<PAGE>
 
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                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549
 
                               ----------------
 
                                   FORM 10-Q
 
(MARK ONE)
 
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
    EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 1998
 
                                      OR
 
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
    EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO
 
                        COMMISSION FILE NUMBER 0-28294
 
                               ----------------
 
                             SILICON GAMING, INC.
            (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
<TABLE>
 <S>                              <C>
           CALIFORNIA                               77-0357939
 (STATE OR OTHER JURISDICTION OF                 (I.R.S. EMPLOYER
 INCORPORATION OR ORGANIZATION)               IDENTIFICATION NUMBER)
</TABLE>
 
                             2800 W. BAYSHORE ROAD
                              PALO ALTO, CA 94303
                   (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
 
                           TELEPHONE: (650) 842-9000
             (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
 
                               ----------------
 
  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 the number of shares outstanding of each of the issuer's classes of
Common Stock, as of the latest practicable date.
 
  14,250,055 shares of Common Stock, $.001 par value, were outstanding as of
                                July 31, 1998.
 
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<PAGE>
 
                              SILICON GAMING, INC.
 
                         QUARTERLY REPORT ON FORM 10-Q
 
                       FOR THE PERIOD ENDED JUNE 30, 1998
 
                                     INDEX
 
<TABLE>
<CAPTION>
                                                                            PAGE
                                                                            ----
 <C>     <S>                                                                <C>
 PART I  FINANCIAL INFORMATION
 Item 1. Financial Statements:
         Consolidated Balance Sheets--June 30, 1998 and December 31,
         1997............................................................     3
         Consolidated Statements of Operations--Three months and six
         months ended June 30, 1998 and June 30, 1997....................     4
         Consolidated Statements of Cash Flows--Six months ended June 30,
         1998 and June 30, 1997..........................................     5
         Notes to Consolidated Financial Statements......................     6
 Item 2. Management's Discussion and Analysis of Financial Condition and
         Results of Operations...........................................     8
 PART II OTHER INFORMATION
 Item 4. Submission of Matters to a Vote of Security Holders.............    20
 Item 5. Other Information...............................................    20
 Item 6. Exhibits and Reports on Form 8-K................................    21
         Signature.......................................................    22
</TABLE>
 
                                       2
<PAGE>
 
                         PART I--FINANCIAL INFORMATION
 
ITEM 1. FINANCIAL STATEMENTS
 
                              SILICON GAMING, INC.
 
                          CONSOLIDATED BALANCE SHEETS
 
                       (IN THOUSANDS, EXCEPT SHARE DATA)
 
<TABLE>
<CAPTION>
                                                          JUNE 30,  DECEMBER 31,
                                                            1998        1997
                                                          --------  ------------
<S>                                                       <C>       <C>
                         ASSETS
 
CURRENT ASSETS:
  Cash and equivalents..................................  $  6,776    $ 16,352
  Short-term investments................................       --        4,705
  Accounts receivable (net of allowances of $200 and
   $50).................................................     7,764       4,930
  Inventories...........................................    13,866       6,335
  Prepaids and other....................................     1,192       1,334
                                                          --------    --------
    Total current assets................................    29,598      33,656
PROPERTY AND EQUIPMENT, NET.............................     8,888       8,844
PARTICIPATION UNITS, NET................................     3,733       4,825
OTHER ASSETS, NET.......................................     1,464       1,713
                                                          --------    --------
                                                          $ 43,683    $ 49,038
                                                          ========    ========
          LIABILITIES AND SHAREHOLDERS' EQUITY
 
CURRENT LIABILITIES:
  Accounts payable......................................  $  5,168    $  3,151
  Accrued liabilities...................................     4,466       2,983
  Deferred revenue......................................     1,236       1,478
  Current portion of long-term obligations..............     1,089         285
                                                          --------    --------
    Total current liabilities...........................    11,959       7,897
OTHER LONG-TERM LIABILITIES.............................       582       1,007
LONG-TERM OBLIGATIONS...................................    25,190      22,637
REDEEMABLE CONVERTIBLE PREFERRED STOCK--6,884,473 shares
 authorized at June 30, 1998; shares outstanding: June
 30, 1998--1,474,641; December 31, 1997--2,769,424......     1,666       3,065
SHAREHOLDERS' EQUITY
  Common Stock, $.001 par value; 50,000,000 shares
   authorized; shares outstanding: June 30, 1998--
   14,167,589; December 31, 1997--13,149,737............    56,160      54,131
  Warrants..............................................     3,107       3,107
  Notes receivable from shareholders....................      (189)       (207)
  Unrealized gain on investments........................       --            1
  Accumulated deficit...................................   (54,792)    (42,600)
                                                          --------    --------
    Total shareholders' equity..........................     4,286      14,432
                                                          --------    --------
                                                          $ 43,683    $ 49,038
                                                          ========    ========
</TABLE>
 
                See notes to consolidated financial statements.
 
                                       3
<PAGE>
 
                              SILICON GAMING, INC.
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
 
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
                                  (UNAUDITED)
 
<TABLE>
<CAPTION>
                                         THREE MONTHS ENDED  SIX MONTHS ENDED
                                              JUNE 30,           JUNE 30,
                                           1998      1997      1998     1997
                                         --------- --------- -------- --------
<S>                                      <C>       <C>       <C>      <C>
REVENUE:
  Hardware.............................. $   5,462 $  1,542  $  7,886 $  1,542
  Software..............................     1,941       31     2,661       31
  Participation.........................       858       92     1,740       92
                                         --------- --------  -------- --------
    Total revenue....................... $   8,261 $  1,665  $ 12,287 $  1,665
 
OPERATING EXPENSES:
  Cost of sales and related
   manufacturing expenses...............     5,836    2,321     9,026    3,262
  Research and development..............     2,838    2,429     5,554    4,436
  Selling, general and administrative...     3,922    3,120     7,873    5,246
                                         --------- --------  -------- --------
    Total costs and expenses............    12,596    7,870    22,453   12,944
                                         --------- --------  -------- --------
  Loss from operations..................     4,335    6,205    10,166   11,279
  Interest (income)/expense, net........     1,093 $   (268)    2,026 $   (680)
                                         --------- --------  -------- --------
NET LOSS................................ $   5,428 $  5,937  $ 12,192 $ 10,599
                                         ========= ========  ======== ========
Basic and diluted net loss per share.... $    0.39 $   0.58  $   0.91 $   1.06
                                         ========= ========  ======== ========
Shares used in computation..............    13,755   10,195    13,417    9,995
                                         ========= ========  ======== ========
</TABLE>
 
 
 
                See notes to consolidated financial statements.
 
