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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, 1998
 
[_]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)
 
<TABLE>
 <C>                                            <S>
                  California                                      77-0357939
         (State or other jurisdiction                          (I.R.S. Employer
       of incorporation or organization)                      Identification No.)
 
                   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:
<CAPTION>
                 Title of class                   Name of each exchange on which registered
                 --------------                   -----------------------------------------
 <C>                                            <S>
                     None                                            None
</TABLE>
 
          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, 1999: $8,263,413
 
   Number of shares outstanding of the issuer's Common Stock, $.001 par value,
as of February 28, 1999: 14,288,502
 
                     DOCUMENTS INCORPORATED BY REFERENCE:
 
   Portions of the definitive Proxy Statement for the Registrant's Annual
Meeting of Shareholders to be held on May 25, 1999, 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 interactive, video-based slot
machines for use in casinos and other gaming establishments. The Company's
products combine a multimedia gaming platform with software-based games. The
Company believes its products are 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.
 
   The Company's products 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 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, the product's
modular components and Machine Management System(TM) software provide easy-to-
use diagnostics designed to minimize player inconvenience and machine down
time. The Company currently offers several products including Odyssey(TM), a
multi-game machine that can play up to six different games on the same
machine, and Quest, a single-game machine.
 
   The Company was granted product approval for Odyssey from the Nevada Gaming
Commission in March 1997, allowing the Company to commence commercial
distribution of its product. The Company typically places machines in casinos
for an evaluation period prior to sale, consistent with industry practice. The
Company sells machines outright to casinos and also places machines in casinos
and receives a predetermined percentage of the net win per machine. In
December 1998 the Company introduced its first wide-area progressive product,
The Big Win. This is a set of computer-linked slot machines located in
numerous casinos that share a common top award prize. The Company receives a
predetermined percentage of the amounts wagered on these machines as revenue
and is responsible for payment of the game's progressive jackpot prizes.
 
   Through December 31, 1998, the Company has installed 3,609 Odyssey and
Quest machines in approximately 180 properties throughout Connecticut, Iowa,
Louisiana, Michigan, Mississippi, Missouri, Nevada, New Mexico, certain
Canadian provinces and Uruguay. Of these machines, 2,920 have been sold
outright or placed on a revenue-sharing basis. After returns, 620 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. Included in
the Company's revenue and installed base at December 31, 1998 are 160 machines
installed in Nevada that are connected to the wide-area progressive system.
142 of these wide-area progressive machines were returned to the Company in
January 1999 following a decision by the Company to modify the initial game
that was released on the wide-area progressive system.
 
Industry Background
 
   According to industry sources, casino gaming revenue in the United States
in 1992, 1993, 1994, 1995, 1996 and 1997 was approximately $9.9 billion, $12.6
billion, $14.0 billion, $18.0 billion, $22.4 billion and $25.8 billion,
respectively, and continued growth was forecast for 1998 and 1999. 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 1997 was 63% in Nevada and 70% in
Atlantic City. Jurisdictions where gaming has been legalized more recently
have reported similar statistics. For example, in 1997, slot machines
accounted for 74% of casino revenue in Illinois and 76% in Missouri. In
addition to
 
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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 1998, 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 $94. A new slot machine from a major
manufacturer, equipped with player tracking and slot accounting software,
costs approximately $8,000 and generally has a useful life that can exceed
five years. At this price, a new slot machine earning the Las Vegas Strip
average would recoup its purchase price in 85 days. While certain markets have
lower average wins per day than the Las Vegas Strip, many other markets have
win per day figures that are significantly higher. For example, in 1998,
Harrahs Marina Hotel & Casino in Atlantic City reported win per machine per
day of $288 and Harrah's riverboat casino in Joliet, Illinois reported win per
machine per day of $276. Many of the native American gaming establishments
often have daily win per machine numbers much higher than these levels, as
evidenced by the Mohegan Sun in Montville, Connecticut, reporting win per
machine per day during November 1998 of $398.
 
   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 hold percentage 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 Game Magic, a 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.
 
                                       3
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   In the mid 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 recently have
exceeded $25 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 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.
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 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 as a whole has enjoyed significant growth over
the past decade, the Company believes that there has been very little growth
in the slot machine manufacturing segment. The Company believes that most of
the growth and new investment in the gaming industry over this period has come
from the investment 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.
 
   In contrast, SGI has focused its resources primarily on developing what it
believes will be the next generation of interactive slot machines. Since its
inception the Company has developed and refined a gaming platform that takes
advantage of personal computer-based technology to offer a more visually
appealing and complex gaming experience. 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.
 
   The market for slot machines has become increasingly competitive since the
Company was formed, and the number of new game and product introductions has
increased significantly from historical levels. The proliferation of new
product offerings has benefitted casino operators who are able to leverage
their position with slot machine manufacturers and who have demanded higher
levels of perfomance from new products. The casino operators are willing to
try new products or new games for existing products that offer the prospect of
higher win per machine per day. At the same time, operators are also much
quicker to remove or replace a slot machine whose performance is less than
that of other competing products. Casino operators have also been able to
benefit from the level of competition to keep the average selling price of new
slot machines from increasing significantly, despite the higher cost and
complexity of new-generation products. As a result, the slot machine
manufacturing industry can now be characterized by high competition and low
levels of profitability.
 
   Certain slot machine manufacturers have responded to this pressure from the
casino operators by placing machines in casinos and participating in the
revenue stream generated from the product, either by participating in the net
win per machine or in the gross amount wagered on the machine. This has
allowed manufacturers to achieve a higher revenue per machine than an outright
sale to the casino operator. Casino operators are increasingly reluctant to
place machines in their casinos on a participation basis in the belief that
this represents a profit shift from the casino operator to the manufacturer.
Manufacturers have responded by selling their newest
 
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and most successful games, or games that they think will be highly successful,
on a participation basis only. Casino operators have only tolerated this where
the game is highly successful, as the net win to the casino is still
attractive. This has also contributed to the casino operators' willingness to
remove non-performing slot machines from their floors. In the first quarter of
1999, speculation has mounted that certain casino operators are lobbying and
seeking legislative assistance to restrict or even prohibit a gaming machine
manufacturer from receiving a percentage of profits or revenue from a gaming
machine placed on a casino floor in Nevada. Although no legislation has been
formally proposed or adopted, any such legislation and imitation in other
jurisdictions could have a material adverse impact upon the ability of slot
machine manufacturers to continue to participate in the revenue streams
generated by their products.
 
   The Company believes that it is uniquely placed among slot machine
manufacturers because of the potential to leverage the technology that is
inherent in its products. The Company believes its products are significantly
more complex than competing products but at the same time are more flexible so
that new and innovative game types can be deployed on its game platforms. This
will allow the Company to develop game types and game themes that can offer
play characteristics that cannot be easily imitated by its competitors and
that take full advantage of the underlying technology of the product. By doing
so, the Company hopes to offer a richer, more entertaining gaming experience
for the casino customer and thereby generate a higher win per day per machine.
The Company believes that this will also assist it in placing machines with
casino operators on a participation basis, which should prove more profitable
for the Company than a one-time sale of the machine.
 
   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 it is generally difficult to forecast. In
addition, international markets have often served as an outlet for used
machines. SGI is currently focussed on establishing and solidifying its market
position in North America. Given the relatively small size of the Company
compared to certain of its competitors, the Company does not believe it has
adequate resources to simultaneously develop products for both the North
American and international markets. As a result, SGI does not currently
contemplate entering any international markets with the exception of certain
Canadian provinces. SGI remains open to taking advantage of opportunities in
international markets, but only if this can be accomplished without any
adverse impact on its domestic business.
 
   SGI's initial product, Odyssey,(TM) is a multi-game,video-based slot
machine which includes a hardware platform bundled with a suite of up to six
games, play stoppage entertainment and the Machine Management System(TM)
software. The Odyssey's multigame platform offers the casino operator
flexibility to evaluate, analyze and optimize game offerings for its
particular customer base. During 1998, SGI introduced Quest, a lower-priced,
single-game platform that shares many components with the Odyssey. SGI
anticipates that Quest will allow operators to roll out and promote those
games which have been most successful in their properties. SGI believes that
players will ultimately identify with individual games as opposed to the game
platform, and that the single-game platform will enable operators to leverage
the brand identity of popular games such that they are easily recognizable and
accessible on the casino floor.
 
   SGI sells its products outright to casino operators and other potential
purchasers offering several pricing programs. For the Odyssey this consists 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. Quest is sold as a bundled package of the hardware unit and a single
game for a fixed price. The Company also offers a participation program where
it will place either Odyssey or Quest on a casino floor in exchange for a
share in the aggregate win generated by the machine. Typically, under this
program 20% of the aggregate win goes to the Company, subject to a
predetermined minimum. In December 1998, the Company introduced its first
wide-area progressive product, The Big Win. Machines placed in casinos on the
progressive
 
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system are priced such that the Company receives a predetermined share of the
gross amount wagered on the machine.
 
   SGI believes that the Odyssey has achieved a leadership position within the
multi-game segment of the video slot machine market. Since it commenced sales
in 1997 the Company has also learned a great deal about what makes a game
successful and which characteristics of a game are most appealing to gaming
customers. The Company believes that it has one of the most successful
blackjack games with Top Hat 21, a successful poker game with Lucky Draw
Poker, and one of the more successful multi-line, multi-coin games with
Vacation USA. At the same time the Company believes that it has not yet fully
exploited the technological potential of its game platform and that many of
its game offerings are in fact similar to competing products. This places the
Company at a competitive disadvantage because of the higher cost of its
product.
 
   The introduction of Quest during 1998 was designed to allow the Company to
increase its penetration of the casino floor by offering a wider array of
product and price points to the casino operator. The introduction of the wide-
area progressive products in December 1998 further increased the Company's
product offerings. The Company intends to offer additional platform choices
such as slant-top machines during 1999 to further diversify its product
offering; however, it will be limited by the rate of acceptance of video-based
slot machines as compared to traditional reel-based machines.
 
   The Company believes that its ultimate success will come not from the
breadth of platform offerings, but from the play characteristics of the
individual games offered on those platforms and from the total gaming
experience that it can provide to patrons playing its products.
 
Products
 
   The Company has developed a family of products 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. The Company's
products utilize 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, the Company's products run games that are
software based, allowing SGI and casino operators to adapt their game
offerings to 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 platforms so far have been designed to resemble a traditional
slot machine in many respects. Its machines occupy the same footprint as a
traditional slot machine and are 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 products the Company has introduced so far are their
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. However, for players who are
uncomfortable or unfamiliar with touchscreen devices, 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 products that the Company has introduced all share a common gaming
platform. The principal electronic hardware used in the SGI gaming platform
consists of complex multimedia and personal computer
 
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("PC") components. The central processing unit is an Intel 200-MHz 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 products. To achieve a high level of multimedia performance from its
system, the Company's machines use 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 high-density 4 gigabyte hard disk
drive for the multi-game machines and by a smaller 2-gigabyte hard disk drive
for single game machines. All of 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 platforms employ 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 platforms are 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. The different platforms share many common components, making it
easier for the Company's games to be played on different platforms and for
customer technical staff to work on the Company's different product offerings.
There can be no assurance, however, that the Company will continue to use
common components or 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.
 
   SGI's machines were designed to accept future hardware upgrades to 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. The Company introduced its first product
into the Nevada market in December 1998, The Big Win, that incorporates this
networking capability in a wide-area progressive system. The Company
anticipates introducing products into the market during 1999 that will
incorporate group play and tournament capabilities.
 
   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
 
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<PAGE>
 
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 a medium for commercial messages.
 
  Games and Other Software
 
   While SGI believes that the design of its machines 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 platforms 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.
 
   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 or a reel-based slot
machine, the game itself is only one aspect of the entertainment experience.
 
   The development cycle for the Company's games has been reduced
significantly since the Company's initial introduction of games in 1997. The
Company developed a standard "engine" for each game type that it introduced
such as video-reels, keno, poker and multi-line, multi-coin. In addition, for
every game that is introduced the Company develops a number of different
percentaging models that each have a different hold percentage. The
percentaging models are developed to meet jurisdictional regulatory
requirements, local market conditions and to offer flexibility to the casino
operators. The number of percentaging models vary by game type. For example,
Arabian Riches, a reel-based game introduced during 1998 has 38 different
percentaging variations and Phantom Belle, a poker-based game, has 29
different percentaging variations. The choice of gaming platform can also
affect the development cycle for games; however, to date the Company has used
a common gaming platform for all of its products. Development of a new game
engine is a lengthy process but one that can be leveraged and used on
subsequent game offerings. The ability to leverage existing game engines and
percentaging models allows the Company to develop new game themes and to
introduce these new game titles much faster than if it had to develop a brand
new game engine with unique percentaging requirements. This has been reflected
in the increase in the number of new game titles that the Company introduced
in 1998 as compared to 1997.
 
   All of SGI's games embed an engaging and entertaining theme story to help
attract patrons to the Company's machines. Some of the games developed and
introduced during 1998 include the following:
 
     Top Hat 21--An old top hat and a magic wand set on a stage appear to
  come to life to deal a game of 21. All of the features of the regular table
  game are offered, including splits, double-down and buying insurance. The
  magic hat also offers players assistance by spelling out helpful hints
  during game play. With each winning hand, there is also a chance to double
  winnings by playing the Hi/Low Double Up game.
 
     Buccaneer Gold--A traditional three-reel slot machine set to the theme
  of a pirate ship and its exotic booty. When symbols on the wheels are
  matched according to the pay table, the player wins, and the screen
  displays a jackpot celebration such as "gold coins" being spilled from a
  treasure chest or fired from a musket. Buccaneer Gold has added bonus
  features that include random Free Spins, Double Jackpot Time, and Bonus
  Daggers, five in all, that players collect to win a special award.
 
     Banana-Rama--A traditional three-reel game with infectious jungle
  rythms, Banana-Rama is best known for the on-screen anctics of the game's
  two animated host monkeys, Banana and Clyde. The characters interact with
  each other and with the player and celebrate jackpots with the player. A
  bonus feature takes the player to the Oyster Bar for a pick-till-you-win
  bonus game where players can select up to twelve oysters and collect the
  awards lying inside each of the oysters. The players continue doing this
  until the collect symbol appears at which time they return to the game.
 
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     Vacation USA--The Company's first multi-line, multi-coin game takes the
  player across the country to see the sights and win some cash. Vacation USA
  is a nickel game that allows the player to wager up to 50 coins a play.
  This game features two accumulator bonuses that hit with varying
  frequencies. Players collect interstate signs on active paylines and when
  they have sufficient signs to cross the country, players take off in the
  Winnebago and go "on Vacation". Players select different destinations and
  collect prizes for visiting each until they find the collect symbol and
  return to the game.
 
     The Big Win--A multi-line, multi-coin nickel game that is a campy game-
  show spin-off, offering kitschy colors, "cocktail music" and a "live"
  studio audience. The Big Win offers three different bonus games that will
  appear if a player gets three bonus symbols on the 4 X 4 game playfield.
  There is a choice of Kaplunko, a pinball style game where an award puck
  cascades down through a field of pins and comes to rest in an award bin,
  Pik'N'Match where players match hidden awards, or Instant Win where a
  single choice tells it all. A double or nothing feature allows players to
  risk all from their bonus round. The Big Win is also networked as a wide-
  area progressive with a top prize starting at $250,000 that grows based on
  the amount of game play.
 
