SECURITIES AND EXCHANGE COMMISSION

                             WASHINGTON, D.C. 20549

                                   FORM 10-KSB

(Mark One)
                  ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE
        |x|       SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 1997

                                       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)


<PAGE>



Check whether the registrant (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the 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 there is no disclosure of delinquent filers in response to Item 405 of
Regulation S-B 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 $137,000.

As of March 15, 1998, 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 27, 1998 of
$4.50 per share, was approximately $7,245,000.(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.


                                       2

<PAGE>


                                     PART I

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

Item 1.  DESCRIPTION OF BUSINESS

     Thinking Tools, Inc. (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 "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 augments programmer
productivity gained through the use of off-the-shelf tools through the help of
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 used in all of the Company's current
generation of simulations.


                                       3

<PAGE>


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


                                       4

<PAGE>


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.

[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. Every experienced person knows 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.


                                        5

<PAGE>


         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.

     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 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.

                                       6
<PAGE>

     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 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.

The Year 2000 Problem - A Unique Business Opportunity

     The Company's unique technology and approach can be applied to a wide
variety of business problems. The risks that the Year 2000 date change problem
pose to business present a unique product opportunity to the Company.

     The Year 2000 problem stems from the way dates are stored in the computers
used to manage business processes and other key tasks. For decades, computer
software has used only two digits rather than four to represent the year. In
addition, two-digit dates are often embedded within many kinds of equipment
which use microprocessors


                                       7

<PAGE>


including telephone systems, facsimile machines, burglar alarms, point-of-sale
systems, factory floor equipment and scanners. For example, 1997 is represented
as "97." With the Year 2000, computers encounter a new millennium for the first
time. Programs that work with two-digit years are set to interpret "00" as 1900,
not 2000.

     This simple error could trigger consequences of a magnitude and complexity
that are only now becoming fully apparent. These span from software systems
failing on January 1, 2000, to calculating insurance premiums incorrectly, money
transactions being rejected, elevators or telephone systems not working, or even
complete business failure.

     Solving the problem presents an immense challenge. The information
departments of many large organizations have been building systems for more than
30 years. Most of those systems contain date coding, which is often buried
within complex algorithms or interconnected programs. The problem also extends
beyond older computers to software running on hundreds of networked PCs which
also need to be checked. These applications are often interconnected through
many interfaces, typically through shared files or databases. Resolving these
interfaces presents difficult technical and project management challenges for
Year 2000 efforts, because any changes made to an interface may affect all
applications sharing that interface.

     Organizations are now beginning to realize they will not be able to fix and
test everything in time, resulting in potential degradation or failure of key
business functions. During each phase of the process, it is therefore important
to prioritize wisely and to document efforts in the event of audits or
litigation.

     Until recently, the bulk of the tools available to organizations to help
solve Year 2000 problems have been information technology focused products and
services designed to help organizations through the phases of conversion,
pre-testing, validation testing and testing links with other organizations.
Organizations have had virtually no tools to assess and manage the risks
associated with the date change from a business perspective and to document the
organization's efforts. Thinking Tools recognized the opportunity to create a
mission-critical simulation software program that automates the process of
assessing and managing business risks associated with the millennium date
change.

Think 2000 - A Year 2000 Risk Simulation Product

     Each of Thinking Tools' agent-based, adaptive simulation software products
provides a unique environment enabling companies to engage in risk-free,
trial-and-error problem solving. The fully graphical, interactive products are
decision support, training and communications tools that show ranges of risk and
solutions for complex processes.

     While the Year 2000 problem was previously viewed as primarily an
information technology ("IT") problem, potential Year 2000 systems failures are,
in many cases, demanding attention from both IT personnel and executive
management. Many corporate officers and risk managers are looking for ways to
address the potential business and crisis management issues associated with the
millennium date change. Unlike most Year 2000 software tools which focus on
fixing or testing specific software code problems, Think 2000 enables executive
decision-makers to assess the overall impact of the Year


                                       8

<PAGE>


2000 date change from a business perspective, to better prioritize redemption
projects and to document the organization's activities in the event of audits or
litigation.

     Announced in September 1997, Think 2000 is a mission-critical simulation
software program that automates the process of assessing and managing business
risks associated with the Year 2000 date change. Think 2000 simulates the impact
of various Year 2000 project plans or testing strategies in four steps:

[bullet] First, with Think 2000's graphical interface, the user builds a
         business model that reflects the interdependencies among departments
         and applications.

[bullet] Second, the user enters one or more proposed mitigation plans or
         testing strategies.

[bullet] Third, Think 2000 runs a simulation based on the user's business model
         that reveals potential effects of alternative plans on revenue,
         customers and productivity through the year 2005. As the simulation
         runs, Think 2000 displays a picture of the business impact. This
         positions the organization to select its approach and to determine its
         strategy based on the simulated results of the alternative plans.

[bullet] Fourth, Think 2000 supports ongoing refinement of plans and actions as
         the organization's awareness increases and the Year 2000 remediation
         process evolves.

     Throughout the process, Think 2000 documents what the organization did,
when, and based on what assumptions, providing a record of how the organization
managed its Year 2000 efforts. Think 2000 is designed to allow organizations to
assess and prepare for Year 2000 problems through the entire Year 2000
initiative, from planning through compliance testing.

Other Products Developed with Partners

     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. Major examples include:

     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.


                                       9

<PAGE>

     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
conditions 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 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

     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. 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. Historically, however, a significant portion of revenues has been
derived from a limited number of relatively large development projects
contracted for by a small number of customers. 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
completed as of December 31, 1997. The Company historically has not had, and at
December 31, 1997, did not have, any substantial firm order backlog. During
1997, the


                                       10

<PAGE>

Company sought to implement its previously announced strategy to change its
focus from customer projects to self-funded development of simulations for
broader markets. As part of this strategy, the Company is seeking to leverage
its existing products and technology platform to become a product-oriented,
sales-driven company. During this transition period, revenues are not expected
to be material, as the Company will be focusing on developing new product sales
channels. The Company's current and planned expense levels are based in part on
its expectations as to future revenue.

     Revenues to Systems Engineering Solutions, Inc. ("SESI") (a prime
contractor for work in logistics for the United Stated Army and the United
States Air Force), Genentech, and Matcom accounted for 68%, 16% and 11% of
revenues respectively for the year ended December 31, 1997. Revenues from SESI,
Systemhouse, ORD, and Bell Canada accounted for 28%, 25%, 24% and 14%
respectively, of the Company's revenues in the year ended December 31, 1996. The
Company does not believe it is materially dependent upon sales to these
customers

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 can be used to develop parts of the user interface for
simulations. Authoring tools are used for 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 there are numerous other companies that produce
simulation software programs for a variety of industries and uses, including
simulation software products for use in chemical engineering, energy,
manufacturing and retailing.


