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                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549
 
                               ----------------
 
                                   FORM 10-K
 
                               ----------------
(Mark One)
[X]ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
   ACT OF 1934
 
                      For the year ended December 31, 1998
 
[_]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
   EXCHANGE ACT OF 1934
 
               For the transition period from         to
 
                        Commission file number 0-27116
 
                               ----------------
 
                            PYRAMID BREWERIES INC.
            (Exact name of registrant as specified in its charter)
 
<TABLE>
<S>                                            <C>
                 Washington                                      91-1258355
       (State or other jurisdiction of                        (I.R.S. Employer
       incorporation or organization)                        Identification No.)
</TABLE>
 
                          91 So. Royal Brougham Way,
                               Seattle, WA 98134
              (Address of principal executive offices) (Zip Code)
 
      Registrant's telephone number, including area code: (206) 682-8322
 
       Securities registered pursuant to Section 12(b) of the act: None.
 
          Securities registered pursuant to Section 12(g) of the Act:
 
                          Common Stock $.01 Par Value
 
                               ----------------
 
  Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [_]
 
  Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [_]
 
  The aggregate market value of the voting stock held by non-affiliates of the
registrant at March 1, 1999, was $10,730,404.
 
  The number of shares outstanding of the registrant's common stock as of
March 1, 1999, was 8,224,352.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
  Portions of the Company's Proxy Statement for the Annual Meeting of
Stockholders to be held on May 13, 1999 are incorporated by reference into
Part III of this Form 10-K.
 
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<PAGE>
 
                             PYRAMID BREWERIES INC.
 
        ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1998
 
<TABLE>
<CAPTION>
                                                                           Page
                                                                           ----
 <C>      <S>                                                              <C>
 PART I

 Item 1.  Business......................................................     1
 Item 2.  Properties....................................................     4
 Item 3.  Legal Proceedings.............................................     5
 Item 4.  Submission of Matters to a Vote of Security Holders...........     5
 Item 4A. Executive Officers of the Registrant..........................     5

 PART II

 Item 5.  Market for Registrant's Common Equity and Related Stockholder
           Matters......................................................     6
 Item 6.  Selected Financial Data.......................................     7
 Item 7.  Management's Discussion and Analysis of Financial Condition
           and Results of Operations....................................     8
 Item 8.  Financial Statements..........................................    13
 Item 9.  Change in and Disagreements with Accountants on Accounting and
           Financial Disclosure.........................................    13

 PART III

 Item 10. Directors and Executive Officers of the Registrant............    13
 Item 11. Executive Compensation........................................    13
          Security Ownership of Certain Beneficial Owners and
 Item 12. Management....................................................    13
 Item 13. Certain Relationships and Related Transactions................    13

 PART IV

 Item 14. Exhibits, Financial Statement Schedules, and Reports on Form
           8-K..........................................................    14
</TABLE>
 
<PAGE>
 
                                    PART I
 
Item 1 -- Business
 
  Pyramid Breweries Inc. (the Company) is one of the leading brewers of fresh,
full-flavored specialty beers, generally known as craft beers. The Company
also produces a line of handcrafted sodas and operates restaurants adjacent to
its two breweries, under the Pyramid Alehouse brand name. The Company produces
and markets more than twenty ales and lagers under the Pyramid and Thomas
Kemper brands. The Company's two breweries, one in Seattle, Washington
(Seattle Brewery) and one in Berkeley, California (Berkeley Brewery), had an
estimated total annual production capacity of 172,000 barrels as of the end of
1998. The Seattle Brewery opened in March 1995 and has an estimated annual
beer production capacity of 92,000 barrels. The Berkeley Brewery was completed
in February 1997 with an initial estimated annual beer production capacity of
80,000 barrels, and a maximum design capacity in excess of 200,000 barrels. In
March 1997, Pyramid added root beer and other premium sodas to its business
when it acquired the assets of the Thomas Kemper Soda Company.
 
  The Company's breweries and restaurants were developed in accordance with
its strategy of operating breweries in selected metropolitan areas serving
regional markets. The breweries produce high quality, full-flavored beers in
small batches using traditional brewing methods. The Company believes that the
breweries and adjacent alehouses provide increased consumer awareness and
loyalty for the Company's brands by increasing opportunities for sampling and
local product promotion.
 
  Craft beers are a small segment of the estimated $50 billion dollar brewing
industry. The Institute for Brewing Studies estimates that sales of craft
beers increased by between one and two percent in 1998 and accounted for
approximately 3.0% of the total barrels of beer shipped by domestic brewers
that year. Craft beers are distinguishable from mass-produced beers by their
wide range of fuller flavors and adherence to traditional European styles and
ingredients.
 
  The Company has been successful in marketing wheat beers, which comprise one
of the largest segments in the craft brewing industry. The Company has also
successfully introduced fruit flavored beers to complement its more
traditional ales and lagers. Pyramid Hefeweizen, Pyramid Apricot Ale and
Pyramid Snowcap are the Company's best selling ales. Under the Thomas Kemper
brand, the Company brews authentic German styles and also several adventurous
styles popularized in other European countries. Thomas Kemper Weizenberry and
Thomas Kemper Hefeweizen are currently the Company's best selling beers within
the Thomas Kemper brand. On March 7, 1997, the Company acquired substantially
all of the operating assets and assumed certain liabilities of the Thomas
Kemper Soda Company. This acquisition supplemented the Company's line of craft
beers with Thomas Kemper Soda's premium soft drinks including root beer and
cream soda. The Company has since added an orange cream soda and a black
cherry soda to the Thomas Kemper Soda product line.
 
  Craft beers generally sell for retail prices ranging from $4.99 to $7.49 per
six pack; retail prices are set independently by distributors and retailers.
The Company's retail prices are usually at the high end of this range.
Increased consumer demand for high quality, full-flavored beers allows for a
price premium relative to mass-produced domestic beers. This price premium
results in higher profit margins, which motivate distributors and retailers to
offer and promote craft beers. The Company's craft beers are sold primarily in
Washington, Oregon and California, which accounted for approximately 84% of
the Company's 1998 beer sales. The Company's alehouse and soda operations
contributed 24% and 13% of net sales in 1998, respectively.
 
Business Strategy
 
  The Company's strategy has been to develop a network of company-owned and
operated breweries producing and marketing a wide selection of high quality,
full-flavored ales, lagers and sodas for regional markets. Adverse market
conditions (see "Competition"), have caused the Company to redirect its
development
 
                                       1
<PAGE>
 
efforts and refocus sales and marketing resources on its main West Coast
markets serviced by its existing breweries. As market conditions improve, the
Company intends to continue its development efforts by: (i) expansion in
selected metropolitan areas by developing or acquiring additional breweries,
(ii) producing a wide selection of craft beers under multiple brands, (iii)
maintaining quality control of its beers by producing its beers in Company-
operated breweries, (iv) promoting its products primarily through consumer
sampling and education combined with targeted advertising, (v) distributing
its beers through an independent network of wholesale distributors, and (vi)
in appropriate locations, operating restaurants adjacent to the breweries to
provide sampling for the full range of the Company's beverage products.
 
 Expansion through Regional Breweries
 
  The Company's strategy is to eventually develop a network of breweries in
highly visible locations within selected metropolitan areas. The Company may
develop or acquire additional breweries, and in appropriate locations,
restaurants as demand for its craft beer brands grows. The Company's breweries
and restaurants are focal points for marketing, creating brand awareness and
generating sampling opportunities for the Company's products. The proximity of
the Company's breweries to their markets also optimizes product freshness,
reduces freight costs and minimizes the inventory of kegs required to service
draft accounts.
 
 Wide Selection of Craft Beers under Multiple Brands
 
  The Company produces a wide range of craft beers to appeal to a variety of
discerning consumer tastes. The Company currently markets its products under
two brands, Pyramid and Thomas Kemper. The Pyramid brand accounted for 87% of
the Company's beer sales in 1998. The Company will also seek opportunities to
develop or acquire other distinctive regional brands, similar to its existing
Thomas Kemper brand, which may be unique to their local markets. The multiple
brand strategy, coupled with a wide range of styles, enables the Company to
obtain better market penetration through greater shelf space in bottled beer
retail stores and additional tap handles in draft beer outlets.
 
 Production in Company Operated Breweries
 
  The Company brews all of its beers in company-operated breweries providing
direct control of the entire production process from purchase of ingredients
to packaging and shipment. The Company believes this direct control provides
strategic advantages over competitors who contract production of their
products to other breweries. The advantages of direct control over the
production process include greater flexibility to innovate, the ability to
cost effectively switch production of styles and packaging, greater control of
product quality and freshness, better control over production costs and
minimization of the risk that brewing capacity may be diverted to the products
of other companies at short notice.
 
 Promotion Based on Local Awareness and Product Sampling
 
  The Company uses its breweries and restaurants to build brand awareness and
generate opportunities for sampling of the Company's products at their
freshest. The Company's sales strategy emphasizes sales to the draft market to
further provide sampling and awareness. Experience in the craft beer industry
indicates that the local status of a brand is an important success factor.
 
  The Company's breweries and restaurants are extensively used to entertain
the beer trade and build relationships with distributors. The breweries and
their highly knowledgeable employees are an important source of education and
training for the Company's distributors and retailers.
 
  To further increase brand awareness and provide product sampling
opportunities, the Company uses event marketing, sponsorships, beer festivals
and targeted charitable donations of its products. The Company has an award-
winning Web site and an active public relations program. The Company also uses
general media advertising targeted to certain markets and it advertises in
craft beer publications.
 
                                       2
<PAGE>
 
 Independent Distribution Network
 
  The Company distributes its products through a network of selected
independent distributors rather than align itself with the distribution system
of a single larger brewer. This approach allows the Company to select
distributors in each market that it believes will focus the greatest attention
on its products and best promote its high quality craft beers and sodas.
Additionally, the ability to change distribution arrangements for performance
related issues is an important advantage. During 1998, the Company distributed
its products in a total of 34 states and Canada.
 
 Restaurant Operations
 
  The Company operates restaurants adjacent to its Seattle and Berkeley
breweries. The two restaurants, which are operated under the Pyramid Alehouse
brand name, provide opportunities for product sampling and increase brand
awareness. The restaurants contributed sales of $6,285,000 in 1998,
representing approximately 24% of total net sales. The restaurants have a
total of over 700 seats, plus outdoor eating areas, and are both situated in
highly visible, high traffic locations. The Pyramid Alehouse in Seattle is
close to the Kingdome, currently home to the Seattle Seahawks football team
and the Seattle Mariners baseball team. A new Mariners' stadium, scheduled to
open in July 1999, is currently under construction immediately opposite the
Pyramid Alehouse entrance and a new outdoor football stadium and exhibition
center is scheduled to be constructed on the site of the existing Kingdome.
The Pyramid Alehouse in Berkeley is situated on one of the main arterials
through the city and only seven blocks from Interstate 80. The Berkeley
Outdoor Cinema has been established in the Alehouse parking lot. The Alehouses
had approximately 500,000 guest visits during 1998; guest purchases
approximated $1.9 million of the Company's beers and sodas and more than
$180,000 in branded clothing and other merchandise.
 
Products
 
  The Company produces over 20 authentic, full-flavored, European beer styles
using traditional ingredients and brewing methods. Eight of these styles are
available on a seasonal basis, and others are available only in certain
geographical areas in accordance with the Company's regional marketing
strategy. Each unique beer style is brewed with malted barley and wheat
grains, hops and, where appropriate, natural fruit extracts and spices. The
Company avoids the use of less expensive ingredients in the belief that
quality is supremely important success in the craft beer segment. A similar
philosophy is adopted with regard to the Company's soda products. Each batch
of soda is made from high quality ingredients, rather than from diluting mass-
produced syrups. The sodas are characterized by much more pronounced flavors.
The Company's beverages are not pasteurized and are currently distributed only
in bottles and kegs.
 