     Bonus Belle--An enhanced version of Phantom Belle that adds a new
  dimension to the video poker experience. During regular play, the ghostly
  dealer occasionally tosses chips into a separate bonus pot near the edge of
  the table. When players receive the special bonus playoff card, another
  ghostly character appears and joins the game. The full-bodied apparition
  then challenges the player to a winner-take-all showdown for the bonus pot.
 
   The Company believes that the combination of its attractive machines, 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.
 
   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 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.
 
   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 experience which might cause the customer to discontinue play. For
this reason, many of the Company's game offerings to date consist of enhanced
versions of traditional casino games, including reel-based slot games, so that
the rules of the game will be well known. SGI intends to present these games
using enhanced graphics and sound to enrich the play experience, but will not
change the fundamental characteristics or objective of the game. In addition,
the machine will offer traditional game controls for those players unfamiliar
or uncomfortable with the touchscreen interface.
 
   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.
 
   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
 
                                       9
<PAGE>
 
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 machines 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 the 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 and received a U.S. patent with respect
  to its algorithm.
 
     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. This is necessary to ensure that the game being
  played corresponds exactly to that designed by the manufacturer and
  approved by regulatory authorities. Traditional slot machines need to be
  authenticated manually, a process usually performed only after a sizable
  jackpot award. The 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 or malicious attempts to cheat the
  machine. Any detected anomalies will cause the machine to signal the loss
  of integrity immediately. The Company has filed for and received patent
  protection for certain aspects of its authentication methodology.
 
     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
  full benefit of 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. In this way, disputes can be quickly resolved at the machine's
  location without the operator 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. However, given the maturity of the game platform, the development
tools and the software code base, the Company anticipates higher levels of
productivity that will result in either increased product output or an overall
reduction in the level of development expenses. During the years ended
December 31, 1998, 1997 and 1996, the Company's research and development
expenses were $11,853,000, $9,283,000 and $7,030,000, respectively. At
December 31, 1998, 62 of the Company's 163 full-time employees were engaged in
research and development.
 
 
                                      10
<PAGE>
 
   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
three to eight months and costs approximately $250,000 to $750,000.
 
   SGI is 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 variations of the multi-coin, multi-line,
Australian type games which have proved popular and successful in 1998. These
initial games are intended to help customers look beyond the unfamiliar
technology to recognizable game types. In addition, the Company has developed
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.
 
   Some of the games currently under development include the following:
 
     Silver Bell Express--A traditional three-reel slot machine set to the
  theme of a train riding through the old wild west. At random intervals
  during play, punch stamps are added to the players boarding passes. When
  they collect 10 punches they enter a double jackpot bonus period. The game
  also features three bonus games that each offer a unique secondary
  proposition. The play-based bonuses on this game are hidden to prevent
  bonus shopping by other players.
 
     Eureka--This multi-line, multi-coin wagering experience takes players
  deep inside a derelict coal mine on the way to hidden fortune. Featuring
  two separate accumulator bonuses embedded in the basic 4 X 4 playing field,
  players can follow a coal cart as it speeds its way into a long-sealed mine
  shaft on their way to discovering riches.
 
     Star Bucks--Players rocket across the cosmos in their spaceship in this
  variation of the traditional three reel slot machine. Offering multiple
  bonus features when specific bonus sysmbols appear on the active payline,
  and with the help of two navigational droids, players assume the helm of
  the spaceship in this sci-fi wagering experience.
 
   Completion of the 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.
 
   The product development strategy to date has focussed on enhancing
traditional gaming experiences by offering variations of existing casino-type
games. Familiarity with these game types attracts customers to these games.
The company has also taken this strategy a step further by introducing games
based on familiar brands or activities, such as the Vacation USA game. The
next phase in the Company's product development strategy will be to introduce
completely new types of wagering experiences. The Company intends to introduce
game types that reflect different types of wagering experiences in the second
half of 1999.
 
   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, bowling, football or
golf. The Company also anticipates developing more of its games for
progressive formats in which the Company's machines would
 
                                      11
<PAGE>
 
be networked to support a common jackpot that is significantly larger than
that which a stand-alone machine could offer, or to support additional
networked features such as tournaments and peer-to-peer play.
 
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 and the perceived likelihood of the customer winning. 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 either casino operators or
other slot manufacturers in establishing the next generation of wagering
entertainment. The Company recognizes that it is a small player in the gaming
industry at this point and that it may have to leverage the skills and
experience of these third parties to help in the development or deployment of
new products.
 
   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 right 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
expects that it would charge fees for any customization or development work
that it performs for any other parties.
 
   The Company currently sells product through a direct sales force that is
based in Nevada. The Company is planning to distribute product through third
parties including other slot machine manufacturers or casino operators to help
in the penetration of new markets without the need for additional hiring. As
at December 31, 1998, 61 of the Company's 163 full-time employees were engaged
in sales and marketing.
 
   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, 1998, the Company had filed
applications to sell its product in Nevada, New Jersey, Mississippi, Missouri,
Colorado, Iowa, Indiana, Illinois, and certain native American jurisdictions
in Connecticut, Louisianna, Michigan, Minnesota and New Mexico. To date, the
Company has received both corporate approval and approval to sell its product
in Nevada, Missouri, Mississippi and certain native American jurisdictions in
Connecticut, Louisiana, Michigan, Minnesota and New Mexico and has also
received corporate approval in Colorado and New Jersey. 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.
 
                                      12
<PAGE>
 
  Pricing
 
   The Company sells its products to casino operators and other potential
purchasers offering several pricing programs. For the Odyssey this consists 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. Quest is sold as a bundled package of the hardware unit and a single
game for a fixed price. Based on its belief that its products 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.
 
   Similar to several of its competitors, the Company also offers a 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's plan is unique
because the Company also offers the casino operator a buyout option at any
point after the 90 day minimum evaluation period, something not currently
offered in the industry. Under the buyout option, the operator receives a
credit towards the purchase of the hardware and must purchase its choice of
software at list price. The Company believes that licensing revenue from game
software may eventually constitute a substantial portion of its revenue.
 
   Products placed in casinos that are connected to a wide-area progressive
system, including all ancillary equipment such as signs and chairs, remain the
property of the Company. The casino operator is not required to purchase the
equipment but agrees to keep the machines on the floor for a specified minimum
period and to share in the amount wagered on the machines with the Company.
The amount of handle received by the Company will vary depending on the game
type and denomination offered. Typically, for progressive games offered to
casino operators, manufacturers retain between 3.5% and 6% of the gross amount
wagered. The manufacturer is then responsible for payment of jackpot prizes
and promotional and administrative expenses connected with the operation of
the wide-area progressive system.
 
Competition
 
   The current slot machine market is highly competitive and is dominated by a
small number of manufacturers, many 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, price,
ease of use, service, support and training, distribution, and name and product
recognition. The principal competitors in the slot machine market are IGT and
Bally Gaming. IGT may be viewed as a dominant competitor, with a 1998 market
share estimated at 75%; Bally Gaming's 1998 market share is estimated at 10%.
Additional competitors or potential competitors include WMS Industries Inc.,
Anchor Gaming, Inc., Powerhouse Technologies, Inc., Aristocrat Leisure
Industries, Universal Distributing, Sigma Games, Casino Data Systems, Acres
Gaming Inc. and Innovative Gaming Corporation of America. 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, nor can there be any
assurance that the manufacturers of traditional slot machines will not develop
products that are superior to, or that achieve greater market acceptance than,
the Company's product. A number of the Company's larger customers who operate
multiple casinos have also indicated that they may become involved in the
design, development and manufacture of slot machines, although to date none
have actually done so. 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 any of the Company's products or specific game titles display
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
 
                                      13
<PAGE>
 
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 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 gaming authorities.
 
   In addition, SGI owns exclusive rights to the algorithm for its random
number generator, the key component of the Company's gaming machine that
determines the outcome of each proposition. SGI's algorithm, which may have
uses outside the gaming industry, 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.
 
Employees
 
   As of December 31, 1998, the Company had 163 full-time employees, including
62 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. The Company manufactured its product at
its Mountain View, California facility. The Company has installed
manufacturing lines with 5,000 unit per year capacity. As this exceeds the
Company's current requirement, expansion of this facility is not expected. As
of December 31, 1998, the Company had 38 full-time employees in manufacturing.
In March 1999 the Company announced the closure of its Mountain View
manufacturing facility and the relocation of its manufacturing activities to
its Las Vegas, Nevada facility.
 
                                      14
<PAGE>
 
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, 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
 
                                      15
<PAGE>
 
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.
 
   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,
 
                                      16
<PAGE>
 
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 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. 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
 
                                      17
<PAGE>
 
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.
 
   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
 
                                      18
<PAGE>
 
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.
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.
 
   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
 
                                      19
<PAGE>
 
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 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.
 
   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.
 
                                      20
<PAGE>
 
   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
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
 
                                      21
<PAGE>
 
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, conditioned,
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 components 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 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
 
                                      22
<PAGE>
 
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 the central monitoring facility for its wide-area progressive system, and
a 4,000 square foot facility in Reno, Nevada that houses a sales and support
organization.
 
Item 3: Legal Proceedings
 
   In February 1999 the Company filed a complaint against International Game
Technology, Inc. ("IGT") seeking a declaration of noninfringement and
invalidity of US Patent no. 5,823,873, describing a method of playing
electronic video poker games. The suit was originally filed in the United
States District Court for the Northern District of California, as a result of
threat of litigation by IGT. IGT responded by filing a complaint in the
District of Nevada alleging infringement of the same patent. As that case has
been transferred from Reno to be heard in Las Vegas, the Company intends to
dismiss the California action and pursue its claims against IGT in the Las
Vegas case. On March 16, 1999 the Company was unsuccessful in preventing IGT
from issuing a temporary restraining order that prevents the Company from
shipping the disputed product until the injunction hearing that has been set
for April 15, 1999 in Las Vegas. If the Company is unsuccessful in preventing
IGT from gaining an injunction until the patent trial is heard, the Company
will be prevented from shipping the disputed product until such time as the
patent trial is resolved. Management believes that the patent trial would be
at least two to five months after the April 15 hearing. The claims in the
lawsuit relate to a game that the Company released in February 1999 called
Multi-Draw Poker. The Company's management strongly denies the assertions of
infringement and in the litigation has asked the court to rule that its game
does not infringe. The costs of defending this suit may be substantial and may
require significant amounts of senior management time, and an adverse result
in such litigation could materially and adversely affect the Company's
liquidity and capital resources.
 
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>
   Andrew S. Pascal........ 33  Chief Executive Officer, acting Chief
                                Financial Officer
   Paul D. Mathews......... 34  Vice President Corporate Development &
                                Government Affairs
   Paul D. Miltenberger.... 33  Vice President Sales
   Alison Stroh............ 36  Vice President Marketing
   Betsy B. Sutter......... 38  Vice President Human Resources
</TABLE>
 
   Andrew S. Pascal has served as Chief Executive Officer of the Company since
February, 1999 and acting Chief Financial Officer since March, 1999. He had
previously held the title of 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 worked from June 1985 to October 1994. Mr. Pascal held the position
of 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 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.
 
   Paul D. Mathews joined SGI in November 1995 from Casino Data Systems
("CDS"), a designer and manufacturer of casino management information systems
and gaming devices, where from March 1995 to
 
                                      23
<PAGE>
 
November 1995 he was Director of Regulatory Compliance responsible for
corporate and product licensing in all gaming jurisdictions. Prior to joining
CDS, Mr. Mathews spent five years with the Nevada State Gaming Control Board
in the Corporate Securities and Investigation Divisions.
 
   Paul D. Miltenberger joined SGI in April, 1996 as Business Planning Manager
and in April 1997 became Director of Sales Planning, a position he held until
September 1998 when he was promoted to Vice President of Sales. Prior to
joining SGI, Mr. Miltenberger worked at Tektronics, a high-technology
manufacturer of color printers and test equipment, where from June 1995 to
April 1996 he held the position of Strategic Analysis Manager. Prior to
Tektronics, Mr. Miltenberger worked at Conner Peripherals, Inc. between August
1990 and June 1995 as Manager of Strategic Reporting.
 
   Alison Stroh joined SGI in January 1997 as Director of Multi-Player Systems
until January 1999 when she was promoted to Vice President, Marketing. Prior
to joining SGI, Ms. Stroh worked for CDS where from May 1994 to December 1996
she was Director of New Product Development, responsible for introduction of
new games including wide-area progressive products. Prior to joining CDS, Ms.
Stroh spent eight years with the Nevada State Gaming Control Board, most
recently as a Senior Agent Audit Division, Research and Development.
 
   Betsy B. Sutter joined SGI in March 1997 from Digital Equipment
Corporation, where from 1989 she had been the Human Resources Manager for
their Research and Advanced Technology Division in Palo Alto. Between 1985 and
1989, Ms. Sutter had been the Human Resources Manager at Aehr Test Systems.
Prior to this she had human resources experience with other high technology
companies including Hitachi America Ltd. and General Electric Corporation.
 
                                      24
<PAGE>
 
                                    PART II
 
Item 5: Market for Registrant's Common Equity and Related Shareholder Matters
 
Stock Price History
 
<TABLE>
<CAPTION>
                                    1998           1997
             (Fiscal Year)     -------------- --------------
                                 High    Low   High    Low
                               -------- ----- ------ -------
         <S>                   <C>      <C>   <C>    <C>
         First Quarter........ 11 3/16  8 1/4 21 3/8 14 5/8
         Second Quarter....... 10 3/8   7 1/2 17 3/8 13
         Third Quarter........  9 15/16 3 1/8 15     12 1/2
         Fourth Quarter.......  3 7/8   1 3/8 14 7/8 10 7/16
                               ======== ===== ====== =======
</TABLE>
 
   The preceding table sets forth the high and low closing sale prices as
reported on the Nasdaq Stock Market for the Company during each of the
quarters in 1998 and 1997. The Company's stock traded under the symbol SGIC'.
In February 1999 the Company's Common Stock was delisted from the Nasdaq
National Market and the Company's stock now trades on the NASD Over-The-
Counter (OTC) bulletin board system under the symbol SGIC'.
 
Dividend Policy
 
   The Company has never paid cash dividends on its Common stock. The Company
presently intends to retain all cash for use in the operation and expansion of
the Company's business and does not anticipate paying any cash dividends in
the near future.
 