                                       11

<PAGE>


Any of such companies may be potential competitors of the Company and may
produce products which compete with the Company's business simulation products.
In addition, 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 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. 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


                                       12

<PAGE>

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.

     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 released
its first product in the end of the third quarter of 1997. See "Business-Think
2000-A Year 2000 Risk Simulation Product" for a discussion to the Company's
Think 2000 product.

     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.

     Thought and Decision Processes. The Company has built simulations that
ascribe 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
products based on this work would create a picture of this dynamic and often
very complex process that helps the user to explore what he or she knows or
assumes about the process. This model will be used to clarify communication with
others and to further understand the thought process under examination. The
first application was in the area of complex strategic decision-making. Future
commercial applications could help corporate customers as they collect, organize
and apply 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.


                                       13

<PAGE>


     The Company is seeking to implement its previously announced strategy of
changing its focus from customer projects to self-funded product development. In
furtherance of this strategy, during 1997 the Company focused primarily on the
development and commercial introduction of Think 2000, a Year 2000 risk
simulation software program, which was introduced in September 1997. Think 2000
is the first simulation product the Company internally funded and is bringing
to a broader market. The Company has made a significant investment in the
development and commercialization of Think 2000, and as a result, does not
currently anticipate significant revenues in the near future from other sources.
The Company currently has limited capital and human resources and is focusing
such resources primarily on Think 2000. Any failure of the Company to
successfully commercialize Think 2000 or to meet demands for such product on a
timely basis could have a material adverse effect on the Company's business,
operating results and financial condition. The Company is relying on the success
of Think 2000, as well as the successful development, commercialization and
marketing of additional products for its long-term viability and growth.

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.

Software Development Asset-WHITEBOARD

     WHITEBOARD augments off-the-shelf programming tools to allow the Company's
software programmers to rapidly 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:


                                       14

<PAGE>


[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.

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

[bullet] Interfaces to standard 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 to produce highly visual, game-like interfaces. WHITEBOARD
allows programmers to add full multimedia effects including sound, graphics and
digital video. WHITEBOARD runs on IBM PC compatible computers using Windows
3.1or 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.

     WHITEBOARD 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. WHITEBOARD made
it possible to develop Think 2000 in a seven-month period.

Sales and Marketing

     On September 29, 1997, the Company took a step toward implementing its
growth strategy by introducing Think 2000. Think 2000 is a mission-critical
simulation software program that automates the process of assessing and managing
business risks associated with the Year 2000 date change. Think 2000 includes
the first simulation product the Company internally funded and is bringing to a
broader market. The target market for Think 2000 includes executives, risk
managers, legal counsel and auditors.


                                       15

<PAGE>


The Company believes that Think 2000 would be especially useful to companies in
financial services, banking, insurance, government and healthcare, retail and
communications, as well other organizations with complex information technology
infrastructures. The Company is offering Think 2000 directly to customers, and
through select Year 2000 service providers and value added resellers ("VARs").

     The Company intends to continue to recruit senior marketing and sales
executives, to further develop the product strategy and implement and expand the
Company's distribution strategy.

     Prior to the launch of Think 2000, the Company had 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 and government 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 products through its existing
strategic partners, new service providers as well as by initiating direct sales
to customers. The Company is also in discussion with additional prospective
VARs. As the Company moves into new specific product areas, it intends to seek
alliances in such areas. The Company plans to continue making presentations and
appearances at academic forums and corporate-sponsored events.

     The Company entered into a Vertical Market Software Development/Licensing
Agreement, dated October 12, 1994 and as amended in December 1996, with Coopers
pursuant to which the Company receives 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.

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


                                       16

<PAGE>


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.

     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
may also, upon request, customize these packages on a project basis.

     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 plans to continue its custom business. The Company intends
to focus any 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.

     The Company intends to continue building management depth and breadth and
expand the Company's marketing and sales capabilities. The Company intends to
hire senior marketing and sales executives 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.

Personnel

     As of December 31, 1997, the Company had a total of sixteen full-time
employees, including Mr. John Hiles, the Company's Founder, Chief Technology
Officer, and Secretary, Mr. Charles Isaacs, the Company's Vice President,
Engineering, Mr. Philip F. Whalen, Jr., the Company's former Chief Executive
Officer and President, and Mr. Moshe Zarmi (then acting as a full-time
consultant to the Company). On February 12, 1998, the Company promoted Mr. Moshe
Zarmi, to the position of Chief Executive Officer and President. Mr. Zarmi
replaced Philip F. Whalen, Jr., who resigned on February 12, 1998. 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.


                                       17

<PAGE>


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.

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 forward-looking 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 $8,726,000 as of
December 31, 1997, 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. In September 1997, the
Company introduced a new product, Think 2000, a Year 2000 risk simulation
software program. The Company has made a significant investment in the
development and commercialization of Think 2000, and, as a result, does not
currently anticipate significant revenues in the near future from other
sources. The Company has limited capital and human resources and is continuing
to focus such resources primarily on Think 2000. There can be no assurance that
Think 2000 will achieve commercial acceptance or result in significant revenues
or profits to the Company.


                                       18

<PAGE>


There can also be no assurance that if Think 2000 does achieve commercial
acceptance the Company will be able to meet demand for such product. Any failure
of the Company to successfully commercialize Think 2000 or to meet demands for
such product on a timely basis cold have a material adverse effect on the
Company's business, operating results and financial condition.

     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. 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 completed
as of December 31, 1997. The Company historically has not had, and at December
31, 1997, did not have, any substantial firm order backlog. 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.


                                       19

<PAGE>


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 market acceptance. There can be no assurance that the Company's product
development efforts will be successful. Further, the Company is relying on the
success of its current products, principally Think 2000, as well as the
successful development, commercialization and marketing of additional products
for its long-term viability and growth. Any failure of the Company to
commercialize its products or to meet demands for such products on a timely
basis could have a material adverse effect on the Company's business, operating
results and financial condition.

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.


                                       20

<PAGE>


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
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 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.