                                       4
<PAGE>
 
                              SILICON GAMING, INC.
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
 
                                 (IN THOUSANDS)
                                  (UNAUDITED)
 
<TABLE>
<CAPTION>
                                                             SIX MONTHS ENDED
                                                                 JUNE 30,
                                                             ------------------
                                                               1998      1997
                                                             --------  --------
<S>                                                          <C>       <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
  Net loss.................................................. $(12,192) $(10,599)
  Reconciliation to net cash used in operating activities:
    Depreciation and amortization...........................    2,351       741
    Accrued interest........................................    1,344       --
    Accretion of debt discount..............................      736       --
    Deferred rent...........................................      106        92
    Provision for bad debt..................................      150       --
    Gain from disposal of property..........................      (28)      --
  Changes in assets and liabilities:
    Accounts receivable.....................................   (2,984)   (1,215)
    Inventories.............................................   (7,531)   (5,631)
    Prepaid and other.......................................      142      (805)
    Participation units.....................................      668       --
    Accounts payable........................................    2,017     1,344
    Accrued liabilities.....................................     (392)      562
    Deferred revenue........................................     (242)      371
                                                             --------  --------
      Net cash used in operating activities.................  (15,855)  (15,140)
                                                             --------  --------
CASH FLOWS FROM INVESTING ACTIVITIES:
  Acquisition of property and equipment.....................   (1,816)   (4,537)
  Proceeds from disposal of property and equipment..........       75       --
  Purchase of short-term investments........................      --     (2,977)
  Sales and maturities of short-term investments............    4,704     5,730
  Other Assets, net.........................................       47      (162)
                                                             --------  --------
      Net cash provided by (used in) investing activities...    3,010    (1,946)
                                                             --------  --------
CASH FLOWS FROM FINANCING ACTIVITIES:
  Sale of Common Stock, net of notes receivable.............      630       375
  Collection of note receivable.............................       18        10
  Proceeds from term loans..................................    2,897       --
  Repayment of term loans...................................     (137)      --
  Repayment of capital lease obligations....................     (139)      (88)
                                                             --------  --------
      Net cash provided by financing activities.............    3,269       297
                                                             --------  --------
NET DECREASE IN CASH AND EQUIVALENTS........................   (9,576)  (16,789)
  Beginning of period.......................................   16,352    25,583
                                                             --------  --------
  End of period............................................. $  6,776  $  8,794
                                                             ========  ========
SUPPLEMENTARY DISCLOSURES OF CASH FLOW INFORMATION:
  Cash paid during the period for interest.................. $     87  $     51
                                                             ========  ========
NONCASH INVESTING AND FINANCING ACTIVITIES:
  Conversion of preferred stock to Common Stock............. $  1,399  $    531
                                                             ========  ========
</TABLE>
 
                See notes to consolidated financial statements.
 
                                       5
<PAGE>
 
                             SILICON GAMING, INC.
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
1. BASIS OF PRESENTATION
 
  The accompanying consolidated balance sheet as of June 30, 1998, the
consolidated statements of operations for the three and six months ended June
30, 1998 and 1997, and the consolidated statements of cash flows for the six
months ended June 30, 1998 and 1997, are unaudited. In the opinion of
management, these financial statements have been prepared on the same basis as
the audited financial statements and include all adjustments, consisting only
of normal recurring adjustments and accruals, necessary for the fair
presentation of the financial position and operating results as of such dates
and for such periods. The unaudited information should be read in conjunction
with the audited consolidated financial statements of Silicon Gaming, Inc.
("Silicon Gaming" or the "Company") and the notes thereto for the year ended
December 31, 1997 included in the Company's Annual Report on Form 10-K filed
with the Securities and Exchange Commission.
 
  Certain prior year amounts have been reclassified to conform to the current
year presentation.
 
2. INVENTORIES
 
  Inventories are stated at lower of cost (first-in, first-out) or market and
consist of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                           JUNE 30, DECEMBER 31,
                                                             1998       1997
                                                           -------- ------------
     <S>                                                   <C>      <C>
     Raw materials........................................ $ 4,469     $3,028
     Work in process......................................     866        468
     Finished goods.......................................   8,531      2,839
                                                           -------     ------
                                                           $13,866     $6,335
                                                           =======     ======
</TABLE>
 
3. 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. As of
June 30, 1998, four customers accounted for 25%, 19%, 13% and 12% of accounts
receivable. As of December 31, 1997, two customers accounted for 32% and 21%
of accounts receivable. For the three months ended June 30, 1998, one customer
accounted for 19% of revenue and for the six months ended June 30, 1998, five
customers accounted for 26%, 17%, 13%, 10% and 10% of revenue. For both the
three and six months ended June 30, 1997, two customers accounted for 56% and
14% of revenue.
 
4. LONG-TERM OBLIGATIONS
 
  Long-term obligations consist of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                        JUNE 30,  DECEMBER 31,
                                                          1998        1997
                                                        --------  ------------
     <S>                                                <C>       <C>
     Senior Discount Notes ($30 million principal
      obligation)...................................... $23,013     $22,277
     Capital lease obligations.........................     506         645
     Other long-term obligation........................   2,760           0
                                                        -------     -------
                                                         26,279      22,922
     Current obligation................................  (1,089)       (285)
                                                        -------     -------
     Long-term portion................................. $25,190     $22,637
                                                        =======     =======
</TABLE>
 
                                       6
<PAGE>
 
                             SILICON GAMING, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  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
(8.5% at June 30, 1998) plus 1%. There were no amounts outstanding under this
agreement as of June 30, 1998. The line of credit requires the Company to
comply with certain financial covenants, with which the Company was in
compliance as of June 30, 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 June 30, 1998, the Company had $1,843,000
outstanding under this agreement. The agreement requires the Company to comply
with certain financial covenants, with which the Company was in compliance as
of June 30, 1998.
 
  In June 1998, the Company entered into a secured equipment term loan with
available credit up to $3 million. Borrowings bear interest at 14% per annum
for a term of 42 months. As of June 30, 1998, the Company had $917,000
outstanding under this agreement. The agreement requires the Company to comply
with certain financial covenants, with which the Company was in compliance as
of June 30, 1998.
 
5. 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 net assets during the period from non-owner sources. Comprehensive loss,
which is comprised of the Company's net loss for the periods and unrealized
gains (losses) on investments, was $5,430,000 and $5,938,000 for the quarters
ended June 30, 1998 and 1997, respectively, and $12,193,000 and $10,576,000
for the six months ended June 30, 1998 and 1997, respectively.
 
  In June 1997, the FASB 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. Adoption of this statement
will not impact the Company's consolidated financial position, results of
operations or cash flows. The Company will adopt this statement in its
financial statements for the year ending December 31, 1998.
 
6. SUBSEQUENT EVENTS
 
  On July 8, 1998, the Company completed the private placement of $17.25
million principal obligation Senior Discount Notes ("Notes") due September 30,
2002. Commencing January 1, 1999 the Notes bear interest at 12.5% per annum,
payable semi-annually. The Company is required to redeem $3 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, increasing to 100% over 9 months. In connection with the offering,
purchasers of the Notes were issued 5-year 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 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. The Company is
required, after approval is received by the necessary gaming regulatory
authorities, to register the Common Stock underlying the warrants with the
Securities and Exchange Commission, no later than January 1, 1999. Gross
proceeds to the Company before fees and other expenses were $14.95 million.
Offering costs of $50,000 will be included in other assets in July 1998 and
will be amortized as an adjustment to interest expense over the term of the
Notes.
 