Competition
 
  Competition within the craft beer and soda markets is based on product
quality, taste, consistency, freshness, distribution, price, ability to
differentiate products, promotional methods and other product support. The
number of competitors has increased dramatically in the past three years.
Statistics from the Institute of Brewing Studies indicate there were more than
1,300 craft brewers in the United States at the end of 1998. Approximately two
thirds of these brewers are brewpubs that sell all of their production at
retail on the brewery premises. The remaining brewers market their products
through similar channels to those utilized by the Company and, although many
have limited geographic distribution, the result is significantly increased
competition in all markets.
 
  The Company's past sales growth was achieved predominantly through
increasing penetration in Washington, Oregon and California, which the Company
believes comprise one of the largest and most competitive craft beer markets
in the United States, in terms of the number of specialty breweries and
heightened consumer awareness of craft beer. As this market has matured, the
Company has experienced intensified competition, increased seasonality and
aggressive price promotions. These market conditions will continue to
adversely affect the Company's operating margins.
 
                                       3
<PAGE>
 
  As the Company has expanded its distribution network outside Washington,
Oregon and California, and as other craft brewers have expanded their
distribution to these markets, the Company has encountered and will continue
to encounter increasing competition from other craft brewers. Although certain
competitors distribute their products nationally and may have greater sales
and financial resources than the Company, the Company believes that being a
local supplier of high quality, traditionally brewed ales and lagers will
differentiate the Company's products and allow it to obtain good market share
in those markets adjacent to its breweries.
 
  The Company also competes against producers of imported specialty beers.
Although imported beers currently account for a much greater share of the U.S.
beer market than craft beers, the Company believes that craft brewers have a
number of competitive advantages over specialty beer imports, including lower
transportation costs, no importation duties, proximity to and familiarity with
local consumers, a higher degree of product freshness and eligibility for
lower federal excise taxes.
 
  In response to the rapid growth of the craft beer segment in prior years,
all of the national domestic brewers have introduced full-flavored beers. The
Company expects that certain national brewers, with their greater financial
resources, access to raw materials and their influence over their established
national distribution networks, will seek further participation in the craft
beer segment by introduction of more full-flavored beers and through
investments in, or the formation of distribution alliances with craft brewers.
The increasing participation of the national brewers will likely increase
competition for market share and increase price competition within the craft
beer segment. The Company believes that the national brewers' participation
may also increase consumer education and awareness of craft beers, and thus
serve to further expand the existing market. The Company is aware that certain
national brewing companies are using their considerable influence over their
independent distributors to induce them to exclude competing products from
their portfolios. This has the effect of reducing the distribution options for
the Company's products. While such actions have not at this time denied access
to any market for the Company's products, there can be no guarantee that this
will not happen in the future.
 
Item 2 -- Properties
 
  The Company currently owns and operates two breweries; one in Berkeley,
California, and one in Seattle, Washington. In November 1997, the Company
closed its Kalama, Washington brewery and redistributed production between its
Seattle and Berkeley breweries. The estimated total annual capacity of the two
breweries was 172,000 barrels at the end of 1997 and 1998, based on product
mix.
 
 The Berkeley Brewery
 
  Completed and opened in February 1997, the Berkeley Brewery and its adjacent
Pyramid Alehouse are housed in a leased building of approximately 122,000
square feet. The brewery had an estimated production capacity of 80,000
barrels at the end of 1998, with a designed maximum potential capacity in
excess of 200,000 barrels which can be achieved by adding fermentation
capacity. The Pyramid Alehouse has seating for 380 plus an outdoor seating
area. The building was leased commencing November 1995 for a 15-year term,
with options to extend the lease term for two five-year periods. The Company
also has the option to add an additional 29,000 square feet of adjacent space
and the option to purchase the entire building during the lease term.
 
 The Seattle Brewery
 
  In March 1995, the Company completed the Seattle Brewery, Alehouse and
corporate offices near downtown Seattle. This brewery and 340 seat restaurant,
operated as the Pyramid Alehouse, consists of approximately 25,000 square feet
of leased building area. The brewery has an estimated production capacity of
92,000 barrels. The Seattle Brewery lease expires in 2004, with options to
extend the lease term for three five-year periods. The Company has also leased
approximately 12,000 square feet of warehouse space adjacent to the Seattle
Brewery for a period of seven years, also expiring in 2004, and has options to
extend the lease term for three additional five-year periods.
 
                                       4
<PAGE>
 
Item 3 -- Legal Proceedings
 
  In June 1996, the Company, certain of its directors, former directors and
officers, were named as defendants in a securities class action lawsuit,
Steckman v. Hart Brewing Inc., et al., Case No. 961077, U.S. District Court,
Southern District of California. The lawsuit alleged that the prospectus for
the Company's December 1995 initial public offering failed to disclose certain
material information. In June 1998, the court entered an order and judgment
dismissing this lawsuit. The Company's insurance carrier refunded legal costs
up to the deductible limit on the policy of $250,000.
 
  The Company is involved from time to time in claims, proceedings and
litigation arising in the ordinary course of business. The Company does not
believe that any such claim, proceeding or litigation, either alone or in the
aggregate, will have a material adverse effect on the Company's financial
position or results of operations.
 
Item 4 -- Submission Of Matters To A Vote Of Security Holders
 
  The Company's annual meeting is scheduled for 10 a.m. on May 13, 1999 at the
Hyatt Regency Bellevue at Bellevue Place, 900 Bellevue Way NE, Bellevue,
Washington 98004. Matters to be voted on will be included in the Company's
proxy statement to be filed with the Securities and Exchange Commission and
distributed to stockholders prior to the meeting.
 
Item 4a -- Executive Officers of the Registrant
 
  The name, age and position of each person who is an officer of the Company
is as follows:
 
<TABLE>
<CAPTION>
     Name             Age                             Position
     ----             ---                             --------
     <S>              <C> <C>
     George Hancock   54  Chief Executive Officer, Chairman of the Board
     Richard Denmark  54  Chief Financial Officer, Vice President -- Finance and Secretary
     Eddie Black      44  Vice President -- Sales and Marketing
     George Arnold    47  Vice President -- Brewery Operations
     Anne Doherty     46  Vice President -- Retail Operations
</TABLE>
 
  George Hancock has served as Chief Executive Officer since May 1992, as
President from July 1995 until December 1996 and as Chairman of the Board
since January 1997. He previously acted as Chairman of the Board of the
Company from July 1989 until July 1995 and has been a director since 1989. He
was President of Penknife Computing, Inc., a computer software company, from
1988 to May 1992. Mr. Hancock was previously employed by the international
professional services firm of Coopers & Lybrand, where he was primarily
responsible for management consulting projects. Mr. Hancock was also the
founder of two startup software companies in England and the United States. He
was awarded a Masters Degree in Business Administration by Cranfield Institute
of Technology, England in 1981. He qualified as an accountant in England in
1967.
 
  Richard Denmark was appointed as Chief Financial Officer, Vice President --
Finance and Secretary in September 1997. Mr. Denmark is responsible for all
finance and administration, including strategic planning, investments and
acquisitions, risk management and investor relations. Mr. Denmark has an
extensive management and financial background. He most recently served as a
Director, Executive Vice President and Chief Financial Officer for Ocean
Beauty Seafoods Inc., an international seafood processor and distributor, with
21 sales and production facilities in 11 states, Japan and Thailand. Prior to
joining Ocean Beauty, Mr. Denmark held various executive positions during an
18-year career with Bank of America and was responsible for corporate and
international lending operations. Mr. Denmark earned a Masters Degree in
Business Administration from the University of California at Berkeley.
 
  Edward Black was appointed as Vice President -- Sales and Marketing in
November 1997. Mr. Black has an extensive background in all aspects of the
alcohol and non-alcohol beverage industry. Most recently he held the position
of Vice President of sales for Tazo LLC in Portland, Oregon. Prior to his
tenure at Tazo, Mr. Black spent nine years as Director of National Retail
sales for the Heileman/Stroh Brewing company. He was instrumental in the
success of the Henry Weinhard's brand and played a major role in the
development and
 
                                       5
<PAGE>
 
successful launch of Henry Weinhard's soda line. He has also held management
positions with Barton Brands, importers of Corona beer and All Brand
Importers, formerly importers of Dos Equis, Fosters and Moosehead beers. In
addition to his extensive supplier experience, he has considerable experience
in both wholesale as General Manager of a full service beer and wine
distributor and retail as Store Director of a supermarket.
 
  George Arnold has served as Vice President -- Brewery Operations since
September 1996. He joined the Company in November 1995 as project manager for
brewery operations at the Berkeley Brewery. Mr. Arnold came to the Company
with 21 years of brewing experience, holding various operations and management
positions with the G. Heileman Brewing Company (USA) and the Swan Brewery
(Australia). Mr. Arnold has extensive brewing experience including new plant
layout, installation and commissioning, brewing data management, quality
control, efficiency and loss control and product development. Mr. Arnold
earned a B.A. degree from the University of Wisconsin--La Crosse, a Diploma in
Brewing from the Siebel Institute of Technology and a Masters of Brewing
Science degree from the University of Birmingham, England.
 
  Anne Doherty has served as Vice President -- Retail Operations since
February 1997. Ms. Doherty joined the company in 1994 and has been responsible
for overall operations of the Seattle and Berkeley Alehouses, tour programs
and retail stores. Prior to joining the Company, Ms. Doherty was employed from
1977 to 1993 by Restaurants Unlimited, a Seattle-based, full-service
restaurant company. Ms. Doherty held several management positions in various
restaurant concepts located in Washington, California and Hawaii during her
employment with Restaurants Unlimited.
 
                                    PART II
 
Item 5 -- Market for Registrant's Common Equity and Related Stockholder
Matters
 
  Trading in Pyramid Breweries Inc.'s Common Stock began on December 14, 1995,
and is quoted on the NASDAQ Stock Market's National Market under the ticker
symbol "PMID".
 
  The following table sets forth the high and low sales prices of Pyramid
Breweries Inc.'s Common Stock for the years ended December 31, 1997 and 1998.
 
<TABLE>
<CAPTION>
                                                                    High   Low
                                                                    ----- -----
     <S>                                                            <C>   <C>
     Calendar Quarters -- 1997
       First Quarter............................................... $4.75 $3.50
       Second Quarter..............................................  3.88  3.00
       Third Quarter...............................................  3.56  2.63
       Fourth Quarter..............................................  3.38  2.50
     Calendar Quarters -- 1998
       First Quarter...............................................  3.13  2.69
       Second Quarter..............................................  3.25  2.56
       Third Quarter...............................................  2.63  1.25
       Fourth Quarter..............................................  1.88  1.13
</TABLE>
 
  On March 1, 1999, the Company had 298 stockholders of record. The last
reported sale price per share on March 1, 1999, was $2.06. The Company had no
sales of unregistered securities during 1998.
 
                                DIVIDEND POLICY
 
  The Company intends to retain all earnings to finance the development and
expansion of its business and does not expect to pay cash dividends on its
Common Stock in the foreseeable future. Any future declaration of dividends
will depend, among other things, on the Company's results of operations,
capital requirements and financial condition, and on such other factors as the
Company's Board of Directors may in its discretion consider relevant. In
addition, the Company is required to maintain a minimum tangible net worth
under the Line of Credit, which may restrict the Company's ability to pay
dividends. Except for S Corporation distributions declared prior to the
Company's initial public offering, the Company has not declared or paid cash
dividends.
 