Item 6: Selected Consolidated Financial Data
 
<TABLE>
<CAPTION>
                                 Years Ended December    Nine Months    Year
                                          31,               Ended       Ended
                                ------------------------ December 31, March 31,
                                 1998     1997    1996     1995(1)      1995
                                -------  ------- ------- ------------ ---------
                                   (in thousands except per share amounts)
<S>                             <C>      <C>     <C>     <C>          <C>
Statement of Operations Data:
  Net sales.................... $22,281  $ 9,550 $    --    $   --     $
  Loss from operations.........  32,009   22,984  14,533     4,059       1,851
  Net loss.....................  37,670   22,986  13,634     3,974       1,866
  Basic and diluted net loss
   per share................... $  2.75  $  2.16 $  2.54    $ 2.34          --
Shares used in computation.....  13,696   10,666   5,364     1,695          --
 
<CAPTION>
                                            December 31
                                ------------------------------------- March 31,
                                 1998     1997    1996       1995       1995
                                -------  ------- ------- ------------ ---------
                                                (in thousands)
<S>                             <C>      <C>     <C>     <C>          <C>
Balance Sheet Data:
  Cash and equivalents......... $ 8,399  $16,352 $25,583    $2,399     $   241
  Short-term investments.......      --    4,705   9,683        --          --
  Working capital..............  10,772   25,759  34,203     2,027      (1,253)
  Total assets.................  41,744   49,038  39,646     3,486         486
  Long-term debt...............  39,809   22,637     778       272          --
  Redeemable Convertible
   Preferred Stock.............   1,666    3,065   6,455     8,496         967
  Total shareholders' equity
   (deficiency)................ (18,452)  14,432  30,061    (5,946)     (2,003)
</TABLE>
--------
(1) Effective April 1, 1995, the Company changed its fiscal year end from
    March 31 to December 31.
 
 
                                      25
<PAGE>
 
Item 7: Management's Discussion and Analysis of Financial Condition and
Results of Operations
 
Overview
 
   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. In
1997 the Company successfully introduced its first product, OdysseyTM, a
multi-game, video-based slot machine, into the Nevada market. Since that time
the Company has rolled out Odyssey into other jurisdictions including
Connecticut, Iowa, Louisiana, Michigan Mississippi, Missouri, New Mexico,
certain Canadian provinces and Uruguay. In 1998 the Company introduced Quest,
a single-game platform that utilizes many of the same components as the
Odyssey to increase its penetration of the casino floor.
 
   In December 1998, the Company introduced its first wide-area progressive
product, The Big Win. Under a wide-area progressive system, numerous slot
machines are linked by computer networks and share a common top award that is
usually much greater than the award that a single, unlinked machine could
support. The network links machines in different casinos, and can be extended
from its current installed base in Las Vegas to include other locations across
Nevada.
 
   Through December 31, 1998, the Company has installed 3,609 Odyssey and
Quest machines in approximately 180 properties. Of these machines, 2,920 have
been sold outright or placed on a revenue-sharing basis. After returns, 620
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. Included in the Company's installed base at December 31, 1998 was 160
machines installed in Nevada that are connected to the wide-area progressive
system. 142 of the wide-area progressive machines were returned to the Company
in January 1999 following a decision by the Company to modify the initial game
that was released on the wide-area progressive system.
 
   At December 31, 1998 the Company had cash and equivalents of $8,399,000.
The Company has incurred operating losses each year since inception and as of
December 31, 1998 had an accumulated deficit of $80,270,000 and a deficiency
of shareholders' equity of $18,452,000. The Company has been required to
obtain additional financing each year to be able to fund its ongoing
operations. At December 31, 1998 the Company was not in compliance with the
terms of its line of credit and had overdrawn its credit facility by
$1,457,000. Based on historical levels of cash usage, the above factors raise
substantial doubt about the Company's ability to continue as a going concern.
In the fourth quarter of 1998 the Company took steps to reduce the level of
operating expenses and made a number of management decisions which resulted in
a reduction of the Company's work force by approximately 20% and cuts in
expenditures across the Company. The Company continued to evaluate further
possible ways to reduce operating expenses through outsourcing of different
parts of its business and further downsizing of its workforce. In March 1999
management reduced the size of the Company's workforce by an additional 40%
and made additional cuts to its operating expenses. Management also announced
the relocation of its manufacturing to its Las Vegas, Nevada facility and the
closure of its Mountain View, California manufacturing facility. Management is
currently attempting to renegotiate the terms of its line of credit with its
bank so additional funds will become available to the Company. Management is
also reviewing financing alternatives available to the Company such as
additional share or debt offerings, joint ventures, alternative distribution
channels and sale of all or a portion of the Company's assets to improve the
Company's liquidity position. Management believes that these steps, plus sales
related to new product introductions will provide sufficient cash and working
capital for the Company to meet its ongoing obligations and to allow it to
continue operating as a going concern through at least the end of 1999. See
Note 1 of Notes to Consolidated Financial Statements.
 
   The Company encountered a more difficult and highly competitive market
place in 1998 than it had experienced previously. This, combined with delays
in getting new game titles into the marketplace had a significant negative
impact upon sales. The Company charges a premium for its product compared to
its
 
                                      26
<PAGE>
 
competitors and must generate a higher net win per machine than competing
products to justify the higher sales price to casino operators. Part of the
Company's product strategy involves regular introduction of new game titles
that can be cycled onto existing slot machines to refresh them and maintain
customer interest. Difficulties in introducing new game titles in a timely
manner, particularly through the first half of 1998, led to deteriorating
product performance in the field, which had a negative impact on the ability
of the Company to place additional units. The Company offset the effects of
this by gaining additional jurisdictional approvals and rolling its product
into new markets. The Company also experienced turnover among senior
management during the second half of 1998 that resulted in significant
resources being devoted to internal, rather than external, matters. The impact
of this on the Company's results of operations is difficult to quantify but
contributed to the Company's failure to meet its operational objectives for
1998.
 
   Prior to March 1997 the Company was in the development stage and its
primary activities were focussed on product development, including system
hardware and software, game concept development and software coding. Towards
the end of 1996 the Company began manufacturing slot machines for commercial
distribution. The Company sold its first product in May 1997 following
completion of a customer evaluation period. Prior to this time the Company did
not generate any revenue from product sales. Once the Company started
generating revenue from product sales, the focus of its expenditures changed
from product development to building its infrastructure to support the sale
and distribution of its products.
 
   Silicon Gaming is headquartered in Palo Alto, California and has sales
offices in Reno and Las Vegas, Nevada, and in Gulfport, Mississippi. Product
is manufactured at the Company's location in Mountain View, California. At
December 31, 1998 the Company had 163 employees.
 
Results of Operations
 
   The Company had a net loss of $37,670,000 for the year ended December 31,
1998. This compared to a net loss of $22,986,000 for the year ended December
31, 1997. The increase in net loss was largely due to the Company's operating
expenses increasing at a rate much higher than the rate of growth in revenue,
primarily in anticipation of higher revenue.
 
   The Company had net losses of $22,986,000 and $13,634,000 for the years
ended December 31, 1997 and 1996, respectively. During these periods the
Company was devoting significant resources to building an organizational
infrastructure in such areas as sales, marketing, manufacturing, customer-
support and administrative support, all in anticipation of an increase in
sales and shipment volume associated with the planned rollout of its products.
 
  Revenues
 
   The Company generates hardware revenue from the sale of its products and
related parts and accessories. All products are sold with licensed software
and customers have the choice of either a paid-up or renewable annual license.
The Company places products in casinos under a participation program where it
receives 20% of the net win generated by the product as revenue. The Company
also places machines in casinos that are linked to a wide-area progressive
system in exchange for a predetermined share of the gross amount wagered on
the machine. Amounts received from the participation program and the wide-area
progressive system are recorded as participation revenues. Total revenue units
include machines sold outright as well as machines placed under the
participation programs.
 
                                      27
<PAGE>
 
   The Company generated revenues as follows:
 
<TABLE>
<CAPTION>
                                                       Year Ended   Year Ended
                                                      December 31, December 31,
                                                          1998         1997
                                                      ------------ --------------
                                                        (in $'000, except for
                                                           machine numbers)
   <S>                                                <C>     <C>  <C>     <C>
   Hardware sales.................................... $14,126  63% $ 7,636   80%
   Software sales....................................   4,657  21%     567    6%
   Participation revenue.............................   3,498  16%   1,347   14%
                                                      ------- ---- ------- -----
     Total revenue................................... $22,281 100% $ 9,550  100%
                                                      ======= ==== ======= =====
   Total revenue units...............................   1,622        1,298
</TABLE>
 
   As can be seen from the above table, the Company was able to increase
revenue during the year ended December 31, 1998 by 133% to $22,281,000 from
the $9,550,000 recorded in the year ended December 31, 1997. A large portion
of this increase can be explained by the increase in volume in the number of
machines sold or generating revenue for the Company, which increased by 25%,
or 324 units, from 1,298 in 1997 to 1,622 in 1998. The Company did not have
revenue in the year ended December 31, 1996. The average selling price on
machines sold outright decreased from $11,050 in 1997 to $10,230 in 1998
reflecting the increased levels of competition in the industry and a resulting
higher level of discounts given to strategic corporate customers during 1998.
 
   SGI sells its products outright to casino operators and other potential
purchasers offering several pricing programs. For the Odyssey this consists 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. Quest is sold as a bundled package of the hardware unit and a single
game for a fixed price. The Company also offers a participation program where
it will place either Odyssey or Quest on a casino floor in exchange for a
share in the aggregate win generated by the machine. Typically, under this
program, 20% of the aggregate win goes to the Company, subject to a
predetermined minimum. In December 1998, the Company introduced its first
wide-area progressive product, The Big Win. Machines placed in casinos on the
progressive system are priced such that the Company receives a predetermined
share of the gross amount wagered on the machine. In January, 1999, 142 of the
160 wide-area progressive machines were returned to the Company following a
decision by management to modify the original game that was released on the
wide-area progressive system. Revenues generated from the participation
program and from the wide-area progressive product are included as
Participation revenue in the above table.
 
   The increases in participation revenue and in software revenue in 1998
compared to 1997 reflect the full year impact in 1998 of machines in the
participation programs, which were first offered in June 1997, and the larger
installed base from which the Company derives software license revenue.
Software revenue increased by $4,090,000 or 721% in 1998 as a result of these
factors. The Company believes that participation revenue will increase in
absolute as well as relative terms as it rolls additional product out on its
wide-area progressive systems, and that in relative terms, hardware and
software revenues will decrease from current levels.
 
   During 1998, two customers accounted for 11% and 10% of revenues. In 1997
three different customers accounted for 27%, 12% and 12% of revenue. The
Company expects that a significant portion of its revenue will remain
concentrated within a limited number of strategic customers within the gaming
industry due to the increasing consolidation that is taking place among casino
operators. As an equipment vendor to the gaming industry, the Company sells
infrequently to many customers and the volume of sales to any particular
customer may vary significantly from period to period. As a result, there can
be no assurance that the above strategic customers will continue to account
for a significant percentage of the Company's revenue in the future. The loss
of any strategic customer could have a material adverse affect on the
Company's business and results of operations.
 
                                      28
<PAGE>
 
  Cost of Sales
 
   Cost of sales includes the direct cost of product sales as well as the
unabsorbed costs of the Company's manufacturing operations. Cost of sales also
includes license fees and royalties paid to third parties, depreciation on
machines placed on the participation programs as well as the costs directly
associated with running the wide-area progressive system, including payments
of jackpot awards. Cost of sales were $24,062,000, $10,421,000 and $2,458,000
for the years ended December 31, 1998, 1997 and 1996, respectively. The year-
to-year increases in cost of sales is largely driven by the higher number of
machines sold or placed on one of the Company's participation programs in 1998
as compared to 1997, the absence of product sales prior to May 1997, royalties
of $2,200,000 paid to a third party in 1998 in connection with a new game
offering, as well as the cost of operating the wide-area progressive system
that was introduced in the fourth quarter of 1998. The Company also recorded
$5,200,000 in expense during the second half of the year related to lower of
cost or market and excess and obsolete inventories.
 
   Amounts recorded under cost of sales for the year ended December 31, 1996
relate to manufacturing expenses incurred as the Company established a
manufacturing facility and prepared to begin manufacture of product. Because
the Company did not generate any product revenue in 1996, cost of sales did
not include any direct product costs. Cost of sales represented 108% of
revenues in 1998 and 109% of revenues in 1997. The marginal decrease in cost
of sales as a percentage of revenues is a reflection of the charges that the
Company has booked related to inventory and due to the royalty payments that
the Company agreed to pay to a third party. These charges offset the benefits
of efficiencies gained as manufacturing volumes have increased, reflecting the
largely fixed cost of the manufacturing facility. The per-unit manufacturing
cost has decreased as the Company began to realize benefits from the tooling
of certain of its hardware components, and from cost reductions in many of the
components included in its machines. Through the end of 1998 the Company has
been able to reduce the per-unit material cost of its products by
approximately 50% from the first products it produced in 1996. The Company
does not anticipate that this rate of cost reduction will continue into future
periods. The Company anticipates that as it introduces more unique, fully
integrated specialty products, per-unit costs may actually increase in future
periods.
 
  Research and Development
 
   Research and development ("R&D") expenses include payroll and related costs
of employees engaged in the ongoing design and development activities of the
Company, costs paid to outside contractors and specialists, 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 products. R&D expenses were
$11,853,000, $9,283,000 and $7,030,000 for the years ended December 31, 1998,
1997 and 1996, respectively.
 
   Increases over these periods are largely the result of incremental hiring
of personnel, increased use of engineering consultants and license fees and
similar costs associated with the acquisition of outside technologies. Prior
to 1997 the focus of R&D activities was in the successful development of the
Company's initial product, Odyssey, and the initial suite of games that the
Company offered. Since that time, R&D activities have focussed on new game
development, the introduction of new product platforms, and the development of
new game types such as the wide-area progressive system. The Company is
focussed on ensuring that it can offer additional features into its products
that will fully capitalize the underlying technology used. This is expected to
require significant R&D resources to continue the development of the product
platform to facilitate the elaborate requirements of the game development
process and to enable it to introduce new game types into the slot machine
market. With the reductions in its workforce, the Company anticipates that the
level of R&D activity will decrease in absolute dollars in future periods.
 
  Selling, General & Administrative
 
   Selling, general and administrative ("SG&A") expenses include payroll and
related costs for executive and administrative personnel, sales and customer-
support organization personnel, and marketing and licensing
 
                                      29
<PAGE>
 
personnel, corporate overhead costs, legal and associated costs, costs
associated with obtaining and retaining corporate and product licenses in
various jurisdictions, and fees for professional services. Approximately 50%
of SG&A expenses are headcount related. SG&A expenses were $18,375,000,
$12,830,000 and $5,045,000 for the years ended December 31, 1998, 1997 and
1996, respectively.
 
   Increases in SG&A expenses over these periods are largely attributable to
the hiring of additional personnel and in costs associated with applying for
corporate and product licenses as the Company began selling product into new
jurisdictions. The Company also incurred costs as it created and established a
customer-support organization to support the rollout of its product, and as it
established a marketing organization upon the commercial distribution of its
products in 1997. A significant portion of these increases occurred during
1997 when the Company commenced sales of the Odyssey and built its
infrastructure in the Nevada and Mississippi markets. Additional increases in
SG&A expenses in 1998 were due to severance payments made to senior management
and increases in bad debt provisions of $1,600,000 due to problems with
customer collections. The Company intends to restrict the growth in SG&A
expenses as much as possible in future periods and expects SG&A expenses in
absolute dollars and as a percentage of revenue to decline.
 
  Interest Income and Expense
 
   Interest income was $618,000, $1,238,000 and $1,016,000 for the years ended
December 31, 1998, 1997 and 1996, respectively. Fluctuations in the level of
interest income are directly attributable to fluctuations in the level of
average cash and investment balances that the Company holds. The timing of
share offerings, issuance of Senior Discount Notes, and the rate of spending
on operations have impacted the average level of cash and investments held.
 
