SECURITIES AND EXCHANGE COMMISSION

                             WASHINGTON, D.C. 20549

                                   FORM 10-KSB
(Mark One)


          [X]     ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE
                  SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 1996

                                       OR


          [ ]     TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE
                  SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________   to ________

                        Commission file number 000-21295
                                               ---------

                              THINKING TOOLS, INC.
     ----------------------------------------------------------------------
                 (Name of small business issuer in its charter)

          Delaware                                   77-0436410
-------------------------------         ----------------------------------
(State or other jurisdiction of        (I.R.S. Employer Identification No.)
incorporation or organization)

One Lower Ragsdale Drive, 1-250
Monterey, California                                                 93940
---------------------------------------                           ----------
(Address of principal executive offices)                          (Zip Code)

Issuer's telephone number      (408) 373-8688
                            -----------------

Securities registered under Section 12(b) of the Exchange Act:

        Title of each class          Name of each exchange on which registered
        -------------------          -----------------------------------------

               None                                None
     ----------------------          -----------------------------------------

Securities registered pursuant to Section 12(g) of the Exchange Act:

                          Common Stock, $.001 par value
  ----------------------------------------------------------------------------
                                (Title of Class)
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Check whether the registrant (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 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 [ ]

Check if disclosure of delinquent filers pursuant to Item 405 of Regulation S-B
is not contained herein, and no disclosure will 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-KSB or any amendment to
this Form 10-KSB.
                                                                             [X]

The Registrant's revenues for its most recent fiscal year was $908,000.

As of March 19, 1997, 4,641,758 shares of common stock (the "Common Stock") of
the Registrant were outstanding. The aggregate market value of the shares of
Common Stock held by non-affiliates of the Registrant, based on a closing sale
price of the Common Stock on the Nasdaq SmallCap Market on March 19, 1997, of
$9.25 per share, was approximately $14.9 million.1

Transitional Small Business Disclosure Format (Check one): Yes [ ]   No  [X]


--------
1        For purposes of this Report, the number of shares held by
         non-affiliates was determined by aggregating the number of shares held
         by Officers and Directors of Registrant, and by others who, to
         Registrant's knowledge, own 10% or more of Registrant's Common Stock,
         and subtracting those shares from the total number of shares
         outstanding.


<PAGE>
                                     PART I

This Annual Report of Form 10-KSB contains forward looking statements that
involve certain risks and uncertainties. The Registrant's actual results could
differ materially from the results discussed in the forward looking statements.
See "Description of Business - Cautionary Statements Regarding
Forward-Looking Statements."

Item 1.     DESCRIPTION OF BUSINESS

            Thinking Tools, Inc. (the "Registrant" or the "Company") was
incorporated in Delaware on August 8, 1996, as a wholly-owned subsidiary of
Thinking Tools, Inc., a California corporation (the "Predecessor Company"). On
August 28, 1996, the Predecessor Company was merged with and into the Company.
References herein to the "Registrant" or the "Company" include the Predecessor
Company.

            The Company develops powerful and flexible PC-based business
simulation software programs that enable users to simulate real life business
situations, explore complex operational problems and improve functional and
problem solving skills. The Company's agent-based, adaptive simulation software
has a broad range of potential business applications, including strategic
planning, sales and marketing, training, competitive positioning, product
marketing, operational planning and logistics.

            The Company believes that its products are unique because they
combine its proprietary agent-based programming with user-friendly interactive
interfaces like those used in sophisticated computer games to produce
interactive adaptive business simulations. Agent-based, adaptive simulations can
be used to model competitive situations, simulate consumer behavior, demonstrate
the impact of management actions, seek system vulnerabilities and explore
complex operational systems. The Company's products employ user-friendly
interfaces to enable business people to comfortably interact with complex
systems.

            The Company's agent-based programming enables autonomous agents in
simulations to respond to user behaviors in realistic and unpredictable ways.
This is in contrast to other commercial simulations and simulation tools, which
are generally based on formulas, equations, or deterministic algorithms. The
multiplicity of autonomous agents and the results of their interactions with
each other and with the user, give the Company's simulations a depth that
mirrors the complex, adaptive behavior of systems found in the real world.

            The Company's capabilities in developing highly sophisticated
simulations are built upon its skill in programming autonomous and adaptive
agents, its large and growing library of reusable simulation objects, and its
experience gained from developing computer games. The Company's creative control
is based on its proprietary development environment, WHITEBOARD(TM), which
supports interface building, object creation, simulation management, object
management and application frameworks. WHITEBOARD simplifies and supports the
construction of agent-based simulations and is the core of the Company's current
generation of simulations.

            The Company was formed to purchase, on December 30, 1993, certain
assets of the Business Simulation Division (the "Division") of Maxis, Inc., a
leading computer game company and creator of the simulation game SimCity(TM).
Through the purchase agreement with Maxis, Inc., the


<PAGE>

Company acquired the Division's equipment, staff, work-in-progress, customers,
prospects, software tools, libraries and processes.

Industry Overview

            Computer simulation is an imitation of selected properties of
reality, usually for the purpose of getting answers or practicing and rehearsing
problem solving skills. Prior to the advent of digital computers, scale models
and analog computers were used in design to simulate ship hulls and other
structures. Whether eighteenth century wooden scale models or the latest
adaptive simulations, these tools help their users understand the dynamic
behavior of complex systems.

            Simulations were among the earliest digital computer applications.
Since the first days of digital computers, simulations using equations have been
applied to scientific and engineering problems. The quintessential example of a
computer simulation is the flight simulator. The flight simulator teaches the
pilot to be a problem solver rather than a rule follower. It does not predict
that the right engine will fall off of the aircraft on the next flight, but
rather helps the pilot learn how to react to such an emergency. If only a very
limited number of problems could occur on a flight, the pilot could merely be a
rule follower. But the reality is that the number of problems that can arise is
unimaginably large, so the good pilot must be able to solve problems in a cool,
calm, collected manner. Many jobs in business present a level of complexity and
magnitude similar to that of problems that a pilot faces. These occupations
require top problem solving skills. Rule following is insufficient. Thus,
simulation can be as valuable to business people as to pilots.

            Business simulations first began to appear shortly after the
introduction of the digital computer. Companies have attempted to simulate
complex adaptive systems with models that were either fixed (deterministic) or
stochastic (probability-based). Alternatively, companies have developed their
own custom systems based on executive information system (EIS) software
packages. In all cases, the models lacked the adapting and evolving
characteristics of real world systems; particularly because the most interesting
business systems are made up of elements (e.g., customers, competitors and
markets) that adapt their behaviors to each other. The elements in these systems
modify their external behavior and internal structure in order to make more
efficient use of their environments. Models based on formulae alone cannot
effectively recreate these complex, adaptive systems.

            In order to imitate a complex adaptive system, a model must have two
properties. First, the model has to have richness to duplicate at least selected
aspects of the real world system's complexity. To accomplish this, most of the
Company's simulations now involve greater than 10,000 objects - or working parts
- roughly the same number of parts contained in an automobile. Second, the model
must have adaptive behavior - in other words some parts of the model must be
able to adapt their behavior to the actions of the human user and to the other
parts. In the Company's simulations, these adaptive parts are agents. As a
result, the Company refers to its products as "agent-based, adaptive
simulations." Some further definitions will help to explain how this is
accomplished:

         [bullet] Object. A way to organize the code and data of a software
                  program. An object is a self contained capsule of data and
                  logic that is an independent piece of the program.


                                      -2-

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         [bullet] Agent. An object designed to take action on its own. An agent
                  selects its action using information it chooses from a range
                  of available actions.

                           Autonomous Agent. An agent that selects its behavior
                           with the goal of achieving a better fit to the
                           requirements of its environment.

                           Adaptive Agent. An agent that creates new behaviors
                           in a non-random way with the goal of achieving a
                           progressively better fit to the requirements of its
                           environment.

            Both adaptive and autonomous agents can be used to produce adaptive
simulations. Adaptive simulations customize the learning experience by allowing
the simulation to discern each user's vulnerabilities and then confront that
user with simulated events that focus on his or her weaknesses. This hostile
environment introduces the challenges that a particular user needs most to
understand. Training based on adaptive simulations emphasizes diagnosis,
planning, and problem solving skills rather than rote learning or
routine/automatic responses.

            The Company believes that adaptive simulation methods are most
effective in the following applications:

         [bullet] Decision Making. Adaptive simulations assist the user who
                  makes decisions or takes actions and who has to deal with
                  complex adaptive systems such as markets or organizations -
                  any situation where the decision maker benefits by a problem
                  solving approach rather than a rule following approach.

         [bullet] Training. Adaptive simulations provide a practice field for
                  the imagination, where people can learn by doing, without the
                  risk or danger of prohibitively high cost. Experienced people
                  know that they learn through failure, but professionals are
                  taught to do their best to avoid failure because of its high
                  cost. Simulations make learning through failure a routine and
                  acceptable practice by eliminating the real world consequences
                  of failure.

         [bullet] Rehearsal. Individual and group rehearsal of responses to
                  simulated contingencies used to evaluate the users' ability to
                  handle various emergencies.

         [bullet] Shared Awareness. Simulation of proposed uses of critical
                  knowledge. Where does each department or employee fit? What
                  does the business look like? What changes are necessary and
                  why? What is the plan?

            The adaptive business simulation software industry is in its
infancy. When computing power was prohibitively expensive, only the largest
companies could hope to gain the benefit of sophisticated business simulation.
But, as computing power has dropped in price, even small companies have come to
possess hardware capable of supporting adaptive simulations, provided that the
software is available. The market for adaptive simulation software is expected
by the Company to continue to grow dramatically as the fixed cost of supporting
hardware continues to drop.


                                      -3-

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            The Company believes that the use of simulation models in the
business world will continue to increase as a result of the following:

         [bullet] Increasing demand for employees who can go beyond rule
                  following to solve problems - even in computer environments.

         [bullet] Increasing use of computers to assist decision-makers with
                  complex strategic issues, including operational support
                  software for problem management and resolution.

         [bullet] Increasing recognition of models and simulations as
                  cost-effective alternatives to specialized personnel in the
                  areas of marketing and sales.

         [bullet] Increasing use of multimedia software to support collaboration
                  among geographically separated workgroups.

         [bullet] Increasing PC performance allowing the use of advanced
                  graphics and multimedia to represent business situations.

         [bullet] Increasing importance of competitive product positioning and
                  shortening the development time for products.

The Thinking Tools Solution

            The Company's approach to simulation is known as agent-based,
adaptive simulation (as distinct from equation-based simulation). Agent-based
methods involve software environments filled with many agents. As the agents
interact they individually select behavior rules that guide their actions. These
actions in turn influence the rule selections made by other agents. The overall
system behavior that results from the application of all of these individual
behavior rules is called emergent behavior.

            Emergent behavior shapes many familiar, everyday business phenomena.
From gradual and small shifts in consumer preference to precipitous and dramatic
victories or defeats in product competition, emergent behavior can result from
interactions among the relatively simple decisions or choices made by the
individual actors in the system. The most dramatic examples of emergent behavior
lead to "routs," where complex structures or behaviors break down.

            Emergent behavior helps explain the routs that occur in sports,
military history and business. There are many examples of the underdog team
winning a major tournament against overwhelming odds. The underdog team,
outclassed man for man, seems to do everything perfectly, while the highly
favored team falls apart or collapses. Teams are complex adaptive systems where
emergent behavior plays a critical role. Each individual player on a team is an
autonomous agent and the interaction between those agents produces a result
(either positive or negative) that may be much greater than the expected sum of
the parts. Emergent behavior is typically far more complex than the behavior of
individual agents in the system. Adaptive simulations developed by the Company
imitate the emergent behavior of complex business processes, organizations or
markets.

            The Company has combined its experience in developing agent-based
simulations with its skill derived from building computer game human interfaces.
The human interface found in many

                                       -4-
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computer games is very different from almost all other software. The distinction
is the difference between a place and a surface.

            Most business software presents the user with an information
surface: users put information onto the surface and the software processes it,
or the software puts information onto the surface and users make use of it. On
the other hand, the human interface used in many computer games is an artificial
environment or place created by software and reflected in a multimedia format.
Users perceive and sometimes shape or manage the systems present in those
places. This style is much more closely related to film or theater than to
information surface interfaces found in other types of software. As a result of
this combination of strengths, the Company is able to produce software products
that are accessible and adaptive. These tools make it easy for users to become
involved and assume a role in the system that they are exploring.

            The Company's business process simulations address complex
management tasks which require almost continuous use of judgment, insight and
problem solving skills, focusing on assisting users to develop these skills. The
simulations also provide operational support that helps users as they plan and
solve problems. These simulations promote the user's thinking about the complex
systems upon which their operations depend. The Company believes that the
principle competitive advantages of its products over other business process
simulations include the adaptive nature of these simulations and their familiar
and easily accessible human interface. They are capable of providing users an
experience, not just information.

Products

            The Company's products are fully-graphical, interactive and provide
constant graphical feedback with a wide variety of responses to the user's
actions. To date, the Company's technology has been used to develop a variety of
such products. Four major examples follow:

            SimRefinery is a demonstration program which was released by the
Division in late 1992 and purchased by the Company along with certain assets of
the Division. The user in SimRefinery learns about refineries by taking an
active role in the simulation as the plant manager of the refinery. The program
shows how supply and demand conditions interact, including the impact that
changes in supply and demand conditions and changes in marketplace objectives
have on the financial performance of the refinery. SimRefinery continues to
serve as one of the Company's model demonstration programs.

            SimHealth is a simulation of the impact of various proposed reforms
on the United States health care system and has some 5,000 objects. It simulates
both the supply and demand sides of health care, showing the impact of choices
and values on the financial health of the system and on its usage and demand.
The program was developed for the Markle Foundation ("Markle") in 1994 under a
contract negotiated by the Division, and assumed and completed by the Company.

            TeleSim is a simulation of a local telephone exchange market for a
particular business region, including the competitors in that region. The
package simulates the world of a telephone company, including the telephone
company's sales and service regions and its market opportunities and
vulnerabilities. The user can actively explore the impact that changes in the
condition of supply and demand or the emphasis of different corporate objectives
have on the financial performance of the corporation and on its competitive
environment. Competing companies in the simulation are

                                       -5-

<PAGE>

changes in the conditions of supply and demand or emphasis of different
corporate objectives driven by adaptive agents that base their strategies in
part on the actions taken by the user. TeleSim has some 12,000 objects. After
its initial development under a contract with Coopers and Lybrand L.L.P.
("Coopers") in 1994, Coopers sold the TeleSim product to NYNEX Corporation and
Pacific Telecom, Inc. Subsequent versions of TeleSim have been produced and sold
through Coopers to Sprint Corp. and AT&T Corp. In late 1996, the Company
obtained marketing rights for Telesim and has added Bell Canada to its list of
customers.

            Project Challenge is a simulation of the management of information
systems projects. Project Challenge users sit in the office of the Project
Manager where they create a model of their project, then manage the project
in benign, realistic or hostile environments. A variety of novel displays
keep the user informed about project conditions, including scheduling, budget
and human resources. This simulation program can assist in both training and
operational roles. Project Challenge is highly sophisticated, incorporating over
15,000 objects. The development of the simulation was funded by SHL Systemhouse,
Inc. ("Systemhouse"), a division of MCI Corp.; however, the Company retained the
rights to create variations of this specific simulation for management of other
kinds of projects, such as construction projects. The Company anticipates that
Project Challenge will also serve as a foundation for training or operational
support applications in other business disciplines.