                                       21

<PAGE>


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. Moshe Zarmi, 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. Zarmi 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 and Principal Stockholders

     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. 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


                                       22

<PAGE>


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 the middle of the third quarter of fiscal 1998. 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, and
may need to raise additional debt or equity financing to fund its future
operations and growth strategy. The Company anticipates that it will be required
to seek additional funding through public or private sales of debt or equity
securities. The Company is currently evaluating its financing options; however,
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 are 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.


                                       23

<PAGE>


Future Sales of Restricted Securities

     The Company had 4,641,758 shares of Common Stock outstanding as of December
31, 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 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.

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

     The Company has reserved from the authorized, but unissued, Common Stock,
600,000 shares of Common Stock for issuance to key employees, officers,
directors, and consultants pursuant to the Company's 1997 Stock Option Plan (the
"1997 Plan"), 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 "1996 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 Capital Group, L.P. ("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 1997 Plan, the
1996 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 Regulation M 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


                                       24

<PAGE>


adversely affected and holders of such securities may be unable to sell such
securities.

Share Price 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 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, 1997, were
$109,000. Annual lease payments for the year ending December 31, 1998, are
expected to be $98,000 plus common area charges of approximately $11,000. This
lease expires in September 1999.

     In December 1997, the Company's management decided to restructure and
consolidate the Company's facilities in order to reduce operating expenses and
concentrate its resources on Think 2000. Accordingly, the Company's office
located at 6541 Via Del Oro, San Jose, California 95119 was closed, and the
Company recognized an anticipated loss on lease cost of $24,000. Annual lease
payments for the year ended December 31,


                                       25

<PAGE>


1997 for the San Jose facility were $54,046. See "Management's Discussion and
Analysis or Plan of Operation."

     Management believes that the Company's current Monterey facilities are
sufficient to meet the development needs for the foreseeable future and that the
facilities are adequately insured.

Item 3.  LEGAL PROCEEDINGS

     There are no material legal proceedings pending against the Company.


                                       26

<PAGE>


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

     At the Company's Annual Meeting of Stockholders held on December 5, 1997,
the stockholders re-elected the following individuals for one-year terms
pursuant tot he following votes:

                                  For        Against     Abstain
                                  ---        -------     -------
Mr. Fred Knoll                 3,033,858        0           0
Mr. Phillip F. Whalen, Jr.     3,033,858        0           0
Mr. John Hiles                 3,033,858        0           0
Mr. Marc Cooper                3,033,858        0           0
Ms. Esther Dyson               3,033,858        0           0
Mr. Frederick Gluck            3,033,858        0           0
Mr. Ted Prince                 3,033,858        0           0
Mr. Fran Saldutti              3,033,858        0           0

     The stockholders also approved a proposal to adopt the Thinking Tools, Inc.
1997 Stock Option Plan. The holders of 3,033,258 shares of Common Stock voted
for the proposal, the holders of 500 shares of Common Stock voted against the
proposal and the holders of 100 shares of Common Stock abstained from voting.

     Finally, the stockholders ratified the appointment of Deloitte & Touche LLP
as the independent public accountants to audit the Company's consolidated
financial statements for the fiscal year ending December 31, 1997. The holders
of 3,033,858 shares of Common Stock voted for the ratification, no holder of
shares of Common Stock voted against the ratification, and no holders of shares
of Common Stock abstained from voting.


                                       27

<PAGE>

                                     PART II

Item 5.  MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

     The Company'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 December 31,1997.

Period                                         High            Low
------                                         ----            ---
Fiscal 1997
  First Quarter                               10 1/2          8 1/4
  Second Quarter                              10 3/8          8 3/4
  Third Quarter                               13 1/8          8 1/2
  Forth Quarter                                19             3 1/2

Fiscal 1996
  Fourth Quarter (from October 25, 1996)      9 1/2           7 1/4

     On March 27, 1998, the closing price for a share of Common Stock, as
reported by the Nasdaq SmallCap Market, was $4 1/2.

     The number of holders of record for the Company's Common Stock as of March
27, 1998, was eleven. 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 Company 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


                                       28

<PAGE>


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.

     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 Commons 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 Commons Stock. In July
1996, Technologies made additional loans to the Company in an aggregate
principle amount of $502,000 and received the Technologies Warrants to purchase
468,242 shares of Commons 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 believed that each such
transaction was exempt from registration pursuant to Section 4(2) of the
Securities Act and/or rule 506 promulgated thereunder.

     In August 1996, the Company issued options under its 1996 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.

     As of December 31, 1997 the Company had 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. Such
customers are not affiliated with the Company. The Company does not


                                       29

<PAGE>


believe that it is materially dependent upon sales to these customers. Contracts
with such customers have been fully completed as of December 31, 1997. The
Company historically has not had, and at December 31, 1997, did not have, any
firm order backlog. During 1997, the Company sought to implement its previously
announced strategy to change its focus from customer projects to self-funded
development of simulations for broader markets. As part of this strategy, the
Company is seeking to leverage its existing products and technology platform to
become a product-oriented, sales-driven company. During this transition period,
revenues are not expected to be material, as the Company will be focusing on
developing new product sales channels. The Company's current and planned expense
levels are based in part on its expectations as to future revenue.

     As of December 31, 1997, the Company had experienced cumulative losses of
$8,726,000 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.

     During 1997, the Company focused primarily on the development and
commercial introduction of Think 2000, a Year 2000 risk simulation software
program, which was introduced in September 1997. Think 2000 is the first
simulation product the Company internally funded and is bringing to a broader
market. The Company has made a significant investment in the development and
commercialization of Think 2000, and as a result, does not currently anticipate
significant revenues in the near future from other sources. The Company
currently has limited capital and human resources and is focusing such resources
primarily on Think 2000. Any failure of the Company to successfully
commercialize Think 2000 or to meet demands for such product on a timely basis
could have a material adverse effect on the Company's business, operating
results and financial condition. The Company is relying on the success of Think
2000, as well as the successful development, commercialization and marketing of
additional products for its long-term viability and growth.

     In order to reduce operating expenses and concentrate its resources on
Think 2000, in December 1997 the Company closed the administrative office which
it had opened at 6541 Via Del Oro, San Jose, California during 1997,
reconsolidating the Company's operations in its Monterey, California facility.
As a result of the restructuring, the Company recorded a charge of $121,000 for
the year ended December 31, 1997, which amount included $24,000 in lease costs,
$60,000 in wages and compensation pay and $37,000 in other costs related to the
closing of the San Jose facility.

     The Company has also taken other steps to reduce the Company's operating
expenses, including significantly reducing the number of its sales and marketing
consultants, as well as terminating certain other non-essential personnel. The
Company is currently focusing its resources primarily on product development,
sales support and marketing for Think 2000.