   Interest expense was $6,261,000, $1,240,000 and $84,000 for the years ended
December 31, 1998, 1997 and 1996, respectively. The increases in interest
expense are due to increases in the Company's level of long-term indebtedness
over the period. The Company raised $25 million in September 1997 from the
issuance of Senior Discount Notes (the 1997 Notes) and raised an additional
$15 million in June 1998 from the issuance of additional Senior Discount Notes
(the 1998 Notes). The Company also raised approximately $3.6 million from
equipment financing borrowing during 1998. The substantial increase in
interest expense in 1998 reflects the full year interest cost of the 1997
notes as well as the interest costs associated with the 1998 Notes, the
repricing of stock warrants and the equipment financing. The Company
anticipates that interest expense will increase in 1999 due to the full-year
impact of interest expense on amounts borrowed during 1998.
 
  Income Taxes
 
   The Company has not been required to pay income taxes due to the fact that
it has had net operating losses in each period since the Company's inception.
As of December 31, 1998 the Company had net operating loss carryforwards of
approximately $69,100,000 and $35,800,000 for federal and state income tax
purposes, respectively. These loss carryforwards will begin to expire
beginning in the Year 2000 if not utilized. The Company also has R&D credit
carryforwards of approximately $815,000 and $720,000 for federal and state
income tax purposes as of December 31, 1998 which expire beginning 2010.
 
   A valuation allowance has been recorded for any deferred tax assets due to
uncertainty regarding the ultimate realization of these assets resulting from
the lack of earnings history of the Company. The Tax Reform Act of 1986 and
the California Act of 1987 impose restrictions on the utilization of net
operating loss and tax credit carryforwards in the event of an "ownership
change" as defined by the Internal Revenue Code. The Company's ability to
utilize its net operating loss and tax credit carryforwards is subject to
limitation pursuant to these restrictions. As of March 31, 1998, approximately
$4 million of the Company's net operating loss carryforwards was subject to
such limitation and is dependent on the Company's future profitability and the
utilization of its net operating loss carryforwards over a period of time.
 
                                      30
<PAGE>
 
Financial Condition
 
   The Company's financial condition has deteriorated substantially since
December 31, 1997. Cash and equivalents and short-term investments decreased
by $12,658,000 and were $8,399,000 as at December 31, 1998 compared to
$21,057,000 at December 31, 1997. This decrease in resources is primarily due
to the ongoing losses from operations that the Company has incurred, despite
the $18.6 million proceeds that the Company raised in June 1998 from an
additional offering of Senior Discount Notes and from equipment financing
completed during the year.
 
   As of December 31, 1998 the Company had an accumulated deficit of
$80,270,000 and a shareholder's deficiency of $18,452,000 and has had
operating losses every year since its inception. The Company was required to
obtain a waiver from its bank during the year to maintain its revolving line
of credit facility and was not in compliance with a number of the covenants at
December 31, 1998. These factors may raise doubt about the Company's ability
to continue as a going concern. In the fourth quarter of 1998 the Company took
steps to reduce the level of operating expenses and made a number of
management decisions which resulted in a reduction of the Company's work force
by approximately 20% and cuts in expenditure across the Company. The Company
continued to evaluate further possible ways to reduce operating expenses
through outsourcing of different parts of its business and further downsizing
of its workforce. In March 1999 management reduced the size of the Company's
workforce by an additional 40% and made additional cuts to its operating
expenses. Management also announced the relocation of its manufacturing to its
Las Vegas, Nevada facility and the closure of its Mountain View, California
manufacturing facility. Management is currently attempting to renegotiate the
terms of its line of credit with its bank so those additional funds will
become available to the Company. Management is also reviewing financing
alternatives available to the Company such as additional share or debt
offerings, joint ventures, alternative distribution channels and sale of all
or a portion of the Company's assets to improve the Company's liquidity
position. Management believes that these steps, plus sales related to new
product introductions will provide sufficient cash and working capital for the
Company to meet its ongoing obligations and to allow it to continue operating
as a going concern through at least the end of 1999. However, the success of
any new product introductions is subject to various risks and uncertainties,
and there is no assurance that such new products will generate the amount of
revenue hoped for by the Company. In the event it is unable to generate
sufficient cash from operations or identify new sources of capital, the
Company will be required to significantly limit or shut down all or some of
its operations.
 
   The net cash used in operating activities was $32,110,000, $29,909,000 and
$12,000,000 for the years ended December 31, 1998, 1997 and 1996,
respectively. The increase from 1997 to 1998 was due to the increase in net
operating losses and due to increases in the Company's working capital
requirements, predominantly in inventory and receivables. This increase was
offset partially by increases in depreciation, amortization, bad debt
provisions, and accrued interest. Inventory levels, particularly raw materials
and finished goods, increased significantly in 1998. This increase occurred as
the Company ramped up its level of operations in anticipation of sales demand,
and was unable to reduce these levels once the anticipated sales levels did
not materialize. The increase in receivables is largely due to problems in
collections from several customers, which also resulted in the Company having
to increase its bad debt reserves during 1998 by approximately $1,600,000. The
increase in cash used in operating activities between 1996 and 1997 was
primarily due to the increases in operating losses over this period and due to
increases in net working capital, predominantly increases in inventories and
receivables, offset partially by increases in payables and deferred revenues.
In July 1999 the Company is required to begin interest payments on its 1997
Notes and its 1998 Notes.
 
   Net cash provided by investing activities was $1,245,000 for the year ended
December 31, 1998 as compared to net cash used in investing activities of
$3,077,000 and $12,657,000 for the years ended December 31, 1997 and 1996,
respectively. The decrease in 1998 from 1997 is due to the sale and maturity
of the Company's short-term investments that were redeemed during 1998. This
offset the increased investment in fixed assets, particularly in connection
with the introduction and rollout of the wide-area progressive system and
additional units placed on participation programs that the Company made in
1998. The decrease between 1997
 
                                      31
<PAGE>
 
and 1996 was primarily due to increases in the net proceeds from the purchase,
sale and maturity of short-term investments, offset by increases in the
acquisition of fixed assets, primarily computer equipment and software. The
Company anticipates continued investment in fixed assets during 1999 as it
continues to expand its wide-area progressive system.
 
   Net cash provided by financing activities was $22,912,000, $23,755,000 and
$47,841,000 for the years ended December 31, 1998, 1997 and 1996,
respectively. Fluctuations in net cash provided by financing activities are
due to the timing of the company's various share and debt offerings. In 1998
the Company raised net proceeds of $14,950,000 from the issuance of Senior
Discount Notes and $3,586,000 from the proceeds of new equipment financing
arrangements. In 1997 the Company financed its operations primarily through
the proceeds of $23,055,000 from the issuance of Senior Discount Notes plus
detachable warrants. In 1996 the Company financed its operations with funds
received from its initial public offering, of which the Company received
proceeds, net of underwriting discounts and offering expenses, of $32,858,000,
and from the proceeds from private placement of Redeemable Convertible
Preferred Stock prior to the initial public offering.
 
   In February 1999 the Company filed a complaint against International Game
Technology (IGT) seeking a declaration of noninfringement and invalidity of US
Patent no. 5,823,873, describing a method of playing electronic video poker
games. The suit was originally filed in the United States District Court for
the Northern District of California, as a result of threat of litigation by
IGT. IGT responded by filing a complaint in the District of Nevada alleging
infringement of the same patent. As that case has been transferred from Reno
to be heard in Las Vegas, the Company intends to dismiss the California action
and pursue its claims against IGT in the Las Vegas case. On March 16, 1999 the
Company was unsuccessful in preventing IGT from issuing a temporary
restraining order that prevents the Company from shipping the disputed product
until the injunction hearing that has been set for April 15, 1999 in Las
Vegas. If the Company is unsuccessful in preventing IGT from gaining an
injunction until the patent trial is heard, the Company will be prevented from
shipping the disputed product until such time as the patent trial is resolved.
Management believes that the patent trial would be at least two to five months
after the April 15 hearing. The claims in the lawsuit relate to the Company's
recently released game Multi-Draw Poker. The costs of defending such a suit
may be substantial and may require significant amounts of senior management
time, and an adverse result in such litigation could materially and adversely
affect the Company's liquidity and capital resources.
 
Recently Issued Accounting Standards
 
   In the first quarter of 1998, the Company adopted Statement of Financial
Accounting Standards No. 130, "Reporting Comprehensive Income", which requires
an enterprise to report, by major components and as a single total, the change
in its net assets during the period from nonowner sources.
 
   In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 131, "Disclosures about Segments of an
Enterprise and Related Information", which establishes annual and interim
reporting standards for an enterprise's business segments and related
disclosures about its products, services, geographic areas, and major
customers. For the year ended December 31, 1998, the Company operated in one
business segment.
 
   In June 1998, the FASB issued Statement of Financial Accounting Standards
No. 133, "Accounting for Derivative Instruments and Hedging Activities". This
statement requires companies to record derivatives on the balance sheet as
assets or liabilities measured at fair value. Adoption of this standard has no
impact upon the Company's consolidated financial position, results of
operations or cash flows as the Company does not currently have any derivative
financial instruments covered by this standard.
 
Year 2000 Issues
 
   The inability of computers and software programs to recognize and properly
process data fields containing a two-digit year is commonly know as the Year
2000 issue. As the Year 2000 approaches, such computer systems
 
                                      32
<PAGE>
 
may be unable to accurately process certain data-based information. This could
result in system failures or miscalculations causing disruption of operations
including, among other things, a temporary inability to process transactions,
send invoices or engage in normal business activity.
 
   During 1997 the Company implemented an enterprise-wide management
information system based on Oracle applications software, which supports all
of the Company's major business applications, including sales and customer
service, manufacturing and distribution, and finance and accounting. The
Company completed an upgrade of this system in November 1998 to ensure that
the system is Year 2000 compliant. As a result, management believes that the
Year 2000 issue will not pose any significant operational problems for its
computer systems.
 
   During 1998 the Company established a Year 2000 committee comprised of
senior management to provide leadership and direction to the Year 2000 effort
throughout the Company. The committee is using a multi-step approach in
managing the Year 2000 project. The major steps include an inventory of all
systems and devices with potential Year 2000 problems, assigning priority to
identified items, assessing the Year 2000 compliance of items deemed material
to the Company, repairing or replacing material items that are determined not
to be Year 2000 compliant, testing material items, and designing and
implementing contingency and business continuation plans. The Company has
completed the inventory of its critical systems, made an assessment of Year
2000 compliance and has identified all systems to be upgraded or replaced. The
Company expects to have this process completed by June, 1999. The Company has
recently initiated formal communications with the suppliers with which it has
material active contracts to determine the extent to which the Company is
vulnerable to those third parties' failure to remediate their own Year 2000
issues. The Company cannot accurately predict the outcome of other companies'
remediation efforts.
 
   The Company utilizes third-party vendors for processing data such as
payroll, 401(k) administration and medical benefits processing. The Company
has initiated communications with its vendors to determine the status of their
systems. Should these vendors not be compliant in a timely manner, the Company
may be required to process transactions manually or delay processing until
such time the vendors are Year 2000 compliant. No contingency plan has yet
been developed, however it is expected that contingency plans could be
developed, if needed, on short notice.
 
   A number of the Company's customers have contacted the Company to determine
if the Company's products are Year 2000 compliant. The Company has tested its
products and believes that the products will correctly process data such that
the Year 2000 issue will not affect the operation of its products. However,
because the Company's product must run on third party slot management and
tracking systems, there is still a risk that the Company's products will not
work properly with such third party software. This risk is exacerbated because
the Company's products continue to display date fields as a two-digit rather
than a four-digit field. The Company has developed a solution to this problem
that is currently undergoing review by industry regulators that will overcome
this display problem. Upon regulatory approval, the Company intends to offer a
platform upgrade to all of its customers that will fix the current version of
product, and expects this to be delivered and installed to all customers
before June 1999. As a result, it does not anticipate any significant problem
with its products being Year 2000 compliant. There can still be no guarantee
that the Company's product will be able to run with third party software after
December 31, 1999 however.
 
   The total cost associated with required product and systems modifications
to become Year 2000 compliant is not expected to be material to the Company's
financial position. The Company spent approximately $450,000 during 1998 in
getting its major business systems upgraded and Year 2000 compliant. The
Company plans on using both internal and external resources during 1999 to
continue to replace and test hardware and software for Year 2000 compliance.
Currently the Company does not anticipate spending more than $500,000 in
connection with its Year 2000 projects during 1999. The majority of this will
be spent on the purchase of new or replacement hardware and software and
upgrades, and on updating software code for its products, and this will be
funded from operations. The anticipated costs and scope of the Year 2000
project are based on management's best estimates using information currently
available and numerous assumptions about future events. However, there
 
                                      33
<PAGE>
 
can be no guarantee that these estimates will be achieved and actual results
could differ materially from these plans.
 
   The failure to correct a material Year 2000 problem could result in an
interruption in, or failure of, certain normal business activities or
operations. Such failures could materially and adversely affect the Company's
results of operations, liquidity and financial condition. Due to the general
uncertainty inherent in the Year 2000 problem, resulting in part from the
uncertainty of the Year 2000 readiness of third-party suppliers and customers,
the Company is unable to determine at this time whether the consequences of
Year 2000 failures will have a material impact on the Company's results of
operations, liquidity or financial condition. The Year 2000 project is
expected to reduce the Company's level of uncertainty about the Year 2000
problem, and in particular, about the Year 2000 compliance and readiness of
its products.
 
Outlook
 
   This outlook section contains a number of forward-looking statements that
reflect the Company's current views with respect to future events and future
financial performances. Because they relate to future activities, there is a
high degree of risk that such events will not materialize and readers should
not place undue influence upon them as actual results may differ materially.
 
   To date the Company has focussed many of its resources on creating a
business based on high-volume manufacturing and placement of slot machines
with a goal of capturing market share. The Company has struggled in its
endeavors against many competitors who are significantly larger and who have
much greater resources than the Company. The Company has emphasized selling
game platforms and strived to penetrate the market through frequent software
releases of new game titles. Changes in the competitive landscape since the
Company was formed have forced the Company to reevaluate its basic business
strategy. The Company has incurred significant expenses in developing a fully
integrated, high overhead business that assumed a much higher level of unit
sales than the Company has been able to achieve, resulting in unacceptable
levels of profitability for the Company.
 
   Management has spent time in the latter half of 1998 reviewing the basic
business strategy of the Company and intends to reorganize the business around
the core competencies that it has created. At the same time management intends
to simplify the business and focus resources so that it can significantly
reduce the level of corporate overhead, minimize the level of cash usage,
transition the business to one that takes advantage of revenue-sharing
opportunities and focus on achieving profitability.
 
   The Company has sold over 2,900 machines to date and understands the need
to continue to support its products and the needs of its existing customers.
At the same time, the Company needs to focus on how to best exploit the
technology inherent in its game platforms so that it can provide game
experiences and game features that are unique to the Company and that cannot
be easily exploited or imitated by its competitors. By emphasizing the quality
of the wagering attraction, including the game itself, rather than the volume
of new game titles, the Company hopes to be able to command premium floor
locations in its customers' casinos, and as a result achieve a premium level
of performance. Where necessary, the Company intends to partner with outside
parties, including casino operators and or other slot manufacturers, to
accomplish these goals. The announced joint-product development and marketing
agreement with Anchor Gaming is the first example of where the Company will
seek external skills to complement its own resources.
 