                                       7
<PAGE>
 
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
        RESULTS OF OPERATIONS
 
  THIS DISCUSSION INCLUDES A NUMBER OF FORWARD-LOOKING STATEMENTS WHICH
REFLECT THE COMPANY'S CURRENT VIEWS WITH RESPECT TO FUTURE EVENTS AND
FINANCIAL PERFORMANCE. THESE FORWARD-LOOKING STATEMENTS ARE SUBJECT TO CERTAIN
RISKS AND UNCERTAINTIES, INCLUDING THOSE REFERRED TO IN THE RISK FACTORS
SECTION BELOW AND ELSEWHERE HEREIN AND CONTAINED IN THE COMPANY'S PREVIOUSLY
FILED ANNUAL REPORT ON FORM 10-K, THAT COULD CAUSE ACTUAL RESULTS TO DIFFER
MATERIALLY FROM HISTORICAL RESULTS OR THOSE ANTICIPATED. IN THIS DISCUSSION,
THE WORDS "ANTICIPATES," "BELIEVES," "EXPECTS," "INTENDS," "FUTURE" AND
SIMILAR EXPRESSIONS IDENTIFY FORWARD-LOOKING STATEMENTS. READERS ARE CAUTIONED
NOT TO PLACE UNDUE RELIANCE ON THESE FORWARD-LOOKING STATEMENTS, WHICH SPEAK
ONLY AS OF THE DATE HEREOF.
 
  The following discussion should be read in conjunction with the unaudited
consolidated financial statements and notes thereto included in Part I--Item 1
of this Report and the audited consolidated financial statements and notes
thereto included in the Company's Annual Report on Form 10-K filed with the
Securities and Exchange Commission.
 
OVERVIEW
 
  Silicon Gaming, Inc. ("SGI" or "the Company") is engaged in the design,
development, production, marketing and sale of what it believes will be the
next generation of interactive slot machines for use in casinos and other
gaming establishments. The Company's first product, Odyssey(R), combines an
advanced multimedia gaming platform with software-based games that the Company
believes to be more engaging and entertaining than other gaming devices
currently available and will, as a result, generate increased win per machine
for the casino operator. The Company recently announced its new product,
Quest(TM), which is designed as a lower-priced, single-game product to further
meet the needs of casino operators, add flexibility to the Company's product
line, and allow further penetration and expansion of new and existing markets.
 
  Odyssey and Quest 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 majority of today's slot machines are
"hardware dominant", consisting of a fixed and unvarying game played on
spinning reels or a small video screen mounted within a large metal box. By
contrast, the Company's machines are "software dominant", in that the
attraction and entertainment value of its machines is created by software
programs that run SGI's games. Odyssey offers a selection of a suite of up to
six different games on a single machine, while Quest is designed as a single-
game machine. The Company expects that casino operators will be able to
quickly and easily upgrade SGI's machines simply by installing new software,
rather than replacing an entire slot machine.
 
  The Company commenced commercial sale of Odyssey in May 1997, prior to which
it was in the development stage. Since introducing Odyssey the Company has
focused its efforts on entering new markets and jurisdictions, introducing its
product and ramping up its sales in such markets. As of June 30, 1998 the
Company had an installed base of over 2,700 machines. The Company shipped 818
machines to customers during the quarter ended June 30, 1998, increasing its
installed base by 35%. Odyssey is licensed for sale in Nevada, Missouri,
Mississippi, Indiana, Connecticut, Alberta-Canada and certain native American
tribes in Louisiana, Mississippi, and New Mexico. The Company has received its
corporate license in these jurisdictions as well as New Jersey, Minnesota, and
certain native American tribes in Michigan and is in the process of gaining
licenses in additional jurisdictions. The Company offers multiple denomination
machines to its customers and in June 1998 began operating its "game factory"
concept which intends to introduce new game titles to customers on a monthly
basis. In June the Company introduced Arabian Riches(TM), and has recently
introduced Riddle of the
 
                                       8
<PAGE>
 
Sphinx(TM) and Banana-Rama(TM) into Nevada. The Company plans to introduce
these games into other jurisdictions pending regulatory approval.
 
  The Company generates revenue from machine sales direct to customers as well
as from software license and participation revenue. The Company installs units
on casino floors through direct sales, as well as on a trial basis, consistent
with industry practice. The Company's initial sales of Odyssey include the
hardware platform bundled with a suite of six games, play stoppage
entertainment and the Machine Management System(TM). The Company recently
announced its new product Quest, which has been designed as a lower-priced,
single-game product. The Company offers two alternative purchase programs,
consisting of the sale of hardware bundled with either (1) a single-game or a
suite of games or (2) a renewable one-year software license, including access
to the Company's entire game library for the term of the license. In addition,
the Company offers a revenue participation plan that allows the Company to
share with casino operators the aggregate win generated by the machines, with
20% going to the Company. Under this plan, the casino accumulates credits that
may be applied to the purchase of the machines after a 90-day, minimum
evaluation period.
 
  The Company was incorporated in California on July 27, 1993. Its principal
offices are located at 2800 W. Bayshore Road, Palo Alto, California 94303. The
Company also maintains sales and support offices in Las Vegas and Reno,
Nevada, and in Gulfport, Mississippi.
 
RESULTS OF OPERATIONS
 
  The Company had a net loss of $5,428,000 in the quarter ended June 30, 1998,
a decrease of $509,000, or 9%, from $5,937,000 for the quarter ended June 30,
1997. Revenue increased to $8,261,000 in the quarter ended June 30, 1998, an
increase of $6,596,000, or 396%, from $1,665,000 for the quarter ended June
30, 1997. This increase in revenue was primarily due to the fact that the
Company commenced sale of its product in May 1997. Since that time the Company
has focused its efforts on entering new markets and jurisdictions, introducing
its product and ramping up its sales in such markets. This increase in revenue
is coupled with increases in resources the Company has devoted to
manufacturing development and production, research and development, building a
sales, support and administrative infrastructure, hiring additional
administrative staff, ramping up the Company's marketing activities, and
financing its operations. This resulted in an increase of costs, expenses and
net interest expense to $13,689,000 for the quarter ended June 30, 1998 from
$7,602,000 for the quarter ended June 30, 1997.
 
  The Company had a net loss of $12,192,000 for the six months ended June 30,
1998, an increase of $1,593,000, or 15%, from $10,599,000 for the six months
ended June 30, 1997. The Company was in the development stage, without
revenue, until its first sales in May 1997. Accordingly, the Company recorded
only two months of revenue during the six moths ended June 30, 1997, and the
prior period may not be comparable to current or future periods. The Company
had revenue of $12,287,000 for the six months ended June 30, 1998, an increase
of $10,622,000, or 638%, from $1,665,000 for the six months ended June 30,
1997. This increase in revenue was offset by increases in costs, expenses and
net interest expense to $24,479,000 in the six months ended June 30, 1998 from
$12,264,000 for the six months ended June 30, 1997.
 
  The Company sold its first machines in Nevada in May 1997. Since that time
the Company has been broadening the markets in which it sells its product and
expanding its game software library. The Company's quarterly and annual
operating results have been, and will continue to be, affected by a wide
variety of factors that could have a material adverse effect on revenue and
profitability during any particular period. This includes such factors as the
level of orders which are received and can be shipped in a quarter, the
rescheduling or cancellation of sales or trial orders by its customers, the
timing and/or ability of the Company to obtain the licenses necessary to
conduct its business, the Company's ability to introduce new software or
hardware products and technologies on a timely basis, new product
introductions by the Company's competitors, and the level of expenditures in
manufacturing, research and development, and sales, general and administrative
functions. Accordingly, it is not possible to estimate future revenue and
operating expenses based upon historical operating performance.
 
