable options without vesting
restrictions, which significantly differ from the Company's stock option awards.
These models also require subjective assumptions, including future stock price
volatility and expected time to exercise, which greatly affect the calculated
values. The Company's calculations were made using the minimum and Black-Scholes
option pricing models with the following weighted average assumptions: expected
life, 12 months following vesting; stock

                                       43
<PAGE>
 
volatility, 39.2% subsequent to the initial public filing in 1996; risk-free
interest rates, 6% in 1995 and 6.7% in 1996; and no dividends during the
expected term. The Company's calculations are based on a multiple option
valuation approach and forfeitures are recognized as they occur. If the computed
fair values of the 1995 and 1996 awards had been amortized to expense over the
vesting period of the awards, pro forma net loss would have been $3,982,000
($0.49 per share) in 1995 and $14,345,000 ($1.45 per share) in 1996. However,
because options vest over several years and grants prior to 1995 are excluded
from these calculations, these amounts may not be representative of the impact
on future years' earnings, assuming grants are made in those years.


7. INCOME TAXES

The Company has had losses since inception and therefore has not provided for
income taxes.

Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amount of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes, as well as operating loss
and tax credit carryforwards. Significant components of the Company's deferred
income tax assets as of December 31, 1995 and 1996 are as follows:

                                                     December 31,
                                                 ------------------
(In thousands)                                      1995       1996
-------------------------------------------------------------------
Net deferred tax assets:
 Net operating losses                            $ 2,031    $ 7,009
 Research and development credits                    150        489
 Capitalized research and development costs          428         87
 Accruals deductible in different periods           (183)       364
 Depreciation and amortization                        53        (88)
                                                 ------------------
                                                   2,479      7,861
Valuation allowance                               (2,479)    (7,861)
                                                 ------------------
Total                                            $     -    $     -
                                                 ==================

Due to the uncertainty surrounding the realization of the benefits of its
favorable tax attributes in future tax returns, the Company has fully reserved
its net deferred tax assets as of December 31, 1995 and 1996, respectively.

At December 31, 1996, the Company had net operating loss carryforwards of
approximately $18,600,000 and $17,200,000 for federal and state income tax
purposes, respectively. These carryforwards begin to expire in 2000.

The Company also has research and development credit carryforwards of
approximately $240,000 and $250,000 available to offset future federal and state
income taxes, respectively, as of December 31, 1996. These carryforwards begin
to expire in 2010.

Section 382 of the Internal Revenue Code and the applicable California law
impose annual limitations on the use of net operating loss and tax credit
carryforwards if there is a change in ownership, as defined, within any three-
year period. As a result of certain stock offerings, the annual deductibility of
a substantial portion of the federal net operating loss and tax carryforwards
may be limited.


8. RELATED PARTIES

For the year ended March 31, 1995, the nine-month period ended December 31, 1995
and the year ended December 31, 1996, the Company paid approximately $166,000,
$23,000 and $8,000, respectively, to a partnership in which a founder of the
Company is a partner in exchange for management services and administrative
support. Additionally, for the year ended March 31, 1995 and the nine-month
period ended December 31, 1995, payroll and other expenses, including rent,
utilities and travel, amounting to $467,000 and $71,000, respectively, were paid
on behalf of the Company by affiliated companies and were subsequently
reimbursed by the Company.

                                       44
<PAGE>
 
UNAUDITED QUARTERLY CONSOLIDATED FINANCIAL DATA
-----------------------------------------------
<TABLE>
<CAPTION>
                                                                      Three Months Ended                  
                                                   ---------------------------------------------------     Nine-Month
(In thousands, except per share amounts)                 June 30         September 30     December 31        Period
----------------------------------------------------------------------------------------------------------------------
<S>                                                    <C>                 <C>             <C>             <C>      
1995:
 Net loss                                               $  (735)            $  (1,321)      $  (1,918)      $  (3,974)
 Net loss per share                                       (0.09)                (0.16)          (0.24)          (0.48)
                                                        =============================================================
</TABLE> 

<TABLE> 
<CAPTION> 
                                                                  Three Months Ended
                                             ---------------------------------------------------------------       Total
(In thousands, except per share amounts)      March 31         June 30          September 30     December 31        Year
-------------------------------------------------------------------------------------------------------------------------
<S>                                           <C>              <C>               <C>              <C>          <C> 
1996:
 Net loss                                     $  (2,336)        $  (3,647)        $  (3,705)      $  (3,946)    $  (13,634)
 Net loss per share                               (0.26)            (0.32)            (0.35)          (0.37)         (1.36)
                                              ============================================================================ 

</TABLE> 

SHAREHOLDERS' INFORMATION

Stock Price History
                                                                  1996
                                                          ---------------------
(Fiscal Year)                                               High         Low
--------------------------------------------------------------------------------
Third Quarter                                              11           8 1/4
Fourth Quarter                                             17 1/8       9 7/8
                                                           =====================


The preceding table sets forth the high and low closing sale prices as reported
on the Nasdaq Stock Market since the Company's initial public offering completed
in August 1996.


INDEPENDENT AUDITORS' REPORT

To the Board of Directors and Shareholders of Silicon Gaming, Inc.:

We have audited the accompanying consolidated balance sheets of Silicon
Gaming, Inc. (a development stage company) and subsidiaries as of December 31,
1995 and 1996, and the related consolidated statements of operations,
shareholders' equity (deficiency) and cash flows for the year ended March 31,
1995, the nine months ended December 31, 1995, the year ended December 31,
1996 and cumulative from inception (July 27, 1993). These financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements based on our audits.

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

In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of Silicon Gaming, Inc. and
subsidiaries at December 31, 1995 and 1996, and the results of their operations
and their cash flows for the periods stated above in conformity with generally
accepted accounting principles.


DELOITTE & TOUCHE LLP

San Jose, California

January 17, 1997

                                       45