                                       6
<PAGE>
 
                     SELECTED FINANCIAL AND OPERATING DATA
 
Item 6 -- Selected Financial Data
 
  The following selected financial data should be read in conjunction with the
Company's Financial Statements and the Notes thereto and "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
included elsewhere in this Form 10-K.
 
                            SELECTED FINANCIAL DATA
          (Dollars in thousands, except per share and operating data)
 
<TABLE>
<CAPTION>
                                           Years Ended December 31,
                                    -------------------------------------------
                                     1998     1997     1996     1995     1994
                                    -------  -------  -------  -------  -------
<S>                                 <C>      <C>      <C>      <C>      <C>
Income Statement Data:
Gross sales.......................  $27,326  $29,447  $25,913  $25,321  $13,509
Less excise taxes.................    1,672    1,971    1,954    1,902      866
                                    -------  -------  -------  -------  -------
Net sales.........................   25,654   27,476   23,959   23,419   12,643
Cost of sales.....................   20,026   20,861   14,930   13,369    7,025
                                    -------  -------  -------  -------  -------
Gross margin......................    5,628    6,615    9,029   10,050    5,618
Selling, general and
 administrative expenses..........    7,903    8,320    6,221    4,085    2,722
Restructuring charge..............      --     1,600      --       --       --
                                    -------  -------  -------  -------  -------
Operating (loss) income...........   (2,275)  (3,305)   2,808    5,965    2,896
Other income (expense), net.......      580      (70)     934     (179)     489
                                    -------  -------  -------  -------  -------
Income (loss) before income taxes.   (1,695)  (3,375)   3,742    5,786    3,385
Benefit (provision) for income
 taxes............................      559    1,232   (1,050)    (471)     --
                                    -------  -------  -------  -------  -------
Net (loss) income.................  $(1,136) $(2,143) $ 2,692  $ 5,315  $ 3,385
                                    =======  =======  =======  =======  =======
Basic and diluted net (loss)
 income per share.................  $ (0.14) $ (0.26) $  0.33  $   --   $   --
                                    =======  =======  =======  =======  =======
Weighted average shares
 outstanding......................    8,213    8,206    8,200      --       --
                                    =======  =======  =======  =======  =======
Pro forma data: (unaudited)
  Income before income taxes, as
   reported.......................  $   --   $   --   $   --   $ 5,786  $ 3,385
  Pro forma income tax provision..      --       --       --    (2,019)  (1,181)
                                    -------  -------  -------  -------  -------
  Pro forma net income............  $   --   $   --   $   --   $ 3,767  $ 2,204
                                    =======  =======  =======  =======  =======
  Pro forma net income per share..  $   --   $   --   $   --   $  0.55  $  0.34
                                    =======  =======  =======  =======  =======
  Pro forma shares outstanding....      --       --       --     6,823    6,646
                                    =======  =======  =======  =======  =======
Balance Sheet Data:
  Working capital (deficit).......  $ 6,453  $ 6,499  $10,609  $26,106  $  (397)
  Fixed assets, net...............   27,559   28,600   27,924    9,541    5,156
  Total assets....................   37,432   38,747   43,491   42,982    6,957
  Long-term debt, net of current
   portion........................      --       --       --       --     1,000
  Stockholders' equity............   34,586   35,700   37,768   35,243    3,696
Operating Data (in barrels):
  Beer barrels shipped............  105,900  121,200  128,100  123,100   72,100
  Soda barrels shipped............   26,700   22,200      --       --       --
  Total barrels shipped...........  132,600  143,400  128,100  123,100   72,100
  Beer production capacity at
   year-end.......................  172,000  172,000  193,000  170,000   87,000
</TABLE>
 
                                       7
<PAGE>
 
Item 7 -- Management's Discussion and Analysis of Financial Condition and
Results of Operations
 
Overview
 
  Pyramid Breweries was incorporated in 1984 and is engaged in the brewing and
sale of craft beers and sodas and in restaurant operations. The Company
currently sells its beverage products primarily in Washington, Oregon and
California under the Pyramid and Thomas Kemper brand names and operates two
restaurants, under the Pyramid Alehouse name, each adjacent to its Seattle,
Washington and Berkeley, California breweries. The Company's revenues consist
of sales of beer and soda to third-party distributors and retail sales of
beer, sodas, food, apparel and other items in its restaurants. For the years
ended December 31, 1998 and 1997, approximately 62% and 66%, respectively, of
the Company's net sales were sales of beer to third party distributors. In
March of 1997, the company acquired substantially all of the assets and
assumed certain liabilities of the Thomas Kemper Soda Company which accounted
for 13% and 11% of net sales in 1998 and 1997, respectively. In February of
1997, the Pyramid Alehouse opened in Berkeley. Total retail alehouse sales
accounted for 24% and 23% of total net sales in 1998 and 1997, respectively.
 
  The Company's sales volumes and selling prices are affected by several
factors such as level of consumer demand in existing markets, sales in new
distribution areas, availability of beer distributors in new and existing
markets, and competitive factors, including the increase or decrease in the
number of competing craft beers, new product introductions and promotional
pricing. During 1998, management believes that the frequency of price
promotions in the craft beer industry increased significantly. Sales in the
craft beer industry generally reflect a significant degree of seasonality with
the second and third calendar quarters reflecting stronger sales than in the
first and fourth calendars quarters.
 
  The Company's operating results are subject to quarterly fluctuations due to
a variety of factors and the Company anticipates that its operating margin
will fluctuate as a result of many factors, including (i) lower sales volumes
due to changes in demand and lower selling prices due to increased product
availability, (ii) increased depreciation and other fixed and semi-fixed
operating costs as a percent of sales during periods when the Company's
breweries are producing below capacity, (iii) sales seasonality and
competition, (iv) increased raw material or packaging costs, and (v) changes
in the sales mix. Increased selling and promotional costs incurred as the
Company protects its business in existing markets and develops its business in
new geographic areas may also cause operating margins and operating income to
decrease. Given increased competition and unfavorable market factors, the
Company has focused its marketing activities and resources on the Western and
Southwestern markets. In addition, the Company's Kalama brewery was closed in
late 1997 and production was redistributed between the Company's Seattle and
Berkeley breweries to increase operating efficiency. The Company recorded a
one-time restructuring charge against earnings of approximately $1,600,000 for
write-offs related to the disposal of fixed assets, severance payments and
other plant closure costs.
 
  The Company sells its craft beers in bottles and kegs. Although bottled
products normally sell for a higher per barrel selling price, gross margin on
the Company's draft products are typically higher as a percentage. Changes in
the proportion of sales of bottled and draft products therefore will affect
the Company's gross margin. For 1998 and 1997, approximately 62% and 63%,
respectively, of the Company's sales of craft beers were bottled products.
 
  This report contains forward-looking statements within the meaning of
Section 21E of the Securities Exchange Act of 1934, which are subject to the
"safe harbor" created by that section. These forward-looking statements
include, but are not limited to, statements concerning future revenues,
operating margins, expenses and cash needs. The Company's actual future
results could differ materially from those projected in the forward-looking
statements. Some factors, which could cause future actual results to differ
materially from the Company's recent results or those projected in the
forward-looking statements, are described below. The Company assumes no
obligation to update the forward-looking statements for such factors.
 
 
                                       8
<PAGE>
 
Results of Operations
 
 Year Ended December 31, 1998 Compared to Year Ended December 31, 1997
 
  Gross Sales. Gross sales decreased by 7.2% to $27,326,000 in the year ended
December 31, 1998 from $29,448,000 for the 1997 year. The sales decrease was
primarily the result of a 12.6% reduction in beer shipments in 1998 to 105,900
barrels from 121,200 barrels in 1997. Alehouse sales remained consistent from
year to year although the Berkeley Alehouse was open for eleven months in
1997. Soda shipments increased 20.3% to 26,700 barrels in 1998 from 22,200 in
1997 primarily due to the shorter 1997 sales period as the Thomas Kemper Soda
business was acquired in March 1997. Wholesale beer sales in Washington,
Oregon and California declined by 12.6% in 1998 compared to 1997 sales. Sales
in Washington, Oregon and California accounted for 84% of the Company's beer
sales in 1998 and 1997.
 
  Excise Taxes. Excise taxes were 6.1% and 6.7% of gross sales in 1998 and
1997, respectively. Excise taxes were slightly lower as a percentage of gross
sales in 1998 due to lower beer sales and to a greater proportion of soda
sales in 1998 compared to 1997, which do not bear excise taxes.
 
  Gross Margin. Gross margin decreased 14.9% to $5,628,000 in the 1998 year
from $6,615,000 in the 1997 year. Gross margin as a percentage of net sales
declined to 21.9% in the 1998 year from 24.1% in the 1997 year. The decrease
in gross margin was due primarily to the application of certain fixed and
semi-fixed costs to lower level of beer volumes in 1998.
 
  Selling, General and Administrative Expenses. Selling, general and
administrative expenses decreased by 5.0% to $7,904,000 in the 1998 year from
$8,320,000 in the 1997 year. As a percentage of net sales, selling, general
and administrative expenses increased to 30.8% of net sales in the 1998 year
from 30.3% of net sales in the 1997 year. The increase in selling, general and
administrative expenses as a percent of sales was due to lower net sales and
increased expenditures related to the upgrading of the company's computer
systems, legal and other expenses.
 
  Restructuring Charge. In October 1997, the Company announced a restructuring
of the Company's marketing and brewery operations, including a refocusing of
marketing resources on Western and Southwestern markets and the closure of the
Company's Kalama, Washington plant. The Company incurred a one-time charge of
$1,600,000 in the fourth quarter of 1997 for write-offs related to the
disposal of fixed assets, severance payments and other plant closure costs.
 
  Other Income (Expense), net. Other income (expense), net increased to income
of $580,000 in the 1998 year from expense of $70,000 in 1997. The increase was
mainly from the Company's insurance carrier's reimbursement of $250,000 in
legal costs and gains on the sale of equipment in 1998 compared to losses on
the disposal of fixed assets in the prior year. Interest income was $309,000
and $352,000 for the years ended 1998 and 1997, respectively.
 
  Net Loss. The Company incurred a net loss of $1,136,000 for the 1998 year
compared with net loss of $2,143,000 in the 1997 year. As a percentage of net
sales, the net loss decreased to 4.4% for the 1998 year from 7.8% for the 1997
year.
 
 Year Ended December 31, 1997 Compared to Year Ended December 31, 1996
 
  Gross Sales. Gross sales increased by 13.6% to $29,448,00 in the year ended
December 31, 1997 from $25,913,000 for the 1996 year. The sales increase was
primarily the result of the opening of the Berkeley Alehouse in February 1997
and the acquisition of the Thomas Kemper Soda business in March 1997. Beer
barrels shipped decreased by 5.4% to 121,000 in the year ended December 31,
1997 from 128,00 barrels for the 1996 year. Soda barrel shipments totaled
22,000 for 1997. Wholesale beer sales in Washington and Oregon declined by
9.8% in 1997 compared to 1996; sales in California increased by 15% in 1997
following the opening of the Berkeley Brewery and Alehouse in the first
quarter of that year. Sales in Washington, Oregon and California accounted for
84% of the Company's 1997 beer sales.
 
  Excise Taxes. Excise taxes were 6.7% and 7.5% of gross sales in 1997 and
1996, respectively. Excise taxes were lower as a percentage of gross sales in
1997 due to a slightly lower average federal excise tax rate resulting from
lower barrels shipped in 1997 and a greater proportion of retail and soda
sales in 1997, which do not bear excise taxes.
 