     The Company expects to incur substantial operating expenses in the future
to support its development costs, expand its sales and marketing capabilities
and for other general and administrative expenses. The Company's results of
operations may vary

                                       30
<PAGE>


significantly from quarter to quarter during this ongoing period of development.

Results of Operations

     Comparison of years ended December 31, 1997 and 1996

     Revenues. Revenues for the year ended December 31, 1997 decreased by
$771,000 or 85% to $137,000 from $908,000 for the year ended December 31, 1996.
During 1996 and 1997 the Company's revenues were derived primarily from a
relatively small number of contracts and in 1997 the Company's revenues included
sales of the Company's software products.

     Gross Margin. Gross margin for the year ended December 31, 1997 was 5% of
revenues as compared with 29% of revenues for the year ended December 31, 1996.
A substantial portion of the decline in gross margin resulted from one specific
project. Contract cost approximated contract revenues on the contract.

     Selling, General and Administrative Expenses. Selling, general and
administrative expenses increased by $1,758,000, or 125%, for the year ended
December 31, 1997, to $3,162,000, from $1,404,000 for the year ended December
31, 1996. Selling, general and administrative expenses consisted primarily of
wages and benefits, legal, accounting, and consulting expenses and rents. The
increase in selling, general and administrative expenses was due mainly to
launching the Think 2000 product, and increased sales and marketing activities,
hiring a new CEO and senior sales personnel, new insurance policy premiums and
costs to establish an office in San Jose, California. The Company expects
general and administrative expenses to decrease in future periods and sales and
marketing costs to increase as the Company reduces certain costs as part of a
restructuring plan and increases sales and marketing expenses as new strategic
planning and sales and marketing programs are implemented.

     Research and Development. Research and development expenses for the year
ended December 31, 1997 increased by $1,513,000, or 1015%, to $1,662,000 from
$149,000 for the year ended December 31, 1996. This increase was primarily due
to the shifting of development efforts from software development contracts to
internal development of new software products. The Company anticipates that
research and development costs will increase in future periods as the Company's
business strategy shifts from custom development projects to product sales.

     Interest Expense. Interest expense for the year ended December 31, 1997
decreased by $1,344,000, or 99%, to $9,000, from $1,353,000 for the year ended
December 31, 1996. The decrease was due to the repayment of substantially all
debt or the conversion of loans to equity as of December 31, 1996.

     Other Income, net. Other income for the year ended December 31, 1997
increased by $131,000, or 98%, to $264,000 from $133,000 for the year ended
December 31, 1996. This increase was primarily due to interest income generated
from investing the excess proceeds raised from the IPO.


                                       31

<PAGE>


     Net Loss. As a result of the foregoing, net loss for the year ended
December 31, 1997 increased by $2,048,000 or 81%, to $4,562,000 from $2,514,000
for the year ended December 31, 1996.

Liquidity and Capital Resources

     Since its inception and through December 31, 1997, the Company has incurred
cumulative losses aggregating approximately $8,726,000, 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, 1997, the Company had cash and cash equivalents of
approximately $2,597,000, working capital of approximately $2,075,000 and
stockholder's equity of approximately $2,369,000. At December 31, 1997, the
Company had no long-term liabilities outstanding.

     The Company's operating activities used cash of $3,884,000 and $1,495,000
in 1997 and 1996, respectively. The funds were used for the Company's product
development and to fulfill various contract obligations.

     The Company's financing activities used cash of $167,000 for the fiscal
year ending December 31,1997, compared to providing cash of $8,227,000 in 1996
primarily as a result of the Company's initial public offering. The decrease in
the cash balance for the fiscal year ended December 31, 1997 is primarily due to
the operating losses incurred in 1997.

     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 the middle of the third quarter of fiscal 1998. 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.

     The Company may need to raise additional debt or equity financing to fund
its future operations and growth strategy. The Company anticipates that it will
be required to seek additional funding through public or private sales of debt
or equity securities. The Company is currently evaluating its financing options;
however, there can be no assurance that additional funds will be available on
favorable terms or at all.

Year 2000

     The Company has developed plans to address the changes that need to be made
to its own computer system and applications for the implications of Year 2000.
The Company


                                       32

<PAGE>


is also communicating with its application vendors, suppliers, financial
institutions and other with which it is doing business to address the impact of
the Year 2000. The Company does not anticipate that the financial impact of
making the required changes to its system and applications will be material to
the Company's consolidated financial position or results of operations.

Significant Financial and Business Developments

     On February 12, 1998, Thinking Tools, Inc. announced the appointment of
Moshe Zarmi as President and Chief Executive Officer. Mr. Zarmi replaced Phillip
F. Whalen, Jr. who resigned to pursue other interests.

     In order to reduce operating expenses and concentrate its resources on
Think 2000, in December 1997 the Company closed the administrative office which
it had opened at 6541 Via Del Oro, San Jose, California during 1997,
reconsolidating the Company's operations in its Monterey facility. As a result
of this restructuring, the Company recorded a charge of $121,000 for the year
ended December 31, 1997, which amount included $24,000 in lease costs, $60,000
in wages and compensation pay and $37,000 in other costs related to the closing
of the San Jose facility.

     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 $7,860,347 (net
of underwriting discounts, commissions and expenses of $1,239,663) 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 not of underwriting discounts, commissions, and
expenses of $177,450 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 and accrued interest 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.



                                       33

<PAGE>


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.


                                       34

<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          42   Chairman of the Board, Director
Mr. Moshe Zarmi         60   President, Chief Executive Officer, Director
Mr. John Hiles          50   Founder, Chief Technology Officer, Secretary, Director
Ms. Patricia Kessler    59   Vice President of Finance and Administration
Mr. Charlie Isaacs      39   Vice President of Engineering
Mr. Marc Cooper         36   Director
Ms. Esther Dyson        46   Director
Mr. Frederick Gluck     62   Director
Dr. Ted Prince          50   Director
Mr. Fran Saldutti       50   Director
Mr. Mort Meyerson       58   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.