Customers

            Historically, the Company has created its products for a number of
large companies, as well as governmental agencies, foundations, textbook and
traditional publishers and consulting firms. The following list identifies
certain of the Company's direct customers:

      Coopers & Lybrand L.L.P.             Systems Engineering Solutions, Inc.
      SHL Systemhouse, Inc.                Xerox Corp.
      Andersen Consulting L.L.P.           Harcourt General, Inc.
      Markle Foundation

            Some of the Company's customers have contracted for the Company's
development of specific simulations in order to resell such simulations as a
value added component of their consulting or other services. The following list
identifies certain end-users who have purchased the Company's products directly
from customers of the Company:

      AT&T Corp.                           Sprint Corp.
      NYNEX Corporation                    Pacific Telecom, Inc.
      U.S. Army                            U.S. Air Force
      Office of Research and
       Development

            Sales to Systems Engineering Solutions, Inc. ("SESI") (a prime
contractor for work in logistics for the United States Army and the United
States Air Force), Systemhouse, the Office of Research and Development ("ORD"),
and Bell Canada in the year ended December 31, 1996 ("Fiscal 1996"), accounted
for 28%, 25%, 24% and 14%, respectively, of the Company's sales for such period.
Sales to Markle, ORD and Systemhouse in the year ended December 31, 1995
("Fiscal 1995"), accounted for 27%, 14% and 13%, respectively, of the Company's
sales for such period. The Company does not believe that it is materially
dependent upon sales to these customers.


                                      -6-

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Competition

            The market for business simulation software is highly competitive,
subject to rapid technological change and emerging industry standards. The
Company believes that the principal competitive factors in its markets are new
technology and techniques, product performance, product maintenance, support and
price. The software industry in general is highly competitive and most
established companies in the business software field are substantially larger
and have greater financial resources than the Company.

            Presently, internal development of business simulations by companies
seeking simulation capability represents the main source of competition to the
Company's products and services. However, because it generally is not economical
for a business to develop and continually upgrade such a product for its own
needs alone, the Company believes that internal development produces a less cost
effective solution to the developer's needs.

            Internal developers are currently limited to using equation-based
simulation tools for their simulation program development. Equation-based models
will not duplicate the adaptive or chaotic behavior of complex business systems
as do those available from the Company. No generally available sources of tools
will help corporate technical staff to design models of complex adaptive systems
competitive with those of the Company. Finally, even if internal developers had
programming tools for agent-based simulations, the design know-how like that
refined and practiced at the Company would still be required to create rich and
effective tools, and are unlikely to be available in an in-house setting.

            Authoring tools such as MacroMedia's Director and Asymmetrix'
Toolbook can be used to develop parts of the user interface for simulations.
Authoring tools are developing a rich suite of multimedia effects and are
optimal for building interesting graphic user interfaces and interactive
applications. However, these tools cannot match the extensive customized and
specialized agent-based, adaptive simulation objects possessed by the Company.

            The Company believes that the following companies constitute the
principal participants in the business simulation software market at this time:

            Aspen Technologies, Inc. ("Aspen") supplies computer-aided chemical
engineering software products to the process manufacturing industries. Aspen's
software allows chemical engineers to create mathematical models of
manufacturing processes and to predict the performance of such procedures under
varying equipment configurations and conditions.

            GSE Systems, Inc. ("GSE") designs, develops and supplies high
fidelity, real time simulation software, systems and services for the energy and
manufacturing industries. GSE develops simulation products for nuclear power
plants, fossil fuel plants, petroleum refineries, chemical processing plants and
other industrial manufacturing plants.

            Integrated Systems, Inc. provides software development tools in
several industries. Its products help manufacturers develop and simulate dynamic
systems.

            IntelliCorp, Inc. ("IntelliCorp.") develops and markets computer
software that helps in creating knowledge-based computer systems, solving
difficult problems and distributing information.IntelliCorp.'s software is aimed
at the mainstream business market.

                                       -7-
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            Legacy Software, Inc. develops entertainment and education software
products for homes and schools.

            Meta-Software, Inc. develops, markets and supports simulation and
library generation software products for use in integrated circuit design.

            MPSI Systems, Inc. ("MPSI") develops and markets proprietary
computer application software and related databases used by multi-outlet
retailers. MPSI's product constructs a mathematical model of a retail market,
allowing clients to simulate various market changes.

            PRI Automation, Inc. manufactures factory automation systems used in
the fabrication of integrated circuits by semiconductor manufacturers.

            Games developers may also choose to enter the business simulation
software market in the future and become competitors of the Company.

            The Company believes that its combination of computer game
interfaces, agent-based programming and design of complex adaptive system models
differentiates its products from those of its competitors.

Product Development

            The Company believes that its programming technology, resources and
experience will allow it to move beyond the current generation of simulation
products. Several advanced capabilities developed and cultivated by the Company
since its inception play a critical role in its product development work.

         [bullet]  The Company has developed a process for investigating,
                   describing and modeling complex adaptive systems.
                   Conceptual and detailed design steps in this process make
                   it possible to translate an understanding of the complex
                   adaptive system into specifications required by programmers
                   to build the final product. The Company has developed and
                   refined its ability to program both autonomous and adaptive
                   agents that make it possible for the simulator to produce
                   new behaviors at run time, while remaining within a range
                   of realistic behavior.

         [bullet]  The Company continues to introduce and apply newer, more
                   powerful techniques for programming its agents, including
                   methods based on biological processes.

         [bullet]  The Company has succeeded in creating a class of "bad
                   agents," known as "Malion agents," to explore
                   vulnerabilities in systems, networks or practices so that
                   the user can then repair them.

            The following markets are ones in which the Company is either
already pursuing, or plans to pursue, product applications.

            Business Management and Training. In these simulations, the Company
intends to focus on markets that lend themselves specifically to the strengths
of simulation. Namely, these are markets requiring simulations mirroring
circumstances involving multiple central variables amongst which

                                      -8-

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tradeoffs continually need to be made, with outcomes that are not always
intuitively obvious. An example of a business process simulation is Project
Challenge, which trains corporate employees in the art of project management.
The Company has recently begun planning and developing the concept for a second
product in this category. Products in the business process category generally
will be designed to support easy field-modification by the training department
or student, but will not require custom programming by the Company for each
potential customer.

            Contingency and Security. These proposed simulations will provide
emergency response service providers with a means of training, rehearsing and
planning their crises procedures. The Company believes that this field is
particularly appropriate for simulation since all parts of an organization must
be involved, the actual event being prepared for happens rarely, if at all, and
the consequences of the event can be disastrous if not handled properly. The
first proposed product is being developed to address technology crises within
corporations, but related products may be developed for other forms of emergency
response.

            Risk Management. These proposed simulations will provide day-to-day
operational support to managers and technical professionals who must allocate
limited resources to projects designed to reduce risk. Organizations face
several problems of such large scale that their resources are not sufficient to
"fix everything." Usually the departments and sections of large organizations
view their own problems as the highest risk. Simulations in this category will
help those who are responsible for planning these defensive measures to think
about the problem in a rational way that is tightly connected to the most
critical needs of the organization's business functions. The Company has
recently begun development of a product in this category.

            Internet and Intranet Simulations as Marketing Tools. Simulations of
a host's business would reside on its home page or intranet and combine the key
properties of adaptive and interactive simulators with the accessibility of wide
area networks. Because these proposed simulations will emulate games, the
Company believes that Internet users will view them as compelling and engaging
ways to spend time. While protecting the individual consumers' identity, the
site would track and provide to the host valuable marketing information relating
to the way consumers learn, think and decide about the hosts' products, and if
so desired, on competitive products as well. In this way the host could collect
valuable marketing information. The Company has not yet begun the development of
any specific product in this category.

            Adaptive Supply and Distribution. The Company has completed a proof
of concept simulation in the area of self-ordering distribution that the Company
believes could change the way companies think about and plan their supply,
distribution, replenishment and logistics capabilities. The Company believes
that a simulation of this type would be of substantial interest in corporate,
military and other government circles.

            Thought and Decision Processes. The Company is working on a
simulation that ascribes motives, goals, thoughts and strategies to other people
or groups in order to make sense of their past behavior and to anticipate their
future behavior. The simulation provides users with a means of building and
updating models of the thought and decision processes of other individuals or
groups (for example, the competition or other departments within an
organization.) The product is intended to create a picture of this dynamic and
often very complex process that helps the user to explore what she knows or
assumes about the process. This simulation will be used to clarify communication
with others and to further understand the thought process under examination. The
first application in

                                       -9-

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development is in the area of complex strategic decision-making. Future
commercial applications will be designed to help corporate customers as they
collect, organize and apply this complex and subtle knowledge about their
business decisions, or those of their competitors and customers.

            The development of simulation software products is a highly complex
and labor intensive process. The amount of time and investment required to
complete a particular product may vary depending upon a variety of factors,
which may or may not be anticipated at the commencement of product development.
Accordingly, there can be no assurance that any product which the Company may
seek to develop will be completed within anticipated budgets or time frames, if
at all. Furthermore, there can be no assurance that completed products will
achieve commercial acceptance or result in revenues or profits to the Company.

Intellectual Property

            The Company does not have any patents and to date has not filed
patent applications on its products. The Company believes that certain of its
technology may qualify for patent protection and is pursuing this course.
However, the Company also recognizes that patents are often insufficient to
protect software. The Company regards the software that it owns or licenses as
proprietary and relies primarily on a combination of trade secret laws,
nondisclosure agreements and other protection methods to protect its rights to
its products and proprietary rights.

            It is the Company's policy that all employees and third-party
developers sign nondisclosure agreements. This may not afford the Company
sufficient protection for its know-how and its proprietary products, and other
parties may develop similar know-how and products, duplicate the Company's
know-how and products or develop patents that would materially and adversely
affect the Company's business.

            The Company believes that its products and services do not infringe
the rights of third parties. However, there can be no assurance that third
parties may not assert infringement claims against the Company, with such claims
resulting in the Company being required to enter into royalty arrangements, pay
other damages or defend against litigation, any of which could materially and
adversely affect the Company's business.

The Core Technology Asset-WHITEBOARD

            WHITEBOARD is a collection of technologies that allows the Company's
software programmers to build an adaptive simulation for any type of company or
industry. WHITEBOARD incorporates in the simulations all major variables for
situations defined by the programmer. The Company's simulation development
process allows the programmer to change variables and to see the effect of any
other combination of variables. WHITEBOARD is comprised of four main components:

         [bullet] An object-oriented database engine to manage and access
                  thousands of objects while a simulation is running.

         [bullet] A library of predefined business simulation objects and tools
                  to enable the programmer to edit these objects and to build
                  customized objects.

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         [bullet] An object integration component to allow users to import and
                  use objects from other technical environments, including other
                  Company simulations.

         [bullet] The technical capability to add multimedia effects and
                  approaches.

            WHITEBOARD is a powerful tool for building simulations of complex
adaptive systems critical for simulating business environments. WHITEBOARD was
developed to provide programmers with a tool for easily building realistic
business simulations with a capacity for adaptive behavior, realistic
duplication of crisis or chaos situations and animation and graphical displays.
While incorporating advanced object-oriented concepts, it also focuses on the
graphics area and is designed for visual analysis. WHITEBOARD allows programmers
to add full multimedia effects including sound, graphics and digital video. This
permits the designer to approach simulations in the most realistic way possible.
WHITEBOARD runs on IBM PC compatible computers using Windows 3.1 or Windows 95.
It is written in the widely used "C" programming language and it runs with
Novell software in a workgroup environment.

            The object-oriented database allows programmers to build complex
applications by importing existing objects from other of the Company's
applications--both finished products and work-in-progress. The programmer can
also edit existing simulation objects or add new types of simulation objects to
simulate new types of situations. In effect, the engine is a specialized tool
for rapidly building business simulations. For example, a family of performance
support or training applications for specific types of projects could be
developed substantially faster than Project Challenge--the foundation upon which
they could be based.

            The Company plans to enhance WHITEBOARD to include tools that will
allow the programmer to build customized simulation objects based on library
objects or other objects. The library of objects built into WHITEBOARD can be
further extended so that generic situations and processes can be highly
customized to the precise application required by the programmer.

            The WHITEBOARD technology has been validated through use in the
development of the Company's products. Programmers have been able to carry out
design, simulation and testing that would have otherwise been inordinately time
consuming and expensive, at a fraction of the cost and the time spent. Use of
WHITEBOARD has reduced the time required for prototyping the simulation and
testing the marketing and launch of a product to as little as a few months. The
Company believes that the ability of WHITEBOARD to contribute to reductions in
cycle time and to model strategic choices provides a significant competitive
factor to the Company.

Sales and Marketing

            To date, the Company has not devoted significant financial resources
to marketing, and customers have come through word-of-mouth or following
referrals from Maxis, Inc. and others. The Company has also generated inquiries
by presentations at industry and academic forums with high level corporate
audiences. John Hiles, the Company's Founder and Chief Technology Officer, is a
highly sought after speaker at such events.

            The Company intends to distribute its product through its existing
strategic partners as well as by initiating direct sales to customers through
its proposed sales force, and through value added resellers ("VARs").


                                      -11
<PAGE>
            The Company entered into a Vertical Market Software
Development/Licensing Agreement, dated October 12, 1994, with Coopers pursuant
to which the Company receives a royalty from Coopers in exchange for the grant
to Coopers of a worldwide, perpetual license to use and reproduce TeleSim
subject to the following: (i) for a period equal to the greater of five years
from Coopers' final acceptance of TeleSim or any period of one year of non-use
by Coopers of TeleSim, the Company may not license or sell TeleSim worldwide
without Coopers' written approval and (ii) the Company may use TeleSim in any
product for use outside the telecommunications industry, and for any
non-competitive product, including other products for the telecommunications
industry, provided that the Company shall not use Coopers' confidential
information or trademarks. In December 1996, this agreement was modified to
allow the Company to license TeleSim or any derivative thereof to any
telecommunications industry customer in exchange for a royalty on each such sale
to be paid to Coopers.

            The Company also entered into a Development Agreement, dated June
30, 1995, with Systemhouse, pursuant to which the Company receives a royalty
from Systemhouse in exchange for the grant to Systemhouse of a worldwide,
exclusive right to use, market, sell, distribute and license Project Challenge
for systems integration.

            The Company is also in discussion with additional prospective VARs.
As the Company moves into new specific product areas, it intends to seek
strategic alliances in such areas. The Company plans to continue making
presentations and appearances at academic forums and corporate-sponsored events.

            In October 1996, the Company raised approximately $8.5 million in
net proceeds through its initial public offering of Common Stock (the "IPO"). A
portion of the proceeds from the IPO is being used to implement the Company's
marketing and sales efforts. The Company has begun to hire a direct sales force.
A senior marketing and sales executive is expected to be hired to further
develop the product strategy and implement and expand the Company's distribution
strategy.

Growth Strategy

            The Company devoted its initial efforts to demonstrating the
feasibility of the use of adaptive simulation for business applications by
developing customized software programs for large clients pursuant to strategic
distribution arrangements. The Company also assembled a highly-skilled technical
team, established a growing library of reusable software objects and enhanced
its WHITEBOARD technology.

            The Company's success in completing major projects for industry
leaders has validated the concept underlying the Company's technology. This has
positioned the Company to expand the scope of its operations to include the
development of internally-funded software products and the direct marketing of
the Company's products. In addition, the Company has continued to selectively
accept custom projects funded by third parties.

            The Company's goal is to develop a variety of simulations in
divergent business areas. As a part of this strategy, the Company intends to
undertake self-funded development of new simulations with broader market appeal
and to adapt certain previously developed simulations, rights to which were
retained by the Company, for sale as turnkey packages to new vertical markets.
The Company will also, upon request, customize these packages on a project
basis.

                                      -12-
<PAGE>

            The Company plans to continue to expand its custom business
selectively, while moving to invest in specific horizontal and vertical products
and distribution channels aimed at the high end corporate and professional
service markets. The Company intends to focus its custom business on projects
that either allow for further development of an important technology on a paid
basis, or facilitate the development of relationships with distribution partners
which could provide benefits to the Company beyond the custom project. Custom
projects will not be limited exclusively to the corporate sector, but may
include the military and intelligence communities, because of their interest in
leading edge technology. An important feature of the Company's "custom" strategy
is to reduce the required amount of custom development for each product, and
therefore its cost. The Company will seek to accomplish this goal by increasing
its use of semi-custom designs (design families) and through improved
development of object library creation techniques.