  The Company's products, Odyssey and Quest, are significantly different from
the products offered by its competitors. Because sales of the Odyssey, Quest
and their related software will comprise the Company's only
 
                                       9
<PAGE>
 
source of revenue for the foreseeable future, the Company's quarterly and
annual operating results will depend on the success of these single products
that are subject to the new product risks described in the preceding
paragraph. In addition, the success of Odyssey and Quest will also depend upon
the Company's ability to generate new and successful software-based games
which are readily accepted in the marketplace. Historically, the Company has
generally recognized a substantial portion of its revenue in the last month of
a given quarter. A significant portion of the Company's expenses are fixed in
the short term, and the timing of increases in expenses is based in large part
on the Company's forecast of future revenue. As a result, if revenue does not
meet the Company's expectations, it may be unable to quickly adjust expenses
to levels appropriate to actual revenue, which could have a material adverse
effect on the Company's business and results of operations.
 
  As a result of the foregoing, the Company's operating results and stock
price may be subject to significant volatility, particularly on a quarterly
basis. Any shortfall in net revenue or operating results from levels expected
by securities analysts could have an immediate and significant adverse effect
on the trading price of the Company's Common Stock.
 
  The market price of the Company's Common Stock has fluctuated significantly
since its initial public offering in July 1996. The market price of the Common
Stock could be subject to significant fluctuations in the future based on
factors such as announcements of new products or game titles by the Company or
its competitors, quarterly fluctuations in the Company's financial results or
other gaming machine manufacturing companies' financial results, changes in
analysts' estimates of the Company's financial performance, general conditions
in the gaming or gaming machine manufacturing industries, conditions in the
financial markets and general conditions in the political or business
environment which might adversely affect the gaming industry. In addition, the
stock market in general has experienced extreme price and volume fluctuations,
which have particularly affected the market prices for many high technology
companies and which have often been unrelated to the operating performance of
the specific companies. The market price of the Company's Common Stock has
declined substantially from its historic highs and may continue to experience
significant fluctuations in the future.
 
 Revenue
 
  Revenue for the quarter ended June 30, 1998 was $8,261,000, an increase of
$6,596,000, or 396%, from $1,665,000 for the quarter ended June 30, 1997.
Revenue for the quarter ended June 30, 1998 consisted of $5,462,000, or 66%,
in hardware sales, $1,941,000, or 24%, in software license revenue and
$858,000, or 10%, in participation revenue. Revenue for the quarter ended June
30, 1997 consisted of $1,542,000, or 93%, in hardware sales, $31,000, or 2%,
in software license revenue and $92,000, or 5%, in participation revenue.
 
  Revenue for the six months ended June 30, 1998 was $12,287,000, an increase
of $10,622,000, or 638%, from $1,665,000 for the six months ended June 30,
1997. Revenue for the six months ended June 30, 1998 consisted of $7,886,000,
or 64%, in hardware sales, $2,661,000, or 22%, in software license revenue and
$1,740,000, or 14%, in participation revenue. Revenue for the six months ended
June 30, 1997 consisted of $1,542,000, or 93%, in hardware sales, $31,000, or
2%, in software license revenue and $92,000, or 5%, in participation revenue.
 
  As of June 30, 1998 the Company had an installed base of over 2,700
machines, as compared to 402 machines as of June 30, 1997. During the quarter
ended June 30, 1998, the Company shipped 818 machines, increasing its
installed base by 35%. Revenue was recognized on 606 and 235 units for the
quarters ended June 30, 1998 and 1997, respectively, with the remaining units
(net of returns) subject to an initial evaluation period. Revenue was
recognized on 916 and 235 units for the six-months ended June 30, 1998 and
1997, respectively. The Company had 732 units with customers under
participation arrangements as of June 30, 1998, compared to 96 units as of
June 30, 1997. As of June 30, 1998, the Company recognized revenue in seven
jurisdictions across the United States and Canada.
 
  The large increases between the periods are primarily due to the fact that
the Company was in the development stage, without revenue, until its first
sales in May 1997. Since that time the Company has focused
 
                                      10
<PAGE>
 
its efforts on entering new markets and jurisdictions, introducing its product
and ramping up its sales and broadening the markets in which it sells its
product. Because the Company was without revenue in four of the six months
ended June 30, 1997, the prior period differs from, and may not be comparable
to, current or future periods, and it is not possible to estimate future
revenue and operating expenses based upon historical data. Due to the early
stage of the Company's product cycle and its efforts to expand and enter new
markets, the Company believes the revenue generated from sales will increase
significantly in the current year. As the Company's base of installed units
continues to increase, the Company believes license revenue will increase and
participation revenue will decrease as a percentage of total revenue and in
absolute dollars. Anticipated increases in revenue, however, are subject to a
number of risks and uncertainties. See "Risk Factors Uncertain Market
Acceptance; Risk of Technical Errors; Single Product", "--Competition", "--
Rapidly Changing Technology" "--Slow Trend in Legalized Gambling", and "--
Regulatory Approval."
 
 Cost of Sales and Related Manufacturing Expenses
 
  Cost of sales and related manufacturing expenses include direct costs of
product sales, payroll and related costs for manufacturing personnel, overhead
costs and depreciation of participation units. Cost of sales and related
manufacturing expenses were $5,836,000, or 71% of revenue, as compared to
$2,321,000, or 139% of revenue, for the quarters ended June 30, 1998 and 1997,
respectively. Cost of sales and related manufacturing expenses were
$9,026,000, or 73% of revenue, as compared to $3,262,000, or 196% of revenue,
for the six months ended June 30, 1998 and 1997, respectively. Gross profits
for 1998 were 29% and 27% for the three and six months ended June 30, 1998,
respectively. The Company was in the development stage until May 1997, without
revenue, and manufacturing expenses did not include direct costs of product
sales. As such, the Company experienced negative gross profits in the three
and six months ended June 30, 1997. Increases in costs, as well as
improvements in gross profit between the periods are due primarily to the
increased value and cost of product sales as a direct result of increased
volume and revenue recognized in the same periods. The net increase between
periods is offset by decreases in per-unit product costs resulting from
reductions in cost of materials and buying efficiencies, as well as
efficiencies in manufacturing from tooling certain hardware components. Due to
significant reductions in cost of materials, cost of sales for inventory sold
in the six months ended June 30, 1998 are in excess of what the per-unit costs
are expected to be in future periods. As a result of these changes, the prior
periods differ from, and may not be comparable to, current or future periods.
 
  Cost of sales and manufacturing expenses are expected to increase through
1998 as the Company increases sales of its product and expands its
manufacturing capacity and infrastructure to produce its product in greater
commercial quantities. The Company expects to achieve a further reduction in
per-unit manufacturing costs in future periods and improved gross profit in
those same periods. However, aggregate fixed manufacturing costs are expected
to increase as the Company's manufacturing volume increases. The anticipated
manufacturing efficiencies are subject to a number of risks and uncertainties.
See "Risk Factors--Limited Manufacturing Experience."
 
 Research and Development
 
  Research and development ("R&D") expenses include payroll and related costs
of employees engaged in ongoing design and development activities, fees to
outside contractors, prototype development expenses, overhead costs, equipment
depreciation and costs of supplies. To date, the Company has expensed all
costs associated with the research, design and development of its product. R&D
expenses were $2,838,000, or 34% of revenue, as compared to $2,429,000, or
146% of revenue, for the quarters ended June 30, 1998 and 1997, respectively.
R&D expenses were $5,554,000, or 45% of revenue, as compared to $4,436,000, or
266% of revenue for the six months ended June 30, 1998 and 1997, respectively.
Increases in R&D expenses over these periods have resulted from the
incremental hiring of personnel, development of new games and products,
including Quest and a wide area progressive system, increased use of
engineering consultants and license fees and similar costs associated with the
acquisition of outside technologies. The Company believes that a significant
level of R&D expense is required due to the technical nature of its product
and the elaborate requirements of the game development
 
                                      11
<PAGE>
 
process. Accordingly, the Company anticipates devoting substantial resources,
including additional personnel, to R&D and expects that these costs will
increase in absolute dollars in future periods; however, these costs are
expected to decrease as a percentage of revenue and as a percentage of total
costs and expenses.
 