     Moshe Zarmi has been President, Chief Executive Officer, and a director of
Thinking Tools, Inc. since February 12, 1998. From February 1997 to December
1997, Mr. Zarmi was a consultant to the Company. Mr. Zarmi has 30 years
experience mainly in high technology industries. February 1993 to January 1997,
Mr. Zarmi was CEO of Geotest, a


                                       35

<PAGE>


leading Automated Test Equipment company based in Southern California. His
extensive business experience includes a tenure at Israel Aircraft Industries
(IAI), where he held various positions in finance and administration, as well as
head of US marketing and sales. Mr. Zarmi also served as President of ATG, the
Canadian subsidiary of IAI. Additionally, Mr. Zarmi headed his own company which
specialized in technology transfer and worked mainly with Israeli high
technology companies doing business in the United States. Mr. Zarmi attended Tel
Aviv University and holds a MBA from Columbia University.

     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 30,
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 led 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.

     Charlie Isaacs the Vice President of Engineering, has been with the Company
since June, 1997. Mr. Isaacs came to Thinking Tools with 17 years of experience
in software engineering and systems integration and more than 12 years of
experience in leading complex software development projects. He was most
recently vice president and general manager of the Answer Systems Division of
Platinum Technology, Inc. where he built his staff from 12 to 73 employees and
drastically reduced operating expenses despite considerable growth. Products
developed during his tenure won several awards for technology innovation. From
1980 to 1995, Mr. Isaacs was with GTE Government Systems in a sequence of
positions of increasing responsibility. His last position with GTE was vice
president of engineering and operations. Mr. Isaacs received a Bachelor of
Science, Electrical Engineering from the University of California Santa Barbara
in 1980 and a Master in Business Administration from California Lutheran
University in Thousand Oaks, California in 1989.

     Patricia Kessler has been the Vice President of Finance and Administration
since January 1997. Ms. Kessler is the President and Founder of Kessler and
Associates a Business and Finance Consulting Firm, specializing in start-up and
small to medium sized companies. From February 1994 to January 1997 she was
Chief Financial Officer for Geotest Inc. a leading automated test equipment
company based in Southern California. Her extensive Business, Accounting and
Administration experience includes working as a senior financial manager and
operations manager for various organizations such as Arthur


                                       36

<PAGE>


Young (Management Service Group), Warner Lambert (Western Regional Offices),
Monier LTD (US Corporate Office), and Hughes Aircraft. Ms. Kessler received her
BSBA degree at Fresno State University and a MBA from California State
University at Long Beach.

     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.

     Esther Dyson has been a member of the board of directors since October
1994. From 1983 to 1997 Ms. Dyson has served as president of EDventure Holdings,
and now is EDventure Holdings chairman. EDventure Holdings is a diversified
company focusing on emerging information technology worldwide, and on the
emerging computer markets of Central and Eastern Europe. Since 1997, Ms. Dyson
has been chairman of the Electronic Frontier Foundation. Ms. Dyson is a member
of the board of directors of the Global Business Network, ComputerLand Poland
and Cygnus Solutions, and she is a member of the advisory board of Perot
Systems. She is a limited partner in the Maryfield 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 Board 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


                                       37

<PAGE>


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 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.

     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, 1997, and December 31, 1996 to those persons who were, at December
31, 1997, (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").


                                       38

<PAGE>


                           SUMMARY COMPENSATION TABLE


<TABLE>
<CAPTION>
                                                                                       Long Term
                                                                                     Compensation
                                                  Annual Compensation                   Awards
                                    ---------------------------------------------------------------

Name and Principal Position  Year     Salary ($)       Bonus ($)      Other Annual    Securities
                                                                      Compensation    Underlying
                                                                           ($)         Options/    Compensation
                                                                                         SARs
------------------------------------------------------------------------------------------------------------------
<S>                          <C>        <C>             <C>            <C>            <C>              <C>
Phillip F. Whalen, Jr.       1997       $164,339        ------         ------                          -----
Former CEO                   1996        $14,584        ------         ------         430,000(1)

John Hiles(2)                1997       $158,758        ------         ------           -----          -----
Founder, Chief               1996       $135,507        $25,000        ------           -----          -----
Technology Officer
</TABLE>

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

(1)  Mr. Whalen joined the Company on December 1, 1996, and this amount
     represents his salary from that date through December 31, 1996. Mr. Whalen
     submitted his resignation on February 12, 1998. All options, exercisable
     and unexercisable, held by Mr. Whalen as of December 31, 1997 expired upon
     the termination of his employment.

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

                            1997 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.
No stock options were granted in 1997.

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 1997 Plan and 1996 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


                                       39

<PAGE>


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.

     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 1997, there were no options granted to
directors.

     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.


                                       40

<PAGE>


Arrangements with Directors and Executive Officers

     Mr. Zarmi's employment arrangements with the Company guarantee him an
annual base salary of $175,000 plus a bonus to be determined by the Compensation
Committee of the Board of Directors. Additionally, in connection with his
employment by the Company, Mr. Zarmi received (i) an option under the 1996 Plan
to purchase 230,000 shares of Common Stock at $2.50 per share, such option
vesting in equal annual installments over three years commencing March 2, 1997
provided that Mr. Zarmi remains an employee of the Company; (ii) an option under
the 1997 Plan to purchase 190,000 shares of Common Stock at $4.50 per share,
such options vesting at such time the market price of the Common Stock is $20.00
per share or higher for 20 consecutive trading days, and provided that Mr. Zarmi
remains an employee of the Company. The vesting of all options granted to Mr.
Zarmi is subject to acceleration under certain circumstances.

     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. 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, commencing October 1, 1997, Mr. Knoll
will be compensated for such services at the rate of $150,000 per annum. Payment
of Mr. Knoll's compensation will be deferred until the Board of Directors
determines to make payments in respect thereof. 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.

Item 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     The following table sets forth as of December 31, 1997 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 Officers, 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.


                                       41

<PAGE>


      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. Philip 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


                                       42

<PAGE>


     Drive, 1-250, Monterey, California 93940.

(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


                                       43

<PAGE>


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.

     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.

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

(a) The following documents are filed as part of this report:

Exhibit
 No.                 Description
-------              -----------

3.1      Certificate of Incorporation of Thinking Tools, Inc.(1)


                                       44

<PAGE>


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)
4.8      1997 Stock Option Plan(3)
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)
16.      Letter on change in certifying accountant(4)
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 Exhibit A of the Company's Proxy
     Statement, dated November 13, 1997.

(4)  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 1997.


                                       45
<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 27, 1998
                                  THINKING TOOLS, INC.