            The Company intends to continue building management depth and
breadth and expand the Company's marketing and sales capabilities. The Company
recently hired a Chief Executive Officer and an acting Chief Financial Officer.
The Company also intends to hire a senior marketing and sales executive to
further develop the product strategy and implement and expand the Company's
distribution strategy. The Company plans to establish a direct sales force to
focus on key products and markets and to solicit custom business. The Company is
using a portion of the net proceeds of the IPO for implementing this growth
strategy.

Personnel

            As of March 19, 1997, the Company had a total of 19 full-time
employees, including Mr. Phillip F. Whalen, Jr., the Company's Chief Executive
Officer and President, Mr. John Hiles, the Company's Founder, Chief Technology
Officer, and Secretary, Ms. Barbara Portner, the Company's acting Chief
Financial Officer, eight software engineers, two producers, three artists, one
business developer and two administrative personnel. None of the Company's
employees is represented by a labor union and the Company has not experienced
any work stoppages. The Company considers its relations with its employees to be
good.

            The market for qualified personnel, especially that for software
engineers and programmers, is highly competitive. The Company believes that its
future success will depend, in part, on its continued ability to hire,
assimilate and retain qualified personnel including management, sales and
marketing, executive and direct sales force personnel.

Government Regulation

            The Company is subject to regulation under various federal and state
laws regarding, among other things, occupational safety, environmental
protection, hazardous substance control and product advertising and promotion.
The Company believes that it has complied with these laws and regulations in all
material respects and it has not been required to take any action to correct any
material noncompliance. The Company does not currently anticipate that any
material capital expenditures will be required in order to comply with federal,
state and local laws or that compliance with such laws will have a material
effect on the financial condition or competitive position of the Company.

                                      -13-
<PAGE>

Cautionary Statements Regarding Forward-Looking Statements

            Statements in this Annual Report on Form 10-KSB under the captions
"Description of Business" and "Management's Discussion and Analysis or Plan of
Operation," as well as statements made in press releases and oral statements
that may be made by the Company or by officers, directors or employees of the
Company acting on the Company's behalf, that are not statements of historical
fact, constitute "forward-looking statements" within the meaning of the Private
Securities Litigation Reform Act of 1995. Such forward-looking statements
involve known and unknown risks, uncertainties and other factors that could
cause the actual results of the Company to be materially different from the
historical results or from any future results expressed or implied by such
forward-looking statements. In addition to statements which explicitly describe
such risks and uncertainties, readers are urged to consider statements labeled
with the terms "believes," "belief," "expects," plans," "anticipates," or
"intends" to be uncertain and forward-looking. All cautionary statements made in
this Annual Report on Form 10-KSB should be read as being applicable to all
related forwardlooking statements wherever they appear. Investors should
consider the following risk factors as well as the risks described elsewhere in
this Annual Report on Form 10-KSB.

Limited Operating History; Accumulated Deficit; History of Losses; Uncertain
Future Profitability.

            The Company commenced operations in December 1993 and is still in
the early stage of developing products. Since its inception, the Company has
experienced cumulative losses of $4,164,000 as of December 31, 1996, and has not
experienced any quarter of profitable operations. Consequently, its operations
are subject to numerous risks associated with the development of a new business.
The Company expects to continue to incur operating losses for the foreseeable
future, principally as a result of expenses associated with the Company's
product development efforts and anticipated sales, marketing and general and
administrative expenses. The Company's long-term viability and growth will
depend on the successful development, commercialization and marketing of its
proposed products. There can be no assurance that the Company will be able to
develop adequate revenue sources to successfully complete the development,
commercializing and marketing of its proposed products or that if it is
successful in doing so it will be able to achieve and maintain profitability.

Fluctuations in Operating Results; Substantial Revenues Derived from Limited
Customers.

            The Company's operating results may vary significantly from quarter
to quarter or year to year, depending on factors such as the timing of product
development, the timing of increased research and development and sales and
marketing expenses, the timing and size of orders and the introduction of new
products by the Company. Consequently, revenue or profit may vary significantly
from quarter to quarter or year to year and revenue or profit in any period will
not necessarily be predictive of results in subsequent periods.

            Historically, a significant portion of the Company's revenues have
been derived from a limited number of relatively large development projects
contracted for by a small number of customers. Sales to SESI, Systemhouse, ORD,
and Bell Canada during the fiscal year ended December 31, 1996, accounted for
28%, 25%, 24% and 14%, respectively, of the Company's sales for such period.
Sales to Markle, ORD and Systemhouse during the fiscal year ended December 31,
1995, accounted for 27%, 14% and 13%, respectively, of the Company's sales for
such period.

                                      -14-

<PAGE>

            Such customers are not affiliated with the Company. The Company does
not believe that it is materially dependent upon sales to these customers.
Contracts with such customers have been fully or substantially completed as of
December 31, 1996.

            The Company historically has not had, and at December 31, 1996, did
not have, any substantial firm order backlog. To the extent that the Company's
business continues to be derived from a limited number of large customer orders,
any inability by the Company as it completes such orders to obtain new orders
could have a material adverse effect on the Company's business, financial
condition and results of operations. The Company is currently working on a
limited number of customer orders. There can be no assurance that the Company
will obtain additional sources of revenue prior to completing such projects. The
Company's current and planned expense levels are based in part on its
expectations as to future revenue.

Dependence on Emerging Market for Business Simulation Software.

            The markets for business simulation software in general, and
agent-based, adaptive simulation software in particular, are still emerging,
making it difficult to predict with any assurance the future size of the
markets. There can be no assurance that such software will achieve broad-based
market acceptance, that markets for such software will continue to grow or that
increased sales of the Company's products will occur or continue as a result of
any such growth. There can be no assurance that alternatives to the Company's
agent-based, adaptive simulation software, such as object-oriented tools,
authoring tools or game methods will not achieve greater market acceptance than
the Company's agent-based, adaptive simulation software. Even if agent-based,
adaptive simulation achieves market acceptance and that market grows, there can
be no assurance that the Company will obtain a significant share of that market.

Risk of Competition

            There can be no assurance that other companies will not develop
programs such as those offered by the Company or alternative software
applications which meet the same needs of customers, or that potential customers
will not choose to meet their needs through in-house development rather than by
purchasing the Company's products. The Company expects to be subject to
competition from companies with substantially greater resources. There can be no
assurance that the Company will be able to respond to competitive pressures, or
that the effect of competitive pressures will not change the demand for, or
pricing of, the Company's products and services. To the extent that competitors
achieve performance, price or other selling advantages, the Company could be
adversely affected. There can be no assurance that the Company will have the
resources required to respond effectively to market or technological changes or
to otherwise compete successfully in the future.

Uncertainties Related to Development of Additional Products.

            Significant additional efforts will be required for the Company to
develop additional agent-based, adaptive simulation products. Any such future
efforts are subject to certain risks including, but not limited to, the risk
that new simulations will be difficult to develop into commercially viable
products free of competitive challenges and that any such products may fail to
achieve and sustain


                                      -15-
<PAGE>

market acceptance. There can be no assurance that the Company's product
development efforts will be successful.

Technological Change; Risk of Obsolescence; Industry Standards.

            The software industry is characterized by rapid technological
change, frequent introductions of new products, changes in customer demands and
evolving industry standards. The introduction of products embodying new
technology or the adaptation of products to the market and the emergence of new
industry standards often render existing products obsolete and unmarketable.

            The Company believes that its success will depend on its ability to
enhance its existing products and otherwise respond and keep pace with
technological developments and emerging industry standards. There can be no
assurance that the Company will be successful in developing enhanced or new
products that respond to technological changes or evolving industry standards in
a timely manner, or at all. Additionally, there can be no assurance that
technological changes or evolving industry standards will not render the
Company's products and technologies obsolete.

Uncertainties Regarding Intellectual Property.

            The Company does not have any patents and has not filed patent
applications on its products. The Company regards the software that it owns or
licenses as proprietary and relies primarily on a combination of trade secret
laws, nondisclosure agreements and other technical copy protection methods (such
as embedded coding) to protect its rights to its products and proprietary
rights. It is the Company's policy that all employees and third-party developers
sign nondisclosure agreements; however, this may not afford the Company
sufficient protection for its know-how and its proprietary products.

            Other parties may develop similar know-how and products, duplicate
the Company's know-how and products or develop patents that would materially and
adversely affect the Company's business, financial condition and results of
operations. Third parties may assert infringement claims against the Company,
and such claims may result in the Company being required to enter into royalty
arrangements, pay damages or defend litigation, any of which could materially
and adversely affect the Company's business, financial condition and results of
operations.

Limited Marketing Experience; Need for Additional Personnel.

            The Company has very limited marketing resources and limited
experience in marketing and selling its products and services. The Company will
have to further develop its marketing and sales force or rely principally on
VAR's, collaborators, licensees or others to provide for the marketing and sales
of its products and services. There can be no assurance that the Company will be
able to establish adequate marketing and sales capabilities or make arrangements
with VAR's, collaborators, licensees or others to perform such activities.

            Achieving market penetration will require significant efforts by the
Company to create awareness of, and demand for, its proposed products.
Accordingly, the Company's ability to expand its customer base will depend upon
its marketing efforts, including its ability to establish an effective internal
sales organization or strategic marketing arrangements with others. The failure
by the Company to successfully develop its marketing capabilities, internally or
through others, would have

                                      -16-

<PAGE>

a material adverse effect on the Company's business, financial condition and
results of operations. Further, there can be no assurance that the development
of such marketing capabilities will lead to sales of the Company's proposed
products.

            The success of the Company will also depend upon its ability to hire
and retain additional qualified management, marketing and financial personnel,
as to which there can be no assurance. The Company will compete with other
companies with greater financial and other resources for such personnel.

Risks Associated with Growth Strategy.

            The Company's growth strategy is expected to place a significant
strain on its management, administrative, operational, financial and other
resources. The Company's success will be dependent upon its ability to hire
additional highly qualified personnel to support the Company's product
development and marketing efforts, including monitoring operations, controlling
costs and maintaining effective management, inventory and credit controls. The
Company has limited experience in effectuating rapid expansion and managing a
broad range of products and services and significant operations. There can be no
assurance that the Company will be able to continue to manage its operations or
that any inability to do so will not adversely affect its business, financial
condition or results of operations.

Dependence on Key Personnel.

            The Company is dependent upon the continued efforts and abilities of
its senior management, particularly those of Mr. Phillip F. Whalen, Jr., the
Company's President and Chief Executive Officer and Mr. John Hiles, the
Company's Founder, Chief Technology Officer, and Secretary. The Company has
entered into an Employment Agreement with Mr. Hiles which is subject to
automatic annual renewals unless terminated by the Company or Mr. Hiles upon
ninety days' prior written notice. The loss or unavailability of Mr. Hiles or
Mr. Whalen for any significant period could have a material adverse effect on
the Company's business, financial condition and results of operations. The
Company maintains a $5,000,000 key-man life insurance policy on Mr. Hiles. The
Company's operations are also dependent upon its ability to attract and retain
qualified programmers and software engineers. There can be no assurance that the
Company will be able to attract and retain such skilled personnel, and failure
to do so could have a material adverse effect on the business, financial
condition and results of operations of the Company. All employees of the Company
are at-will employees.

Control by Management.

            Mr. John Hiles owns 1,076,677 shares of Common Stock which
represents approximately 23.2% of the Company's outstanding Common Stock. Mr.
Fred Knoll, the Company's Chairman of the Board, controls Thinking Technologies,
L.P., a limited partnership and principal stockholder of the Company
("Technologies"), which owns 1,955,081 shares of Common Stock, representing
approximately 42.1% of the Company's outstanding Common Stock. Together, Messrs.
Hiles and Knoll own or control an aggregate of 3,031,758 shares of Common Stock,
representing approximately 65.3% of the outstanding Common Stock. As a result of
such ownership and control, Messrs. Hiles and Knoll have the ability to control
the election of the directors of the Company and the outcome of all issues
submitted to a vote of the stockholders of the Company. Additionally, Mr.

                                      -17-
<PAGE>

Knoll controls warrants to purchase 468,242 shares of Common Stock at an
exercise price of $1.07 per share issued to Technologies (the "Technologies
Warrants"), in July 1996, and warrants issued to Technologies to purchase
156,250 shares of Common Stock (the "Bridge Warrants"), at an exercise price of
$3.90 per share, issued by the Company to purchasers of its 10% Senior Secured
Promissory Notes (the "Bridge Notes") in connection with a debt financing
consummated in August 1996 (the "Bridge Financing").

Need For Additional Financing.

            Based on the Company's operating plan, the Company believes its
existing cash balances will be adequate to satisfy its operating and capital
requirements through at least the next 12 months. Such belief is based upon
certain assumptions, and there can be no assurance that such assumptions are
correct. However, the Company does not expect that it will be able to continue
its operations beyond this time without additional financing. There can be no
assurance that additional financing will be available when needed on terms
acceptable to the Company or at all.

NASDAQ Delisting; Low Stock Price.

            The trading of the Company's Securities on NASDAQ is conditioned
upon the Company meeting certain asset, capital and surplus earnings and stock
price tests set forth by such exchange. To maintain eligibility for trading on
NASDAQ, the Company will be required to maintain total assets in excess of
$2,000,000, capital and surplus in excess of $1,000,000 and (subject to certain
exceptions) a bid price of $1.00 per share. If the Company fails any of the
tests, the Common Stock may be delisted from trading on such exchange.

            The effects of delisting include the limited release of the market
prices of the Company's securities and limited news coverage of the Company.
Delisting may restrict investors' interest in the Company's securities and
materially adversely affect the trading market and prices for such securities
and the Company's ability to issue additional securities or to secure additional
financing. In addition to the risk of volatile stock prices and possible
delisting, low price stocks are subject to the additional risks of federal and
state regulatory requirements and the potential loss of effective trading
markets. In particular, if the Common Stock were delisted from trading on such
exchange and the trading price of the Common Stock was less than $5 per share,
the Common Stock could be subject to Rule 15g-9 under the Securities Exchange
Act of 1934, as amended, which, among other things, requires that broker/dealers
satisfy special sales practice requirements, including making individualized
written suitability determinations and receiving purchasers' written consent,
prior to any transaction.

            If the Company's securities could also be deemed penny stocks under
the Securities Enforcement and Penny Stock Reform Act of 1990, this would
require additional disclosure in connection with trades in the Company's
securities, including the delivery of a disclosure schedule explaining the
nature and risks of the penny stock market. Such requirements could severely
limit the liquidity of the Company's securities.

Future Sales of Restricted Securities.

            The Company had 4,641,758 shares of Common Stock outstanding as of
March 19, 1997. Of these shares, all 1,610,000 shares of Common Stock sold in
the IPO are freely transferable by persons other than affiliates of the Company,
without restriction or further registration under the

                                      -18-
<PAGE>

Securities Act of 1933, as amended (the "Securities Act"). The remaining
3,031,758 shares of Common Stock (the "Restricted Shares") outstanding were sold
by the Company in reliance on exemptions from the registration requirements of
the Securities Act and are "restricted securities" as defined in Rule 144 under
the Securities Act.

            The sale of a substantial number of shares of Common Stock or the
availability of Common Stock for sale could adversely affect the market price of
the Common Stock prevailing from time to time. The Company, its officers,
directors and existing stockholders have entered into agreements with the
underwriter of the IPO, Barington Capital Group, L.P. ("Barington") which
prohibit them from selling stock in the Company for certain periods of time
following the IPO without the prior written consent of the underwriter.

Effect of Previously Issued Options, Warrants and Underwriter's Options on Stock
Price.

            The Company has reserved from the authorized, but unissued, Common
Stock, 376,000 shares of Common Stock for issuance to key employees, officers,
directors, and consultants pursuant to the Company's 1996 Stock Option Plan (the
"Plan"); 273,964 shares of Common Stock for issuance to officers, directors and
a consultant pursuant to stock options granted outside of the Plan; 456,250
shares of Common Stock for issuance upon exercise of the Bridge Warrants; and
468,242 shares of Common Stock for issuance upon exercise of the Technologies
Warrants. In connection with the IPO, the Company also sold to Barington, for
nominal consideration, options to purchase an aggregate of 140,000 shares of
Common Stock at a price per share equal to $10.40 (160% of the IPO price per
share), subject to adjustment as provided therein (the "Underwriter's Options").