   The Company also intends to leverage its investment in the infrastructure
that it has already put in place. To this end, the Company intends to
aggressively introduce new products that can be deployed on its wide-area
progressive system and to expand the geographical coverage of its wide-area
progressive systems during 1999 including into the Native American
marketplace.
 
   The Company will continue to introduce new game title releases for sale and
to refresh the game offerings on its installed base of Odyssey and Quest
machines during 1999. The Company intends to change its focus from
 
                                      34
<PAGE>
 
one of frequent game releases to one that emphasizes the quality and feature
content of new game titles. It will also offer product extensions and
variations of existing successful game titles. The Company also understands
that it must emphasize more than selling a platform that has a variety of game
applications upon it. The Company hopes to partner with casino operators to
provide a unique, fully integrated gaming experience which encompasses
packaging, merchandising, signage systems and, in some cases, unique platform
packaging as well. By doing this, the Company aims to provide a more complete
and feature rich experience for the gaming patron that is unique to the
Company. By partnering with casino operators the Company hopes to achieve
premium placement of its product.
 
   The Company also intends to take steps during 1999 to further reduce its
level of corporate overhead. Management is currently reviewing a number of
proposals to outsource or relocate certain non-critical business functions in
an attempt to reduce costs. Management is also taking steps to reduce the
level of investment that the Company has in inventories and accounts
receivable so that it can operate the business with a lower level of working
capital. If the Company achieves its objectives for 1999, the volume of
manufacturing and product sales will not increase significantly from 1998
levels.
 
   The Company's future results of operations and the other forward-looking
statements contained in this outlook--in particular the statements regarding
potential partnerships with casino operators or third parties, expansion of
the wide-area progressive system and anticipated cost reductions--involve a
number of risks and uncertainties. In addition to the factors discussed above,
among the other factors that could cause actual results to differ materially
are the following: the success of the Company's game titles that it introduces
into the market, changes in customer order patterns, competitive factors such
as new competitor product or game introductions or changes in pricing
strategies, reluctance of casino operators to use participation-based
products, the Company's level of financial resources and adequate cash flows,
the stability of the Company's management team and workforce, and the ability
of the Company to meet all initial and ongoing licensing requirements in the
jurisdictions in which it sells products.
 
   The Company believes that it has the product offerings, facilities,
personnel, and competitive resources needed for business success, but future
revenue, costs, margins and profits are all influenced by a number of factors,
including those discussed above and the need for the Company to raise
additional funds, all of which are inherently difficult to predict.
 
Factors Affecting Future Results
 
   Management of Changing Business--The Company is planning to shift its
business strategy from one of high-volume manufacturing and placement of slot
machines with a goal of capturing market share, to a strategy that emphasizes
the quality and feature content of new game titles and takes advantage of
revenue-sharing opportunities. It will offer product extensions and variations
of successful existing games, however the emphasis will shift from volume-
based to one of providing a unique, fully-integrated gaming experience. This
transition represents a significant challenge for the Company and its
management and employees, and places increased demand on its systems and
controls. The Company's ability to manage this change will require the Company
to continue to change, expand and improve its operational, management and
financial systems and controls to manage any outsourcing or relocation of
existing activities. Key to effecting this change in business is the ability
of the Company to sell its existing inventory of Odyssey and Quest products in
a timely manner and to resolve outstanding collections issues with customers
to provide sufficient working capital during this transition process. If the
Company is not able to generate adequate funds from its working capital in a
timely manner, the Company's business, operating results and financial
condition will be materially and adversely affected.
 
   Liquidity--The Company has funded its operations to date primarily through
private and public offerings of its equity securities, the issuance of Senior
Discount Notes, term and equipment loans and from bank borrowings. At December
31, 1998 the Company had a deficiency of shareholders' equity of $18,452,000
and was not in compliance with the terms of its line of credit. Management is
currently attempting to renegotiate the terms of its line of credit with its
bank so that additional funds will become available to the Company. Management
is
 
                                      35
<PAGE>
 
also reviewing financing alternatives available to the Company such as
additional share or debt offerings, joint ventures, alternative distribution
channels and sale of all or a portion of the Company's assets. If the plans
that management has undertaken to improve the Company's liquidity position are
not successfully completed in a timely manner it is probable that insufficient
funds will exist to satisfy the Company's operating requirements. The Company
will be required to make adjustments to its operating activities to operate
within the restrictions of its liquidity and this could have a material
adverse affect upon the Company's business, operating results and financial
condition. To the extent that the Company sells additional shares or issues
any convertible debt securities, this could result in additional dilution to
existing shareholders. There can be no assurance that the Company will be able
to successfully renegotiate its existing credit facility or be able to raise
additional funds when and if needed.
 
   Volatility of Stock--The market price of the Company's stock has been
highly volatile and subject to large fluctuations. The Company's stock price
may be affected by factors such as actual or unanticipated fluctuations in the
Company's results of operations, new product or technical introductions by the
Company or any of its competitors, developments with respect to patents,
copyrights or proprietary rights, conditions or trends in the gaming industry,
changes in or failure by the Company to meet securities analysts'
expectations, continued listing of the Company's stock on the Nasdaq National
Market, general market conditions and other factors. In February 1999, the
Company's common stock was removed from the Nasdaq National Market, a distinct
tier of the Nasdaq stock market, as the Company was no longer in compliance
with the minimum requirements relating to tangible net worth and share price.
The Company's stock now trades on the Over The Counter (OTC) Bulletin Board.
This may affect the level of trading activity in the Company's stock, result
in higher bid/ask spreads, and increase the cost of raising additional equity
for the Company.
 
   Retention of Personnel--The operations of the Company depend to 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.
The Company experienced high turnover among its senior management during the
second half of 1998, and in February 1999 announced the appointment of a new
Chief Executive Officer. The Company also reduced its workforce by
approximately 20% in December 1998 and by a further 40% in March 1999. These
factors, combined with the Company's poor operating results and the
significant decrease in the price of the Company's Common Stock may have an
adverse affect on the Company's ability to retain and motivate its key
employees. Competition is intense for highly skilled product development
employees in particular. In addition, the Company's officers and key employees
are not bound by non-competition agreements that extend beyond their
employment at the Company, and there can be no assurance that employees will
leave the Company or compete against the Company. The Company's failure to
attract additional qualified employees or to retain its existing employees
could have a material adverse affect on the Company's operating results and
financial condition. Should the Company offer additional stock option grants
to its existing employees to encourage them to continue their employment at
the Company, this may result in additional dilution to existing shareholders.
 
   Customer Retention--The Company's ability to sell product may be hampered
due to the financial position of the Company which presents risks to customers
that the Company may not be able to fulfill its obligations under license
agreements or be available to provide warranty, repair or upgrade services on
products that it has already sold. The Company has experienced negative
reaction from customers who have these views during the first quarter of 1999
and who have indicated that they may not purchase additional product from the
Company. Certain of the Company's competitors who have significantly greater
financial and marketing resources than the Company are also trying to take
advantage of the Company's financial position and are fueling the speculation
about the Company's financial position. To the extent that this results in the
loss of any of the Company's strategic customers or results in a loss of sales
opportunities, the Company's business, operating results and financial
condition may be adversely affected.
 
   Intellectual Property Rights--The Company regards its product as
proprietary and relies primarily on a combination of patent, 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 costly, and there can
 
                                      36
<PAGE>
 
be no assurance that the Company will be able to effectively protect its
technology from misappropriation by competitors.
 
   As the number of software products in the gaming industry increases and the
functionality of these products further overlap, software developers and
publishers or competitors 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 with a desire
to disrupt the Company's business. The Company was notified by one of its
competitors of a potential infringement claim during September of 1998 that
resulted in the Company entering into a license and royalty agreement with the
competitor and incurring an expense of $2,200,000. The Company was also
notified in February 1999 that another of its new game titles might
potentially infringe the same intellectual property rights and filed a lawsuit
against this competitor seeking a declaration of noninfringement and
invalidity of the competitor's patent. The competitor responded by filing a
complaint against the Company alleging patent infringement. On March 16, 1999
the Company was unsuccessful in preventing the competitor from issuing a
temporary restraining order that prevents the Company from shipping the
disputed product until the injunction hearing that has been set for April 15,
1999 in Las Vegas. If the Company is unsuccessful in preventing the competitor
from gaining an injunction until the patent trial is heard, the Company will
be prevented from shipping the disputed product until such time as the patent
trial is resolved. Management believes that the patent trial would be at least
two to five months after the April 15 hearing. Although management believes
that this claim is without merit and has received independent legal advice
that supports this view, there can be no assurance that this dispute can be
settled without incurring significant additional cost to the Company. Any such
claims or litigation can be costly and result in a diversion of management's
attention, which could have a material adverse 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 affect on the Company's
business, operating results and financial condition.
 
   Changing Legislative Environment--A number of Nevada gaming sources and
competitors of the Company have disclosed during the first quarter of 1999
that they are aware of legislation that may be introduced into the 1999
session of the Nevada Legislature which could impact the Company's revenue and
earnings from its installed base of participation machines in the Nevada
market. The contemplated legislation may restrict or prohibit a gaming machine
manufacturer from receiving a percentage of profits or revenue from a gaming
machine placed on a casino floor in Nevada. Any such legislation, if passed in
Nevada or other jurisdictions, would require the Company to review its
business strategy of placing its premium products on a participation basis
with casino operators and require it to end its practice of placing machines
in casinos and sharing in the net win with the casino operators. Although no
legislation has been introduced to date, any such legislation if implemented
would have a material adverse impact on the Company's business, operating
results and financial condition.
 
   The opening of new casinos, including casinos in jurisdictions where gaming
has recently been legalized historically has driven growth for demand in slot
machines. 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. Certain
markets, which currently permit gaming, are contemplating legislation to
limit, reduce or eliminate gaming. If successful such legislation could limit
growth opportunities for the Company. As a result of these factors, there can
be no assurance that the slot machine market will sustain the rate of growth
that was possible in the first half of this decade.
 
   Rapidly Changing Technology--The Company's products utilize hardware
components that have been developed primarily for the personal computer and
multimedia industries. These industries are characterized by rapid
technological change 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
 
                                      37
<PAGE>
 
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.
 
   Dependence on Single-Source Suppliers--The Company currently obtains a
number of its systems components from single-source suppliers. In particular
the touchscreen and picture tube that comprise the video display are supplied
by MircoTouch 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. Even where the Company has multiple
sources of supply for a component, industry-wide component shortages, such as
those that have occurred with various computer components, could significantly
delay productivity, increase costs or both. The Company is also considering
exclusive outsourcing arrangements whereby a single third party contract
manufacturer will assemble all or a significant portion of new products that
the Company is planning to introduce. The failure or delay by any supplier to
furnish the Company with the required components or products would have a
material adverse effect on the Company's business, financial condition and
results of operations.
 
Item 7A
 
   Market Rate Disclosure: The following discussion about the Company's market
risk disclosures involves forward-looking statements. Actual results could
differ materially from those projected in the forward-looking statements. The
Company is exposed to market risk related to changes in interest rates and
equity security price risk. The Company does not have derivative financial
instruments for speculative or trading purposes.
 
   The Company has fixed rate long-term debt of approximately $40 million
outstanding as at December 31, 1998 and a hypothetical ten percent increase or
decrease in interest rates would not have a material impact on the fair market
value of this debt. The fair value of the Company's Senior Discount Notes may
be lower than the recorded value, but the Company is unable to estimate the
fair value at this time. Silicon Gaming, Inc. does not hedge any interest rate
exposures.
 
Financial Information By Quarter (unaudited)
 
<TABLE>
<CAPTION>
                                        Three Months Ended
                                -------------------------------------
                                March 31  June 30  Sept. 30  Dec. 31   Total Year
                                --------  -------  --------  --------  ----------
                                  (in thousands, except per share amounts)
<S>                             <C>       <C>      <C>       <C>       <C>
1998:
  Sales........................ $ 4,026   $ 8,261  $  4,989  $  5,005   $ 22,281
  Net loss..................... $(6,764)  $(5,428) $(14,702) $(10,776)  $(37,670)
  Basic and diluted net loss
   per share(1)................ $ (0.51)  $ (0.39) $  (1.06) $  (0.77)  $  (2.75)
                                -------   -------  --------  --------   --------
1997:
  Sales........................ $    --   $ 1,665  $  2,847  $  5,038   $  9,550
  Net loss..................... $(4,662)  $(5,937) $ (6,344) $ (6,043)  $(22,986)
  Basic and diluted net loss
   per share(1)................ $ (0.48)  $ (0.58) $  (0.58) $  (0.51)  $  (2.16)
                                -------   -------  --------  --------   --------
</TABLE>
--------
(1) 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 basic and diluted net loss per share.
 
 
                                      38
<PAGE>
 
Item 8: Financial Statements and Supplementary Data
 
  Index to Financial Statements and Supplementary Data
 
<TABLE>
<CAPTION>
                                                                          Page
     Financial Statements:                                                ----
     <S>                                                                  <C>
     Consolidated Balance Sheets at December 31, 1998 and 1997...........  40
     Consolidated Statements of Operations for the years ended December
      31, 1998, 1997 and 1996............................................  41
     Consolidated Statements of Shareholders's Equity (Deficiency) for
      the years ended December 31, 1998, 19997 and 1996..................  42
     Consolidated Statements of Cash Flows for the years ended December
      31, 1998, 1997 and 1996............................................  43
     Notes to Consolidated Financial Statements..........................  44
     Independent Auditors' Report........................................  56
</TABLE>
 
Item 9: Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
 
   Not applicable.
 
                                       39
<PAGE>
 
                              SILICON GAMING, INC.
 
                          CONSOLIDATED BALANCE SHEETS
                       (In thousands, except share data)
 
<TABLE>
<CAPTION>
                                                              December 31,
                                                             ----------------
                                                              1997     1998
                                                             -------  -------
<S>                                                          <C>      <C>
                           ASSETS
CURRENT ASSETS:
  Cash and equivalents...................................... $ 8,399  $16,352
  Short-term investments....................................     --     4,705
  Accounts receivable (net of allowances of $1,650 in 1998
   and $50 in 1997).........................................   5,340    4,930
  Inventories...............................................  12,024    6,335
  Investments to fund jackpot winners.......................     288      --
  Prepaids and other........................................   1,410    1,334
                                                             -------  -------
    Total current assets....................................  27,461   33,656
PROPERTY AND EQUIPMENT, NET.................................  12,922   13,669
OTHER ASSETS, NET...........................................   1,361    1,713
                                                             -------  -------
                                                             $41,744  $49,038
                                                             =======  =======
     LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIENCY)
CURRENT LIABILITIES:
  Accounts payable.......................................... $ 1,480  $ 3,151
  Accrued liabilities.......................................   8,154    2,983
  Deferred revenue..........................................   1,766    1,478
  Line of credit............................................   4,000      --
  Current portion of long-term obligations..................   1,289      285
                                                             -------  -------
    Total current liabilities...............................  16,689    7,897
OTHER LONG-TERM LIABILITIES.................................   2,032    1,007
LONG-TERM OBLIGATIONS.......................................  39,809   22,637
REDEEMABLE CONVERTIBLE PREFERRED STOCK--6,884,473 shares
 authorized at December 31, 1998; shares outstanding:
 December 31, 1998--1,474,641; December 31, 1997--
 2,769,424..................................................   1,666    3,065
SHAREHOLDERS' EQUITY (DEFICIENCY): Common Stock, $.001 par
 value; 50,000,000 shares authorized; shares outstanding:
 December 31, 1998--14,242,313; December 31, 1997--
 13,149,737                                                   57,398   54,131
  Warrants..................................................   4,548    3,107
  Notes receivable from shareholders........................    (128)    (207)
  Accumulated deficit....................................... (80,270) (42,600)
  Accumulated other comprehensive income....................     --         1
                                                             -------  -------
    Total shareholders' equity (deficiency)................. (18,452)  14,432
                                                             -------  -------
                                                             $41,744  $49,038
                                                             =======  =======
</TABLE>
 
                See Notes to Consolidated Financial Statements.
 