                                  By:  /s/ Moshe Zarmi
                                       -----------------------------------
                                       Moshe Zarmi
                     President and Chief Executive Officer,
                                       Director

     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 27, 1998                  /s/ Moshe Zarmi                   .
                                       -----------------------------------
                     President and Chief Executive Officer,
                                       Director
                                       (Principal Executive Officer)

                                       /s/ Marc Cooper
                                       -----------------------------------
Dated:  March 27, 1998                 Marc Cooper, Director

                                       /s/ Esther Dyson
                                       -----------------------------------
Dated:  March 27, 1998                 Esther Dyson, Director

                                       /s/ Frederick Gluck
                                       -----------------------------------
Dated:  March 27, 1998                 Frederick Gluck, Director

                                       /s/ John Hiles
                                       -----------------------------------
Dated:  March 27, 1998                 John Hiles, Director

                                       /s/ Fred Knoll
                                       -----------------------------------
Dated:  March 27, 1998                 Fred Knoll, Director

                                       /s/ Ted Prince
                                       -----------------------------------
Dated:  March 27, 1998                 Dr. Ted Prince, Director

                                       /s/ Fran Saldutti
                                       -----------------------------------
Dated:  March 27, 1998                 Fran Saldutti, Director

Dated:  March 27, 1998                 /s/ Patricia Kessler
                                       -----------------------------------
                                       Patricia Kessler
                                       Chief Financial Officer


                                       46

<PAGE>


                              THINKING TOOLS, INC.
                          INDEX TO FINANCIAL STATEMENTS


                                                                 Page

Independent Auditors' Report                                     F-2

Balance Sheets at December 31, 1997 and 1996                     F-3

Statements of Operations for the Years Ended
December 31, 1997 and 1996                                       F-4

Statements of Stockholders' Equity for the Years
Ended December 31, 1997 and 1996                                 F-5

Statements of Cash Flows for the Years
Ended December 31, 1997 and 1996                                 F-6

Notes to Financial Statements                                    F-7


                                      F-1

<PAGE>


INDEPENDENT AUDITORS' REPORT


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

We have audited the accompanying balance sheets of Thinking Tools, Inc. as of
December 31, 1997 and 1996, and the related statements of operations,
shareholders' equity and cash flows for the years 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 audits.

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

In our opinion, such financial statements present fairly, in all material
respects, the financial position of the Company at December 31, 1997 and 1996,
and the results of its operations and its cash flows for the years 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
financial statements, the Company's recurring losses from operations and lack of
revenues raise substantial doubt about its ability to continue as a going
concern. Management's plans concerning these matters are also described in Note
1. The financial statements do not include any adjustments that might result
from the outcome of this uncertainty.

DELOITTE & TOUCHE LLP

San Jose, California
February 2, 1998


                                      F-2
<PAGE>


THINKING  TOOLS,  INC.

<TABLE>
<CAPTION>
BALANCE  SHEETS
DECEMBER 31, 1997 AND 1996 (In thousands, except share and per share amounts)
------------------------------------------------------------------------------------------------------

<S>                                                                             <C>          <C>
ASSETS                                                                            1997         1996

CURRENT ASSETS:
  Cash and equivalents                                                          $ 2,597      $ 6,869
  Accounts receivable                                                                 7          230
  Prepaid expenses and other current assets                                         131          147
                                                                                -------      -------
     Total current assets                                                         2,735        7,246

PROPERTY AND EQUIPMENT, Net                                                         265          101

OTHER ASSETS                                                                         29           10
                                                                                -------      -------
TOTAL                                                                           $ 3,029      $ 7,357
                                                                                =======      =======

LIABILITIES AND SHAREHOLDERS' EQUITY

CURRENT LIABILITIES:
  Accounts payable                                                                $ 200        $ 181
  Accrued expenses                                                                  359          193
  Notes payable                                                                      88          127
  Current portion of capital lease obligations                                       13           17
                                                                                -------      -------
     Total current liabilities                                                      660          518
CAPITAL LEASE OBLIGATIONS, Net of current portion                                    -           12
                                                                                -------      -------
     Total liabilities                                                              660          530
                                                                                -------      -------
COMMITMENTS AND CONTINGENCIES (Note 7)

SHAREHOLDERS' EQUITY:
  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
    shares issued and outstanding                                                     5            5
  Additional paid-in capital                                                     11,288       11,288
  Deferred stock compensation                                                      (198)        (302)
  Accumulated deficit                                                            (8,726)      (4,164)
                                                                                -------      -------
     Total shareholders' equity                                                   2,369        6,827
                                                                                -------      -------
TOTAL                                                                           $ 3,029      $ 7,357
                                                                                =======      =======
</TABLE>


See notes to financial statements.


                                      F-3

<PAGE>


THINKING TOOLS, INC.

<TABLE>
<CAPTION>
STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1997 AND 1996 (In thousands,
except per share amounts)
------------------------------------------------------------------------------------------------------

                                                                                  1997         1996
<S>                                                                             <C>          <C>
REVENUES:
  Contract                                                                      $   116      $   908
  Product                                                                            21            -
                                                                                -------      -------

     Total revenues                                                                 137          908

COST OF REVENUES                                                                    130          649
                                                                                -------      -------

     Gross profit                                                                     7          259
                                                                                -------      -------

OPERATING EXPENSES:
  Selling, general and administrative                                             3,162        1,404
  Research and development                                                        1,662          149
                                                                                -------      -------

     Total operating expenses                                                     4,824        1,553
                                                                                -------      -------

LOSS FROM OPERATIONS                                                             (4,817)      (1,294)
                                                                                -------      -------

OTHER INCOME (EXPENSE):
  Interest expense                                                                   (9)      (1,353)
  Interest and other income                                                         264          133
                                                                                -------      -------

     Total other income (expense)                                                   255       (1,220)
                                                                                -------      -------

NET LOSS                                                                        $(4,562)     $(2,514)
                                                                                =======      =======

NET LOSS PER SHARE                                                              $ (0.98)     $ (0.80)
                                                                                =======      =======

SHARES USED IN CALCULATING NET LOSS PER SHARE                                     4,642        3,152
                                                                                =======      =======
</TABLE>


See notes to financial statements.


                                      F-4

<PAGE>


THINKING  TOOLS,  INC.

<TABLE>
<CAPTION>
STATEMENTS OF SHAREHOLDERS' EQUITY YEARS
ENDED DECEMBER 31, 1997 AND 1996
(In thousands, except share amounts)
------------------------------------------------------------------------------------------------------------------------

                                                   Common Stock    Additional    Deferred                    Total
                                                -------------------  Paid-in       Stock     Accumulated   Shareholders'
                                                  Shares   Amount    Capital    Compensation   Deficit        Equity

<S>                                              <C>           <C>    <C>            <C>        <C>           <C>
BALANCES,  January 1, 1996                       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
  issuance 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

Amortization of deferred stock compensation              -       -           -         104             -           104
Net loss                                                 -       -           -           -        (4,562)       (4,562)
                                                 ---------     ---    --------       -----       -------       -------

BALANCES,  December 31, 1997                     4,641,758     $ 5    $ 11,288       $(198)      $(8,726)      $ 2,369
                                                 =========     ===    ========       =====       =======       =======
</TABLE>


                                      F-5

<PAGE>


THINKING  TOOLS,  INC.