            The existence of any outstanding options issued under the Plan, the
Bridge Warrants, the Underwriter's Options, and other outstanding options and
warrants may prove to be a hindrance to future financing, since the holders of
such warrants and options may be expected to exercise them at a time when the
Company would otherwise be able to obtain additional equity capital on terms
more favorable to the Company. In addition, the holders of such securities have
certain registration rights, and the sale of the shares issuable upon exercise
of such securities or the availability of such shares for sale could adversely
affect the market price of the Common Stock. Additionally, if the holders of the
Underwriter's Options were to exercise their registration rights to effect a
distribution of such Underwriter's Options or underlying securities, such
underwriter, prior to and during such distribution, would be unable to make a
market in the Company's securities and would be required to comply with other
limitations on trading set forth in Rules 10b-2, 10b-6 and 10b-7 promulgated
under the Securities Exchange Act of 1934, as amended. Such rules restrict the
solicitation of purchasers of a security when a person is interested in the
distribution of such security and also limit market making activities by an
interested person until the completion of the distribution. If such underwriter
were required to cease making a market, the market and market price for such
securities may be adversely affected and holders of such securities may be
unable to sell such securities.

Share Prices May Be Highly Volatile.

            The market prices of equity securities of computer technology and
software companies have experienced extreme price volatility in recent years for
reasons not necessarily related to the individual performance of specific
companies. Accordingly, the market price of the Common Stock may be highly
volatile. Factors such as announcements by the Company or its competitors
concerning products, patents, technology, governmental regulatory actions, other
events affecting computer

                                      -19-

<PAGE>

technology and software companies generally as well as general market conditions
may have a significant impact on the market price of the Common Stock and could
cause it to fluctuate substantially.

Lack of Dividends.

            The Company has not paid any dividends on the Common Stock since its
inception and does not intend to pay any dividends to its stockholders in the
foreseeable future. The Company currently intends to reinvest earnings, if any,
in the development and expansion of its business.

Anti-Takeover Effects of Certain Provisions of Certificate of Incorporation and
Delaware Law.

            The Company's Certificate of Incorporation authorizes the issuance
of 3,000,000 shares of undesignated preferred stock with such designations,
rights and preferences as may be determined from time to time by the board of
directors. Accordingly, the board of directors is empowered, without obtaining
stockholder approval, to issue such preferred stock with dividend, liquidation,
conversion, voting or other rights that could adversely affect the voting power
or other rights of the holders of the Common Stock. In the event of issuance,
the preferred stock could be utilized, under certain circumstances, as a method
of discouraging, delaying or preventing a change in the control of the Company.
Certain provisions of Delaware law may also discourage third party attempts to
acquire control of the Company.

Item 2.     DESCRIPTION OF PROPERTY

            The Company's principal offices are currently located at One Lower
Ragsdale Drive, 1-250, Monterey, California 93940. The Company leases
approximately 5,046 square feet of office space at this location pursuant to a
lease dated August 19, 1994. Annual lease payments for the year ended December
31, 1996, were $105,000. Annual lease payments for the Monterey facility for the
year ending December 31, 1997, are expected to be $98,000 plus common area
charges of approximately $11,000. This lease expires on March 31, 1998; however,
the Company expects to extend the lease prior to its expiration.

            The Company plans to open a headquarters office of approximately
5,000 square feet in the San Jose, California area during 1997. Such office
would be utilized for executive, sales and marketing, general and administrative
and other functions. The Company's Monterey facility would be maintained
primarily as a development center. Monthly lease payments for the San Jose
facility are not expected to exceed $10,000.

            Management believes that its current Monterey facilities are
sufficient to meet the development needs for the foreseeable future. Most
immediate future growth will be accommodated by the proposed San Jose facility.
Management believes the Company's facilities are adequately insured.

Item 3.     LEGAL PROCEEDINGS

            There are no material legal proceedings pending against the Company.


                                      -20-
<PAGE>

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

            No matters were submitted to a vote of stockholders during the
fourth quarter of Fiscal 1996.

                                      -21-
<PAGE>

                                     PART II

Item 5.     MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER
            MATTERS

             Registrant's Common Stock is traded on the Nasdaq SmallCap Market
under the symbol "TSIM." The Common Stock began trading on the Nasdaq SmallCap
Market on October 25, 1996.

            The following table sets forth the quarterly high and low bid prices
of a share of Common Stock as reported by the Nasdaq SmallCap Market for the
period commencing with the trading of the Common Stock on October 25, 1996, and
ending on March 19, 1997.

Period                                                  High         Low
------                                                  ----         ----
Fiscal 1996
  Fourth Quarter (from October 25, 1996)............... 8 1/2        7 1/4

Fiscal 1997
  First Quarter (through March 19, 1997)............... 10 1/2       8 1/4


            On March 19, 1997, the closing price for a share of Common Stock, as
reported by the Nasdaq SmallCap Market, was $9.25.

            The number of holders of record for Registrant's Common Stock as of
March 19, 1997, was three. This number excludes individual stock holders holding
stock under nominee security position listings.

            The Company has not paid any dividends on the Common Stock since its
inception and does not intend to pay any cash dividends to its stockholders in
the foreseeable future. The Company currently intends to reinvest earnings, if
any, in the development and expansion of its business.

            In the past three years, the Registrant has made the following sales
of unregistered securities, all of which sales were exempt from the registration
requirements of the Securities Act pursuant to Section 4(2) thereof and as
otherwise indicated herein.

            In August 1996, the Company, through Barington, acting as placement
agent, issued and sold 18.25 Units of its securities, each Unit consisting of
one $100,000 principal amount 10% Senior Notes and Warrants to purchase 25,000
shares of Common Stock at an exercise price of $3.90 per share (60% of the IPO
price per share), at $100,000 per Unit solely to accredited investors. The
Company believes that each issuance and sale of such securities was exempt from
registration pursuant to Section 4(2) of the Securities Act and/or Rule 506
promulgated thereunder. Barington received, for its services, a placement fee of
10% of the gross proceeds from the sale of the Units, Warrants to purchase
45,625 shares of Common Stock at $3.90 per share (which were canceled in
connection with the IPO) and reimbursement of certain expenses.

                                      -22-

<PAGE>

            In August 1996, the Company issued options under its Stock Option
Plan. The Company believes that the issuance of these options was exempt from
registration pursuant to Sections 3(b) and 4(2) of the Securities Act and Rule
701 promulgated thereunder.

            In September 1994, pursuant to a stock purchase and loan agreement,
dated September 28, 1994, by and between Technologies and the Company, which
proceeds were used in connection with the purchase of the Division from Maxis,
Inc. (the "Technologies Agreement"), Technologies purchased 61.11% of the
Company's authorized and issued Common Stock for the purchase price of $100,000,
and loaned to the Company $1,200,000. In August 1996, such loan, including
accrued interest thereon, was converted to 263,158 shares of Common Stock. In
July 1996, Technologies made additional loans to the Company in an aggregate
principal amount of $502,000 and received the Technologies Warrants to purchase
468,242 shares of Common Stock. In August 1996, upon the repayment by the
Company of such loan, including accrued interest thereon, Technologies purchased
6.25 units in the Bridge Financing. The Company believes that each such
transaction was exempt from registration pursuant to Section 4(2) of the
Securities Act and/or Rule 506 promulgated thereunder.

            The Company has granted options to purchase an aggregate of 649,000
shares of Common Stock to certain members of the Company's board of directors
and to employees and consultants. The Company believes that the issuance of such
option was exempt from registration pursuant to Sections 3(b) and 4(2) of the
Securities Act.

Item 6.     MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION

            The following discussion should be read in conjunction with the
accompanying financial statements and notes thereto appearing elsewhere in this
annual report on Form 10-KSB.

Overview

            The Company commenced operations in December 1993 to develop and
market business simulation software. Since its inception, the Company has been
engaged in research and development activities and organizational efforts,
including the development of its initial products, recruiting personnel,
establishing marketing and manufacturing capabilities and raising capital.

            The Company commenced commercial activities in January 1994, but to
date has not generated substantial revenues from the sale of its products.
Revenues generated to date have been primarily derived from software development
projects completed under contracts with customers. Historically, a significant
portion of such revenues have been derived from a limited number of relatively
large development projects contracted for by a small number of customers. Sales
to the SESI, Systemhouse, ORD, and Bell Canada during the fiscal year ended
December 31, 1996, accounted for 28%, 25%, 24% and 14%, respectively, of the
Company's sales for such period. Sales to Markle, ORD and Systemhouse during the
fiscal year ended December 31, 1995, accounted for 27%, 14% and 13%,
respectively, of the Company's sales for such period. Such customers are not
affiliated with the Company. The Company does not believe that it is materially
dependent upon sales to these customers. Contracts with such customers have been
fully or substantially completed as of December 31, 1996. The Company
historically has not had, and at December 31, 1996, did not have, any
substantial firm order backlog. The Company's current strategy is to change its
focus from custom projects to self-

                                      -23-

<PAGE>

funded development of simulations for broader markets by leveraging its existing
products and technology platform to become a product-oriented, sales-driven
company.

            As of December 31, 1996, the Company had experienced cumulative
losses of $4,164,000 and has not experienced any quarter of profitable
operations. The Company expects to incur additional operating losses for the
foreseeable future. The Company's operations to date have been funded primarily
through private sales of debt and equity securities and the IPO.

            The Company expects to incur substantial operating expenses in the
future to support its development costs, expand its sales and marketing
capabilities and organization, expand its work force and for other general and
administrative expenses. The Company's results of operations may vary
significantly from quarter to quarter during this period of development.

Results of Operations

            Comparison of years ended December 31, 1996 and 1995

            Revenues. Revenues for the year ended December 31, 1996, decreased
by $421,000 or 32%, to $908,000, from $1,329,000, for the year ended December
31, 1995. During each of such periods the Company's revenues were derived
primarily from a relatively small number of development contracts.

            Gross Margin. Gross margin for the year ended December 31, 1996, was
29% of revenues as compared with 47% of revenues for the year ended December 31,
1995. A substantial portion of the decline in gross margin came from one
specific project. This project was performed for the federal government and the
scope of such project had not been sufficiently defined prior to the acceptance
and performance of the project. As a result of such lack of specificity, the
Company believes that the amount of time spent on this project was at least two
times greater than the Company's estimate. Because, however, such contract was
with the United States government, the Company was not permitted to re-negotiate
pricing and was required to complete the project.

            Selling, General and Administrative Expenses. Selling, general and
administrative expenses increased by $652,000, or 87%, for the year ended
December 31, 1996, to $1,403,000, or 154% of revenues, from $751,000, or 57% of
revenues, for the year ended December 31, 1995. Selling expenses included costs
of preparing project proposals and software demonstrations. General and
administrative expenses consisted primarily of employee benefits, labor costs
and consulting expenses. The increase in selling, general and administrative
expenses was primarily due to non-cash compensation charges resulting from
employee stock options granted in July, August and December, increased
consulting expenses, travel expenses, new insurance policy premiums, recruiting
fees and increased involvement by the Company's technical development team in
the preparation of Company's proposals and presentations. The Company expects
general and administrative expenses to increase in future periods as the Company
incurs additional costs related to being a public company and expands its staff
and facilities.

            Research and Development. Research and development expenses for the
year ended December 31, 1996, decreased by $179,000, or 55%, to $149,000, or 16%
of revenues, from $328,000, or 25% of revenues, for the year ended December 31,
1995. This decrease was primarily

                                      -24-

<PAGE>

due to the shifting of development efforts from initial internal software
development to customer software development contracts.

            As the Company's business strategy shifts from custom development
projects to product sales, the Company expects that research and development
expenses will increase in future periods.

            Interest Expense. Interest expense for the year ended December 31,
1996, increased by $1,213,000, or 866%, to $1,353,000, or 149% of revenues, from
$140,000, or 11% of revenues, for the year ended December 31, 1995. This
increase was primarily due to interest associated with borrowings from
Technologies, the bank line of credit and the Bridge Notes, and the issuance of
the Technologies Warrants and the Bridge Warrants for debt. All such loans were
paid in full or were converted to equity as of December 31, 1996.

            Other Income, net. Other income for the year ended December 31,
1996, increased by $123,000, or 1,230% to $133,000, or 15% of revenues, from
$10,000, or 1% of revenues, for the year ended December 31, 1995. This increase
was primarily due to an increase in fees received for assisting customers with
product presentations and demonstrations in connection with the resale by such
customers of the Company's products, and an increase in interest income from
increased cash balances.

            Net Loss. As a result of the foregoing, net loss for the year ended
December 31, 1996, increased by $1,925,000, or 327%, to $2,514,000 from $589,000
for the year ended December 31, 1995.

Liquidity and Capital Resources

            Since its inception and through December 31, 1996, the Company has
incurred cumulative losses aggregating approximately $4,164,000, and has not
experienced any quarter of profitable operations. The Company expects to
continue to incur operating losses for the foreseeable future, principally as a
result of expenses associated with the Company's product development efforts and
anticipated sales, marketing and general and administrative expenses. During the
past two fiscal years, the Company has satisfied its cash requirements
principally from advances from stockholders, private and public sales of equity
securities and, to a limited extent, from cash flows from operations. The
primary uses of cash have been to fund research and development and for sales,
general and administrative expenses.

            At December 31, 1996, the Company had cash and cash equivalents of
approximately $6,869,000 and working capital of approximately $6,728,000 and
stockholder's equity of approximately $6,827,000. At December 31, 1996, the
Company had no long-term liabilities outstanding except for $12,000 due under
capital leases.

            The Company's operating activities used net cash of $1,495,000 and
$297,000 in 1996 and 1995, respectively. The funds were used for the Company's
product development and to fulfill various contract obligations.

            The Company's financing activities provided net cash of $8,227,000
and $195,000 in 1996, and 1995, respectively. The increase in cash balance for
the fiscal year ended December 31, 1996, is due to the IPO in October 1996.

                                      -25-

<PAGE>

            Based on the Company's operating plan, the Company believes that its
existing cash balances, together with revenues from continuing operations, will
be sufficient to satisfy its capital requirements and finance its operations
through at least the next twelve months. Such belief is based upon certain
assumptions, and there can be no assurance that such assumptions will prove to
be correct. The Company's current and planned expense levels are based in part
on its expectations as to future revenue.

Significant Financial and Business Developments

            Pursuant to a plan of reorganization, in August 1996, Technologies
converted $1,200,000 aggregate principal amount of outstanding indebtedness,
plus an aggregate of approximately, $120,000 of accrued interest, into an
aggregate of 263,158 shares of Common Stock.

            On August 28, 1996, the Company closed the Bridge Financing which
provided gross proceeds of $1,825,000 to the Company from the issuance of
promissory notes and warrants to purchase 456,250 shares of common stock. The
Company repaid $502,000 principal amount plus $123,000 of accrued interest
related to loans from Technologies from a portion of such proceeds. Technologies
purchased $625,000 aggregate principal amount of promissory notes pursuant to
the Bridge Financing.

            On October 30, 1996, the Company received net proceeds of
approximately $7,860,350 (net of underwriting discounts and commissions and
approximately $1,239,700 of related expenses payable by the Company) from the
issuance of 1,400,000 shares of Common Stock at $6.50 per share, pursuant to the
IPO. On November 20, 1996, the Company received additional net proceeds of
approximately $1,187,550 from the issuance of 210,000 shares of Common Stock,
pursuant to the exercise in full of the underwriter's over-allotment option
granted as part of the IPO. Approximately, $1,856,500 of the net proceeds of the
IPO were used to retire outstanding indebtedness under the promissory notes
issued in the Bridge Financing. The remainder of the net proceeds of the IPO are
being used to fund the Company's sales and marketing and product development
efforts, and for working capital and general corporate purposes.

Item 7.     FINANCIAL STATEMENTS

            The Financial Statements and Notes thereto can be found beginning on
page F-1, "Index to Financial Statements," at the end of this Form 10-KSB.