                                       40
<PAGE>
 
                              SILICON GAMING, INC.
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                     (In thousands, except per share data)
 
<TABLE>
<CAPTION>
                                                      Year Ended December 31,
                                                      -------------------------
                                                       1998     1997     1996
                                                      -------  -------  -------
<S>                                                   <C>      <C>      <C>
REVENUE:
  Hardware........................................... $14,126  $ 7,636  $   --
  Software...........................................   4,657      567      --
  Participation......................................   3,498    1,347      --
                                                      -------  -------  -------
  Total revenue......................................  22,281    9,550      --
 
OPERATING EXPENSES:
  Cost of sales and related manufacturing expenses...  24,062   10,421    2,458
  Research and development...........................  11,853    9,283    7,030
  Selling, general and administrative................  18,375   12,830    5,045
                                                      -------  -------  -------
  Total costs and expenses...........................  54,290   32,534   14,533
                                                      -------  -------  -------
    Loss from operations.............................  32,009   22,984   14,533
  Interest income....................................    (618)  (1,238)  (1,016)
  Interest expense...................................   6,261    1,240       84
  Other (income) expense--net........................      18      --        33
                                                      -------  -------  -------
NET LOSS                                              $37,670  $22,986  $13,634
                                                      =======  =======  =======
BASIC AND DILUTED NET LOSS PER SHARE                  $  2.75  $  2.16  $  2.54
                                                      =======  =======  =======
SHARES USED IN COMPUTATION                             13,696   10,666    5,364
                                                      =======  =======  =======
</TABLE>
 
 
 
                See Notes to Consolidated Financial Statements.
 
                                       41
<PAGE>
 
                              SILICON GAMING, INC.
 
         CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DEFICIENCY )
                      (In thousands, except share amounts)
 
<TABLE>
<CAPTION>
                                                           Notes                  Accumulated
                             Common Stock                Receivable                  Other
                          -------------------               From     Accumulated Comprehensive
                            Shares    Amount   Warrants Shareholders   Deficit      Income      Total
                          ----------  -------  -------- ------------ ----------- ------------- --------
<S>                       <C>         <C>      <C>      <C>          <C>         <C>           <C>
BALANCES, January 1,
 1996...................   2,737,989  $    84   $   25     $ (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...      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, net of costs of
 $3,895.................   3,500,000   32,855                                                    32,855
Other comprehensive
 income (loss)..........                                                                23
Net loss and
 comprehensive net
 loss...................                                               (13,634)                 (13,611)
                          ----------  -------   ------     -----      --------       -----     --------
BALANCES, December 31,
 1996...................  10,608,105   49,848       25      (221)      (19,614)         23       30,061
Options exercised for
 cash...................      49,083      200                                                       200
Collection of notes
 receivable.............                                      14                                     14
Employee stock purchase
 plan issuances.........      99,894      696                                                       696
Repurchase of Common
 Stock..................     (17,377)      (3)                                                       (3)
Conversion of Series A1
 Redeemable Preferred
 Stock..................   1,219,032    1,371                                                     1,371
Conversion of Series B1
 Redeemable Preferred
 Stock..................   1,191,000    2,019                                                     2,019
Warrants issued in
 conjunction with Senior
 Notes..................                         3,082                                            3,082
Other comprehensive
 income (loss)..........                                                               (22)
Net loss................                                               (22,986)                 (23,008)
                          ----------  -------   ------     -----      --------       -----     --------
BALANCES, December 31,
 1997...................  13,149,737   54,131    3,107      (207)      (42,600)          1       14,432
Options exercised for
 cash...................      97,400      217                                                       217
Collection of notes
 receivable.............                                      75                                     75
Employee stock purchase
 plan issuances.........     151,808      935                                                       935
Repurchase of Common
 Stock..................     (54,130)      (6)                 4                                     (2)
Net exercise of
 warrants...............      34,309       25      (25)
Conversion of Series A1
 Redeemable Preferred
 Stock..................     113,189      128                                                       128
Conversion of Series B1
 Redeemable Preferred
 Stock..................     750,000    1,271                                                     1,271
Warrants issued in
 conjunction with Senior
 Notes..................                         1,466                                            1,466
Stock compensation
 arrangements...........                  697                                                       697
Net loss................                                               (37,670)
Other comprehensive
 income (loss)..........                                                                (1)
Comprehensive loss......                                                                        (37,671)
                          ----------  -------   ------     -----      --------       -----     --------
BALANCES, December 31,
 1998...................  14,242,313  $57,398   $4,548     $(128)     $(80,270)      $ --      $(18,452)
                          ==========  =======   ======     =====      ========       =====     ========
</TABLE>
 
                See Notes to Consolidated Financial Statements.
 
                                       42
<PAGE>
 
                              SILICON GAMING, INC.
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (In Thousands)
 
<TABLE>
<CAPTION>
                                                    Year Ended December 31,
                                                   ----------------------------
                                                     1998      1997      1996
                                                   --------  --------  --------
<S>                                                <C>       <C>       <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
 Net loss........................................  $(37,670) $(22,986) $(13,634)
 Reconciliation to net cash used in operating
  activities:
 Depreciation and amortization...................     4,700     2,623       668
 Accrued interest................................     3,594       672       --
 Provision for bad debt..........................     1,600        50       --
 Accretion of debt discount......................     1,905       359       --
 Deferred rent...................................       213       202       133
 Stock compensation..............................       697       --        --
 Common and Preferred Stock issued for
  services.......................................       --        --        261
 Loss (gain) on disposal of property.............       (35)      --         33
 Changes in assets and liabilities:
  Accounts receivable............................    (2,010)   (4,980)
  Inventories....................................    (5,689)   (5,858)     (477)
  Prepaids and other.............................       (64)     (133)     (520)
  Participation units............................      (361)   (5,325)      --
  Accounts payable...............................    (1,671)    1,993       788
  Deferred revenue...............................       288     1,478       --
  Accrued liabilities............................     2,389     1,996       748
                                                   --------  --------  --------
   Net cash used in operating activities.........   (32,110)  (29,909)  (12,000)
                                                   --------  --------  --------
CASH FLOWS FROM INVESTING ACTIVITIES:
 Acquisition of property and equipment...........    (3,271)   (7,817)   (3,013)
 Proceeds from sale of assets....................       127       --          7
 Purchases of short-term investments.............       --     (6,725)  (14,310)
 Sales and maturities of short-term investments,
  net............................................     4,704    11,681     4,650
 Other assets, net...............................      (315)     (216)        9
                                                   --------  --------  --------
   Net cash provided by (used in) investing
    activities...................................     1,245    (3,077)  (12,657)
                                                   ========  ========  ========
CASH FLOWS FROM FINANCING ACTIVITIES:
 Proceeds from debt financing and issuance of
  warrants, net of costs.........................    14,950    23,055       --
 Sale of Common Stock, net.......................     1,146       893    32,858
 Sale of Redeemable Convertible Preferred Stock,
  net of issuance costs..........................       --        --     14,457
 Collection of note receivable...................        79        14         1
 Proceeds from notes payable.....................     3,586       --        --
 Repayment of notes payable......................      (564)      --        --
 Proceeds from line of credit....................     4,000       --        --
 Proceeds from sale/leaseback of property and
  equipment......................................       --        --        667
 Repayment of capital lease obligation...........      (285)     (207)     (142)
                                                   --------  --------  --------
   Net cash provided by financing activities.....    22,912    23,755    47,841
                                                   --------  --------  --------
NET INCREASE (DECREASE) IN CASH AND EQUIVALENTS..    (7,953)   (9,231)   23,184
CASH AND EQUIVALENTS:
 Beginning of period.............................    16,352    25,583     2,399
                                                   --------  --------  --------
 End of period...................................  $  8,399  $ 16,352  $ 25,583
                                                   ========  ========  ========
SUPPLEMENTARY DISCLOSURES OF CASH FLOW
 INFORMATION--
 Cash paid during the period for interest........  $    360  $    106  $     70
                                                   ========  ========  ========
NONCASH INVESTING AND FINANCING ACTIVITIES:
 Issuance of Common and Preferred Stock for notes
  receivable.....................................  $    --   $    --   $    152
                                                   ========  ========  ========
 Issuance of Common Stock warrants...............  $  1,466  $  3,082  $    --
                                                   ========  ========  ========
 Conversion of Preferred Stock to Common Stock...  $  1,399  $  3,390  $ 16,748
                                                   ========  ========  ========
 Net exercise of Common Stock warrants...........  $     25  $    --   $    --
                                                   ========  ========  ========
</TABLE>
 
                See Notes to Consolidated Financial Statements.
 
                                       43
<PAGE>
 
                             SILICON GAMING, INC.
 
                  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.
 
   Basis of Presentation--The accompanying consolidated financial statements
have been prepared assuming that the Company will continue as a going concern.
The Company has incurred operating losses every year since its inception and
at December 31, 1998 had an accumulated deficit of $80,270,000 of a
shareholders' deficiency of $18,452,000. The Company has been required to
obtain additional financing every year to be able to fund its ongoing
operations. As of December 31, 1998 the Company was not in compliance with the
terms of its line of credit and had overdrawn its credit facility by
$1,457,000, and its cash and equivalents had decreased to $8,399,000. Based on
historical levels of cash useage, the above factors raise substantial doubt
about the Company's ability to continue as a going concern. In the fourth
quarter of 1998 the Company took steps to reduce the level of operating
expenses and made a number of management decisions which resulted in a
reduction of the Company's workforce by approximately 20% and cuts in
expenditures across the Company.The Company continued to evaluate further
possible ways to reduce operating expenses through outsourcing of different
parts of its business and further downsizing of its workforce. In March 1999
management reduced the size of the Company's workforce by an additional 40%
and made additional cuts to operating expenses.Management also announced in
March 1999 the relocation of its manufacturing to its Las Vegas, Nevada
facility and the closure of its Mountain View, California manfacturing
facility (see Note 11). Management is currently attempting to renegotiate the
terms of its line of credit with its bank so that additional funds will become
available to the Company. Management is also reviewing financing and other
strategic alternatives available to the Company such as additional share or
debt offerings, joint ventures, alternative distribution channels and sale of
all or part of the Company's assets to improve the Company's liquidity
position. Management believes that these steps, plus sales related to proposed
new product introductions will provide sufficient cash and working capital for
the Company to meet its ongoing obligations and to allow it to continue
operating as a going concern through at least the end of 1999. The
accompanying consolidated financial statements do not include any adjustments
that might result from the outcome of this uncertainty.
 
   Consolidation--The consolidated financial statements include the Company
and its wholly-owned subsidiaries 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 amounts of revenues and 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. Any gains or losses on the sale of debt
securities are determined on a specific identification basis.
 
   Investments to Fund Jackpot Winners--The Company maintains interest-bearing
deposits which are restricted to meet its obligations for making payments to
jackpot winners from the Company's wide-area progressive system. When a
jackpot is won, the Company will use these proceeds to purchase investments or
 
                                      44
<PAGE>
 
                             SILICON GAMING, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
annuities to meet its periodic payment obligations, or will offer the customer
funds equivalent to the present value of the jackpot prize.
 
   Fair Value of Financial Instruments--The estimated fair value of the
Company's financial instruments, which include cash equivalents, short-term
investments, and investments to fund jackpot winners, approximate their
carrying value. The fair value of the Company's Senior Discount Notes may be
lower than the recorded value but the Company is unable to determine the fair
value at this time.
 
   Inventories--Inventories consist of raw materials, work-in-process and
finished goods and are stated at the lower of cost or market on a first-in,
first-out basis.
 
   Property and Equipment--Property and equipment are stated at cost.
Depreciation and amortization are computed using the straight-line method over
estimated useful lives between eighteen months and seven years. Leasehold
improvements are amortized using the straight-line method over the shorter of
the lease term or the asset's useful life. The Company places gaming machines
and related equipment in customer locations on its participation program or
under its wide-area progressive system and receives a portion of the net win
from each machine. Depreciation of units under such arrangements is the
greater of the ratio that current gross revenue bears to total anticipated
revenue for such unit or straight-line over three years. Ancillary gaming
equipment such as signs and chairs are depreciated over an eighteen-month
period.
 
   Revenue Recognition--Revenue from hardware units and non-renewable software
licenses is recognized upon acceptance by the customer after completion of a
trial period, or upon shipment of the hardware. Renewable software licenses
are recognized ratably over the license period. Amounts due the Company under
revenue participation plans with its customers and from the wide-area
progressive systems are recognized ratably based on the Company's share of
gaming machine play.
 
   Concentration of Credit Risk--Financial instruments which potentially
subject the Company to concentrations of credit risk consist primarily of cash
equivalents, short-term investments, and trade accounts receivable. The
Company invests only in high credit quality short-term debt. The Company
performs ongoing credit evaluations of its customers' financial condition and
limits the amount of credit extended when deemed necessary but generally
requires no collateral. The Company maintains reserves for estimated potential
credit losses. At December 31, 1998, two customers accounted for 16% and 13%
of accounts receivable. A significant portion of the Company's revenues are
concentrated with a small number of strategic customers. For the year ended
December 31, 1998, two customers accounted for 11% and 10% of revenue and the
Company's top 10 customers represented 67% of revenue. In 1997 three different
customers accounted for 27%, 12% and 12% of revenue.
 
   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.
 
   Jackpot Liabilities--Under the Company's wide-area progressive system, the
Company receives a percentage of the amount played on the system to fund the
related jackpot payments. Jackpot liabilities in the amount of the present
value of the jackpot are recorded concurrently with the recognition of the
related revenue. At December 31, 1998, jackpot liabilities representing
amounts accrued for jackpots not yet won that are contractual obligations of
the Company are included in Accrued liabilities. The Company is required to
maintain cash and investments relating to wide-area progressive liabilities in
separate accounts.
 
                                      45
<PAGE>
 
                             SILICON GAMING, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
   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 ("APB 25"). The Company adopted the
disclosure requirements of Statement of Financial Accounting Standards No.
123, Accounting for Stock-Based Compensation, ("SFAS 123"), which require the
disclosure of pro forma net income and earnings per share as if the Company
adopted the fair value-based method in measuring compensation expense as of
the beginning of fiscal 1995.
 