<TABLE>
<CAPTION>
STATEMENTS  OF  CASH  FLOWS
YEARS ENDED DECEMBER 31, 1997 AND 1996 (In thousands)
------------------------------------------------------------------------------------------------------

                                                                                  1997         1996
<S>                                                                             <C>          <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
  Net loss                                                                      $(4,562)     $(2,514)
  Adjustments to reconcile net loss to net cash used in operating activities:
    Depreciation and amortization                                                    57           36
    Stock compensation expense                                                      104          209
    Warrants issued in connection with debt                                           -          900
    Changes in assets and liabilities:
      Accounts receivable                                                           223          (84)
      Prepaid expenses and other assets                                             109           22
      Accounts payable                                                               19          176
      Accrued expenses                                                              166         (206)
      Due to related party                                                            -          (34)
                                                                                -------      -------
         Net cash used in operating activities                                   (3,884)      (1,495)
                                                                                -------      -------
CASH FLOWS FROM INVESTING ACTIVITIES -
  Purchases of property and equipment                                              (221)         (15)
                                                                                -------      -------
CASH FLOWS FROM FINANCING ACTIVITIES:
  Principal payment on short-term notes payable                                    (151)      (2,434)
  Principal payments on capital lease obligations                                   (16)         (14)
  Proceeds from issuance of common stock                                              -        8,470
  Proceeds from issuance of short-term notes payable                                  -        2,205
                                                                                -------      -------
         Net cash provided by (used in) financing activities                       (167)       8,227
                                                                                -------      -------
NET INCREASE (DECREASE) IN CASH AND EQUIVALENTS                                  (4,272)       6,717

CASH AND EQUIVALENTS, Beginning of year                                           6,869          152
                                                                                -------      -------
CASH AND EQUIVALENTS, End of year                                               $ 2,597      $ 6,869
                                                                                =======      =======

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION -
  Cash paid during the year for interest                                        $     9      $   540
                                                                                =======      =======


SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND
  FINANCING ACTIVITIES:
  Liability insurance financed under a note payable                             $   112      $   155
                                                                                =======      =======
  Conversion of notes payable and accrued interest into common stock            $     -      $ 1,320
                                                                                =======      =======
  Equipment acquired under capital leases                                       $     -      $    12
                                                                                =======      =======
</TABLE>


See notes to financial statements.


                                      F-6

<PAGE>


THINKING  TOOLS,  INC.

NOTES  TO  FINANCIAL  STATEMENTS
Years Ended December 31, 1997 and 1996
--------------------------------------------------------------------------------


1.  BUSINESS AND BASIS OF PRESENTATION

Business - Thinking Tools, Inc. (the Company), which was incorporated in
California in December 1993, 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, 1997, 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 3,000,000 shares of $0.001
par value preferred stock and 20,000,000 shares of $0.001 par value common
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 retroactively 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.

Basis of Presentation - The financial statements have been prepared assuming the
Company will continue as a going concern. The Company's lack of product revenues
and recurring losses from operations raise substantial doubt about its ability
to continue as a going concern. The Company's management has developed a 1998
operations plan which includes generating revenues from product sales and
funding working capital requirements through additional equity financing. The
Company's continued existence is dependent on its ability to achieve its 1998
operations plan and its ability to raise additional financing. The financial
statements do not include any adjustments that might result from the outcome of
this uncertainty.


2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Use of Estimates - The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions

                                       F-7
<PAGE>

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. 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.

Contract Revenue and Cost Recognition - Revenues from fixed-price contracts are
recognized using the percentage of completion method, measured by input
measures. Costs of revenues 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.

Product Revenue - The Company recognizes revenue in accordance with American
Institute of Certified Public Accountants Statement of Position 91-1 "Software
Revenue Recognition." Revenue from software licenses is recognized after
shipment of the product and when no significant contractual obligations remain
outstanding. Maintenance revenue is deferred and recognized over the term of the
maintenance agreement, which is typically one year.

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.

Concentration of Credit Risk - Financial instruments that potentially subject
the Company to concentration of credit risk are cash and equivalents and
accounts receivable. Risks associated with cash and equivalents are mitigated by
banking with credit-worthy institutions. The Company performs an ongoing
evaluation of its customers' creditworthiness and generally requires no
collateral.

Prepaid Expenses - Prepaid expenses at December 31, 1997 and 1996 primarily
consists of prepaid insurance which is being amortized over the contract term.

Property and Equipment - Property and equipment are stated at cost. 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. The
Company evaluates the recoverability of long-lived assets on an on-going basis.

Research and Development - Research and development costs are charged to expense
as incurred, while software development costs incurred between the establishment
of technological feasibility and general production release are capitalized.
Since the Company's development process generally results in the establishment
of technological feasibility concurrent with general production release, no
software development costs were capitalized in 1997 or 1996.

                                       F-8
<PAGE>

Interest Expense - In addition to the stated interest on the Company's
borrowings, interest expense in 1996 includes the direct costs of various
financing as well as the fair value of warrants issued in connection with such
borrowings (see Note 7).

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 - During the fourth quarter of 1997 the Company adopted
Statement of Financial Accounting Standards (SFAS) No. 128 "Earnings Per Share."
SFAS 128 requires restatement of all prior year earnings (loss) per share and
presentation of basic and diluted earnings (loss) per share. Due to the
Company's net loss, all convertible securities are antidilutive; hence both
basic and diluted loss per share are computed based on the weighted average
number of shares of common stock outstanding during the period. The 1996
earnings per share amount has been restated to conform with SFAS 128.

Reclassification - Certain 1996 amounts have been reclassified to conform with
the 1997 presentation. Such reclassifications did not affect net loss or
shareholders' equity.