 Selling, General and Administrative
 
  Selling, general and administrative ("SG&A") expenses include payroll and
related costs for administrative and executive personnel, sales and marketing
personnel, overhead costs, legal and associated costs, costs associated with
obtaining corporate and product licenses in various jurisdictions and fees for
professional services. SG&A expenses were $3,922,000, or 47% of revenue, as
compared to $3,120,000, or 187% of revenue, for the quarters ended June 30,
1998 and 1997, respectively. SG&A expenses were $7,873,000, or 64% of revenue,
as compared to $5,246,000, or 315% of revenue, for the six months ended June
30, 1998 and 1997, respectively. Increases in SG&A expenses over these periods
have resulted from the incremental hiring of personnel and expenses associated
with applying for corporate and product licensing in various jurisdictions and
costs associated with establishing a sales and marketing organization as the
Company commenced commercial production and distribution of its product. SG&A
expenses are expected to increase substantially in absolute dollars as the
Company invests in increased sales and marketing-related activities and in
administrative personnel to support its growing infrastructure; however, these
costs are expected to decrease as a percentage of revenue.
 
 Interest Income and Expense
 
  Net interest expense was $1,093,000 for the quarter ended June 30, 1998, as
compared to net interest income of $268,000 for the quarter ended June 30,
1997. Net interest expense was $2,026,000 for the six months ended June 30,
1998, as compared to net interest income of $680,000 for the six months ended
June 30, 1997. Included in these totals was interest income of $107,000 and
$300,000 for the quarter ended June 30, 1998 and 1997, respectively, and
$327,000 and $734,000 for the six months ended June 30, 1998 and 1997,
respectively. Decreases in interest income over these periods were primarily
due to lower average cash and investment balances held compared to prior
periods. Interest expense was $1,200,000 and $32,000 for the quarters ended
June 30, 1998 and 1997, respectively, and $2,353,000 and $54,000 for the six
months ended June 30, 1998 and 1997, respectively. The increases in interest
expense over these periods was primarily due to interest and amortized debt
costs recorded in the periods ended June 30, 1998 for Senior Discount Notes
(the "Notes") issued on September 30, 1997 and for interest expense associated
with the secured equipment term loans.
 
 Income Taxes
 
  The Company has not been required to pay income taxes due to its net
operating losses in each period since inception. As of December 31, 1997, the
Company had net operating loss carryforwards of approximately $40,800,000 and
$24,900,000 for federal and state income tax purposes, respectively. These
loss carryforwards will expire beginning in the year 2000, if not utilized. As
of December 31, 1997, the Company also has R&D credit carryforwards of
approximately $480,000 and $480,000 for federal and state purposes,
respectively, which expire beginning 2010. A valuation allowance has been
recorded for any deferred tax assets due to uncertainties regarding the
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 December 31, 1997, approximately $4 million of the Company's net
operating loss carryforwards was subject to such limitation and this
limitation is dependent on the Company's future profitability and the
utilization of its net operating loss carryforwards over a period of time.
 
LIQUIDITY AND CAPITAL RESOURCES
 
  Cash, cash equivalents and short-term investments were $6,776,000 as of June
30, 1998, compared to $21,057,000 as of December 31, 1997. This decrease was
primarily due to an increase in cash used in operating
 
                                      12
<PAGE>
 
activities as the Company ramped up manufacturing, marketing, and selling of
its product, as well as cash used for the purchase of property and equipment,
which was partially offset by increases in cash provided by investing and
financing activities.
 
  Working capital was $17,639,000 and $25,759,000 at June 30, 1998 and
December 31, 1997, respectively. The decrease in working capital is primarily
due to the decrease in cash and investments offset partially by increases in
inventory, accounts receivable, accounts payable, accrued liabilities and
deferred revenue. These changes are primarily due to the fact that the Company
was ramping up operations, increasing sales, operations and accounts
receivable, as well as increasing inventory on hand to prepare for increased
sales volume in the latter part of the current year.
 
  The Company's net cash used in operating activities was $15,855,000 and
$15,140,000 for the six months ended June 30, 1998 and 1997, respectively.
This increase was primarily due to increases in the Company's net losses,
depreciation and amortization, accrued interest, accretion of debt discount,
and increases in cash used for accounts receivable and inventory. These
changes resulted from increased sales and operations, as well as interest on
financing obtained in the current year.
 
  Net cash provided by investing activities was $3,010,000 for the six months
ended June 30, 1998, as compared to the net cash used in investing activities
of $1,946,000 for the six months ended June 30, 1997. The change was primarily
due to decreases in the acquisition of fixed assets, primarily computer
equipment and software, decreases in other assets, and increases in the net
cash provided by the purchase, sale and maturity of short-term investments.
 
  Net cash provided by financing activities was $3,269,000 and $297,000 for
the six months ended June 30, 1998 and 1997, respectively. The increase was
primarily due to proceeds from term loans and the sale of Common Stock, which
was partially offset by the repayment of capital lease and term loan
obligations.
 
  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
(8.5% at June 30, 1998) plus 1%. There were no amounts outstanding under this
agreement as of June 30, 1998. The line of credit requires the Company to
comply with certain financial covenants, with which the Company was in
compliance as of June 30, 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 June 30, 1998, the Company had $1,843,000
outstanding under this agreement. The agreement requires the Company to comply
with certain financial covenants, with which the Company was in compliance as
of June 30, 1998.
 
  In June 1998, the Company entered into a secured equipment term loan with
available credit up to $3 million. Borrowings bear interest at 14% per annum
for a term of 42 months. As of June 30, 1998, the Company had $917,000
outstanding under this agreement. The agreement requires the Company to comply
with certain financial covenants, with which the Company was in compliance as
of June 30, 1998.
 
  On July 8, 1998, the Company completed the private placement of $17.25
million principal obligation Senior Discount Notes ("Notes") due September 30,
2002. Commencing January 1, 1999 the Notes bear interest at 12.5% per annum,
payable semi-annually. The Company is required to redeem $3 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, increasing to 100% over 9 months. In connection with the offering,
purchasers of the Notes were issued 5-year 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 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
 
                                      13
<PAGE>
 
of the September 1997 warrants was $1,466,000. The Company is required, after
approval is received by the necessary gaming regulatory authorities, to
register the Common Stock underlying the warrants with the Securities and
Exchange Commission, no later than January 1, 1999. Gross proceeds to the
Company before fees and other expenses were $14.95 million. Offering costs of
$50,000 will be included in other assets in July 1998 and will be amortized as
an adjustment to interest expense over the term of the Notes.
 
  At June 30, 1998 the Company's principal sources of liquidity included cash
and equivalents of $6,776,000 and the Company's $10 million line of credit.
Subsequent to June 30, 1998, the Company received $14.95 million in net
financing from the Notes. The Company believes its cash and equivalents, its
revolving line of credit and funds received from the Notes, together with
proceeds from additional financing sources which the Company believes are
available, will be sufficient to meet its anticipated cash needs for working
capital, capital expenditures and business expansion until the Company
generates positive cash flow from operations. However, there can be no
assurances that the Company will generate positive cash flow within the
currently anticipated time frame. In the future, the Company expects to
increase the cash used in operating activities in order to increase commercial
production and distribution of its product, enhance manufacturing
capabilities, expand sales and support operations, increase research and
development activities and add administrative infrastructure.
 