                                       9
<PAGE>
 
  Gross Margin. Gross margin decreased 26.7% to $6,615,000 in the 1997 year
from $9,029,000 in the 1996 year. Gross margin as a percentage of net sales
declined to 24.1% in the 1997 year from 37.7% in the 1996 year. The decrease
in gross margin was due mainly to increased fixed and semi-fixed costs
including depreciation associated with the opening of the Berkeley Brewery,
increased freight costs incurred servicing more distant markets and an
increase in the proportion of retail sales to total sales. As a percentage of
sales, the sales from retail operations, primarily sales of food and
merchandise at the Company's restaurants have a lower gross margin percentage
than wholesale beer sales. Sales at the on-site restaurants increased to 21.6%
of gross sales in 1997 from 14.8% of gross sales in 1996, due mainly to the
opening of the Berkeley Alehouse in February 1997.
 
  Selling, General and Administrative Expenses. Selling, general and
administrative expenses increased by 33.7% to $8,320,000 in the 1997 year from
$6,221,000 in the 1996 year. As a percentage of net sales, selling, general
and administrative expenses increased to 30.3% of net sales in the 1997 year
from 26.0% of net sales in the 1996 year. The increase in selling, general and
administrative expenses was primarily due to the hiring of additional sales
and marketing personnel and the acceleration of promotional activities
incurred in connection with the Company's expansion into new markets. During
1997, the total sales and marketing staff peaked at 38 employees then
decreased to 31 employees by year end as the Company redirected its marketing
efforts.
 
  Restructuring Charge. In October 1997, the Company announced a restructuring
of the Company's marketing and brewery operations, including a refocusing of
marketing resources on Western and Southwestern markets and the closure of the
Company's Kalama, Washington plant. The Company incurred a one-time charge of
$1,600,000 in the fourth quarter of 1997 for write-offs related to the
disposal of fixed assets, severance payments and other plant closure costs.
 
  Other (Expense) Income, net. Other (expense) income, net decreased to an
expense of $70,000 in the 1997 year from income of $934,000 in the 1996 year.
The decrease was due to losses on the disposal of fixed assets, bond
amortization and lower income from the investment of the remaining net
proceeds from the public stock offering.
 
  Net (Loss) Income. The Company incurred a net loss of $2,143,000 for the
1997 year compared with net income of $2,692,000 in the 1996 year. As a
percentage of net sales, net income decreased to (7.8%) for the 1997 year from
11.2% for the 1996 year.
 
Liquidity and Capital Resources
 
  Net cash provided by operating activities for the year ended December 31,
1998 was $728,000 compared to $655,000 for the prior year. At December 31,
1998, the Company had working capital of $6,453,000 compared to $6,499,000 at
December 31, 1997.
 
  Net cash used in investing activities for the year ended 1998 was $898,000
compared to net cash provided by investing activities of $4,930,000 for the
prior year. The cash used in investing activities in 1998 included the
purchase of system software and completion of the installation of soda
production equipment at the Berkeley Brewery. Cash provided by investing
activities during 1997 was primarily redemptions and sales of investments.
 
  The Company has a $15,000,000 line of credit (the Line of Credit) for short-
term operating needs. The Line of Credit revolves through April 30, 1999,
during which time the payments are interest only. At that date, any
outstanding balance will be due in full. Borrowings under the Line of Credit
will accrue interest, at the Company's option, at either the bank's prime rate
or at LIBOR plus 100 basis points. Up to $5,000,000 of the line of credit may
be used to finance acquisitions. Amounts used to finance acquisitions may be
converted to a four-year fully amortizing term loan, with an additional option
to fix the rate of interest at the bank's prime rate plus 125 basis points.
 
  Future capital requirements may vary depending on such factors as the cost
of acquisition of businesses, brands and real estate in the markets selected
for future expansion. Capital expenditures through December 31,
 
                                      10
<PAGE>
 
1998 were approximately $1,586,000, which includes installation of soda
equipment in the Berkeley brewery, upgrading of brewery equipment and
facilities in the Seattle Brewery and the installation of a new computer
system. While there can be no assurance that current expectations will be
realized and plans are subject to change upon further review, the Company
believes that its cash reserves, together with cash from operations and
borrowings under the Line of Credit, will be sufficient for the Company's
working capital needs.
 
  The Company's future cash requirements and cash flow expectations are
closely related to its expansion plans. The Company generally expects to meet
future financing needs through cash on-hand, cash flow from operations and, to
the extent required and available, additional bank borrowings.
 
Year 2000
 
  The year 2000 issue is the result of computer programs being written using
two digits rather than four digits to define the applicable year. Any of the
Company's computer programs that have time-sensitive software may recognize a
date using "00" as the year 1900 rather than the year 2000. If not addressed,
the direct result could be a system failure or miscalculations causing
disruptions of operations, including, among other things, a temporary
inability to process customer transactions or engage in similar normal
business activities.
 
  The Company's Year 2000 Project is proceeding on schedule. Early in 1998,
the Company began a project to improve its information systems by replacing
existing business software. The new system replaces all critical systems and
approximately 90% of all computer systems which the Company's inventory showed
to be affected by the year 2000 issue. The Company's inventory revealed no
other significant problems arising from non-compliant computer chips embedded
in other equipment. The total cost of the Company's Year 2000 Project is
approximately $600,000, including the cost of installing the business
software. Approximately $360,000 has been incurred as of December 31, 1998 and
the project is expected to be completed by mid-1999.
 
  The Company is dependent upon certain suppliers and its wholesale customers.
There are plans to communicate with these companies to assess their readiness
for the year 2000. Contingency plans will be made where practicable to cope
with interruption of supplies or services and failures by wholesalers to
properly service the Company's markets. However, it should be noted that there
are many cases, such as utility supply and servicing of remote markets, where
no feasible alternatives are available to the Company and the Company is
vulnerable to failures by external third parties.
 
  Although management anticipates that its systems and applications will be
year 2000 compliant on a timely basis, there can be no assurance that the
systems of other companies on which the Company's systems rely will be year
2000 compliant in the same time frame. Any such failure on the part of other
companies with whom the Company transacts business, to be year 2000 compliant
on a timely basis, may have an adverse impact on the operations of the
Company.
 
Risk Factors and Forward Looking Statements
 
  Pyramid Breweries Inc. does not provide forecasts of future financial
performance. However this report does contain forward-looking statements
within the meaning of Section 21E of the Securities Exchange Act of 1934,
which are subject to the "safe harbor" created by that section. There are
numerous important factors that could cause results to differ materially from
those anticipated by some of the statements made by the Company. Investors are
cautioned that all forward-looking statements involve a high degree of risk
and uncertainty. Additional information concerning those and other factors is
contained in the Company's Securities and Exchange Commission filings
including its IPO prospectus.
 
  Increasing Competition. The domestic market in which the Company's craft
beers compete is highly competitive for many reasons, including the continuing
proliferation of new craft brewers, new beers, and brew pubs, efforts by
regional craft brewers to expand their production capacities and distribution,
the introduction of fuller-flavored products by certain major national
brewers, and underutilized domestic brewing capacity, which
 
                                      11
<PAGE>
 
facilitates expansion by existing contract brewers and the entry of new
contract brewers. The Company anticipates that intensifying competition from
craft beer and imported beer producers and increased capacity in the craft
beer segment may adversely impact the Company's operating margins. In
addition, the larger national brewers have developed or are developing brands
to compete directly with craft beers. These national competitors have
advantages such as lower production costs, larger marketing budgets, greater
financial and other resources and more developed and extensive distribution
networks than the Company. There can be no assurance that the Company will be
able to grow its volumes or be able to maintain its selling prices in existing
markets or as it enters new markets.
 
  Access to markets. Most of the Company's independent distributors also are
distributors of national brewers who are increasingly using their greater
influence and marketing resources to persuade those distributors to exclude
the products of other breweries from their portfolios. Such actions by
national brewers have the effect of reducing distribution options for the
Company's products. Although the Company has not yet experienced such an
event, it is possible that the Company could effectively be denied access to a
market or markets by these tactics. In the states which comprise the majority
of its sales, the Company has the option to distribute its products direct to
retailers and the Company has previous experience in doing so. However, there
is no assurance that self-distribution can be done in an economic manner over
large territories.
 
  Government Regulations. The Company's business is highly regulated at the
federal, state and local levels, and its brewery and restaurant operations
require various licenses, permits and approvals. The loss or revocation of any
existing licenses, permits or approvals or the failure to obtain any
additional licenses, permits or approvals in new jurisdictions where the
Company intends to do business could have a material adverse effect on the
ability of the Company to conduct its business. Certain states have laws
restricting or forbidding a combined pub and brewery. Further, federal
regulations prohibit, among other things, the payment of slotting allowances
to retailers for beer products. These regulations have the effect of
preventing competitors with greater financial resources from excluding smaller
brewers from retailers. If these regulations were repealed or substantially
modified, there would likely be a material adverse effect on the Company's
business and operating results.
 
  Selling Prices. The future selling prices the Company charges for its craft
beer may decrease from historical levels due to increasing competitive
pressures. The Company has and will continue to participate in price
promotions with its wholesalers and their retail customers. Management
believes that the number and frequency of the Company's promotions will
increase during 1999.
 
  Variability of Margins and Operating Results. The Company anticipates that
its operating margins will fluctuate and may decline as a result of many
factors, including (i) lower sales volumes and selling prices, (ii) increased
depreciation and other fixed and semi-fixed operating costs as a percent of
sales during periods when the Company's breweries are producing below designed
capacity, (iii) increased raw material and packaging costs, (iv) changes in
product mix and packaging, (v) increased transportation costs, (vi) increased
sales from retail operations which have a lower gross margin (as a percentage
of net sales) than beer sales, and (vii) increased selling and promotional
costs incurred as the Company protects its business in existing markets and
develops business in new geographic markets. Increases in federal or state
excise taxes and the impact of an increasing average federal excise tax rate
as production increases may also cause a decline in the Company's gross
margins. The Company pays federal excise taxes on all beer sales and pays
state excise taxes on beer sales occurring in various states at various tax
rates. The federal excise tax is $7.00 per barrel on the first 60,000 barrels
and $18.00 per barrel exceeding 60,000 annually, as long as total annual sales
are less than two million barrels. The Washington state excise tax is $4.78
per barrel annually.
 
  Results of operations in any period should not be considered indicative of
the results to be expected for future periods. Fluctuations in operating
results may also result in fluctuations in the price of the Company's Common
Stock. In future quarters, the Company's operating results may not meet the
expectations of public market analysts or investors. In such an event, the
market price of the Common Stock could be materially adversely affected.
 
                                      12
<PAGE>
 
Impact of Inflation
 
  Although the Company has not attempted to calculate the effect of inflation,
management does not believe inflation has had a material effect on the
Company's results of operations. In the future, increases in costs and
expenses, particularly packaging, raw materials and labor costs may have a
significant impact on the Company's operating results to the extent that such
cost increases cannot be passed along to its customers.
 
Item 8 -- Financial Statements
 
  Financial statements of Pyramid Breweries Inc. are as follows:
 
<TABLE>
<CAPTION>
                                                                           Page
                                                                           ----
   <S>                                                                     <C>
   Report of Independent Public Accountants...............................  17
   Balance Sheets as of December 31, 1998 and 1997........................  18
   Statements of Operations for the Years Ended December 31, 1998, 1997
    and 1996..............................................................  19
   Statements of Stockholders' Equity for the Years Ended December 31,
    1998, 1997 and 1996...................................................  20
   Statements of Cash Flows for the Years Ended December 31, 1998, 1997
    and 1996..............................................................  21
   Notes to Financial Statements..........................................  22
</TABLE>
 
Item 9 -- Change In and Disagreements with Accountants on Accounting and
Financial Disclosure
 
  None.
 