Item 8.     CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
            ACCOUNTING AND FINANCIAL DISCLOSURE

            The Company filed a Form 8-K with the Securities and Exchange
Commission with a Report Date of February 28, 1997, in connection with the
Company's dismissal of KPMG Peat Marwick LLP as the Company's independent
accountants and the engagement of Deloitte & Touche LLP as the Company's
independent accountants.

                                      -26-

<PAGE>
                                    PART III


Item     9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
            COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT

Officers, Directors, Key Employees and Consultants

            The executive officers, directors, key employees and consultants of
the Company are as follows:

<TABLE>
<CAPTION>
Name                                   Age         Position
----                                   ---         --------
<S>                                    <C>         <C>
Mr. Fred Knoll                         41          Chairman of the Board, Director
Mr. Phillip F. Whalen, Jr.             49          President, Chief Executive Officer, Director
Mr. John Hiles                         50          Founder, Chief Technology Officer, Secretary, Director
Mr. Marc Cooper                        35          Director
Ms. Esther Dyson                       45          Director
Mr. Frederick Gluck                    61          Director
Dr. Ted Prince                         49          Director
Mr. Fran Saldutti                      49          Director
Ms. Barbara Portner                    49          Acting Chief Financial Officer
Mr. Rick Rosenbaum                     50          Software Architect
Mr. Bruce Skidmore                     39          Software Architect
Mr. Greg  Rossi                        42          Senior Software Engineer
Mr. Robert Stern                       49          Multimedia Director
Mr. Mort Meyerson                      57          Advisory Committee Member
</TABLE>


            Fred Knoll has been Chairman of the Board and a member of the board
of directors since September 1994. From 1987 to the present, Mr. Knoll has been
the principal of Knoll Capital Management, L.P., a venture capital firm
specializing in the information technology industry. From 1985 to 1987, Mr.
Knoll was an investment manager for General American Investors, responsible for
the technology portfolio, and served as the United States representative on
investments in leveraged buy-outs and venture capital for Murray Johnstone, Ltd.
of Glasgow, Scotland. From 1983 to 1985, Mr. Knoll served as manager of venture
investments for Robert Fleming, Inc., a U.K. merchant bank in New York and was
responsible for managing a venture capital fund as well as managing a team whose
responsibility was to identify public investment opportunities. Mr. Knoll also
held investment positions with the Capital Group (Capital Research/Capital
Guardian) from 1982 to 1983 and General American Investors. During the 1970's,
Mr. Knoll worked in sales and marketing management for Data General and Wang
Laboratories, Inc. Mr. Knoll is a director of numerous companies, including
Arthur Treachers, Inc., a company in the fast service seafood restaurant
business and Lamar Signal Processing, Ltd., a digital processing company, and is
a principal of Valor Capital Management, L.P., a private investment limited
partnership. Mr. Knoll holds a B.S. in Computer Science from M.I.T. and an
M.B.A. from Columbia University in Finance and International Business.

                                      -27-
<PAGE>


            Phillip Whalen has been President, Chief Executive Officer and a
Director of the Company since December 1996. From June 1994 to November 1996,
Mr. Whalen was Vice President of the European operations of Digital Tools, Inc.
("Digital Tools"), where he established an independent business unit for this
leading project management software company. Prior to heading up Digital Tools'
European operation, Mr. Whalen was, from July 1992, to May 1994, Vice President
of Digital Tools' sales, marketing and services in the U.S. at Digital Tools'
headquarters in Cupertino, California. During his tenure, Mr. Whalen made the
AutoPlan project management software product the dominant one in its category.

            From 1990 to 1992, Mr. Whalen was Vice President, Marketing and then
Vice President, Sales for Clarity Software, Inc. ("Clarity"), a UNIX business
software company he helped found. While at Clarity, Mr. Whalen was responsible
for establishing all marketing and sales functions. From 1985 to 1990, Mr.
Whalen was Vice President, Sales and Marketing for cc:Mail Inc., which in five
years grew to become the largest installed, LAN-based, electronic mail software
product before being acquired by Lotus Development Corp. in 1990. Mr. Whalen
received a B.A. in Chemistry from Denison University in 1969 and an M.B.A from
Stanford University Graduate School of Business in 1982.

            John Hiles, the Founder and Chief Technology Officer, has been
Secretary of the Company and a member of its board of directors, since its
inception. Mr. Hiles served as the Company's President from its inception until
November 31, 1996 (except during the period from March to August 1996). Hiles'
career spans 24 years in the software industry. From 1992 to 1993, he served in
various positions with Maxis Business Simulations, including that of General
Manager. While with Maxis, Inc., Mr. Hiles directed the development of SimHealth
and developed a means of transferring the key human interface properties of
entertainment games to business and government simulations. From 1986 to 1992,
Mr. Hiles was President and co-founder of Delta Logic, Inc. From 1984 to 1986,
Mr. Hiles served as Senior Vice President of product development at Digital
Research. From 1976 to 1983, Mr. Hiles was employed by Amdahl where he lead the
development of software products. In 1984, Mr. Hiles was in charge of leading
software development at Mead Data Central. Two of the many products that have
been produced by organizations that he directed were GEM, one of the first
graphical user interfaces for the PC, and UTS, Amdahl's highly successful
mainframe-compatible UNIX operating system which foreshadowed the open systems
movement by several years. Mr. Hiles holds an A.B. from the University of
California at Santa Barbara and took several additional undergraduate and
graduate courses in Computer Science at the University of California at Los
Angeles and the University of California at Irvine.

            Marc S. Cooper has been a member of the board of directors since
January 1997. Since April, 1992, Mr. Cooper has been the Executive Vice
President - Director of Investment Banking and Research for Barington Capital
Group, L.P. From April 1989 to March 1992, Mr. Cooper was a partner of Scharf
Brothers, a private merchant bank involved in acquisitions of domestic and
international industrial and technology companies. From April 1987 to April
1989, Mr. Cooper was a Vice President in the corporate finance department of
Kidder Peabody & Co., Inc., where he was involved in structuring and negotiating
a wide variety of merchant banking and merger and acquisition transactions. From
1982 to 1987, Mr. Cooper was an associate in investment banking at Dean Witter
Reynolds, Inc. Mr. Cooper received an M.B.A. from the New York University
Graduate School of Business Administration, and a B.S. in Management and
Economics from New York University.


                                      -28-

<PAGE>

            Esther Dyson has been a member of the board of directors since
October 1994. Since 1983, Ms. Dyson has served as president of EDventure
Holdings, a diversified company focusing on emerging information technology
worldwide, and on the emerging computer markets of Central and Eastern Europe.
Since 1996, Ms. Dyson has been chairman of the Electronic Frontier Foundation
and was a member of the US National Information Infrastructure Advisory Council,
where she co-chaired the Information Privacy and Intellectual Property
Subcommittee. Ms. Dyson is a member of the board of directors of the Global
Business Network, ComputerLand Poland, Accent Software, Inc., Scala ECE and
Cygnus Solutions, Inc., and she is a member of the advisory board of Perot
Systems. She is a limited partner in the Mayfield Software Fund. Ms. Dyson has
also written articles on industry topics for the Harvard Business Review, The
New York Times, The New York Times Magazine, WIRED Magazine and Forbes Magazine,
among others.

            Frederick W. Gluck has been a member of the board of directors since
October 1994. Mr. Gluck has also served as vice-chairman and a director of
Bechtel Group, Inc. since 1995, and as a member of the Board of Directors of
Bechtel Enterprises, Inc. He also serves as a member of both companies'
executive committees. Prior to joining Bechtel, Mr. Gluck spent more than 25
years with McKinsey & Company, and was ultimately the managing director of the
Company. Mr. Gluck serves on the Harvard Business School board of directors of
the Associates, the Management Education Council of the Wharton School, the
U.S./Hong Kong Economic Cooperation Committee, the Council on Foreign Relations
and the Board of the International Executive Service Corps. Mr. Gluck is also a
member of the Bord of Directors of ACT Networks, Inc.

            Ted Prince has been a member of the board of directors since October
1994. Since 1995, Dr. Prince has been the Chairman and CEO of INSCI Corporation.
Since 1992, Dr. Prince has been the President and founder of Perth Ventures,
Inc., an investment banking and public relations firm which specializes in the
emerging information technology area. Dr. Prince is also an author, publisher
and speaker in the area of emerging information technologies and market trends.
He is the author and publisher of The Technology Fundamentalist, a national
newsletter focusing on emerging computer technologies and market trends. Dr.
Prince has started up several information technology companies including CP
International, a company specializing in text retrieval software, and Harwell
Computer Power, a startup in the same field. From 1984 to 1992, he served as
President and CEO of several companies, including the national computer services
company, Computer Power Group. From 1979 to 1984, Dr. Prince was the Chief
Information Officer of the Australian Social Security Agency where he was
responsible for designing the new national social welfare system.

            Fran Saldutti has been a member of the board of directors since
October 1994. Mr. Saldutti has been, since 1995, a managing general partner of
Ardent Research Partners, L.P., a limited partnership founded in 1992 to invest
exclusively in the information technology markets. From 1990 through February
1995, Mr. Saldutti served as senior technology analyst for Amerindo Investment
Advisers. From 1984 through 1986 he served as Senior Vice President and Director
of Research for Gartner Securities and from 1986 to 1988 as Director of
Technology Research for L.F. Rothschild. Mr. Saldutti moved to the buy side in
1989 as senior technology analyst with Merrill Lynch Asset Management's Sci/Tech
Fund. From 1975 to 1989 Mr. Saldutti either produced, sold or directed
technology research for several leading technology brokerage firms. Mr. Saldutti
maintains board directorships in other technology companies, including Kraft
Kennedy, Lesser, a LAN industry systems integrator and Meta Group, a market
research firm specializing in information technology, on which

                                     - 29 -

<PAGE>

he also serves on the compensation committee. He is a member of the Software and
Services Splinter Group of the New York Society of Securities Analysts.

            Barbara Portner has been the acting Chief Financial Officer since
February 1997. Ms. Portner has over 27 years of experience in finance and human
resources in the high technology software business. From May 1996 to January
1997, Ms. Portner was Vice President of Human Resources and a member of the
Executive team at Simply Interactive, an Internet software start-up company.
Prior to that, from April 1995 to May 1996, Ms. Portner was Director of
Employment Management at Netcom On-Line Communications, Inc., a publicly traded
Internet service provider. From 1990 until March 1995, Ms. Portner was a
financial consultant for software start-up companies such as Azor, Inc. and SI
pharmaceuticals. From 1979 until 1989, Ms. Portner was Chief Financial Officer,
Vice President of Finance and Administration for Consilium, Inc., a public
company which builds and sells a software product for shop floor control. Ms.
Portner holds a B.S. in Mathematics from New York University.

            Rick Rosenbaum, Software Architect, has been employed by the Company
as an applications engineer since its inception. Mr. Rosenbaum has 25 years of
experience in the software industry specializing in computer languages and
simulation applications. Prior to working at the Company, from 1992 to 1993, he
served as Senior Member of the Technical Staff of Maxis, Inc. and, in 1986, as
Manager of the Core Languages Group of Sun Microsystems, and from 1987 to 1992
as Project Manager of Digital Research and Bank of America. Mr. Rosenbaum holds
a B.S. in Electrical Engineering and an M.S. in computer science from the
Georgia Institute of Technology.

            Bruce Skidmore, Software Architect, has been employed by the Company
as an engineering manager since 1993. Mr. Skidmore has 14 years of experience in
the software development industry as, among other things, a Project Manager,
Engineering Manager and Director of Engineering. His technical experience is in
the areas of operating system development and design, networks and application
architectures. From 1992 to 1993 he worked for Maxis, Inc. as Director of
Product Development. From 1986 through 1992, he worked for Poquet and Delta
Logic as Manager of Communications and Systems Software. From 1981 to 1986, he
worked for Digital Research as a Network Project Manager. Mr. Skidmore holds a
B.S. in Computer Science from California Polytechnic State University, San Luis
Obispo.

            Greg Rossi, Senior Software Engineer and the architect of
WHITEBOARD, has been employed by the Company as a programmer since 1994. Mr.
Rossi has 12 years of experience in the software industry focusing on object
data bases and graphic user interfaces. From 1992 to 1993 he worked for Maxis,
Inc. as Senior Member of the Technical Staff. From 1986 to 1992 he worked for
Poquet and Delta Logic as principal programmer. From 1985 to 1988 he worked for
Digital Research as a senior software engineer and from 1982 to 1984 for
Dialogic Systems as programmer. Mr. Rossi has a B.A. in Chemistry and Computer
Science from the University of California at Santa Cruz.

            Robert Stern has been Multimedia Director for the Company since
February, 1997. Mr. Stern has 26 years of experience as a creator, developer,
and producer of a wide range of corporate design and interactive products. He is
the former Creative Director of Simply Interactive. Prior to that he was
President and Executive Producer at Technimation, Inc. a 3D computer animation
company. He has worked on projects for IBM, Apple, AMD, and Acura, to name a
few. Mr. Stern


                                     - 30 -

<PAGE>


holds a BA in graphic design and a M.F.A. in film production from the University
of Washington. He is a frequent lecturer on computer animation and web design.

            Mort Meyerson, the Chairman of the Advisory Committee, has been
Chairman of Perot Systems since 1992. From 1979 to 1986 he was President and
Chief Executive Officer of EDS Information Systems. Mr. Meyerson has had
extensive experience in the software industry, in running large technology
companies and in investing in, growing and capitalizing emerging technology
companies.

Item 10.    EXECUTIVE COMPENSATION

            The following table sets forth compensation paid for the fiscal
years ended December 31, 1996, December 31, 1995, and December 31, 1994, to
those persons who were, at December 31, 1996, (i) the chief executive officer
and (ii) the one other most highly compensated executive officer of the Company,
who was the only other executive officer of the Company who received over
$100,000 in compensation in the form of salary and bonus (collectively, the
"Named Executive Officers").

                           SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>
                                                                                  Long Term
                                                                                Compensation
                                                                                -------------
                                                      Annual Compensation          Awards
                                                -----------------------------------------------
                                                                                  Securities
                                                                   Other Annual   Underlying
                                                                   Compensation    Options/       All Other
Name and Principal Position   Year       Salary ($)      Bonus ($)     ($)            SARs        Compensation
--------------------------------------------------------------------------------------------------------------
<S>                           <C>         <C>           <C>           <C>           <C>               <C>
Phillip F. Whalen, Jr.        1996(1)     $ 14,584      -------       -----         430,000           -----
Chief Executive Officer

John Hiles(2)                 1996        $135,507      $25,000       -----          -----            -----
Founder, Chief                1995        $132,000      -------       -----          -----            -----
Technology Officer            1994        $132,000      -------       -----          -----            -----
</TABLE>
---------

(1)      Mr. Whalen joined the Company on December 1, 1996, and this amount
         represents his salary from that date through December 31, 1996.

(2)      Mr. Hiles was President of the Company until November 30, 1996.


                                     - 31 -

<PAGE>


                            1996 Stock Option Grants

            The Company strives to distribute stock option awards broadly
throughout the organization. Stock option awards are based on the individual's
position and contribution to the Company. The Company's long term performance
ultimately determines compensation from stock options because stock option value
is entirely dependent on the long term growth of the Company's Common Stock
price.

            The following table sets forth certain information concerning
options granted to the Chief Executive Officer and the Named Executive Officers
during the fiscal year ended December 31, 1996.

                        OPTION GRANTS IN LAST FISCAL YEAR

                                Individual Grants
<TABLE>
<CAPTION>

                           Number of
                           Securities           % of Total                          Market
                           Underlying         Options Granted      Exercise or     Price on
                        Options Granted       to Employees in      Base Price       Date of     Expiration
Name                          (#)               Fiscal Year          ($/Sh)          Grant         Date
----------------------------------------------------------------------------------------------------------
<S>                        <C>                     <C>               <C>            <C>         <C>
Phillip F. Whalen, Jr.     230,000(1)              39.00%            $7.65          $9.00       12/01/06
                           150,000(2)              25.40%            $9.00          $9.00       12/01/06
                            50,000(3)               8.50%            $9.00          $9.00       12/01/06
John Hiles                       0                     0                --             --             --
</TABLE>

----------

(1)       Options to purchase 76,667 shares of the Company's Common Stock
          shall become exercisable commencing December 1, 1997, and options to
          purchase an additional 6,388.875 shares of the Company's Common
          Stock shall become exercisable in each of the succeeding months that
          Mr. Whalen is an employee thereafter, until December 1, 1999, at
          which time all such options shall become exercisable.