  Cash flow from the Company's initial commercial sales has been negatively
affected by the revenue participation plan that the Company is offering to its
customers. Under this plan, a customer does not purchase the machine outright,
but pays the Company 20% of the win generated by such machine. The customer
also accumulates credits which may be applied to the purchase of the machines.
Although the Company expects that this plan will generate higher revenue per-
unit than conventional sales, the cash flow generated by sales under the plan
occurs over an extended period, as the aggregate win per day is earned.
 
  The Company's capital requirements will depend on many factors, including,
but not limited to, the rate at which the Company can introduce its product,
the market acceptance and competitive position of such product, the extent to
which the customers choose the revenue participation plan, the response of
competitors to the Company's product, and the ability of the Company to
satisfy the licensing requirements in various jurisdictions applicable to the
Company, its product, and in some jurisdictions, its officers, directors,
employees or principal shareholders. In addition to financing recently
obtained, the Company may be required to seek additional financing before it
achieves positive cash flow. In that event, no assurance can be given that
additional financing will be available or that, if available, it will be
available on terms acceptable to the Company or its shareholders. If adequate
funds are not available to satisfy the Company's short-term or long-term
capital requirements, the Company may be required to limit its operations
significantly.
 
  YEAR 2000 ISSUES. The inability of computers and software programs to
recognize and properly process data fields containing a two-digit year is
commonly known as the Year 2000 issue. As the year 2000 approaches, such
computer systems may be unable to accurately process certain date-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 similar normal business
activities.
 
  During 1997 the Company implemented an enterprise-wide management
information system which supports all of the Company's major business
applications including sales and customer service, manufacturing and
distribution, and finance and accounting. Management has determined that the
Year 2000 issue will not pose significant operational problems for its
computer systems. As a result, any costs attributable to the purchase and
implementation of new software will be capitalized and any other costs
incurred in connection with Year 2000 compliance will be expensed as incurred.
 
  The Company expects that any systems or application changes or upgrades
connected with Year 2000 compliance will be completed before December 31,
1998. The Company expects to use both internal and external resources to
replace and test software for Year 2000 compliance. The total cost to the
Company for these Year 2000 compliance activities has not been and is not
anticipated to be material to its financial position or results of operations.
These costs are not expected to be substantially different from normal costs
that are incurred for
 
                                      14
<PAGE>
 
systems development and implementation, in part due to the reallocation of
internal resources. The total cost of Year 2000 compliance is not expected to
exceed $500,000, the majority of which will be spent on the purchase and
implementation of new software and upgrades during the third quarter of 1998.
These costs and the date by which management expects to complete the Year 2000
compliance are based on management's best estimates, which were derived
utilizing numerous assumptions of future events including the availability of
certain resources, third party product and modification programs and other
factors. However, there can be no assurance that these estimates will be
achieved and actual results could differ materially from those anticipated.
 
  The Company is in the process of obtaining assurances from vendors that
timely updates will be made available to ensure that all purchased software
will be Year 2000 compliant. The Company is also in the process of initiating
formal communications with all of its significant suppliers to determine the
extent to which the Company is vulnerable to Year 2000 issues. However, there
can be no guarantee that if the systems of other companies on which the
Company's systems rely are not timely converted, or if another company fails
to convert, this would not have a material adverse effect on the Company.
 
  The Company currently obtains a significant amount of its revenue from
relatively few customers. There can be no assurance that the Year 2000 issue
will not pose significant problems for the computer systems of these
customers, which could in turn affect the customers' ability to purchase
machines and generate revenue for the Company. Accordingly, there can be no
assurance revenue generated for the Company will not be affected by the Year
2000 issues that these customers might have. The Company cannot predict the
nature of any such changes or their impact on the Company.
 
RISK FACTORS
 
  UNCERTAIN MARKET ACCEPTANCE; RISK OF TECHNICAL ERRORS; SINGLE PRODUCT. To
achieve commercial success, the Company's product must be accepted both by
casino operators and gaming patrons. Because acceptance of the product by
casino operators will ultimately depend on win per machine, the Company
believes that its ultimate success will depend on player acceptance. The
Company's first gaming platform, Odyssey, has only been installed in casinos
for a limited period and the Company has only limited market studies and
player data to support its belief that Odyssey or the Company's new product,
Quest, will be accepted by slot players. There can be no assurance that
Odyssey or Quest will be accepted by casino patrons. Initial player interest
in the product may be affected by its novel design in addition to any inherent
advantages it may have over competing platforms and may therefore not be
indicative of the long-term success of Odyssey or Quest in the marketplace.
Player preferences are highly subjective, vary substantially among geographic
and demographic markets and are subject to unpredictable change. Because the
Company's product offers features not found on traditional slot machines, it
may not appeal to players for whom familiarity and predictability are
important considerations.
 
  The Company sells its machines at prices that are substantially higher than
the prices of most competing products. In light of these higher sale prices,
coupled with the Company's status as a new and relatively small entrant in a
market dominated by larger companies, the success of Odyssey and Quest will
require that it demonstrate superior, as opposed to merely comparable, win per
machine when compared to traditional slot machines and other gaming platforms
offered by more established competitors. Although a number of casinos have
purchased or installed the Company's product, any additional purchases of the
product by these casinos, or others that may conduct similar evaluations in
the future, will be subject to the superior performance of the product on the
casino floor. Because of the limited opportunity for the Company to test its
gaming platform under long-term play conditions, there can be no assurance
that a substantial technical difficulty with, or an undetected error in, the
Company's software or hardware will not arise, possibly resulting in
unanticipated costs, installation and production delays or delays in product
licensing.
 
  The Company's success currently depends on the success of a single product.
Because sales of its slot machine and related software will comprise the
Company's only source of revenue in the foreseeable future, any interruption
in these sales due to a technical problem will prevent the Company from
earning revenue unless and until the cause of such interruption can be
remedied. As the Company moves into new jurisdictions, including
 
                                      15
<PAGE>
 
potential international markets, the Company may be required to make certain
modifications to its product to comply with local regulatory or market
conditions. There can be no assurance that such modifications will be
successful, or that these modifications will be performed in a timely or cost
effective manner. Moreover, should Odyssey or Quest fail to win broad
acceptance in the market, the Company's business, financial condition and
results of operations would be materially and adversely affected, and
investors would be exposed to the loss of all or a substantial portion of
their investment.
 
  EXPECTATION OF LOSSES; NEGATIVE CASH FLOWS. As of June 30, 1998, the Company
has had net losses since inception, and the Company expects to continue to
incur operating losses and negative cash flows at least through the third
quarter of 1998. There can be no assurance that the Company will become
profitable or cash flow positive at any time in the future. The likelihood of
the success of the Company must be considered in light of the expenses,
difficulties and complications that may affect the Company's ability to
achieve profitable operations and the competitive and regulatory environment
in which the Company must operate. To date, the Company's operations have
focused primarily on product development, and the Company has had limited
experience in the areas of manufacturing, sales, product distribution and
customer support. Accordingly, it is not possible to estimate future revenue
and operating expenses based upon historical operating performance. Operating
results will depend, in part, on matters over which the Company has little or
no control, including, without limitation, the ability of the Company to
obtain the licenses necessary to conduct its business, competition, the actual
number of orders for its product, gaming regulations and taxes.
 