                                   PART III
 
Item 10 -- Directors and Executive Officers of The Registrant
 
  For information with respect to the executive officers of the Registrant,
see Item 4A -- "Executive Officers of the Registrant" at the end of Part I of
this report. The information required by this Item concerning the Directors
and nominees for Director of the Company is incorporated herein by reference
to Pyramid Breweries' Proxy Statement for its Annual Meeting of Stockholders,
to be held on May 13, 1999, to be filed with the Commission pursuant to
Regulation 14A.
 
Item 11 -- Executive Compensation
 
  The information required by this Item is incorporated herein by reference to
Pyramid Breweries' Proxy Statement for its Annual Meeting of Stockholders, to
be held on May 13, 1999, to be filed with the Commission pursuant to
Regulation 14A.
 
Item 12 -- Security Ownership of Certain Beneficial Owners and Management
 
  The information required by this Item is incorporated herein by reference to
Pyramid Breweries' Proxy Statement for its Annual Meeting of Stockholders to
be held on May 13, 1999, to be filed with the Commission pursuant to
Regulation 14A.
 
Item 13 -- Certain Relationships and Related Transactions
 
  The information required by this Item is incorporated herein by reference to
Pyramid Breweries' Proxy Statement for its Annual Meeting of Stockholders, to
be held on May 13, 1999, to be filed with the Commission pursuant to
Regulation 14A.
 
                                      13
<PAGE>
 
                                    PART IV
 
Item 14 -- Exhibits, Financial Statement Schedules, and Reports on Form 8-K
 
  (a) Documents filed as part of this report are as follows:
 
    1. Financial Statements: See listing of Financial Statements included
       as a part of this Form 10-K on Item 8 of Part II.
 
    2. Financial Statement Schedules -- None.
 
  (b) No reports on Form 8-K were filed during the last quarter of the period
covered by this Annual Report.
 
    3. Exhibits: The required exhibits are included at the end of the
       Form 10-K Annual Report and are described in the Exhibit Index
       immediately preceding the first exhibit.
 
                                       14
<PAGE>
 
                                  SIGNATURES
 
  Pursuant to the requirements of Section 13 of the Securities Exchange Act of
1934, the registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.
 
February 26, 1999
 
                                          Pyramid Breweries Inc.
 
                                          (Registrant)
 
                                                /s/ Richard M. Denmark
                                          By __________________________________
                                                   Richard M. Denmark
                                                   Vice President and
                                                 Chief Financial Officer
 
  Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
 
<TABLE>
<S>                                                <C>
               /s/ George Hancock                           February 26, 1999
  By _____________________________________________
                   George Hancock
    Chief Executive Officer and Chairman of the
                       Board
             /s/ Richard M. Denmark                         February 26, 1999
  By _____________________________________________
                 Richard M. Denmark
     Vice President and Chief Financial Officer
    (Principal Financial and Accounting Officer)
              /s/ Scott S. Barnum                           February 26, 1999
  By _____________________________________________
                  Scott S. Barnum
                      Director
               /s/ John T. Bryce                            February 26, 1999
  By _____________________________________________
                   John T. Bryce
                      Director
 
             /s/ Thomas H. Schwalm                          February 26, 1999
  By _____________________________________________
                 Thomas H. Schwalm
                      Director
              /s/ John W. Stoddard                          February 26, 1999
  By _____________________________________________
                  John W. Stoddard
                      Director
            /s/ George C. Textor, Jr.                       February 26, 1999
  By _____________________________________________
               George C. Textor, Jr.
                      Director
              /s/ Robert A. Toledo                          February 26, 1999
  By _____________________________________________
                  Robert A. Toledo
                      Director
</TABLE>
 
                                      15
<PAGE>
 
                             PYRAMID BREWERIES INC.
 
                         INDEX TO FINANCIAL STATEMENTS
 
<TABLE>
<CAPTION>
                                                                           Page
                                                                           ----
<S>                                                                        <C>
Report of Independent Public Accountants..................................  17
Balance Sheets as of December 31, 1998 and 1997...........................  18
Statements of Operations for the Years Ended December 31, 1998, 1997 and
 1996.....................................................................  19
Statements of Stockholders' Equity for the Years Ended December 31, 1998,
 1997 and 1996............................................................  20
Statements of Cash Flows for the Years Ended December 31, 1998, 1997 and
 1996.....................................................................  21
Notes to Financial Statements.............................................  22
</TABLE>
 
                                       16
<PAGE>
 
                   REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
 
To the Board of Directors of Pyramid Breweries Inc.:
 
  We have audited the accompanying balance sheets of Pyramid Breweries Inc. as
of December 31, 1998 and 1997, and the related statements of operations,
stockholders' equity and cash flows for each of the three years ended December
31, 1998. 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, the financial statements referred to above present fairly,
in all material respects, the financial position of Pyramid Breweries Inc. as
of December 31, 1998 and 1997, and the results of its operations and its cash
flows for each of the three years ended December 31, 1998 in conformity with
generally accepted accounting principles.
 
                                               /s/ Arthur Andersen LLP
 
Seattle, Washington,
January 29, 1999
 
                                      17
<PAGE>
 
                             PYRAMID BREWERIES INC.
 
                                 BALANCE SHEETS
 
<TABLE>
<CAPTION>
                                                             December 31,
                                                        -----------------------
                                                           1998        1997
                                                        ----------- -----------
<S>                                                     <C>         <C>
                        ASSETS
                        ------
CURRENT ASSETS:
  Cash and cash equivalents............................ $ 5,245,134 $ 5,393,251
  Accounts receivable, net allowance for doubtful
   accounts of $20,000 and $40,000, respectively.......   1,003,789   1,291,681
  Inventories..........................................   1,202,793   1,110,756
  Income taxes receivable..............................         --      250,071
  Prepaid expenses and other...........................     621,009     562,602
  Deferred income taxes................................     444,216     364,662
                                                        ----------- -----------
  Total current assets.................................   8,516,941   8,973,023
                                                        ----------- -----------
  Fixed assets, net....................................  27,558,848  28,600,075
  Deferred income taxes................................     490,576     101,449
  Other................................................     865,286   1,072,613
                                                        ----------- -----------
    Total assets....................................... $37,431,651 $38,747,160
                                                        =========== ===========
         LIABILITIES AND STOCKHOLDERS' EQUITY
         ------------------------------------
CURRENT LIABILITIES:
  Accounts payable..................................... $   218,964 $   703,926
  Accrued expenses.....................................   1,312,593     941,303
  Refundable deposits..................................     462,747     474,700
  Restructuring reserve................................      69,238     354,148
                                                        ----------- -----------
  Total current liabilities............................   2,063,542   2,474,077
  Deferred rent........................................     782,245     573,589
                                                        ----------- -----------
    Total liabilities..................................   2,845,787   3,047,666
                                                        ----------- -----------
COMMITMENTS AND CONTINGENCIES
</TABLE>
 
<TABLE>
<S>                                                    <C>          <C>
STOCKHOLDERS' EQUITY:
  Preferred stock, 10,000,000 shares authorized, none
   issued.............................................         --           --
  Common stock, $.01 par value; 40,000,000 shares
   authorized, 8,219,532 and 8,207,438 shares issued
   and outstanding                                          82,195       82,074
  Additional paid-in capital..........................  35,036,869   35,014,551
  Retained (deficit) earnings.........................    (533,200)     602,869
                                                       -----------  -----------
    Total stockholders' equity........................  34,585,864   35,699,494
                                                       -----------  -----------
    Total liabilities and stockholders' equity........ $37,431,651  $38,747,160
                                                       ===========  ===========
</TABLE>
 
        The accompanying notes are an integral part of these statements.
 
                                       18
<PAGE>
 
                             PYRAMID BREWERIES INC.
 
                            STATEMENTS OF OPERATIONS
 
<TABLE>
<CAPTION>
                                              Years Ended December 31,
                                         -------------------------------------
                                            1998         1997         1996
                                         -----------  -----------  -----------
<S>                                      <C>          <C>          <C>
Gross sales............................. $27,326,473  $29,447,538  $25,912,690
Less excise taxes.......................   1,672,099    1,971,413    1,954,011
                                         -----------  -----------  -----------
Net sales...............................  25,654,374   27,476,125   23,958,679
Cost of sales...........................  20,025,982   20,860,828   14,930,047
                                         -----------  -----------  -----------
  Gross margin..........................   5,628,392    6,615,297    9,028,632
Selling, general and administrative
 expenses...............................   7,904,052    8,319,881    6,220,516
Restructuring charge....................         --     1,600,000          --
                                         -----------  -----------  -----------
Operating (loss) income.................  (2,275,660)  (3,304,584)   2,808,116
Other income (expense), net.............     580,254      (70,365)     934,349
                                         -----------  -----------  -----------
Income (loss) before income taxes.......  (1,695,406)  (3,374,949)   3,742,465
Benefit (provision) for income taxes....     559,337    1,232,000   (1,050,817)
                                         -----------  -----------  -----------
Net (loss) income....................... $(1,136,069) $(2,142,949) $ 2,691,648
                                         ===========  ===========  ===========
Basic and diluted net (loss) income per
 share.................................. $     (0.14) $     (0.26) $      0.33
                                         ===========  ===========  ===========
Weighted average shares outstanding.....   8,213,178    8,206,352    8,200,224
                                         ===========  ===========  ===========
</TABLE>
 
 
        The accompanying notes are an integral part of these statements.
 
                                       19
<PAGE>
 
                             PYRAMID BREWERIES INC.
 
                       STATEMENTS OF STOCKHOLDERS' EQUITY
 
<TABLE>
<CAPTION>
                           Common Stock      Additional   Unrealized   Retained        Total
                         ------------------    Paid-in      Loss on    (Deficit)   Stockholders'
                          Shares    Amount     Capital    Investments  Earnings       Equity
                         ---------  -------  -----------  ----------- -----------  -------------
<S>                      <C>        <C>      <C>          <C>         <C>          <C>
Balance, December 31,
 1995................... 8,200,000  $82,000  $35,107,084   $     --   $    54,170   $35,243,254
  Net income............       --       --           --          --     2,691,648     2,691,648
  Shares issued.........     4,656       47       16,953         --           --         17,000
  Unrealized loss on
   investments..........       --       --           --     (184,350)         --       (184,350)
                         ---------  -------  -----------   ---------  -----------   -----------
Balance, December 31,
 1996................... 8,204,656   82,047   35,124,037    (184,350)   2,745,818    37,767,552
  Net loss..............       --       --           --          --    (2,142,949)   (2,142,949)
  Shares issued.........    10,053      100       28,517         --           --         28,617
  Shares repurchased and
   retired..............    (7,271)     (73)    (138,003)        --           --       (138,076)
  Realized loss on
   investments..........       --       --           --      184,350          --        184,350
                         ---------  -------  -----------   ---------  -----------   -----------
Balance, December 31,
 1997................... 8,207,438   82,074   35,014,551         --       602,869    35,699,494
  Net loss..............       --       --           --          --    (1,136,069)   (1,136,069)
  Shares issued.........    12,094      121       22,318         --           --         22,439
                         ---------  -------  -----------   ---------  -----------   -----------
Balance, December 31,
 1998................... 8,219,532  $82,195  $35,036,869   $     --   $  (533,200)  $34,585,864
                         =========  =======  ===========   =========  ===========   ===========
</TABLE>
 
 
        The accompanying notes are an integral part of these statements.
 
                                       20
<PAGE>
 
                             PYRAMID BREWERIES INC.
 