(2)       Provided Mr. Whalen is still an employee of the Company at the time,
          such options shall become exercisable upon the earlier of (i)
          December 1, 1999, and (ii) such time as the market price of the
          Company's Common Stock is $20.00 per share or higher for 20
          consecutive days.

(3)       Provided Mr. Whalen is still an employee of the Company at the time,
          such options shall become exercisable upon the earlier of (i)
          December 1, 1999, and (ii) such time as the market price of the
          Company's Common Stock is $30.00 per share or higher for 20
          consecutive days.


                                      -32-

<PAGE>


                                AGGREGATE OPTION
                        EXERCISES IN LAST FISCAL YEAR AND
                        FISCAL YEAR END OPTION VALUES(1)

<TABLE>
<CAPTION>
                                                      Number of Security Underlying  Value of Unexercised In-The-Money
                              Shares                     Unexercised Options at                Options at
                             Acquired                       December 31, 1996             December 31, 1996 (1)
                            on Exercise      Value         -------------------            ---------------------
Name                            (#)       Realized($)  Exercisable Unexercisable       Exercisable     Unexercisable
----------------------------------------------------------------------------------------------------------------------
<S>                             <C>           <C>           <C>      <C>                    <C>               <C>
Phillip F. Whalen, Jr.          N/A           N/A            0       430,000                 0                $253,000
John Hiles                      N/A           N/A            0             0                 0                0
</TABLE>

---------------
(1)         Amount reflects the market value of the underlying shares of Common
            Stock at the closing sales price reported on the Nasdaq SmallCap
            Market on December 31, 1996 ($8.75 per share), less the exercise
            price of each option.


Compensation Committee

            The Compensation Committee of the Board of Directors is responsible
for determining the compensation of executive officers of the Company and to
administer the Company's 1996 Stock Option Plan. Messrs. Prince and Saldutti,
who are disinterested directors, comprise the Compensation Committee.

General Policies Regarding Compensation of Executive Officers

            The Company's executive compensation policies are intended (1) to
attract and retain high quality managerial and executive talent and to motivate
these individuals to maximize shareholder returns, (2) to afford appropriate
incentives for executives to produce sustained superior performance, and (3) to
reward executives for superior individual contributions to the achievement of
the Company's business objectives. The Company's compensation structure consists
of base salary, annual cash bonuses, and stock options. Together these
components link each executive's compensation directly to individual and Company
performance.

            Salary. Base salary levels reflect individual positions,
responsibilities, experience, leadership, and potential contribution to the
success of the Company. Actual salaries vary based on the Compensation
Committee's subjective assessment of the individual executive's performance and
the Company's performance.

            Bonuses. Executive officers are eligible to receive cash bonuses
based on the Compensation Committee's subjective assessment of the respective
executive's individual performance and the performance of the Company. In its
evaluation of executive officers and the determination of incentive bonuses, the
Compensation Committee does not assign quantitative relative weights to
different factors or follow mathematical formulae. Rather, the Compensation
Committee makes its determination in each case after considering the factors it
deems relevant, which may include consequences for performance that is below
expectations.


                                      -33-

<PAGE>

            Stock Options. Stock options are currently the Company's sole long
term compensation vehicle. The stock options are intended to provide employees
with sufficient incentive to manage from the perspective of an owner with an
equity stake in the business.

            The directors at the Company do not receive any cash compensation
for their participation on the board. During 1996, Messrs. Gluck, Prince and
Saldutti and Ms. Dyson each received options to purchase 10,259 shares of Common
Stock at an exercise price of $1.00 per share.

            In determining the size of individual option grants, the
Compensation Committee considers the aggregate number of shares available for
grant, the number of individuals to be considered for an award of stock options,
and the range of potential compensation levels that the option awards may yield.
The number and timing of stock option grants to executive officers are decided
by the Compensation Committee based on its subjective assessment of the
performance of each grantee. In determining the size and timing of option
grants, the Compensation Committee weighs any factors it considers relevant and
gives such factors the relative weight it considers appropriate under the
circumstances then prevailing. While an ancillary goal of the Compensation
Committee in awarding stock options is to increase the stock ownership of the
Company's management, the Compensation Committee does not, when determining the
amount of stock options to award, consider the amount of stock already owned by
an officer. The Compensation Committee believes that to do so could have the
effect of inappropriately or inequitably penalizing or rewarding executives
based upon their personal decisions as to stock ownership and option exercises.

            In 1993, the Internal Revenue Code was amended to limit the
deductibility of certain compensation expenses in excess of $1 million. These
changes in the tax laws will apply to the compensation paid to executive
officers of the Company in fiscal year ending December 31, 1997. The
Compensation Committee believes that the compensation paid by the Company in
fiscal year ending December 31, 1997, will not result in any material loss of
tax deductions for the Company. The Compensation Committee will continue to
monitor the tax regulations as they are finalized to determine whether any
policy changes are appropriate.

Arrangements with Directors and Executive Officers

            Mr. Whalen's employment arrangements with the Company guarantee him
an annual base salary of $175,000 plus a minimum bonus of $75,000 for the fiscal
year ending December 31, 1997, provided the Company reaches certain milestones
(as to be determined by the Compensation Committee). Mr. Whalen received a
salary of $14,584 Fiscal 1996, representing his prorated salary for his one
month employment. Additionally, in connection with his employment by the
Company, Mr. Whalen received (i) an option under the Plan to purchase 230,000
shares of Common Stock at $7.65 per share, 76,667 of such options vesting on
December 1, 1997, and 6,388.875 of such options vesting in each of the
succeeding months that Mr. Whalen is an employee thereafter, until December 1,
1999, at which time all such options shall be exercisable; (ii) an option
outside of the Plan to purchase 150,000 shares of Common Stock at $9.00 per
share, such options vesting upon the earlier of (A) December 1, 1999, and (B)
such time as the Common Stock is $20.00 per share or higher for 20 consecutive
days; and (iii) an option outside of the Plan to purchase 50,000 shares of
Common Stock, such options vesting upon the earlier of (A) December 1, 1999, and
(B) such time as the Common Stock is $30.00 per share or higher for 20
consecutive days.

                                      -34-

<PAGE>

            John Hiles, the Founder, Chief Technology Officer, Secretary and
former President of the Company, is employed by the Company under an employment
agreement that is subject to automatic annual renewals unless terminated by the
Company or Mr. Hiles upon 90 days' prior written notice. Mr. Hiles currently
receives a salary of $160,000 per year and a minimum bonus of $50,000 for the
fiscal year ending December 31, 1997. Such salary may be increased at the
discretion of the board of directors, and may be supplemented by certain bonuses
at the discretion of the board of directors of the Company. The Company believes
the terms of the arrangement are no less favorable to the Company than the terms
that it could have obtained from an unaffiliated third party.

            Fred Knoll, the Chairman of the Board of the Company, has provided,
and continues to provide certain executive and related consulting services to
the Company as requested by the Company, including, serving as Chairman of the
Board, consulting on various aspects of the Company's business and negotiating
certain contractual and employment arrangements. To date, Mr. Knoll has not been
compensated for such services, however, Mr. Knoll may, in the future, be
compensated for such services at the discretion of the board of directors in an
amount which is not anticipated to be in excess of $150,000 per annum. Mr. Knoll
is also entitled to reimbursement of any expenses which he incurs in connection
with providing services to the Company. Mr. Knoll, through certain affiliates,
controls Technologies.


                                      -35-

<PAGE>

Item 11.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

            The following table sets forth certain information known to the
Company with respect to the beneficial ownership of the Company's voting
securities by (i) each person who is known by the Company to own of record or
beneficially more than 5% of the outstanding Common Stock, (ii) each of the
Company's directors and Named Executive Officer, and (iii) all directors and
executive officers of the Company as a group. Except as otherwise indicated, the
stockholders listed in the table have sole voting and investment powers with
respect to the shares indicated.


Name and Address                     Amount and Nature of        Percentage of
of Beneficial Owner                  Beneficial Ownership           Class(1)
-------------------                  --------------------           -------
Thinking Technologies, L.P.(2)             2,579,573                 49.0%

Mr. Fred Knoll(3)                          2,579,573                 49.0%

Mr. John Hiles(4)                          1,076,677                 23.2%

Mr. Phillip F. Whalen, Jr.(5)                    ---                  ---

Mr. Marc Cooper(6)                               ---                  ---

Ms. Esther Dyson(7) (8)                       25,000                    *

Mr. Frederick Gluck(8) (9)                    25,000                    *

Dr. Ted Prince(8) (10)                        25,000                    *

Mr. Fran Saldutti(8) (11)                     25,000                    *

All directors and                          3,756,250                 70.0%
executive officers as a group
(8 persons)(3)(4)(5)(6)(7)(9)(10)(11)
--------
 *        Less than one percent.

(1)       Percentage of ownership is based on 4,641,758 shares of Common Stock
          outstanding. For each beneficial owner, shares of Common Stock
          subject to convertible securities exercisable within 60 days of the
          date of this Form 10-KSB are deemed outstanding for computing the
          percentage of such beneficial owner.

(2)       Includes 468,242 shares of Common Stock issuable upon the exercise
          of the Technologies Warrants and 156,250 shares of Common Stock
          issuable upon exercise of Bridge Warrants issued as part of the
          Bridge Units purchased by Technologies. Does not include 75,454
          shares of Common Stock which may be purchased by Technologies from
          John Hiles upon the exercise of an outstanding option for $5.00 per
          share. The address of Thinking Technologies, L.P. is 200 Park
          Avenue, Suite 3900, New York, New York 10166.

(3)       Includes 2,579,573 shares beneficially owned by Thinking
          Technologies, L.P., a limited partnership indirectly controlled by
          Mr. Knoll. The address of Mr. Knoll is c/o Knoll Capital Management,
          200 Park Avenue, Suite 3900, New York, New York 10166.

(4)       Includes 75,454 shares of Common Stock which may be purchased by
          Technologies from John Hiles upon the exercise of an outstanding
          option for $5.00 per share. The address of Mr. Hiles is c/o Thinking
          Tools, Inc., One Lower Ragsdale Drive, 1-250, Monterey, California
          93940.

(5)       The address of Mr. Whalen is c/o Thinking Tools, Inc., One Lower
          Ragsdale Drive, 1-250, Monterey, California 93940.


                                      -36-

<PAGE>

(6)       The address of Mr. Cooper is c/o Barington Capital Group, 888 7th
          Avenue, New York, NY 10019.

(7)       The address of Ms. Dyson is c/o EDventure Holdings, Inc., 104 Fifth
          Avenue, 20th Floor, New York, New York 10011-6987.

(8)       Includes an aggregate of 25,000 shares of Common Stock issuable to
          each non-affiliated director of the Company upon exercise of
          outstanding options.

(9)       The address of Mr. Gluck is c/o Bechtel, Inc., 50 Beal Street, San
          Francisco, California 94105.

(10)      The address of Dr. Prince is c/o Perth Ventures, 342 Madison Avenue,
          #716, New York, New York 10173.

(11)      The address of Mr. Saldutti is c/o Ardent Research Partners, 200
          Park Avenue, 39th Floor, New York, New York 10166.


Item 12.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

            In connection with its purchase of certain assets from Maxis, Inc.,
and in order to fund its continuing operations, the Company entered into a stock
purchase and loan agreement, dated September 28, 1994, by and between
Technologies and the Company (the "Technologies Agreement"). Technologies was
formed by Knoll Capital Management, L.P. in order to purchase Common Stock of
the Company and to advance the funds provided for under the Technologies
Agreement. The general partner of Technologies is Knoll Capital Management,
L.P., an affiliate of Mr. Fred Knoll, the Company's Chairman of the Board. Mr.
Mort Meyerson, a member of the advisory committee of the Company, is a limited
partner in Technologies.

            Pursuant to the Technologies Agreement, Technologies purchased
61.11% of the Company's authorized and issued Common Stock, for the purchase
price of $100,000 and loaned to the Company $1,200,000 (the "Loan"). The Loan
was evidenced by a promissory note (the "Technologies Note") due and payable on
September 27, 1999. The Technologies Note provides for the semi-annual payment
of interest at ten percent (10%) per annum beginning when and if the Company
realized $2,000,000 in gross income during any fiscal year. In connection with
the Technologies Agreement, Mr. Hiles executed an irrevocable proxy authorizing
Knoll Capital Management, L.P. to vote his shares of Common Stock, which proxy
was effective until the Company (i) was acquired through a merger or
acquisition; or (ii) effects an initial public IPO in the aggregate amount of
$2,500,000. On and before July 29, 1996, Technologies made additional loans to
the Company in an aggregate principal amount of $502,000, with interest at a
rate of 10% per annum, which loans were due and payable on December 31, 1996
(the "Additional Loan"), but were repaid in connection with the Bridge
Financing. In connection with the Additional Loan, Technologies received
warrants to purchase 468,242 shares of Company Common Stock at an exercise price
of $1.07 per share. The loan was paid in full on December 31, 1996.

            Pursuant to the Technologies Agreement, as long as Technologies
owned 20% of the Company's Common Stock, the Company could not take certain
actions without the approval of the Company's board of directors. Technologies
entered into a Consent, Waiver and Amendment dated as of August 28, 1996, as
amended (the "Consent & Waiver"), with the Company in connection with the Bridge
Financing pursuant to which such covenants terminated upon consummation of the
IPO.

                                      -37-

<PAGE>

            In connection with the Technologies Agreement, the Company and Mr.
Hiles agreed to certain co-sale rights and registration rights. Pursuant to the
Consent and Waiver, these rights terminated upon consummation of the IPO.

            In addition, in connection with the Bridge Financing, pursuant to
the Consent and Waiver, the following transactions were consummated:

            Thinking Tools, Inc., a California corporation ("TTI"), was merged
with and into its wholly-owned subsidiary Thinking Tools, Inc., a Delaware
corporation. Pursuant to the Merger, each share of common stock of TTI
outstanding prior to the Merger was exchanged for .7462 shares of Common Stock.

            Pursuant to a plan of recapitalization adopted by the Company's
board of directors, Technologies converted $1,200,000 aggregate principal amount
of outstanding indebtedness and $120,310 of accrued interest into an aggregate
of 263,158 shares of Common Stock issued to Technologies.

            Technologies purchased $625,000 aggregate principal amount of Bridge
Notes in the Bridge Financing immediately following repayment by the Company of
$502,000 aggregate principal amount of outstanding indebtedness and $123,000 of
accrued interest due to Technologies from the proceeds of the Bridge Financing.

            The Company has no present intention to acquire or merge with a
business or company in which the Company's management or their affiliates or
associates directly or indirectly have an ownership interest. All future
transactions with officers, directors, affiliates and/or controlling
stockholders of the Company will be on terms no less favorable than could be
obtained from unaffiliated parties, and shall be approved by a majority of the
directors of the Company, including a majority of the independent disinterested
directors of the Company.


                                      -38-

<PAGE>


Item 13.    EXHIBITS AND REPORTS ON FORM 8-K.