  CAPITAL REQUIREMENTS. The Company believes that its cash and equivalents,
short-term investments, and its revolving line of credit, together with
proceeds from additional financing sources which the Company believes are
available, will be sufficient to fund its capital and operating requirements
until the Company generates positive cash flow from operations. The Company
recently obtained debt financings to fund its product rollout, expand
operations, and fund its revenue sharing plan and the development of its wide
area progressive system. The cash flow generated by sales under the revenue
sharing plan is recognized over an extended period, as the aggregate win per
day is earned, and therefore has an adverse effect on the Company's working
capital compared to other pricing options. In addition to the financings
recently obtained, the Company may be required to seek additional financing
before it achieves positive cash flow. There can be no assurance that the
Company will be able to obtain such financing, or that, if it is able to
obtain such financing, it will be able to do so on satisfactory terms or on a
timely basis. If additional funds are raised through the issuance of equity,
convertible debt or similar securities, shareholders may experience
substantial dilution, and such securities may have rights or preferences
senior to those of Common Stock. Moreover, if adequate funds are not available
to satisfy the Company's short-term or long-term capital requirements, the
Company may be required to limit or discontinue its revenue sharing plan,
scale back its product rollout, or limit its operations significantly. The
Company's capital requirements will depend on many factors, including, but not
limited to, the rate at which the Company introduces its product, the market
acceptance and competitive position of such product, the extent to which the
customers choose the revenue participation plan, the response of competitors
to the product and the ability of the Company's management and its product to
satisfy the corporate licensing and product licensing requirements in various
jurisdictions.
 
  COMPETITION. The gaming machine industry is characterized by intense
competition that is based on, among other things, a device's ability to
generate win per machine through product appeal to players, and knowledge of
customer requirements such as ease of use, quality of service, support and
training, distribution, name recognition and price. In recent years, the
gaming machine market has been dominated by International Game Technology
("IGT") which, according to industry sources, captured approximately 75% of
the market in 1997. IGT's presence as a competitor is bolstered by its
extensive market presence, distribution capacity, player acceptance and
financial, technological and other resources. Several other companies,
including Bally Gaming International, Inc. ("Bally Gaming"), are established
in, or are seeking to enter, the gaming machine business. Companies in
historically unrelated industries, such as Sega Enterprises Ltd. ("Sega"),
have technological resources that could offer them a competitive advantage in
developing multimedia-based gaming machines. In general, the Company's
existing competitors, as well as many potential new competitors, have
significantly greater financial and technical resources than the Company, as
well as more established customer bases and distribution channels, any of
which could afford them a competitive advantage in developing multimedia-based
 
                                      16
<PAGE>
 
gaming machines. Any success the Company might have may benefit existing
competitors and induce new competitors to enter the market. If Odyssey or
Quest displays a potential to capture a significant share of the gaming
machine market, the Company's competitors can be expected to employ a variety
of tactics to limit erosion of their market share, including price reductions,
acceleration of new product development or acquisition of new, competitive
technologies. In the face of such tactics, there can be no assurance that the
Company will be a successful competitor in the gaming machine industry.
 
  SLOWING IN TREND TO LEGALIZE GAMING. Growth in demand for slot machines
historically has been driven by the opening of new casinos, including casinos
in jurisdictions where gaming has recently been legalized. However, in recent
years, the legalization of gaming in new jurisdictions has been significantly
reduced; therefore, demand based on new openings will be largely limited to
new projects in existing markets. Certain jurisdictions 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
industry will sustain the rate of growth that was possible in the first half
of this decade.
 
  MANAGEMENT OF GROWTH. Execution of the Company's plan of operation will
require significant growth. The Company's current plans for growth will place
a significant strain on the Company's financial, managerial and other
resources. The Company's ability to manage its growth effectively will require
it to continue to improve its operational, financial and management
information systems and to attract, motivate and train key employees. Should
the Company's executives be unable to manage growth effectively, the Company's
business, operating results and financial condition would be materially and
adversely affected.
 
  DEPENDENCE ON KEY PERSONNEL. The operations of the Company depend 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.
Competition is intense for highly skilled product development employees in
particular. There can be no assurance that the Company will be successful in
attracting and retaining such personnel or that it can avoid increased costs
in order to do so. In addition, the Company's officers and key employees are
not bound by noncompetition agreements that extend beyond their employment at
the Company, and there can be no assurance that employees will not leave the
Company or compete against the Company. The Company's failure to attract
additional qualified employees or to retain the services of key personnel
could have a material adverse effect on the Company's operating results and
financial condition. The Company currently maintains a "key-man" life
insurance policy in the amount of $3 million on the life of Andrew S. Pascal,
the Company's Executive Vice President-Marketing and Game Development.
 
  LIMITED PROTECTION OF INTELLECTUAL PROPERTY RIGHTS; RISK OF LITIGATION. The
Company regards its product as proprietary and relies primarily on a
combination of 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 difficult and costly, and there
can be no assurance that the Company will be able to effectively protect its
technology from misappropriation by competitors. In addition, the protections
offered by trademark, copyright and trade secret laws would not prevent a
competitor from designing games having appearance and functionality that
closely resemble the Company's games. At present, the Company's principal
proprietary technology consists of its game authentication algorithm, which is
designed to prevent tampering with the game software that is resident in its
product, and its random number generator algorithm, which determines the
outcome of each gaming proposition. While the Company believes that these
algorithms are unique at present, there can be no assurance that a competitor
of the Company will not succeed in developing an authentication algorithm or a
random number generator algorithm that performs as well as, or better than,
the Company's. Moreover, although the Company has applied for and received
certain patents and trademarks for its intellectual property, there can be no
assurance that such patents and trademarks will not be successfully challenged
in subsequent litigation.
 
  As the number of software products in the industry increases and the
functionality of these products further overlaps, software developers and
publishers may increasingly become subject to infringement claims. The
 
                                      17
<PAGE>
 
Company may also become subject to infringement claims, with or without merit,
that are brought by competitors who are motivated by a desire to disrupt the
Company's business. Although the Company is not currently aware of any claim
that it is infringing upon any intellectual property rights, there can be no
assurance that the Company will not face claims, with or without merit, in the
future. Any such claims or litigation could be costly and could result in a
diversion of management's attention, which could have a material adverse
effect on the Company's business and financial condition. Any settlement of
such claims or adverse determinations in such litigation could also have a
material adverse effect on the Company's business, operating results and
financial condition.
 
  RAPIDLY CHANGING TECHNOLOGY. The Company's product utilizes hardware
components that have been developed primarily for the personal computer and
multimedia industries. These industries are characterized by rapid
technological change and product enhancements. The Company's ability to remain
competitive and retain any technological lead may depend in part upon its
ability to continually develop new slot machine games that take full advantage
of the technological possibilities of state-of-the-art hardware. Should any
current or potential competitor of the Company succeed in developing a
competing software-based gaming platform, such competitor could be in a
position to outperform the Company in its ability to exploit developments in
microprocessor, video or other multimedia technology. The emergence of a suite
of slot machine games that is superior to the Company's in any respect could
substantially diminish the Company's product sales and thereby have a material
adverse effect on the Company's operating results.
 