   Net Loss Per Share--During the fourth quarter of 1997, the Company adopted
Statement of Financial Accounting Standards No. 128, Earnings per Share ("SFAS
128"), which replaces the previously reported primary and fully diluted
earnings per share with basic and diluted earnings per share and requires a
dual presentation of basic and diluted EPS. Basic EPS excludes dilution and is
computed by dividing net income by the weighted average of common shares
outstanding for the period. Diluted EPS reflects the potential dilution that
would occur if securities or other contracts to issue Common Stock were
exercised or converted into Common Stock. Common share equivalents including
stock options, warrants and Redeemable Convertible Preferred Stock have been
excluded for all periods presented, as their effect would be antidilutive.
 
   The following is a reconciliation of the numerators and denominators of the
basic and diluted net loss per share computations (in thousands except per
share amounts):
 
<TABLE>
<CAPTION>
                                                       Year Ended December 31,
                                                       -----------------------
                                                        1998    1997    1996
                                                       ------- ------- -------
   <S>                                                 <C>     <C>     <C>
   Net Loss (Numerator):
   Net loss, basic and diluted........................ $37,670 $22,986 $13,634
                                                       ======= ======= =======
   Shares (Denominator):
   Weighted average common shares outstanding.........  14,047  11,418   6,433
   Weighted average common shares outstanding subject
    to repurchase.....................................     351     752   1,069
   Shares used in computation, basic and diluted......  13,696  10,666   5,364
                                                       ======= ======= =======
   Net Loss Per Share, Basic and Diluted.............. $  2.75 $  2.16 $  2.54
                                                       ======= ======= =======
</TABLE>
 
   Recently Issued Accounting Standard--In the first quarter of 1998, the
Company adopted Statement of Financial Accounting Standards No. 130,
"Reporting Comprehensive Income", which requires an enterprise to report, by
major components and as a single total, the change in its net assets during
the period from nonowner sources.
 
   In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 131, "Disclosures about Segments of an
Enterprise and Related Information", which establishes annual and interim
reporting standards for an enterprise's business segments and related
disclosures about its products, services, geographic areas, and major
customers. For the year ended December 31, 1998, the Company operated in one
business segment.
 
   In June 1998, the FASB issued Statement of Financial Accounting Standards
No. 133, "Accounting for Derivative Instruments and Hedging Activities." This
statement requires companies to record derivatives on the balance sheet as
assets or liabilities measured at fair value. Adoption of this standard has no
impact upon the Company's consolidated financial position, results of
operations or cash flows as the Company does not currently have any derivative
financial instruments covered by this standard.
 
                                      46
<PAGE>
 
                             SILICON GAMING, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
   Reclassifications--Certain prior year amounts have been reclassified to
conform to the current year presentation.
 
2. Short-term investments
 
   Short-term investments consist of the following securities:
 
<TABLE>
<CAPTION>
                                                         Unrealized Unrealized
                                        Amortized Market  Holding    Holding
     December 31, 1997:                   Cost    Value    Gains      Losses
     ------------------                 --------- ------ ---------- ----------
                                                    (in thousands)
     <S>                                <C>       <C>    <C>        <C>
     Available-for-sale corporate debt
      securities.......................  $4,704   $4,705    $ 2        $ 1
                                         ======   ======    ===        ===
</TABLE>
 
   Realized gains or losses on sales of available-for-sale securities for the
year ended December 31, 1998 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. Inventories
 
   Inventories are stated at the lower of cost (first-in, first-out) or market
and consist of the following:
 
<TABLE>
<CAPTION>
                                                                   December 31,
                                                                  --------------
                                                                   1998    1997
                                                                  ------- ------
                                                                  (In thousands)
     <S>                                                          <C>     <C>
     Raw materials............................................... $ 4,294 $3,028
     Work in process.............................................      93    468
     Finished goods..............................................   7,637  2,839
                                                                  ------- ------
                                                                  $12,024 $6,335
                                                                  ======= ======
</TABLE>
 
   Finished goods includes completed finished goods and units on trial.
 
4. Property and equipment
 
   Property and equipment consists of:
 
<TABLE>
<CAPTION>
                                                                December 31,
                                                               ----------------
                                                                1998     1997
                                                               -------  -------
                                                               (In thousands)
     <S>                                                       <C>      <C>
     Furniture, fixtures and office equipment................. $ 1,586  $ 1,375
     Computer equipment.......................................   9,292    7,158
     Manufacturing equipment..................................   1,954    1,425
     Gaming machines & equipment..............................   6,230    5,869
     Leasehold improvements...................................   1,445    1,140
                                                               -------  -------
                                                                20,507   16,967
     Accumulated depreciation and amortization................  (7,585)  (3,298)
                                                               -------  -------
                                                               $12,922  $13,669
                                                               =======  =======
</TABLE>
 
   Included in property and equipment at December 31, 1998 and 1997 are assets
leased under capital leases of $1,000,000 net of accumulated depreciation of
$792,000 and $702,000 as of December 31, 1998 and 1997, respectively. Gaming
machines and equipment include 160 units of wide-area progressive machines. In
January, 1999, 142 of these machines were returned to the Company following a
decision by management to modify the initial game that was released on the
wide-area progressive system.
 
                                      47
<PAGE>
 
                             SILICON GAMING, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
5. Accrued liabilities
 
   Accrued liabilities consists of:
 
<TABLE>
<CAPTION>
                                                                  December 31,
                                                                  -------------
                                                                   1998   1997
                                                                  ------ ------
                                                                       (In
                                                                   thousands)
     <S>                                                          <C>    <C>
     Accrued compensation benefits............................... $  958 $1,330
     Accrued inventory related costs.............................  1,100    --
     Accrued royalties...........................................  1,811    --
     Accrued interest expense....................................  2,782    --
     Other accrued liabilities...................................  1,503  1,653
                                                                  ------ ------
                                                                  $8,154 $2,983
                                                                  ====== ======
</TABLE>
 
6. Leases
 
   The Company leases its facilities under noncancellable operating lease
agreements. The accompanying statements of operations reflect rent expense on
a straight-line basis over the term of the leases. The difference between
straight-line rent expense and actual cash payments is recorded as deferred
rent.
 
   Future minimum operating commitments at December 31, 1998 are as follows:
 
<TABLE>
<CAPTION>
                                                                    Operating
                                                                      Leases
                                                                  --------------
                                                                  (in thousands)
     <S>                                                          <C>
     1999........................................................     $1,252
     2000........................................................      1,254
     2001........................................................      1,266
     2002........................................................      1,292
     2003........................................................        979
     Thereafter..................................................      2,126
                                                                      ------
     Total minimum lease payments................................     $8,169
                                                                      ======
</TABLE>
 
   Rent expense (including prorated common area maintenance charges and
utilities) for the years ended December 31, 1998, 1977 and 1996 was
$1,310,000, $975,000 and $469,000, respectively.
 
7. Borrowing arrangements
 
   In April 1998, the Company entered into a $10 million secured revolving
line of credit agreement based on the Company's eligible accounts receivable,
which expires December 31, 1999. Borrowings bear interest at the bank's prime
rate (7.75% at December 31, 1998) plus 1%. As of December 31, 1998 the Company
had $4,000,000 outstanding under this agreement. The line of credit agreement
requires the Company to comply with certain financial covenants. As of
December 31, 1998 the Company was not in compliance with certain covenants
related to working capital and minimum quarterly net income and had overdrawn
funds based on eligible accounts receivable by $1,457,000. The bank has
subsequently collected the overdrawn funds from the Company.
 
                                      48
<PAGE>
 
                             SILICON GAMING, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
   Borrowing arrangements consist of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                             December 31,
                                                            ----------------
                                                             1998     1997
                                                            -------  -------
     <S>                                                    <C>      <C>
     Senior Discount Notes ($47.25 million and $30 million
      principal obligation, respectively).................. $37,716  $22,277
     Capital lease obligations.............................     360      645
     Other long-term obligations...........................   3,022      --
                                                            -------  -------
                                                             41,098   22,922
     Current obligation....................................  (1,289)    (285)
                                                            -------  -------
     Long-term portion..................................... $39,809  $22,637
                                                            =======  =======
</TABLE>
 
   Future minimum debt commitments at December 31, 1998 are as follows (in
thousands):
 
<TABLE>
<CAPTION>
                                        Senior           Other Long
                                       Discount  Capital    Term
                                        Notes    Leases  Obligations Total Debt
                                       --------  ------- ----------- ----------
     <S>                               <C>       <C>     <C>         <C>
     1999............................  $  2,953   $327     $1,308     $  4,588
     2000............................     5,906     56      1,308        7,270
     2001............................    13,906    --         890       14,796
     2002............................    45,633    --         229       45,862
     2003............................       --     --         --           --
     Thereafter......................       --     --         --           --
                                       --------   ----     ------     --------
       Total minimum payments........    68,398    383      3,735       72,516
     Amount representing interest or
      future discount................   (30,682)   (23)      (713)     (31,418)
                                       --------   ----     ------     --------
     Present value of debt payments..    37,716    360      3,022       41,098
     Current portion.................       --     305        984        1,289
                                       --------   ----     ------     --------
     Long-term portion...............  $ 37,716   $ 55     $2,038     $ 39,809
                                       ========   ====     ======     ========
</TABLE>
 
   On September 30, 1997, the Company completed the private placement of $30
million principal obligation Senior Discount Notes (the "1997 Notes") due
September 30, 2002. In July, 1998 the Company sold an additional $17.25
million principal amount to the same Investors (the "1998 notes"). Commencing
January 1, 1999 the Notes bear interest at 12.5% per annum, payable semi-
annually. The Company is required to redeem $8 million in principal on
September 30, 2001. The Company is permitted to raise additional proceeds from
debt or equity securities of up to $40 million before mandatory redemption of
the Notes. The Notes are callable at the option of the Company at any time,
with an initial redemption price of 93.13% of the aggregate amount as of
December 31, 1998, increasing to 100% over 9 months. In connection with the
offerings, purchasers of the 1998 Notes were issued warrants to purchase
250,000 shares of the Company's Common Stock at a per share price of $8.00.
Additionally, the exercise price of the 375,000 warrants issued in connection
with the September 1997 $30 million Senior Discount Notes was also adjusted
from a per-share price of $15.4375 to a per-share price of $8.00. The value
ascribed to the warrants and to the repricing of the September 1997 warrants
was $1,466,000. Gross proceeds to the Company before fees and expenses were
$25 million in 1997 and $15 million in 1998. The resulting debt discount of
$11,798,250 is being accreted as an addition to interest expense over the term
of the Notes using the effective interest method. Offering costs of $1,945,000
in 1997 and $50,000 in 1998 are included in other assets and are being
amortized as an adjustment to interest expense over the term of the Notes. The
Notes require the Company to comply with certain financial covenants with
which the Company was in compliance as of December 31, 1998.
 
                                      49
<PAGE>
 
                             SILICON GAMING, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
   In June 1998, the Company entered into a secured equipment loan with
available credit of up to $3 million. Borrowings bear interest at 14% per
annum for a term of 42 months. As of December 31, 1998, the Company had
$1,562,000 outstanding under this agreement. The agreement requires the
Company to comply with certain financial covenants, with which the Company was
in compliance as of December 31, 1998.
 
   In March 1998, the Company entered into a secured equipment term loan with
available credit up to $2 million. Borrowings bear interest at 11% per annum
for a term of 36 months. As of December 31, 1998 the Company had $1,698,000
outstanding under this agreement. The agreement requires the Company to comply
with certain financial covenants, with which the Company was in compliance as
of December 31, 1998.
 
8. Redeemable convertible preferred stock
 
   At December 31, 1998, the Company had the following shares of Nonvoting
Redeemable Convertible Preferred Stock outstanding:
 
<TABLE>
<CAPTION>
                                                                   Amount, net
                                                        Shares      of notes
                                                      Outstanding  receivable
                                                      -----------  -----------
                                                       (In thousands, except
                                                           share and per
                                                          share amounts)
   <S>                                                <C>          <C>
   Series A1:
     Conversion of Series A to Series A1 in 1996.....  1,998,332      1,499
     Conversion to 1,219,032 shares of Common Stock
      in 1997........................................ (1,828,549)    (1,371)
     Conversion to 113,189 shares of Common Stock in
      1998...........................................   (169,783)      (128)
                                                      ----------     ------
                                                             --         --
                                                      ----------     ------
   Series B1:
     Conversion of Series B to Series B1 in 1996.....  4,386,141      4,956
     Conversion to 1,191,000 shares of Common Stock
      in 1997........................................ (1,786,500)    (2,019)
     Conversion to 750,000 shares of Common Stock in
      1998........................................... (1,125,000)    (1,271)
                                                      ----------     ------
                                                       1,474,641      1,666
                                                      ==========     ======
   Total Balance, December 31, 1998..................  1,474,641     $1,666
                                                      ==========     ======
</TABLE>
 
   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.
 
   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, 1998.
 
                                      50
<PAGE>
 
                             SILICON GAMING, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
   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.
 
9. 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, 1998, Common
Stock was reserved for issuance as follows:
 
<TABLE>
   <S>                                                              <C>
   Conversion of outstanding Redeemable Convertible Preferred
    Stock..........................................................   983,143
   Issuable under stock purchase warrants..........................   919,443
   Stock Option Plans.............................................. 2,857,324
   Employee Stock Purchase Plans...................................   498,298
                                                                    ---------
                                                                    5,258,208
                                                                    =========
</TABLE>
 
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 1998, the Company issued warrants to purchase 250,000 shares of
Common Stock at $8.00 per share in conjunction with the issuance and sale of
the Company's 1998 Senior Discount Notes (See Note 7). These warrants expire
on September 30, 2002. During 1997, the Company issued warrants to purchase
375,000 shares of Common Stock at $15.4375 per share in conjunction with the
issuance and sale of the Company's 1997 Senior Discount Notes (see Note 7).
These warrants were repriced to $8.00 per share in connection with the
issuance of the Company's 1998 Senior Discount Notes. The warrants expire on
September 30, 2002. 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 and expire in 2001. 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.
 
   In October 1995 the Company obtained a lease line of credit and granted the
leasing company a 5-year warrant to purchase 40,936 shares of Common Stock at
a price of $1.71 per share; such warrant was net-exercised by the holder in
March, 1998.
 
Stock Option Plans
 
   Under the 1994 Stock Option Plan (the "1994 Option Plan"), the Company may
grant incentive or nonstatutory stock options up to 3,892,655 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
 
                                      51
<PAGE>
 
                             SILICON GAMING, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
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.
 
   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 ratably over three years and expire
ten years from the date of grant. The number of shares authorized under this
plan is 200,000.
 
   In 1997, the Board of Directors adopted the 1997 Nonstatutory Stock Option
Plan (the "1997 Option Plan"). Under this plan, the Company may grant
nonstatutory stock options for up to 390,000 shares of Common Stock to
employees and consultants at prices not less than 85% of fair market value on
the effective date of the grant. These options generally expire ten years from
the date of grant and are immediately exercisable.
 