                            STATEMENTS OF CASH FLOWS
 
<TABLE>
<CAPTION>
                                              Years Ended December 31,
                                        --------------------------------------
                                           1998         1997          1996
                                        -----------  -----------  ------------
<S>                                     <C>          <C>          <C>
OPERATING ACTIVITIES:
 Net (loss) income..................... $(1,136,069) $(2,142,949) $  2,691,648
 Adjustments to reconcile net (loss)
  income to net cash provided by
  operating activities --
  Depreciation and amortization........   2,622,238    3,097,926     1,174,011
  Loss (gain) on sales of fixed assets.     (27,782)     432,154       (11,152)
  Restructuring charge.................    (284,910)   1,454,148           --
  Deferred income taxes................    (468,681)  (1,286,338)      450,665
  Realized loss on investments.........         --       287,153       105,245
  Deferred rent........................     208,656      281,769       176,988
 Changes in operating assets and
  liabilities --
  Accounts receivable..................     287,892       (7,255)      882,467
  Inventories..........................     (92,037)      (2,507)     (238,273)
  Prepaid expenses and other...........    (506,141)    (546,722)   (1,057,258)
  Income taxes receivable/payable......     250,071       39,491      (390,648)
  Accounts payable and accrued
   expenses............................    (113,672)    (896,761)     (208,774)
  Refundable deposits..................     (11,953)     (55,497)       63,595
                                        -----------  -----------  ------------
    Net cash provided by operating
     activities........................     727,612      654,612     3,638,514
                                        -----------  -----------  ------------
INVESTING ACTIVITIES:
  Acquisition of Thomas Kemper Soda
   Company.............................         --      (575,802)          --
  Acquisitions of fixed assets.........  (1,586,218)  (6,343,086)  (17,216,449)
  Proceeds from sales of fixed assets..     688,050      473,849        42,676
  Purchases of investments.............         --   (15,005,027)  (27,270,517)
  Redemptions and sales of investments.         --    26,380,066    33,275,279
                                        -----------  -----------  ------------
    Net cash (used in) provided by
     investing activities..............    (898,168)   4,930,000   (11,169,011)
                                        -----------  -----------  ------------
FINANCING ACTIVITIES:
  Proceeds from sale of stock..........      22,439       28,617        17,000
  Principal payments on long-term debt.         --      (382,389)          --
  Repayments to related parties........         --           --     (4,689,866)
  Shares repurchased and retired.......         --      (138,076)          --
                                        -----------  -----------  ------------
    Net cash provided by (used in)
     financing activities..............      22,439     (491,848)   (4,672,866)
                                        -----------  -----------  ------------
(Decrease) increase in cash and cash
 equivalents...........................    (148,117)   5,092,764   (12,203,363)
Cash and cash equivalents at beginning
 of year...............................   5,393,251      300,487    12,503,850
                                        -----------  -----------  ------------
Cash and cash equivalents at end of
 year.................................. $ 5,245,134  $ 5,393,251  $    300,487
                                        ===========  ===========  ============
SUPPLEMENTAL DISCLOSURES:
  Interest paid........................ $       --   $    42,756  $     71,608
                                        ===========  ===========  ============
  Income taxes paid.................... $       --   $    32,203  $    999,800
                                        ===========  ===========  ============
</TABLE>
 
        The accompanying notes are an integral part of these statements.
 
                                       21
<PAGE>
 
                            PYRAMID BREWERIES INC.
 
                         NOTES TO FINANCIAL STATEMENTS
 
1. Nature of Operations and Significant Accounting Policies:
 
 The Company
 
  Pyramid Breweries Inc. (the Company), a Washington corporation was
incorporated in 1984 and is engaged in the brewing, marketing and selling of
craft beers and sodas. The Company operates breweries and restaurants in
Seattle, Washington and Berkeley, California. The Company sells its products
through a network of selected independent distributors primarily in
Washington, Oregon and California under the Pyramid and Thomas Kemper brands.
Pyramid also manufactures a line of handcrafted sodas under the Thomas Kemper
Soda Company label.
 
  In March 1995, the Company opened the Seattle Brewery near downtown Seattle.
This brewery and 340-seat alehouse has an estimated annual production capacity
of 92,000 barrels as of December 31, 1998.
 
  In December 1995, the Company sold 2,000,000 shares of common stock in an
initial public offering (the Offering). Net proceeds from the Offering
amounted to approximately $34,156,000 and have been used to fund the Company's
growth and expansion plans.
 
  In February 1997, the Company opened the Berkeley Brewery in Berkeley,
California. This brewery and 380-seat alehouse has an estimated annual beer
production capacity of 80,000 barrels as of December 31, 1998.
 
  In March 1997, the Company acquired substantially all of the operating
assets and assumed certain liabilities of the Thomas Kemper Soda Company. This
acquisition expanded the Company's product line to include a range of premium
soft drinks, including root beer and cream soda.
 
  In November 1997, the Kalama, Washington brewery was closed. A significant
portion of the Kalama production equipment was transferred to the Company's
Berkeley, California brewery. The Company sold the remaining equipment.
 
 Cash and Cash Equivalents
 
  The Company considers all highly liquid investments with a maturity of three
months or less at the date of purchase to be cash equivalents.
 
 Inventories
 
  Inventories are stated at the lower of cost or market. Cost is determined by
the first-in- first-out method, and market represents the lower of replacement
cost or estimated net realizable value.
 
 Fixed Assets
 
  Fixed assets are stated at cost. Significant additions and improvements are
capitalized. Repairs and maintenance are expensed as incurred. Upon
disposition of fixed assets, gains and losses are reflected in the statement
of income. Depreciation is provided using the straight-line method over lives
ranging from five to 25 years. Leasehold improvements are amortized under the
straight-line method over the shorter of the estimated useful lives of the
improvements or the term of the lease.
 
  Returnable containers (primarily kegs) are capitalized at cost, depreciated
over their estimated useful life of 10 years, and are included in fixed
assets. Refundable deposits represent the Company's liability for deposits
charged to customers for returnable containers.
 
 Preopening Costs
 
  Preopening costs related to new restaurants consisted primarily of the costs
of hiring and training new kitchen and wait and brewery staff and have
historically been capitalized in other assets. These costs were
 
                                      22
<PAGE>
 
                            PYRAMID BREWERIES INC.
 
                  NOTES TO FINANCIAL STATEMENTS--(Continued)
 
amortized over a one-year period commencing from the restaurant opening date.
There were no unamortized preopening costs at December 31, 1998. Net
unamortized preopening costs totaled $114,168 at December 31, 1997.
Amortization of preopening costs totaled $114,168 and $475,725, respectively,
for the years ended December 31, 1998 and 1997.
 
 Package Design Costs
 
  Package design costs relate to the development of product packaging and
labels and are capitalized in other current assets and amortized over a one-
year period. Net unamortized package design costs totaled $288,483 and
$223,544 at December 31, 1998 and 1997, respectively. Amortization of package
design costs totaled $447,734 and $441,121, respectively, for the years ended
December 31, 1998 and 1997.
 
 Goodwill
 
  The excess of cost over fair value of the net assets of businesses acquired
is capitalized and amortized on a straight-line basis over 10 years. Net
unamortized goodwill of $655,381 and $735,637 at December 31, 1998 and 1997,
respectively is included in other assets. Amortization of goodwill totaled
$80,256 and $66,880, respectively, for the years ended December 31, 1998 and
1997.
 
 Income Taxes
 
  The Company is subject to federal and state income taxes and has recognized
deferred taxes in accordance with Statement of Financial Accounting Standards
(SFAS) No. 109, "Accounting for Income Taxes." SFAS No. 109 requires companies
subject to income taxes to adjust their deferred tax assets and liabilities
based on temporary differences between financial statement and tax basis of
assets and liabilities, using enacted tax rates in effect in the years in
which the differences are expected to reverse.
 
 Earnings Per Share
 
  Basic earnings per share is computed based on weighted average shares
outstanding and excludes dilutive securities such as options and warrants.
Diluted earnings per share is computed including the impacts of all
potentially dilutive securities.
 
 Use of Estimates
 
  The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities, the
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.
 
2. Restructuring Charge:
 
  On October 29, 1997, the Company announced a restructuring of the Company's
marketing and brewery operations and recorded a $1,600,000 restructuring
charge. The restructuring included a refocus of marketing resources on Western
and Southwestern markets and the closure of the Kalama, Washington brewery.
The restructuring charge includes $1,100,000 related to the disposal of fixed
assets, $100,000 in severance payments, $215,000 in market realignment costs
and $185,000 in property leases and other plant closure costs.
 
                                      23
<PAGE>
 
                            PYRAMID BREWERIES INC.
 
                  NOTES TO FINANCIAL STATEMENTS--(Continued)
 
  For the period from October 29, 1997 through December 31, 1997 and the year
ended December 31, 1998 the restructuring activity is as follows:
 
<TABLE>
<CAPTION>
                         October 29,     1997      December 31,   1998     December 31,
                            1997       Activity        1997     Activity       1998
                         -----------  -----------  ------------ ---------  ------------
<S>                      <C>          <C>          <C>          <C>        <C>
Fixed assets cost....... $ 2,850,000  $ 2,850,000   $     --    $     --    $     --
Accumulated
 depreciation...........  (1,050,000)  (1,050,000)        --          --          --
                         -----------  -----------   ---------   ---------   ---------
Net book value..........   1,800,000    1,800,000         --          --          --
Estimated proceeds from
 sale of fixed assets...    (700,000)         --     (700,000)        --     (700,000)
Net proceeds from sale
 of fixed assets........         --      (140,310)    140,310    (591,690)    732,000
Assets held for sale....         --      (559,690)    559,690     527,690      32,000
Severance payments......     100,000       60,716      39,284      44,116      (4,832)
Market realignment
 costs..................     215,000       41,901     173,099     158,858      14,241
Other closure costs.....     185,000       43,235     141,765     145,936      (4,171)
                         -----------  -----------   ---------   ---------   ---------
                         $ 1,600,000  $ 1,245,852   $ 354,148   $ 284,910   $  69,238
                         ===========  ===========   =========   =========   =========
</TABLE>
 
3. Thomas Kemper Soda Company Acquisition:
 
  In March 1997, the Company acquired substantially all of the operating assets
and assumed certain liabilities of Thomas Kemper Soda Company, a manufacturer
of premium sodas located in Seattle, Washington. The total purchase price was
$1,700,000. The acquisition was accounted for using the purchase method of
accounting. Accordingly, the purchased assets and assumed liabilities were
recorded at their estimated fair value at the date of acquisition. The excess
purchase price over the estimated fair values of the assets acquired was
$802,513 and is being amortized over 10 years. The results of the acquired
business have been included in the statement of income since the date of
acquisition.
 
  Details of the acquisition follows:
 
<TABLE>
     <S>                                                             <C>
     ASSETS ACQUIRED:
       Inventory...................................................  $  187,977
       Fixed assets................................................     383,393
       Kegs........................................................     326,097
                                                                     ----------
                                                                     $  897,467
                                                                     ==========
     LIABILITIES ASSUMED:
       Accounts payable............................................  $  528,320
       Accrued expenses............................................      70,327
       Keg deposits................................................     143,162
       Note payable................................................     186,240
       Capital leases..............................................     196,149
                                                                     ----------
                                                                     $1,124,198
                                                                     ==========
     PURCHASE PRICE:
       Cash and transactional costs paid...........................  $  575,802
       Liabilities assumed.........................................   1,124,198
                                                                     ----------
                                                                     $1,700,000
                                                                     ==========
</TABLE>
 
 
                                      24
<PAGE>
 
                            PYRAMID BREWERIES INC.
 
                  NOTES TO FINANCIAL STATEMENTS--(Continued)
 
4. Investments:
 
  During 1997, the Company sold its investment portfolio, consisting primarily
of tax-exempt municipal bonds, and reinvested the proceeds in short term
investments classified as cash and cash equivalents. Gross realized gains and
losses from the sale of investments during 1997 were $3,296 and $290,449,
respectively. For the purpose of determining gross realized gains and losses,
the cost of securities is based upon specific identification.
 