3.  PROPERTY AND EQUIPMENT

Property and equipment at December 31 are as follows (in thousands):

                                                              1997        1996

          Equipment                                          $ 296       $ 145
          Furniture and fixtures                                73           7
          Leasehold improvements                                10           6
                                                             -----       -----

                                                               379         158
          Accumulated depreciation and amortization           (114)        (57)
                                                             -----       -----

          Property and equipment, net                        $ 265       $ 101
                                                             =====       =====

At December 31, 1997 and 1996, property and equipment included assets leased
under capital leases of approximately $20,000 and $30,000 (net of accumulated
amortization of $32,000 and $22,000), respectively.

                                      F-9
<PAGE>

4.  ACCRUED EXPENSES

Accrued expenses at December 31 are as follows (in thousands):

<TABLE>
<CAPTION>
                                                                                    1997       1996
    <S>                                                                             <C>        <C>
    Lease abandonment costs                                                         $121       $  -
    Legal and professional fees                                                      112         66
    Payroll and related benefits                                                      72         29
    Accrued severance costs                                                           47          -
    Billings in excess of costs and estimated earnings on uncompleted contracts        -         32
    Other                                                                              7         66
                                                                                    ----       ----
    Total                                                                           $359       $193
                                                                                    ====       ====
</TABLE>


5.  LEASES

The Company leases its office space under two noncancelable operating leases
expiring in 2000. During 1997, the Company consolidated its locations prior to
expiration of one of its leases, resulting in a lease abandonment accrual of
$121,000 at December 31, 1997.

Future minimum rental commitments under the leases at December 31, 1997 are as
follows (in thousands):

    1998                                                         $ 102
    1999                                                            78
    2000                                                            82
    2001                                                            35
                                                                 -----
                                                                 $ 297
                                                                 =====

The Company leases certain office equipment under noncancelable capital leases.
At December 31, 1997, future payments under such leases total $13,000.

Total rent expense, including the abandonment accrual, was approximately
$277,000 and $98,000 for the years ended December 31, 1997 and 1996,
respectively.


6.  INCOME TAXES

Due to the Company's history of net losses, the Company has fully reserved its
net deferred tax benefits (including its net operating losses) and,
consequently, its tax provision (benefit) is nil.

                                      F-10
<PAGE>

Significant components of the Company's deferred tax assets and liabilities as
of December 31 are as follows (in thousands):


                                                               1997        1996
    Deferred tax assets:
      Net operating loss carryforwards                       $2,775        $792
      Accruals and reserves not currently deductible            294         176
                                                             ------        ----
    Total gross deferred tax assets                           3,069         968
    Total gross deferred tax liabilities - depreciation         (14)        (13)
    Less valuation allowance                                 (3,055)       (955)
                                                             ------        ----
    Net deferred tax assets                                  $    -        $  -
                                                             ======        ====

As of December 31, 1997 the Company has net operating loss carryforwards of
$7,071,000 and $7,057,000 for federal and state purposes, respectively. As of
December 31, 1997, the Company also has tax credit carryforwards of $25,000 and
$24,000 for federal and state purposes, respectively. The losses expire
beginning in 2009 and 2002, respectively. Federal and state of California tax
laws impose significant restrictions on the utilization of net operating loss
carryforwards in the event of a change in ownership as defined by the Internal
Revenue Service Code Section 382.


7.  NOTES PAYABLE

Notes payable at December 31, 1997 and 1996 relate to the Company's directors
and officers insurance policy. At December 31, 1997 the note bears interest at
9.25% and is due in monthly installments of approximately $13,000, including
interest, through July 1998.

In September 1994, the Company borrowed $1,200,000 from Thinking Technologies,
L.P. under a note bearing annual interest of 10% 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 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

                                      F-11
<PAGE>

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.


8.  SHAREHOLDERS' 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 7).

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 7). 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-12
<PAGE>

Stock Option Plan

Under the Company's 1996 and 1997 Stock Option Plans (the Plans), options to
purchase up to an aggregate of 976,000 shares of common stock may be granted to
officers, directors, employees or consultants. The Plans 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 Plans become exercisable as determined by the
Board of Directors and must be exercised within ten years.

No options were granted during 1997. During 1996, the Company granted options to
purchase 590,036 shares of common stock (375,036 under the Plan) at a weighted
average exercise price of $6.63. Such 1996 grants had a weighted average fair
value of $7.37 per share at the date of grant. No options have been exercised or
canceled during 1997 and 1996. As of December 31, 1997, 600,964 shares were
available for future grant under the Plans.

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 noncash compensation expense of $104,000 and $209,000
related to such difference in 1997 and 1996, respectively. As of December 31,
1997, an additional $198,000 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, 1997 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              8.1           $ 0.86                167,000            $ 0.86
     $5.00                52,000              8.7             5.00                 26,000              5.00
 $7.65 - $9.00           430,000              8.9             8.28                 76,667              7.65
                         -------                                                  -------            ------

                         649,000              8.4           $ 6.11                269,667            $ 3.19
                         =======                                                  =======            ======
</TABLE>

Additional Stock Plan Information

As discussed in Note 2, 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

                                                   F-13
<PAGE>

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 of 30 to 40 months; stock
volatility, 61% subsequent to the initial public offering in 1996; risk-free
interest rates, approximately 6.0%; 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 $5,524,000 ($1.19 per share) in
1997 and $2,661,000 ($0.84 per share) in 1996.

9.  MAJOR CUSTOMERS

Three customers accounted for 68%, 16%, and 11% of contract revenues for the
year ended December 31, 1997. One other customer accounted for 100% of accounts
receivable at December 31, 1997.

Four customers accounted for 28%, 25%, 24%, and 14% of contract revenues for the
year ended December 31, 1996. Two of these customers accounted for 64% and 28%,
respectively, of accounts receivable at December 31, 1996.


10.  NEW ACCOUNTING PRONOUNCEMENTS

In June 1997, the Financial Accounting Standards Board issued SFAS No. 130
"Reporting Comprehensive Income," which requires that an enterprise report, by
major components and as a single total, the change in its net assets during the
period from nonowner sources; and SFAS No. 131 "Disclosures about Segments of an
Enterprise and Related Information," which establishes annual and interim
reporting standards for an enterprise's business segments and related
disclosures about its products, services, geographic areas, and major customers.
Adoption of these statements will not impact the Company's financial position,
results of operations or cash flows. Both statements are effective in 1998.

In October 1997, the American Institute of Certified Public Accountants issued
Statement of Position No. 97-2 (SOP 97-2), "Software Revenue Recognition,"
establishing new standards for revenue recognition on software sales subsequent
to December 31, 1997. The Company does not expect the adoption of SOP 97-2 to
have a material impact on its financial position or results of operations.

                                    * * * * *

                                      F-14