(a)  The following documents are filed as part of this report or incorporated
     by reference as indicated below

Exhibit
 No.                 Description
-------              -----------
3.1         Certificate of Incorporation of Thinking Tools, Inc.(1)

3.2         By-Laws of Thinking Tools, Inc.(1)

4.1         Form of Underwriter's Option Agreement (1)

4.2         1996 Stock Option Plan(1)

4.3         Form of Stock Certificate(2)

4.4         Form of Private Placement Investors' Warrant(1)

4.5         Technologies Warrant(2)

4.6         Form of Private Placement Note(1)

4.7         Form of Lock-up Agreement(2)

10.1        Employment Agreement between the Company and John Hiles(2)

10.2        Form of Consulting Agreement(1)

10.3        Development Agreement between the Company and Systemhouse dated
            June 30, 1995 (2)

10.4        Services Agreement between the Company and Systemhouse
            dated March 8, 1995(2)

10.5        Vertical Market Software Development/Licensing Agreement
            between the Company and Coopers dated October 12, 1994(2)

10.6        Technologies Agreement between the Company and Technologies
            dated September 26, 1994(2)

10.7        Consent, Waiver and Amendment between the Company and
            Technologies dated August 31, 1996(2)

10.8        Lease between the Company and KI Monterey Research, Inc.
            dated August 19, 1994, as amended(2)

                                      -39-

<PAGE>

10.9        Letter Agreement  between the Company and Phillip F. Whalen, Jr.

11.1        Computation of Net Loss Per Share

16.         Letter on change in certifying accountant3

27.         Financial Data Schedule
--------

(1)       Incorporated herein by reference to the Company's Registration
          Statement on Form SB-2 (Registration No. 33-11321), as filed with
          the Securities and Exchange Commission on September 3, 1996 (the
          "Registration Statement").

(2)       Incorporated herein by reference to Amendment No. 1 to the
          Registration Statement, as filed with the Securities and Exchange
          Commission on October 11, 1996.

(3)       Incorporated herein by reference to the Company's Current Report on
          Form 8-K, as filed with the Securities and Exchange Commission on
          March 7, 1997, and Amendment No. 1 thereto on Form 8-K/A, as filed
          with the Commission on March 14, 1997.

(b) Reports on Form 8-K

            The Registrant did not file any Reports on Form 8-K during the
fourth quarter of Fiscal 1996.


                                      -40-

<PAGE>


                                   SIGNATURES

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

Dated: March 26, 1997

                                  THINKING TOOLS, INC.


                               By: /s/ Phillip F. Whalen, Jr.
                                   --------------------------
                                   Phillip F. Whalen, Jr.
                                   President and Chief Executive Officer


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

Dated:  March 26, 1997             /s/ Phillip F. Whalen, Jr.
                                   -------------------------------------
                                   Phillip F.  Whalen, Jr.
                                   President and Chief Executive Officer
                                   (Principal Executive Officer)

Dated:  March 27, 1997             /s/ Marc Cooper
                                   --------------------------
                                   Marc Cooper, Director

Dated:  March 26, 1997             /s/ Esther Dyson
                                   --------------------------
                                   Esther Dyson, Director

Dated:  March 27, 1997             /s/ Frederick Gluck
                                   --------------------------
                                   Frederick Gluck, Director

Dated:  March 26, 1997             /s/ John Hiles
                                   --------------------------
                                   John Hiles, Director

Dated:  March 26, 1997             /s/ Fred Knoll
                                   --------------------------
                                   Fred Knoll, Director

Dated:  March --, 1997
                                   --------------------------
                                   Dr. Ted Prince, Director

                                      -41-

<PAGE>

Dated:  March 31, 1997             /s/ Fran Saldutti
                                   --------------------------
                                   Fran Saldutti, Director


Dated:  March 27, 1997             /s/ Barbara Portner
                                   --------------------------
                                   Barbara Portner
                                   Chief Financial Officer
                                   (Principal Financial and Accounting Officer)


                                      -42-

<PAGE>

                              THINKING TOOLS, INC.

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

                          INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
                                                                                                   Page

<S>                                                                                                <C>
Independent Auditors' Report ....................................................................  F-2
Independent Auditors' Report ....................................................................  F-3
Balance Sheets at December 31, 1996 and 1995 ....................................................  F-4
Statements of Operations for the Years Ended December 31, 1996 and 1995 .........................  F-5
Statements of Stockholders' Equity (Deficit) for the Years Ended December 31, 1996 and 1995 .....  F-6
Statements of Cash Flows for the Years Ended December 31, 1996 and 1995 .........................  F-7
Notes to Financial Statements ...................................................................  F-8
</TABLE>


                                      F-1
<PAGE>

INDEPENDENT  AUDITORS'  REPORT

To the Board of Directors and Stockholders of
   Thinking Tools, Inc.:

We have audited the accompanying balance sheet of Thinking Tools, Inc. as of
December 31, 1996, and the related statements of operations, stockholders'
equity (deficit) and cash flows for the year then ended. 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 audit. The financial statements of the Company for the year ended December
31, 1995 were audited by other auditors whose report, dated August 16, 1996
(except as to Note 13 to the 1995 financial statements, which was as of August
28, 1996) expressed an unqualified opinion on those statements and included an
explanatory paragraph that described situations which raised substantial doubt
about the Company's ability to continue as a going concern.

We conducted our audit 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 audit provides a reasonable basis for our opinion.

In our opinion, the 1996 financial statements present fairly, in all material
respects, the financial position of the Company at December 31, 1996, and the
results of its operations and its cash flows for the year then ended in
conformity with generally accepted accounting principles.




DELOITTE  &  TOUCHE  LLP

San Jose, California
March 26, 1997


                                      F-2
<PAGE>

                          INDEPENDENT AUDITORS' REPORT

The Board of Directors and Stockholders
Thinking Tools, Inc.:

      We have audited the accompanying balance sheet of Thinking Tools, Inc.
(the Company) as of December 31, 1995, and the related statements of operations,
stockholders' deficit and cash flows for the year then ended. 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 audit.

      We conducted our audit 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 audit provides a reasonable basis for our opinion.

     In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Thinking Tools, Inc. as of
December 31, 1995, and the results of its operations and its cash flows for the
year then ended in conformity with generally accepted accounting principles.

     The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As discussed in Note 1 to the 1995
financial statements, the Company has suffered recurring losses from operations
and has a net capital deficiency that raise substantial doubt about its ability
to continue as a going concern. Management's plans in regard to these matters
are described in Note 13 to the 1995 financial statements. The financial
statements as of and for the year ended December 31, 1995 do not include any
adjustments that might result from the outcome of this uncertainty.




KPMG Peat Marwick  LLP

San Jose, California
August 16, 1996, except as to Note 13 of the 1995
   financial statements which is as of August 28, 1996


                                      F-3
<PAGE>

                              THINKING TOOLS, INC.

                                 BALANCE SHEETS
                      (In thousands, except share amounts)

<TABLE>
<CAPTION>

                                                                                                    December 31,
                                                                                            -----------------------------
                                                                                                1996            1995
                                                                                            --------------  -------------
                                         ASSETS

<S>                                                                                            <C>             <C>
Current assets:
  Cash and equivalents                                                                         $ 6,869         $   152
  Accounts receivable                                                                              230             146
  Costs and estimated earnings in excess of billings on uncompleted contracts                       --              11
  Prepaid expenses and other current assets                                                        147              10
                                                                                               -------         -------
           Total current assets                                                                  7,246             319

Property and equipment, Net                                                                        101             102
Other assets                                                                                        10              11
                                                                                               -------         -------
TOTAL                                                                                          $ 7,357         $   432
                                                                                               =======         =======

                     LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)

Current liabilities:
  Accounts payable                                                                             $   181         $     5
  Accrued expenses                                                                                 161             124
  Billings in excess of costs and estimated earnings on uncompleted contracts                       32             210
  Notes payable                                                                                    127             201
  Current portion of capital lease obligations                                                      17              13
  Due to related party                                                                              --              34
  Deferred revenue                                                                                  --              30
                                                                                               -------         -------
           Total current liabilities                                                               518             617

Long-term liabilities:
  Long-term portion of capital lease obligations                                                    12              18
  Note payable                                                                                      --           1,200
  Interest payable                                                                                  --             155
                                                                                               -------         -------
           Total liabilities                                                                       530           1,990
                                                                                               -------         -------

Commitments and contingencies (Note 6)

Stockholders' equity (deficit):
  Preferred stock, $.001 par value; 3,000,000 shares authorized;
    no shares issued and outstanding                                                                --              --

  Common stock, $.001 par value: 20,000,000 shares authorized;
    4,641,758 and 2,768,600 shares issued and outstanding                                            5               3
  Additional paid-in capital                                                                    11,288              89
  Deferred stock compensation                                                                     (302)             --
  Accumulated deficit                                                                           (4,164)         (1,650)
                                                                                               -------         -------
           Total stockholders' equity (deficit)                                                  6,827          (1,558)
                                                                                               -------         -------

TOTAL                                                                                          $ 7,357         $   432
                                                                                               =======         =======
                                      F-4

</TABLE>
<PAGE>

                              THINKING TOOLS, INC.

                            STATEMENTS OF OPERATIONS
                    (In thousands, except per share amounts)
<TABLE>
<CAPTION>

                                                                                                   Years Ended
                                                                                                   December 31,
                                                                                            ---------------------------
                                                                                                1996          1995
                                                                                            -------------  ------------
<S>                                                                                            <C>             <C>
Contract revenues                                                                              $   908         $ 1,329
Contract costs                                                                                     649             708
                                                                                               -------         -------
           Gross profit                                                                            259             621
                                                                                               -------         -------

Operating expenses:
  Selling, general and administrative                                                            1,403             751
  Research and development                                                                         149             328
                                                                                               -------         -------

           Total operating expenses                                                              1,552           1,079
                                                                                               -------         -------

           Operating loss                                                                       (1,293)           (458)
                                                                                               -------         -------

Interest expense                                                                                (1,353)           (140)
Other income, net                                                                                  133              10
                                                                                               -------         -------

           Total other expenses                                                                 (1,220)           (130)
                                                                                               -------         -------

           Loss  before  income taxes                                                           (2,513)           (588)

Income tax expense                                                                                   1               1
                                                                                               -------         -------

Net loss                                                                                       $(2,514)        $  (589)
                                                                                               =======         =======

Net loss per share                                                                             $ (0.74)        $ (0.19)
                                                                                               =======         =======

Shares used in calculating per share data                                                        3,384           3,141
                                                                                               =======         =======
</TABLE>


                       See Notes to Financial Statements.



                                      F-5
<PAGE>

                              THINKING TOOLS, INC.

                  STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
                      (In thousands, except share amounts)
<TABLE>
<CAPTION>

                                                                                                                          Total
                                                          Common Stock         Additional    Deferred                  Stockholders'
                                                    ---------------------        Paid-in       Stock      Accumulated    Equity
                                                        Shares    Amount         Capital   Compensation     Deficit     (Deficit)
                                                    ----------   --------      ----------  ------------   -----------  -------------
<S>                                                  <C>           <C>          <C>            <C>         <C>           <C>
BALANCES,  January 1, 1995                           2,768,600     $ 3          $    89           --        (1,061)         (969)
Net loss                                                    --      --               --           --          (589)         (589)
                                                    ----------     ---          -------        -----       -------       -------

BALANCES,  December 31, 1995                         2,768,600       3               89           --        (1,650)       (1,558)

Issuance of common stock warrants                           --      --              900           --            --           900
Conversion of notes payable into  common stock         263,158      --            1,320           --            --         1,320
Stock compensation relating to option grants                --      --              511         (311)           --           200
Issuance of common stock in connection
  with the Company's initial public
  offering (net of costs of $1,995)                  1,610,000       2            8,468           --            --         8,470
Amortization of deferred stock compensation                 --      --               --            9            --             9
Net loss                                                    --      --               --           --        (2,514)       (2,514)
                                                    ----------     ---          -------        -----       -------       -------
BALANCES,  December 31, 1996                         4,641,758     $ 5          $11,288        $(302)      $(4,164)      $ 6,827
                                                    ==========     ===          =======        =====       =======       =======
</TABLE>

                       See Notes to Financial Statements.



                                      F-6
<PAGE>

                              THINKING TOOLS, INC.

                            STATEMENTS OF CASH FLOWS
                                 (In thousands)
<TABLE>
<CAPTION>
                                                                                                     Years Ended
                                                                                                    December 31,
                                                                                               ------------------------
                                                                                                  1996         1995
                                                                                               ------------  ----------
<S>                                                                                            <C>             <C>
Cash flows from operating activities:
  Net loss                                                                                     $(2,514)        $  (589)
  Adjustments to reconcile net loss to net cash used in operating activities:
    Depreciation and amortization                                                                   36              20
    Stock compensation expense                                                                     209              --
    Warrants issued in connection with debt                                                        900              --
    Changes in operating assets and liabilities:
      Accounts receivable                                                                          (84)            (43)
      Costs in excess of billings on uncompleted contracts                                          11              25
      Prepaid expenses and other assets                                                             11               7
      Accounts payable                                                                             176              (6)
      Accrued expenses                                                                               2             179
      Billings in excess of uncompleted contracts and deferred revenue                            (208)             76
      Due to related party                                                                         (34)             34
                                                                                               -------         -------
           Net cash used in operating activities                                                (1,495)           (297)
                                                                                               -------         -------
Cash flows from investing activities -
  Purchase of equipment                                                                            (15)            (14)
                                                                                               -------         -------
Cash flows from financing activities:
  Proceeds from issuance of common stock                                                         8,470              --
  Proceeds from issuance of short-term notes payable                                             2,205             201
  Principal payment on short-term notes payable                                                 (2,434)             --
  Principal payments on capital leases                                                             (14)             (6)
                                                                                               -------         -------
      Net cash provided by financing activities                                                  8,227             195
                                                                                               -------         -------
Net increase (decrease) in cash and equivalents                                                  6,717            (116)

Cash and equivalents, beginning of year                                                            152             268
                                                                                               -------         -------
Cash and equivalents, end of year                                                              $ 6,869         $   152
                                                                                               =======         =======


Supplemental disclosure of cash flow information - cash paid during the year for:
  Interest                                                                                     $   540         $    16
                                                                                               =======         =======
  Income taxes
                                                                                               $     1         $     1
                                                                                               =======         =======


Supplemental schedule of noncash investing and financing activities:
  Conversion of notes payable and accrued interest into common stock                           $ 1,320              --
                                                                                               =======         =======
  Liability insurance financed under a note payable                                            $   155              --
                                                                                               =======         =======
  Equipment acquired under capital leases                                                      $    12         $    28
                                                                                               =======         =======
</TABLE>


                       See Notes to Financial Statements.



                                      F-7
<PAGE>

                              THINKING TOOLS, INC.

                          NOTES TO FINANCIAL STATEMENTS
                     Years Ended December 31, 1996 and 1995


1.   Summary of Significant Accounting Policies

     Business - Thinking Tools, Inc. (the Company) was incorporated in
California in December 1993 to purchase certain assets of the business
simulations division of Maxis, Inc. On December 30, 1993, the Company purchased
intangible assets, a contract in process, and property and equipment from Maxis
in exchange for a note payable of $500,000 which was repaid in 1994. The
acquisition was accounted for using the purchase method. The purchase price was
allocated to the assets acquired based on relative fair values as follows:

Contracts in process                                                   $115,000
Acquired in-process research and development                            330,000
Property, equipment and other assets                                     55,000
                                                                       --------
Total                                                                  $500,000
                                                                       ========

     The Company develops agent-based adaptive PC-based business simulation
software that has a broad range of potential applications. Thinking
Technologies, L.P. was the majority shareholder of the Company until October
1996; as of December 31, 1996, Thinking Technologies, L.P. held approximately
42% of the Company's outstanding shares of common stock.

     In June 1996, the Board of Directors authorized a 4.1225-for-1 stock split
for all outstanding shares of the Company's common stock.

     In August 1996, the Company reincorporated in the state of Delaware by
merging with and into a wholly-owned subsidiary which was incorporated in
Delaware in August 1996, with authorized capital consisting of 20,000,000 shares
of $0.001 par value common stock and 3,000,000 shares of $0.001 par value
preferred stock. Pursuant to such merger, each outstanding share of the
Company's common stock was exchanged for .7462 shares of common stock.

     The accompanying financial statements and notes have been restated to give
effect to the stock splits and reincorporation.

     In October and November 1996, the Company completed its initial public
offering (IPO) (including the exercise of the underwriter's over-allotment
option) and issued 1,610,000 shares of common stock at $6.50 per share for net
proceeds of approximately $8,470,000.