  Investment income was approximately $309,000, $350,000 and $1,200,000 for
the years ended December 31, 1998, 1997 and 1996, respectively. Investment
income is reported as a component of other income (expense), net in the
Company's statements of operations.
 
5. Inventories:
 
  Inventories consist of the following:
 
<TABLE>
<CAPTION>
                                                            December 31,
                                                       ------------------------
                                                          1998         1997
                                                       -----------  -----------
   <S>                                                 <C>          <C>
   Raw materials...................................... $   618,302  $   558,591
   Finished goods.....................................     584,491      552,165
                                                       -----------  -----------
                                                       $ 1,202,793  $ 1,110,756
                                                       ===========  ===========
 
  Raw materials primarily include ingredients, flavorings and packaging, as
well as beer held in fermentation prior to the filtration and packaging
process. Finished goods primarily include product ready for shipment, as well
as promotional merchandise held for sale.
 
6. Fixed Assets:
 
  Fixed assets consist of the following:
 
<CAPTION>
                                                            December 31,
                                                       ------------------------
                                                          1998         1997
                                                       -----------  -----------
   <S>                                                 <C>          <C>
   Brewery and retail equipment....................... $17,283,235  $16,528,319
   Furniture and fixtures.............................     618,910      617,009
   Leasehold improvements.............................  13,909,636   13,594,538
   Construction in progress...........................     340,514          --
   Assets held for sale...............................      32,000      559,690
                                                       -----------  -----------
                                                        32,184,295   31,299,556
   Less accumulated depreciation......................  (4,625,447)  (2,699,481)
                                                       -----------  -----------
                                                       $27,558,848  $28,600,075
                                                       ===========  ===========
 
7. Accrued Expenses:
 
  Accrued expenses consist of the following:
 
<CAPTION>
                                                            December 31,
                                                       ------------------------
                                                          1998         1997
                                                       -----------  -----------
   <S>                                                 <C>          <C>
   Salaries, wages and related accruals............... $   314,849  $   268,589
   Barrel taxes.......................................      98,775       98,934
   Other accruals.....................................     898,969      573,780
                                                       -----------  -----------
                                                       $ 1,312,593  $   941,303
                                                       ===========  ===========
</TABLE>
 
 
                                      25
<PAGE>
 
                            PYRAMID BREWERIES INC.
 
                  NOTES TO FINANCIAL STATEMENTS--(Continued)
 
8. Line of Credit:
 
  The Company has an agreement with a commercial bank for a line of credit.
Under the line of credit, the Company may borrow up to $15,000,000 for short-
term operating needs. The line of credit revolves through April 30, 1999,
during which time the required payments will be interest only. At that date,
any outstanding balance will be due in full. Borrowings under the line of
credit will incur interest, at the Company's option, at either the bank's
prime rate or at LIBOR plus 100 basis points. Up to $5,000,000 of the line of
credit may be used to finance acquisitions. Amounts used to finance
acquisitions may be converted to a four-year fully amortizing term loan, with
an additional option to fix the rate of interest at the bank's prime rate plus
125 basis points. The line of credit agreement contains provisions that
require the Company to maintain certain financial ratios and a minimum
tangible net worth. The Company was not in compliance with these covenants as
of December 31, 1998, and obtained a letter of waiver from the bank. There
were no outstanding borrowings on the line of credit during the year ended
December 31, 1998.
 
  The Company had no interest expense during fiscal 1998. Interest expense was
approximately $38,000 and $52,000 in 1997 and 1996, respectively. Interest
expense is reported as a component of other income (expense), net in the
Company's statements of operations.
 
9. Income Taxes:
 
  The benefit (provision) for income taxes included in the statements of
operations consists of the following:
 
<TABLE>
<CAPTION>
                                                        December 31,
                                               --------------------------------
                                                 1998      1997        1996
                                               -------- ----------  -----------
   <S>                                         <C>      <C>         <C>
   Current.................................... $    --  $  (54,337) $  (600,152)
   Deferred...................................  559,337  1,286,337     (450,665)
                                               -------- ----------  -----------
                                               $559,337 $1,232,000  $(1,050,817)
                                               ======== ==========  ===========
</TABLE>
 
  The benefit (provision) for income taxes differed from the amount obtained
by applying the federal statutory income tax rate to income before income
taxes, as follows:
 
<TABLE>
<CAPTION>
                                                              December 31,
                                                             -----------------
                                                             1998  1997  1996
                                                             ----  ----  -----
   <S>                                                       <C>   <C>   <C>
   Federal statutory rate................................... 34.0% 34.0% (34.0)%
   State taxes, net of federal income tax benefit...........  2.1   3.8   (3.6)
   Tax-exempt investment income.............................  --    --    11.3
   Other, net............................................... (3.1) (1.3)  (1.8)
                                                             ----  ----  -----
                                                             33.0% 36.5% (28.1)%
                                                             ====  ====  =====
</TABLE>
 
  Deferred income tax assets and (liabilities) are included in the balance
sheet at December 31, 1998 and 1997, as follows:
 
<TABLE>
<CAPTION>
                          December 31,
                     ------------------------
                        1998         1997
                     -----------  -----------
   <S>      <C>      <C>          <C>
   Accelerated
    depreciation.... $(1,993,243) $(1,367,242)
   Preopening
    expenses........         --       (42,927)
   Package design
    costs...........     215,167      156,674
   Accrued vacation.      74,569       64,767
   Deferred rent....     282,625      176,179
   Restructuring
    charge..........      69,238      345,873
   Net operating
    loss
    carryforwards...   1,565,726      777,178
   Tax credit
    carryforwards...     551,769      244,283
   Other, net.......     168,941      111,326
                     -----------  -----------
                     $   934,792  $   466,111
                     ===========  ===========
</TABLE>
 
                                      26
<PAGE>
 
                            PYRAMID BREWERIES INC.
 
                  NOTES TO FINANCIAL STATEMENTS--(Continued)
 
 
  At December 31, 1998, the Company had operating loss carryforwards for
federal income tax purposes of approximately $4,334,000, which are available
to offset future federal taxable income through 2018. In addition, the Company
had alternative minimum tax credit carryforwards of approximately $552,000,
which are available to reduce future federal income taxes over an indefinite
period.
 
10. 401(k) Plan:
 
  The Company has a profit-sharing 401(k) plan for all eligible employees.
Employees who are at least age 21 become eligible to participate following the
first plan quarter in which they perform at least 250 hours of service.
Employees can elect to contribute up to 13% of their eligible compensation to
the 401(k) plan. The Company generally matches employee contributions (that do
not exceed 10% of the employee's compensation) at the rate of 25%. The Company
may also make additional "profit-sharing" contributions. The Company's
contributions to the 401(k) plan are made at the sole discretion of the
Company. The Company's contribution for the years ended December 31, 1998,
1997 and 1996, totaled $16,354, $35,700 and $170,889, respectively.
 
11. Operating Leases:
 
  The Company leases its office, warehouse and plant facilities under
operating leases in Seattle and Berkeley. The Seattle brewery lease agreement
expires in 2004 and contains options to extend the lease term for three
additional five-year periods. The Seattle warehouse lease agreement expires in
2004 and contains options to extend the lease term for three additional five-
year periods. The Berkeley brewery lease agreement expires in 2010 and
contains options to extend the lease term for two additional five-year
periods. These lease agreements contain provisions for free rent periods and
scheduled rent increases. Accordingly, the Company has recorded deferred rent
of $782,245 and $573,589 at December 31, 1998 and 1997, respectively,
representing the pro rata rent which would have been due if equal payments had
been required under the lease terms. The Company also leases office, storage
and distribution facilities under month-to-month lease agreements.
 
  At December 31, 1998, future minimum rental payments are as follows:
 
<TABLE>
           <S>                                    <C>
           1999.................................. $  454,500
           2000..................................    475,104
           2001..................................    708,779
           2002..................................    816,204
           2003..................................    816,204
           Thereafter............................  3,670,233
                                                  ----------
                                                  $6,941,024
                                                  ==========
</TABLE>
 
  Total rent expense was approximately $718,000, $731,000 and $390,000 in
1998, 1997 and 1996, respectively.
 
12. Commitments and Contingencies:
 
  The Company is involved from time to time in claims, proceedings and
litigation arising in the ordinary course of business. The Company does not
believe that any such claim, proceeding or litigation, either alone or in the
aggregate, will have a material adverse effect on the Company's financial
position or results of operations.
 
13. Major Customers and Financial Instruments:
 
  Financial instruments that potentially subject the Company to credit risk
consist principally of trade receivables and interest-bearing deposits. The
Company's interest-bearing deposits are placed with a major
 
                                      27
<PAGE>
 
                            PYRAMID BREWERIES INC.
 
                  NOTES TO FINANCIAL STATEMENTS--(Continued)
 
financial institution. Wholesale distributors account for substantially all
accounts receivable; therefore, this concentration risk is limited due to the
number of distributors, their geographic dispersion and state laws regulating
the financial affairs of distributors of alcoholic beverages.
 
  During the years ended December 31, 1998, 1997 and 1996, one customer
comprised approximately 21%, 18% and 19% of the Company's revenue,
respectively. Accounts receivable at December 31, 1998 and 1997 include
approximately $297,000 and $312,000, respectively, due from this customer.
 
14. Segment Information:
 
  The Company adopted Statement of Financial Accounting Standards No. 131
(SFAS 131) "Disclosures about Segments of an Enterprise and Related
Information", during 1998. Following the provisions of SFAS 131, the Company
is reporting segment information in the same format as reviewed by the
Company's management (the "Management Approach"), which is organized around
differences in products and services. All segment information is presented
here except for the capital expenditure and total asset line items for 1997
and 1996 because obtaining the information was impracticable.
 
 Products and Services
 
  The Company's reportable segments include brewery operations, soda
operations and alehouses. Brewery operations include the production and sale
of Pyramid Ales and Thomas Kemper beers. Soda operations include the
production and sale of Thomas Kemper soda products. The third segment consists
of two full-service alehouses, which market and sell the full line of the
Company's beer and soda products as well as food and certain merchandise.
 
 Factors used to identify reportable segments
 
  The Company's reportable segments are strategic business units that offer
distinct and different products and services. These segments are managed
separately because each business requires different production, management and
marketing strategies.
 
 Measurement of segment profit and segment assets
 
  The accounting policies of the segments are the same as those described in
the summary of significant accounting policies. The Company evaluates
performance based on profit or loss from operations before income taxes not
including nonrecurring gains and losses. The Company records intersegment
sales at current market prices.
 
                                      28
<PAGE>
 
                            PYRAMID BREWERIES INC.
 
                  NOTES TO FINANCIAL STATEMENTS--(Continued)
 
 
  Segment profit and segment assets are as follows:
 
<TABLE>
<CAPTION>
                                Brewery      Soda
                               Operations Operations Alehouses Other    Total
                               ---------- ---------- --------- ------  -------
                                           (Dollars in thousands)
<S>                            <C>        <C>        <C>       <C>     <C>
Year ended December 31, 1998
  Revenues from external
   customers..................  $17,639     $3,402    $6,285   $  --   $27,326
  Intersegment revenues.......      410         35      (445)     --       --
  Interest income.............      --         --        --       309      309
  Depreciation and
   amortization...............    2,019        109       409       85    2,622
  Operating income (loss).....     (134)       763        88   (2,993)  (2,276)
  Income tax benefit..........      --         --        --       559      559
  Capital expenditures........      851        162       282      291    1,586
  Total assets................   22,618        605     3,474   10,735   37,432
Year ended December 31, 1997
  Revenues from external
   customers..................  $20,225     $2,872    $6,350   $  --   $29,447
  Intersegment revenues.......      500         29      (529)     --       --
  Interest income (expense),
   net........................      --         --        --       314      314
  Depreciation and
   amortization...............    2,095        226       678       99    3,098
  Restructuring charge........    1,600        --        --       --     1,600
  Operating income (loss).....   (1,491)       609       139   (2,562)  (3,305)
  Income tax benefit..........      --         --        --     1,232    1,232
Year ended December 31, 1996
  Revenues from external
   customers..................  $22,088        --     $3,825   $  --   $25,913
  Intersegment revenues.......      428        --       (428)     --       --
  Interest income (expense),
   net........................      --         --        --     1,199    1,199
  Depreciation and
   amortization...............      923        --        178       73    1,174
  Operating income (loss).....    4,241        --        456   (1,889)   2,808
  Income tax provision........      --         --        --    (1,051)  (1,051)
</TABLE>
 
 Other
 
  Other consists of interest income, general and administrative expense,
corporate office assets and other reconciling items that are not allocated to
segments for internal management reporting purposes. Total assets include all
assets except for fixed assets which are presented by segment.
 