  LIMITED MANUFACTURING EXPERIENCE. In order for the Company to be successful,
its product must be manufactured to meet high-quality standards in commercial
quantities at competitive prices. The Company has a limited history of
manufacturing Odyssey and Quest for commercial distribution and has had no
prior experience in large-scale manufacturing of gaming machines. The
transition to large-scale manufacturing of Odyssey and Quest will involve
various risks and uncertainties including unforeseen costs or assembly
difficulties and the possibility that anticipated efficiencies or economies of
scale will fail to materialize as the Company begins manufacturing in greater
volumes. A failure by the Company to successfully manage this transition would
have a material adverse affect on the Company's business, operating results or
financial condition.
 
  DEPENDENCE ON SINGLE-SOURCE SUPPLIERS. The Company currently obtains a
number of its system's components from single-source suppliers. In particular,
the touchscreen and picture tube that comprise the video display are supplied
by MicroTouch Systems, Inc. and Philips Display Components Company,
respectively. The Company does not have long-term supply contracts with these
suppliers but rather obtains these components on a purchase order basis.
Although the design of these components is not unique or proprietary and the
Company believes that it could identify alternative sources of supply, if
necessary, there can be no assurance that the Company would be able to
procure, substitute or produce such components without a significant
interruption in its assembly process in the event that these single sources
were unable to supply these components. 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 failure or delay by any
supplier to furnish the Company with required components would have a material
adverse effect on the Company's business, financial condition and results of
operations.
 
  REGULATORY APPROVAL. The Company will be required to obtain and maintain the
necessary licenses, approvals, findings of suitability and product approvals
in all jurisdictions in which it intends to distribute its product. The
licensing and approval processes can involve extensive examination of the
Company and its officers, directors, employees, principal shareholders and
product and can require significant expenditures of time and resources by the
Company. Distribution of gaming devices in U.S. gaming jurisdictions generally
requires both corporate approval and product approval. In addition to the
initial product approval, the Company is required to submit all software and
hardware modifications to the various regulatory laboratories. These
modifications normally take between 30 and 45 days to process. The regulations
relating to company and product licensing are subject to change, and other
jurisdictions, including the federal government, may elect to regulate or tax
gaming activities. The Company cannot predict the nature of any such changes
or their impact on the Company.
 
                                      18
<PAGE>
 
  Any beneficial holder of the Company's Common Stock may be subject to
investigation by any gaming authority in any jurisdiction in which the Company
does business if such authorities have reason to believe that such ownership
may be inconsistent with the gaming policies of that jurisdiction. Persons who
acquire beneficial ownership of more than certain designated percentages of
the Common Stock may be subject to certain reporting and qualification
procedures. In addition, changes in control of the Company and certain other
corporate transactions may not be effected without the prior approval of
gaming authorities in other jurisdictions in which the Company plans to do
business. Such provisions could adversely affect the marketability of the
Company's Common Stock or prevent certain corporate transactions, including
mergers or other business combinations.
 
  NO DIVIDENDS. The Company has not paid any cash dividends in the past and
does not expect to do so in the foreseeable future.
 
                                      19
<PAGE>
 
                          PART II--OTHER INFORMATION
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
  The Company's 1998 Annual Meeting of Shareholders was held on May 26, 1998.
At the meeting the following seven persons nominated by management were
elected to serve as directors of the Company:
 
<TABLE>
<CAPTION>
                                                                   SHARES
                                                             -------------------
     NOMINEE                                                 VOTED FOR  WITHHELD
     -------                                                 ---------- --------
     <S>                                                     <C>        <C>
     Donald J. Massaro...................................... 10,601,073  27,907
     Andrew S. Pascal....................................... 10,606,097  22,883
     William Hart........................................... 10,603,898  25,082
     Kevin R. Harvey........................................ 10,605,247  23,733
     David S. Morse......................................... 10,605,048  23,932
     Joseph T. Piemont...................................... 10,597,248  31,732
     Thomas J. Volpe........................................ 10,604,298  24,682
</TABLE>
 
  The following additional items were voted upon at the meeting:
 
    1. A proposal to adopt the Company's 1998 Employee Stock Purchase Plan,
  to become effective on August 3, 1998, and to include 450,000 shares of
  Common Stock reserved for issuance through six-month offerings, was
  approved by a vote of 10,106,168 for, 484,324 shares against, 38,488 shares
  abstaining and 0 broker non-votes.
 
    2. A proposal to ratify the appointment of Deloitte & Touche LLP as
  independent auditors of the Company for the fiscal year ending December 31,
  1998 was approved by a vote of 10,593,590 shares for, 20,870 shares
  against, 14,520 shares abstaining and 0 broker non-votes.
 
ITEM 5. OTHER INFORMATION
 
  On July 8, 1998, the Company completed the private placement of $17.25
million principal obligation Senior Discount Notes ("Notes") due September 30,
2002. Commencing January 1, 1999 the Notes bear interest at 12.5% per annum,
payable semi-annually. The Company is required to redeem $3 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, increasing to 100% over 9 months. In connection with the offering,
purchasers of the Notes were issued 5-year 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 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. The Company is
required, after approval is received by the necessary gaming regulatory
authorities, to register the Common Stock underlying the warrants with the
Securities and Exchange Commission, no later than January 1, 1999. Gross
proceeds to the Company before fees and other expenses were $14.95 million.
Offering costs of $50,000 will be included in other assets in July 1998 and
will be amortized as an adjustment to interest expense over the term of the
Notes.
 
  In connection with the Company's 1999 annual meeting of shareholders, under
the recently-amended Securities and Exchange Commission Rule 14a-4, management
may solicit proxies that confer discretionary authority to vote with respect
to any non-management proposal unless the Company has received notice of the
proposal not later than March 8, 1999.
 
                                      20
<PAGE>
 
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
 
  (a) Exhibits.
 
<TABLE>
<CAPTION>
     NUMBER                         EXHIBIT DESCRIPTION
     ------                         -------------------
     <C>    <S>
     10.32  Loan and Security Agreement dated November 25, 1997, by and between
            the Company and Silicon Valley Bank
     10.33  Loan Modification Agreement dated April 23, 1998, by and between
            the Company and Silicon Valley Bank
     10.34  Pledge Agreement dated December 1997, by and between the Company
            and Silicon Valley Bank
     10.35* Intellectual Property Security Agreement dated November 25, 1997,
            by and between the Company and Silicon Valley Bank
     11.1   Statement Regarding Computation of Loss Per Share
     27.1   Financial Data Schedule
</TABLE>
 
  (b) Reports on Form 8-K.
 
    None.
 
--------
 * Certain information in this exhibit has been omitted and filed separately
   with the Securities and Exchange Commission pursuant to a confidential
   treatment request under 17 C.F.R. Sections 200.80(b)(4), 200.83 and 230.46.
 
                                      21
<PAGE>
 
                                   SIGNATURE
 
  PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THE
REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE
UNDERSIGNED THEREUNTO DULY AUTHORIZED.
 
                                          Silicon Gaming, Inc.
 
                                                   /s/ Thomas E. Carlson
                                          By __________________________________
                                                     THOMAS E. CARLSON
                                              VICE PRESIDENT--CHIEF FINANCIAL
                                                          OFFICER
                                              (PRINCIPAL FINANCIAL AND CHIEF
                                                    ACCOUNTING OFFICER)
 
Date: August 14, 1998
 
                                       22