     Use of Estimates - The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported 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,
and such differences may be material to the financial statements. Significant
estimates made by management include the stage of completion, the amount of
costs yet to be incurred on contracts in progress and the valuation of net
deferred tax assets.

     Revenue and Cost Recognition - Revenues from fixed-price contracts are
recognized using the percentage of completion method, measured by input
measures. Contract costs primarily include direct labor and other direct costs.
Provisions for estimated losses on uncompleted contracts are made in the period
in which such losses are determined. Changes in job performance, job conditions
and estimated profitability may result in revisions to costs and revenues and
are recognized in the period in which the revisions are determined. Revenues
from time and materials contracts are recognized as costs are incurred.


                                      F-8
<PAGE>

     The asset, "costs and estimated earnings in excess of billings on
uncompleted contracts," represents revenues recognized in excess of amounts
billed. The liability, "billings in excess of costs and estimated earnings on
uncompleted contracts," represents billings in excess of revenues recognized.

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

     Prepaid Expenses - Prepaid expenses at December 31, 1996 primarily consists
of prepaid insurance which is being amortized over the contract term.

     Property and Equipment - Property and equipment are stated at cost less
accumulated depreciation and amortization. Depreciation is provided using the
straight-line method over the estimated useful lives of the assets of three to
seven years. Leasehold improvements are amortized over the shorter of the
estimated useful lives or the underlying lease term.

     Research and Development - Research and development costs are charged to
expense as incurred. The Company capitalizes software development costs incurred
subsequent to the establishment of technological feasibility. Costs incurred
after the establishment of the technological feasibility of software were not
material in 1996 and 1995 and therefore were expensed.

     Interest Expense - In addition to the stated interest on the Company's
borrowings, interest expense includes the direct costs of various financings as
well as the fair value of warrants issued in connection with such borrowings
(see Note 8).

     Income Taxes - The Company records income taxes using the asset and
liability approach, whereby deferred tax assets and liabilities, net of
valuation allowances, are recorded for the future tax consequences of temporary
differences between financial statement and tax bases of assets and liabilities
and for the benefit of net operating loss carryforwards.

     Stock Compensation - The Company accounts for stock-based awards granted to
employees based on the intrinsic value method in accordance with Accounting
Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees.

     Net Loss Per Share - Net loss per share is computed based on the weighted
average number of shares of common stock outstanding, dilutive common equivalent
shares from stock options and warrants using the treasury stock method and
convertible debt using the if-converted method. In accordance with certain
Securities and Exchange Commission (SEC) Staff Accounting Bulletins, all common
and common equivalent shares issued by the Company at a price less than the
Company's IPO price within a year of the IPO filing (using the treasury stock
method) have been included in the computation of common and common equivalent
shares outstanding for all periods presented prior to the IPO.

2.   Accounts Receivable

     A summary of accounts receivable follows (in thousands):

                                                                  December 31,
                                                                 ---------------
                                                                 1996      1995
                                                                 -----     -----

Completed contract billings                                      $ 212     $  28
Contracts in progress billings                                      --       118
Other receivables                                                   18        --
                                                                 -----     -----

Total                                                            $ 230     $ 146
                                                                 =====     =====


                                      F-9
<PAGE>

3.   Costs and Estimated Earnings on Uncompleted Contracts

     Costs, estimated earnings and billings on uncompleted contracts are
summarized as follows (in thousands):


                                                                  December 31,
                                                                 ---------------
                                                                 1996      1995
                                                                 -----     -----

Costs incurred on uncompleted contracts                          $ 280    $ 249
Estimated earnings                                                  --      309
                                                                 -----    -----

                                                                   280      558
Less billings to date                                             (312)    (757)
                                                                 -----    -----

Total                                                            $ (32)   $(199)
                                                                 =====    =====

     Included in accompanying balance sheets under the following captions (in
thousands):
                                                                  December 31,
                                                                 ---------------
                                                                 1996      1995
                                                                 -----     -----

Costs and estimated earnings in excess
  of billings on uncompleted contracts                           $  --    $  11
Billings in excess of costs and estimated
  earnings on uncompleted contracts                                (32)    (210)
                                                                 -----    -----

Total                                                            $ (32)   $(199)
                                                                 =====    =====

4.   Property and Equipment

     A summary of property and equipment follows (in thousands):

                                                                  December 31,
                                                                 ---------------
                                                                 1996      1995
                                                                 -----     -----

Equipment                                                        $ 145    $ 118
Furniture and fixtures                                               7        7
Leasehold improvements                                               6        6
                                                                 -----    -----


                                                                   158      131
Less accumulated depreciation and amortization                     (57)     (29)
                                                                 -----    -----

Total                                                            $ 101      102
                                                                 =====    =====

     At December 31, 1996 and 1995, property and equipment included assets
leased under capital leases of approximately $30,000 and $29,000 (net of
accumulated amortization of $22,000 and $11,000), respectively.





                                      F-10
<PAGE>

5.   Accrued Expenses

     A summary of accrued expenses follows (in thousands):

                                                                  December 31,
                                                                 ---------------
                                                                 1996      1995
                                                                 -----     -----

Legal and professional fees                                      $  66    $  31
Payroll and related benefits                                        29       72
Other                                                               66       21
                                                                 -----    -----

Total                                                            $ 161    $ 124
                                                                 =====    =====

6.    Leases

      The Company leases office space in Monterey, California, under a
noncancelable operating lease expiring in 1998. Total rent expense under
operating leases was approximately $98,000 and $91,000 for the years ended 1996
and 1995, respectively.

      The Company leases certain office equipment under noncancelable capital
leases expiring in 2000.

      The following is a summary of future minimum lease payments as of December
31, 1996 (in thousands):

Year Ending                                                   Capital  Operating
December 31,                                                  Leases     Lease
------------                                                  ------     -----

    1997                                                      $  19      $  98
    1998                                                         13         25
    1999                                                          2         --
                                                              -----      -----

Total minimum lease payments                                     34      $ 123
                                                                         =====
Less amounts representing interest                               (5)
                                                              -----

Present value of future minimum lease payments                   29
Less current installments under capital lease obligation        (17)
                                                              -----

Long-term portion of capital lease obligations                $  12
                                                              =====

7.   Income Taxes

     The components of income tax expense for each of the years ended December
31, 1996 and 1995 are as follows (in thousands):

                                                  Current   Deferred  Total
                                                  -------   --------  -----

Federal ......................................       $-        $-      $-
State ........................................        1         -       1
                                                     ---       ---     ---

Total ........................................       $1        $-      $1
                                                     ===       ===     ===


                                      F-11
<PAGE>

     The provision for income taxes differs from the amount obtained by applying
the statutory federal income tax rate to income before taxes as follows (in
thousands):

                                                                  December 31,
                                                                 ---------------
                                                                 1996      1995
                                                                 -----     -----

Computed "expected" tax benefit                                  $(746)   $(200)
State franchise tax, net of federal income benefit                   1        1
Losses not utilized                                                746      200
                                                                 -----    -----

Total                                                            $   1    $   1
                                                                 =====    =====

     Significant components of the deferred tax assets and liabilities as of
December 31, 1996 and 1995 are as follows (in thousands):

                                                                  December 31,
                                                                 ---------------
                                                                 1996      1995
                                                                 -----     -----
Deferred tax assets:
  Federal and state net operating loss carryforwards             $ 792    $ 369
  Acquired intangible assets                                       138      149
  Various accruals and reserves                                     38        8
                                                                 -----    -----

Total gross deferred tax assets                                    968      526
Less valuation allowance                                          (955)    (515)
                                                                 -----    -----

Net deferred tax assets                                             13       11
Total gross deferred tax liabilities                               (13)     (11)

Net tax assets and liabilities                                   $  --    $  --
                                                                 =====    =====

     As of December 31, 1996, the Company has net operating loss carryforwards
of $2,000,000 which expire for federal and state purposes through 2011 and 1999,
respectively. Federal and California tax laws impose significant restrictions on
the utilization of net operating loss carryforwards in the event of a shift in
the ownership of the Company, which constitutes an "ownership change" as defined
by the Internal Revenue Service Code, Section 382.

8.   Notes Payable

     A summary of notes payable follows (in thousands):

                                                                  December 31,
                                                                 ---------------
                                                                 1996      1995
                                                                 -----     -----

Insurance note payable                                           $ 127       --
Bank line of credit                                                 --       79
Notes due to Thinking Technologies, L.P.                            --    1,322
                                                                 -----    -----

Total notes payable                                                127    1,409
Less current portion                                              (127)    (201)
                                                                 -----    -----


Long-term portion                                                $  --    1,200
                                                                 =====    =====


                                      F-12
<PAGE>

      The insurance note payable bears annual interest at 8.33% and is due in
monthly installments of approximately $19,000 (including interest) through July
1997.

     The bank line of credit was repaid upon the closing of the bridge financing
described below, at which time the credit facility was closed.

     In September 1994, the Company borrowed $1,200,000 from Thinking
Technologies, L.P. under a note bearing annual interest of 10% and which was
collateralized by all of the Company's assets and the Company's common stock
owned by its President. Interest payable of $180,000 was converted to notes
payable in March 1996. Approximately $1,320,000 of the note balance was
converted into an aggregate of 263,158 shares of common stock in July 1996. The
remaining balance, along with all accrued interest, was repaid in August 1996
upon the closing of the bridge financing described below.

     In 1995, the Company borrowed $122,000 from Thinking Technologies, L.P.
under a note payable bearing annual interest at 7% with an original due date of
December 31, 1995. During 1996, the Company borrowed additional amounts from
Thinking Technologies, L.P. In July 1996, the 1995 and 1996 borrowings and
accrued interest totaling $502,000 were converted into a note payable bearing
annual interest of 10% and which was due on December 31, 1996. These amounts,
together with accrued interest, were repaid in August 1996 upon the closing of
the bridge financing described below. In connection with the July 1996
transaction, the Company issued warrants to Thinking Technologies, L.P. to
purchase 468,242 shares of common stock at an exercise price of $1.07 per share,
expiring December 31, 2006. The Company recorded a noncash interest expense of
approximately $350,000 in 1996 in connection with the issuance of these
warrants.

     In August 1996, the Company closed a bridge financing which provided gross
proceeds of $1,825,000 to the Company from the issuance of units consisting of
promissory notes totaling $1,825,000 (bearing interest at 10%) and warrants to
purchase an aggregate of 456,250 shares of common stock. The Company repaid
$625,000 of existing loans and accrued interest due to Thinking Technologies,
L.P. from a portion of such notes. Thinking Technologies, L.P. purchased units
comprising $625,000 aggregate principal amount of such notes and related
warrants. All borrowings under this bridge financing, together with accrued
interest, was repaid with a portion of the proceeds from the Company's IPO in
October 1996.

     The warrants to purchase 456,250 shares of the Company's common stock are
exercisable at $3.90 per share expiring August 2001. In addition, the Company
issued warrants to purchase 45,625 shares of common stock to the Placement Agent
at the same exercise price; such warrants to the Placement Agent were canceled
in connection with the Company's IPO. The Company recorded a noncash interest
expense of approximately $550,000 in connection with the issuance of the
warrants issued in the bridge financing. In addition, costs of approximately
$280,000 incurred in obtaining the bridge financing were also charged to
interest expense during 1996.

9.   Stockholders' Equity

     Common Stock

     In August 1996, Thinking Technologies, L.P. converted approximately
$1,320,000 of notes and interest into an aggregate of 263,158 shares of common
stock (see Note 8).

     In October and November 1996, the Company completed its IPO (including the
exercise of the underwriter's over-allotment option) and issued 1,610,000 shares
of common stock at $6.50 per share for net proceeds of approximately $8,470,000.
A portion of the proceeds were used to repay amounts outstanding under the
bridge financing (see Note 8). In connection with its initial public offering,
the Company sold to its underwriter options to purchase 140,000 common shares
for $.001 per option. These options are exercisable for a period of five years
at an exercise price equal to 160% of the initial public offering price ($10.40
per share).


                                      F-13
<PAGE>

     Common Stock Options

     Under the Company's 1996 Stock Option Plan (the Plan), options to purchase
up to an aggregate of 376,000 shares of common stock may be granted to officers,
directors, employees or consultants. The Plan provides for issuing both
incentive stock options, which must be granted at fair market value at the date
of grant, as determined by the Plan administrator, and nonqualified stock
options. Options granted under the Plan become exercisable as determined by the
Board of Directors and must be exercised within ten years.

     During 1995 and 1996, the Company granted options to purchase an aggregate
of 58,964 and 590,036 shares of common stock, respectively (375,036 shares under
the Plan in 1996), at a weighted average exercise price of $0.79 and $6.63 per
share, respectively. Such options had a weighted average fair value of $7.37 and
$0.79 per share at the date of grant, respectively. As of December 31, 1996, no
options have been exercised or canceled, and 964 shares were available under the
Plan for future grant.

     Certain of the options granted during 1996 had exercise prices which were
less than the deemed fair value of common stock at the date of grant.
Consequently, the Company has recorded a noncash compensation expense of
approximately $209,000 related to such difference in 1996 and, as of December
31, 1996, an additional $302,000 of deferred stock compensation will be
amortized in future periods over the three-year option vesting term.

     Additional information regarding options outstanding as of December 31,
1996 is as follows:
<TABLE>
<CAPTION>

                          Options Outstanding
-------------------------------------------------------------------------            Options Exercisable
                                              Weighted                         --------------------------------
                                              Average          Weighted                              Weighted
    Range of                                 Remaining         Average                               Average
    Exercise              Number            Contractual        Exercise           Number             Exercise
     Prices             Outstanding          Life (yrs)         Price          Exercisable            Price
     ------             -----------          ----------         -----          -----------            -----
<S>                       <C>                   <C>            <C>               <C>                 <C>
  $0.79 - $1.00           167,000               9.1            $ 0.86            167,000             $ 0.86
      $5.00                52,000               9.7              5.00                 --                 --
  $7.65 - $9.00           430,000               9.9              8.28                 --                 --
                          -------                                                -------

                          649,000               9.7            $ 6.11            167,000             $ 0.86
                          =======                                                =======
</TABLE>

     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
Opinion No. 25, Accounting for Stock Issued to Employees, and its related
interpretations.

     Statement of Financial Accounting Standards No. 123, Accounting for
Stock-Based Compensation (SFAS 123), requires the disclosure of pro forma net
income and earnings per share had the Company adopted the fair value method as
of the beginning of fiscal 1995. Under SFAS 123, the fair value of stock-based
awards to employees is calculated through the use of the minimum value method
for all periods prior to the initial public offering, and subsequently through
the use of option pricing models, even though such models were developed to
estimate the fair value of freely tradable, fully transferable options without
vesting restrictions, which significantly differ from the Company's stock option
awards. These models also require subjective assumptions, including future stock
option price volatility and expected time to exercise, which greatly affect the
calculated values. The Company's calculations were made using the minimum and
Black-Scholes option pricing models with the following weighted average
assumptions: expected life, 30 to 40 months; stock volatility, 61% subsequent
to the initial public offering in 1996; risk-free interest rates, approximately
6%; and no dividends during the expected term. The Company's calculations are
based on a multiple option valuation approach and forfeitures are recognized as
they occur. If the computed fair values of the 1995 and 1996 awards had been
amortized to expense over the vesting period of the awards, pro forma net loss
would have been $2,661,000 ($0.79 per share) in 1996 and $609,000 ($0.19 per
share) in 1995.


                                      F-14
<PAGE>

10.  Concentrations of Credit Risk

     The Company's business is dependent on a few customers, the loss of which
could have a material effect on the Company. The following schedule summarizes
the past distribution of sales by major customer:

                                                                  December 31,
                                                                 ---------------
                                                                 1996      1995
                                                                 -----     -----

Customer A                                                         28%       3%
Customer B                                                         25       13
Customer C (28% of accounts receivable at December 31, 1996)       24       14
Customer D (64% of accounts receivable at December 31, 1996)       14       --
Customer E                                                         --       27

                                   * * * * *




                                      F-15