   The Company repriced outstanding options to purchase 1,013,202 shares to
$9.125, the current market price on January 9, 1998. The Company subsequently
repriced outstanding options to purchase 1,615,505 shares to $4.00, the
current market price on September 11, 1998. In connection with the September
11, 1998 option repricing, employees were restricted from exercising options
for a period of six months from the date of the repricing. Otherwise the
options retain all other original terms. In addition, on December 1, 1998, the
Company repriced 75,000 options to the Company's acting Chief Executive
Officer from $6.00 to $1.875. The fair value of this grant after repricing was
estimated to be $371,000. The Company recorded compensation expense of
$326,000 during the third quarter of 1998 in connection with severance
packages to former management of the Company. All of the above repriced
options are shown as cancelled and regranted in the following table.
 
   Option activity under the 1994 Option Plan, Directors Plan, and 1997 Option
Plan is as follows:
 
<TABLE>
<CAPTION>
                                                                   Weighted
                                                      Number       Average
                                                    of Shares   Exercise Price
                                                    ----------  --------------
     <S>                                            <C>         <C>
     Outstanding, January 1, 1996..................    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
     Granted (weighted average fair value of
      $7.49).......................................  1,150,385      15.02
     Exercised.....................................    (49,083)      4.13
     Cancelled.....................................    (39,529)     12.01
                                                    ----------      -----
     Outstanding, December 31, 1997................  1,897,176      11.36
     Granted (weighted average fair value of
      $4.29).......................................  3,759,563       5.85
     Exercised.....................................    (97,400)      2.23
     Cancelled..................................... (3,605,166)      9.84
                                                    ----------      -----
     Outstanding, December 31, 1998................  1,954,173      $4.09
                                                    ==========      =====
</TABLE>
 
                                      52
<PAGE>
 
                             SILICON GAMING, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
   Additional information regarding options outstanding as of December 31,
1998, is as follows:
 
                    Options Outstanding Options Exercisable
 
<TABLE>
<CAPTION>
                                               Weighted
                                   Number       Average   Weighted    Number     Weighted
                                 Outstanding   Remaining  Average   Exercisable  Average
                                    as of     Contractual Exercise     as of     Exercise
     Range of Exercise Prices   Dec. 31, 1998 Life (yrs)   Price   Dec. 31, 1998  Price
     ------------------------   ------------- ----------- -------- ------------- --------
     <S>                        <C>           <C>         <C>      <C>           <C>
     $  0.105 -- $  1.500....       128,995      7.23      $ 1.38      128,995    $ 1.38
     $  1.875 -- $  1.875....       326,037      9.85        1.88      326,037      1.88
     $  2.375 -- $  3.750....        40,250      9.74        3.33       40,250      3.33
     $  4.000 -- $  4.000....     1,295,457      8.62        4.00    1,295,457      4.00
     $  4.250 -- $  9.375....        42,334      5.30        6.96       26,222      5.47
     $ 10.500 -- $ 10.500....        45,000      7.58       10.50       36,249     10.50
     $ 11.750 -- $ 11.750....         1,100      8.38       11.75        1,100     11.75
     $ 12.250 -- $ 12.250....        15,000      1.39       12.25        7,914     12.25
     $ 14.500 -- $ 14.500....        45,000      8.29       14.50       45,000     14.50
     $ 18.750 -- $ 18.750....        15,000      8.18       18.75        8,750     18.75
                                  ---------      ----      ------    ---------    ------
     $  0.105 -- $ 18.750....     1,954,173      8.59      $ 4.09    1,915,974    $ 3.94
</TABLE>
 
   At December 31, 1998, 674,651, 105,000, and 123,500 shares were available
for future grants under the 1994 Option Plan, Directors Plan, and 1997 Option
Plan respectively. At December 31, 1998, 153,547 shares exercised were subject
to repurchase. As of December 31, 1997 and 1996, 1,826,896 and 835,403 shares
respectively were exercisable with a weighted average exercise price of $11.27
and $6.35, respectively.
 
Employee Stock Purchase Plan
 
   In 1996, the Board of Directors adopted the 1996 Employee Stock Purchase
Plan (the "1996 Purchase Plan"). Under the 1996 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. Due to insufficient
shares remaining in the 1996 Purchase Plan, in 1998 the Board of Directors
adopted the 1998 Employee Stock Purchase Plan (the "1998 Purchase Plan").
Under the 1998 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 or the end of the
6-month offering period, subject to certain limitations. At December 31, 1998,
251,702 shares had been issued under both of the Purchase Plans and 498,298
shares were reserved for further issuance. The weighted average fair value of
those purchase rights granted in 1998, 1997 and 1996 was $3.73, $3.52 and
$2.66, respectively. The Company's calculations were made using the Black-
Scholes option pricing model with the following weighted average assumptions:
expected life of one year for all years; expected interest rate of 5.7%, 6.2%
and 5.4% for 1998, 1997 and 1996, respectively; expected volatility of 75% in
1998, 65% in 1997 and 39.2% subsequent to the initial public filing in July
1996; and no dividends during the expected term.
 
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
and its related interpretations. Accordingly, no compensation expense has been
recognized in the financial statements for employee stock arrangements.
 
                                      53
<PAGE>
 
                             SILICON GAMING, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
   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 stock option 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
volatility, 75% in 1998, 65% in 1997 and 39.2% subsequent to the initial
public filing in July 1996; risk-free interest rates, 5.7% in 1998, 6.2% in
1997, 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
stock-based awards (including awards under the Purchase Plan) had been
amortized to expense over the vesting period of the awards, pro forma net loss
would have been $44,673,000 ($3.26 loss per share) in 1998, $26,815,000 ($2.51
loss per share) in 1997, and $14,345,000 ($2.68 loss per share) in 1996.
 
10. 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, 1998 and 1997 are as follows:
 
<TABLE>
<CAPTION>
                                                                December 31,
                                                               ----------------
                                                                1998     1997
                                                               -------  -------
                                                               (in thousands)
     <S>                                                       <C>      <C>
     Net deferred tax assets:
       Net operating losses................................... $25,596  $15,696
       Research and development credits.......................   1,140      963
       Capitalized research and development costs.............     895      480
       Accruals deductible in different periods...............   4,204      881
       Depreciation and amortization..........................    (250)    (415)
                                                               -------  -------
                                                                31,585   17,605
     Valuation allowance...................................... (31,585) (17,605)
                                                               -------  -------
     Total.................................................... $    --  $    --
                                                               =======  =======
</TABLE>
 
   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, 1998 and 1997, respectively.
 
   At December 31, 1998, the Company had net operating loss carryforwards of
approximately $69,100,000 and $35,800,000 for federal and state income tax
purposes, respectively. These carryforwards begin to expire in 2000. Net
operating losses of approximately $950,000 for federal and state tax purposes
attributable to the tax benefit relating to the exercise of nonqualified stock
options and disqualifying dispositions of incentive stock options are excluded
from the components of deferred income tax assets. The tax benefits associated
with this net operating loss will be recorded as an adjustment to
shareholders' equity when the Company generates taxable income.
 
                                      54
<PAGE>
 
                             SILICON GAMING, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
   The Company also has research and development credit carryforwards of
approximately $815,000 and $720,000 available to offset future federal and
state income taxes, respectively, as of December 31, 1998. These carryforwards
begin to expire in 2010.
 
   The Tax Reform Act of 1986 and the California Act of 1987 impose
restrictions on the utilization of net operating loss and tax credit
carryforwards in the event of an "ownership change" as defined by the Internal
Revenue Code. The Company's ability to utilize its net operating loss and tax
credit carryforwards is subject to limitation pursuant to these restrictions.
As of March 31, 1998, approximately $4 million of the Company's net operating
loss carryforwards was subject to such limitation and is dependent on the
Company's future profitability and the utilization of its net operating loss
carryforwards over a period of time.
 
11. Subsequent events
 
   In February 1999 the Company filed a complaint against International Game
Technology, Inc. (IGT) seeking a declaration of noninfringement and invalidity
of US Patent no. 5,823,873, describing a method of playing electronic video
poker games. The suit was originally filed in the United States District Court
for the Northern District of California, as a result of threat of litigation
by IGT. IGT responded by filing a complaint in the District of Nevada alleging
infringement of the same patent. As that case has been transferred from Reno
to be heard in Las Vegas, the Company intends to dismiss the California action
and pursue its claims against IGT in the Las Vegas case. On March 16, 1999 the
Company was unsuccessful in preventing IGT from issuing a temporary
restraining order that prevents the Company from shipping the disputed product
until the injunction hearing that has been set for April 15, 1999 in Las
Vegas. If the Company is unsuccessful in preventing IGT from gaining an
injunction until the patent trial is heard, the Company will be prevented from
shipping the disputed product until such time as the patent trial is resolved.
Management believes that the patent trial would be at least two to five months
after the April 15 hearing. The claims in the lawsuit relate to a game that
the Company released in February 1999 called Multi-Draw Poker. The Company's
management strongly denies the assertions of infringement and in the
litigation has asked the court to rule that its game does not infringe. The
costs of defending this suit may be substantial and may require significant
amounts of senior management time, and an adverse result in such litigation
could materially and adversely affect the Company's liquidity and capital
resources. No adjustments have been made in the accompanying consolidated
financial statements relating to this litigation.
 
   On March 12, 1999 the Company announced the closure of its Mountain View
California-based manufacturing operations and the relocation of its
manufacturing activities to its Las Vegas, Nevada, facility. The Company also
announced the elimination of 66 positions or 40% of the Company's workforce.
In connection with the elimination of positions, the Company offered 225,000
fully-vested shares to these employees as part of their severance. The Company
also has granted additional options to purchase 2,565,000 shares of common
stock to remaining employees and consultants during March, 1999.
 
                                      55
<PAGE>
 
                         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. and subsidiaries as of December 31, 1998 and 1997, and the
related consolidated statements of operations, shareholders' equity
(deficiency) and cash flows for each of the three years in the period ended
December 31, 1998. Our audits also included the consolidated financial
statement schedule listed in Item 14(a)2. 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, 1998 and 1997, and the results of their
operations and their cash flows for each of the years in the period ended
December 31, 1998 in conformity with generally accepted accounting principles.
Also, in our opinion, such financial statement schedule, when considered in
relation to the basic consolidated financial statements taken as a whole,
present fairly in all material respects the information set forth therein.
 
   The accompanying consolidated financial statements have been prepared
assuming that the Company will continue as a going concern. As discussed in
Note 1 to the consolidated financial statements, the Company's recurring
losses from operations and shareholders' deficiency raise substantial doubt
about its ability to continue as a going concern. Management's plans
concerning these matters are also described in Note 1. The financial
statements do not include any adjustments that might result from the outcome
of this uncertainty.
 
Deloitte & Touche LLP
 
San Jose, California
January 29, 1999
(March 12, 1999
 as to Note 11)
 
                                      56
<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 1999 Annual
Meeting of Shareholders (the "Proxy Statement"), which the Company intends to
file not more 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 1999 annual meeting of shareholders (the "Proxy
Statement") and the information set forth in Item 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.
 
                                      57
<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. See the Index to Consolidated
  Financial Statements and Supplementary data at page 39 of this Form 10-K.
 
     (2) Financial Statement Schedule.
 
     Schedule II - Valuation and Qualifying Accounts and Reserves
 
     (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,
  1998.
 
                                       58
<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 31st day of March, 1999.
 
                                          Silicon Gaming, Inc.
 
                                          By /s/ David S. Morse
                                          _____________________________________
                                                     David S. Morse
                                                  Chairman of the Board
 
   Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
 
<TABLE>
<CAPTION>
             Signature                           Title                    Date
             ---------                           -----                    ----
 
<S>                                  <C>                           <C>
/s/ David S. Morse                   Chairman of the Board           March 31, 1999
____________________________________
   David S. Morse
 
/s/ Andrew S. Pascal                 President, Chief Executive      March 31, 1999
____________________________________ Officer, Acting Chief
   Andrew S. Pascal                  Financial Officer (Principal
                                     Financial and Accounting
                                     Officer) and director
 
/s/ William Hart                     Director                        March 31, 1999
____________________________________
   William Hart
 
/s/ Kevin R. Harvey                  Director                        March 31, 1999
____________________________________
   Kevin R. Harvey
 
/s/ Thomas J. Volpe                  Director                        March 31, 1999
____________________________________
   Thomas J. Volpe
</TABLE>
 
                                       59
<PAGE>
 
                                                                     Schedule II
 
                 VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
 
                        For the Years Ended December 31,
                             (dollars in thousands)
 
<TABLE>
<CAPTION>
                                                  Additions
                                                   charged
                                       Balance at to costs              Balance
                                       beginning     and                at end
Description                            of period  expenses  Deductions of period
-----------                            ---------- --------- ---------- ---------
<S>                                    <C>        <C>       <C>        <C>
Year ended December 31, 1998:
  Allowance for doubtful accounts.....    $ 50     $1,600      $ --     $1,650
Year ended December 31, 1997:
  Allowance for doubtful accounts.....    $ --     $   50      $ --     $   50
Year ended December 31, 1996:
  Allowance for doubtful accounts.....    $ --     $   --      $ --     $   --
</TABLE>
 
                                      S-1
<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 (5)  Amendment No. 1 to Securities Purchase Agreement, by and between the
            Company B III Capital Partners, L.P., a Delaware limited
            partnership dated as of July 8, 1998.
 
  4.2 (5)  Form of Senior Discount Notes (Series B) due September 30, 2002
            dated as of July 8, 1998.
 
  4.3 (5)  Registration Rights Agreement dated July 8, 1998, by and between the
            Company and B III Capital Partners, L.P., a Delaware limited
            partnership.
 
  4.4 (5)  Amended and Restated Warrant Agreement including Form of Common
            Stock Purchase Warrant Certificate No. W-2 dated as of July 8,
            1998, 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(6)  Lease Agreement dated October 7, 1997 between the Registrant and
            Battle Born Development, LLC.
 
 10.27(6)  1997 Nonstatutory Stock Option Plan.
 
 10.32 (6) Loan and Security Agreement dated November 25, 1997, by and between
            the Company and Silicon Valley Bank.
 
 10.33 (6) Loan Modification Agreement dated April 23, 1998, by and between the
            Company and Silicon Valley Bank.
</TABLE>
<PAGE>
 
<TABLE>
 
<CAPTION>
  Exhibit  Description
  -------  -----------
 <C>       <S>
 10.34 (6) Pledge Agreement dated December 1997 by and between the Company and
            Silicon Valley Bank.
 
 10.35 (6) Intellectual Property Security Agreement dated November 25, 1997, by
            and between the Company and Silicon Valley Bank.r 25, 1997, by and
            between the Company and Silicon Valley Bank.
 
 10.36 (7) See Exhibit 4.1.
 
 10.37 (7) See Exhibit 4.2.
 
 10.38 (7) See Exhibit 4.3.
 
 10.39 (7) See Exhibit 4.4.
 
 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").
(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.
(5) Incorporated by reference to identically numbered exhibit in the
    Registrant's Form 8-K filed with the Commission on July 21, 1998.
(6) Incorporated by reference to identically numbered exhibit in the
    Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30,
    1998.
(7) Incorporated by reference to identically numbered exhibit in the
    Registrant's Quarterly Report on Form 10-Q for the quarter ended September
    30, 1998.