15. Related Party Transactions:
 
  From time to time, the Company has obtained loans from its stockholders.
These loans were unsecured, with interest paid semiannually or annually at
rates between 5.65% and 10%. There were no loans from stockholders during
1998. During 1997, the Company had a loan payable to an officer and director
of the Company in the amount of $138, 076. The loan and accrued interest were
repaid in full prior to December 31, 1997. Interest expense of $21,636 and
$33,940 was paid to related parties during the fiscal years ended December 31,
1997 and 1996, respectively.
 
16. Stock Option Plans:
 
  The Company's Amended and Restated 1995 Employee Stock Option Plan (the
Employee Plan) permits the granting of options to employees. A total of
815,000 shares have been reserved under the Employee Plan. The options are
granted at the fair market value of the Company's common stock at the date of
grant. Each outstanding option has a term of 10 years from the date of grant
and, depending on the option, vests over a period of one to five years.
 
                                      29
<PAGE>
 
                            PYRAMID BREWERIES INC.
 
                  NOTES TO FINANCIAL STATEMENTS--(Continued)
 
 
  The Company's Non-employee Director Stock Option Plan (the Director Plan)
provides for the granting of stock options covering 2,500 shares of Common
Stock to be made automatically on the date of each annual meeting of
stockholders to each non-employee director of the Company, so long as shares
of Common Stock remain available under the Director Plan. A total of 125,000
shares have been reserved under the Director Plan. As of December 31, 1998 and
1997, 22,500 and 15,000 options have been granted, respectively. Each
outstanding option granted under this plan has a term of 10 years from the
date of grant and vests immediately.
 
  The Company has adopted the disclosure-only provision of the FASB's
statement No. 123 "Accounting for Stock-Based Compensation." Accordingly no
compensation cost has been recognized for options issued under the Employee
and Director Plans (the Plans). Had compensation cost been recognized based on
the fair value at the date of grant for options awarded under the Plans, the
pro-forma amounts of the Company's net (loss) income and net (loss) income per
share for the years ended December 31, 1998, 1997 and 1996, would have been as
follows:
 
<TABLE>
<CAPTION>
                                                      December 31,
                                           ------------------------------------
                                              1998         1997         1996
                                           -----------  -----------  ----------
   <S>                                     <C>          <C>          <C>
   Net (Loss) Income -- as reported....... $(1,136,069) $(2,142,949) $2,691,648
                                           ===========  ===========  ==========
   Net (Loss) Income -- pro forma......... $(1,606,807) $(3,233,670) $2,078,520
                                           ===========  ===========  ==========
   Net (Loss) Income per share -- as
    reported.............................. $     (0.14) $     (0.26) $     0.33
                                           ===========  ===========  ==========
   Net (Loss) Income per share -- pro
    forma................................. $     (0.20) $     (0.39) $     0.25
                                           ===========  ===========  ==========
</TABLE>
 
  The fair value of options granted was estimated using the Black-Scholes
option-pricing model with the following weighted average assumptions: risk-
free interest rates ranging from 6% to 6.87%; expected option lives of six to
eight years; expected volatility of 40% to 70%; and no expected dividends. The
weighted average fair value of options granted during the years 1998, 1997 and
1996 was $1.76, $1.49 and $6.33, respectively. The effect of applying SFAS No.
123 for providing pro-forma disclosures is not likely to be representative of
the effects in future years.
 
  Information with respect to the Plans follows:
 
<TABLE>
<CAPTION>
                                                                  Weighted-
                                    Shares Subject    Option       Average
                                      to Option    Price Range  Exercise Price
                                    -------------- ------------ --------------
   <S>                              <C>            <C>          <C>
   Options outstanding at December
    31, 1995.......................     266,500    $      19.00     $19.00
     Granted.......................     140,500    $ 4.75-12.25     $10.36
                                       --------    ------------     ------
   Options outstanding at December
    31, 1996.......................     407,000    $ 4.75-19.00     $16.02
     Granted.......................     289,500    $ 2.50- 4.13     $ 2.89
     Forfeitures...................     (47,000)   $10.75-19.00     $17.95
                                       --------    ------------     ------
   Options outstanding at December
    31, 1997.......................     649,500    $ 2.50-19.00     $10.03
     Granted.......................     254,000    $ 1.56- 2.63     $ 2.54
     Forfeitures...................    (251,000)   $ 3.09-19.00     $17.59
                                       --------    ------------     ------
   Options outstanding at December
    31, 1998.......................     652,500    $ 1.56-19.00     $ 4.33
                                       ========    ============     ======
</TABLE>
 
  Shares available for future grants at December 31, 1998 and 1997 totaled
287,500 and 290,500, respectively.
 
                                      30
<PAGE>
 
                            PYRAMID BREWERIES INC.
 
                  NOTES TO FINANCIAL STATEMENTS--(Continued)
 
 
  Information about options outstanding at December 31, 1998 follows:
 
<TABLE>
<CAPTION>
                            Weighted-
                             Average                                    Weighted-
         Options            Remaining               Options              Average
       Outstanding       Contractual Life         Exercisable         Exercise Price
       -----------       ----------------         -----------         --------------
       <S>               <C>                      <C>                 <C>
          20,500             82 months               18,450               $19.00
          77,500             89 months               62,597               $10.75
           7,500             89 months                7,500               $12.25
          11,000             96 months                7,333               $ 4.75
           6,000             98 months                3,667               $ 4.13
           6,000            100 months                2,000               $ 3.75
           7,500            101 months                7,500               $ 3.25
          30,000            101 months                7,500               $ 3.00
         175,000            104 months               77,778               $ 2.88
           7,500            106 months                3,125               $ 3.09
          50,000            107 months               10,833               $ 2.50
           7,500            113 months                7,500               $ 2.63
         241,500            114 months                  --                $ 2.56
           5,000            117 months                  --                $ 1.56
         -------                                    -------
         652,500                                    215,783
         =======                                    =======
</TABLE>
 
  The Company had options exercisable of 270,488 with weighted-average
exercise prices ranging from $2.50 to $19.00 and options exercisable of
192,630 with weighted-average exercise prices ranging from $4.75 to $19.00 as
of December 31, 1997 and 1996, respectively.
 
17. Employee Stock Purchase Plan:
 
  The Company's Employee Stock Purchase Plan (the Purchase Plan) allows
eligible employees to acquire shares of Common Stock of the Company at a
discount. Eligible employees may contribute up to 10% of their base earnings
toward the quarterly purchase of the Company's Common Stock. The employee's
purchase price is 85% of the lesser of the fair market value of the stock on
the first business day or the last business day of the quarterly offering
period. Discounts related to employee stock purchases during 1998, 1997 and
1996 were insignificant. The total number of shares issuable under the plan is
500,000. There were 12,094, 10,053 and 4,656 shares issued under the Purchase
Plan during 1998, 1997 and 1996 at a weighted average price of approximately
$1.86, $2.86 and $3.65 per share, respectively.
 
 
                                      31
<PAGE>
 
                            PYRAMID BREWERIES INC.
 
                  NOTES TO FINANCIAL STATEMENTS--(Continued)
 
 
18. Interim Financial Data (Unaudited):
 
  The following table presents the results of operations for each of the four
quarters in 1998 and 1997. This quarterly information is unaudited, has been
prepared on the same basis as the annual financial information and, in the
opinion of management, reflects all adjustments (consisting only of normal
recurring adjustments) necessary for a fair presentation of the information
for the periods presented. A variety of factors may lead to significant
fluctuations in the Company's quarterly results of operations, including
timing of new product introduction, seasonality of demand, any decrease in the
demand for craft beers and general economic conditions. As a result, the
Company's results of operations for any quarter are not necessarily indicative
of results for any future period.
 
<TABLE>
<CAPTION>
                                     1998 Quarters Ended                        1997 Quarters Ended
                          ------------------------------------------ ------------------------------------------
                          December 31 September 30 June 30  March 31 December 31 September 30 June 30  March 31
                          ----------- ------------ -------  -------- ----------- ------------ -------  --------
                                               (in thousands, except per share amounts)
<S>                       <C>         <C>          <C>      <C>      <C>         <C>          <C>      <C>
Gross sales.............    $6,423       $7,184    $7,510    $6,209    $ 6,334      $8,466    $8,386    $6,261
Less excise taxes.......       399          426       487       360        377         576       561       457
                            ------       ------    ------    ------    -------      ------    ------    ------
Net sales...............     6,024        6,758     7,023     5,849      5,957       7,890     7,825     5,804
Cost of sales...........     4,896        5,190     5,183     4,757      4,913       5,947     5,722     4,279
                            ------       ------    ------    ------    -------      ------    ------    ------
Gross margin............     1,128        1,568     1,840     1,092      1,044       1,943     2,103     1,525
Selling, general and
 administrative
 expenses...............     1,739        1,982     2,025     2,157      2,032       2,086     2,040     2,162
Restructuring charge....       --           --        --        --       1,600         --        --        --
                            ------       ------    ------    ------    -------      ------    ------    ------
Operating (loss) income.      (611)        (414)     (185)   (1,065)    (2,588)       (143)       63      (637)
Other income (expense)
 net....................        76           95       324        85       (80)        (121)       46        85
                            ------       ------    ------    ------    -------      ------    ------    ------
Income (loss) before
 income taxes...........      (535)        (319)      139      (980)    (2,668)       (264)      109      (552)
Benefit (provision) for
 income taxes...........       195           84      (66)       346      1,040          43       (41)      190
                            ------       ------    ------    ------    -------      ------    ------    ------
Net (loss) income.......    $ (340)      $ (235)   $   73    $ (634)   $(1,628)     $ (221)   $   68    $ (362)
                            ======       ======    ======    ======    =======      ======    ======    ======
Basic and diluted net
 (loss) income per
 share..................    $ (.04)      $ (.03)   $  .01    $ (.08)   $  (.20)     $ (.03)   $  .01    $ (.04)
                            ======       ======    ======    ======    =======      ======    ======    ======
Weighted average shares
 outstanding............     8,218        8,214     8,211     8,210      8,207       8,206     8,208     8,205
                            ======       ======    ======    ======    =======      ======    ======    ======
</TABLE>
 
                                      32
<PAGE>
 
                                 EXHIBIT INDEX
 
  The following exhibits are filed as part of this Annual Report on Form 10-K
or are incorporated herein by reference. Where an exhibit is incorporated by
reference, the number, which follows the description of the exhibit, indicates
the document to which cross reference is made. See the end of this exhibit
index for a listing of cross-referenced documents.
 
<TABLE>
<CAPTION>
     Exhibit
       No.                               Description
     -------                             -----------
     <C>      <S>
      3.1(1)  Amended and Restated Articles of Incorporation of Registrant
      3.2(1)  Form of Amended and Restated Bylaws of Registrant
      4.1(1)  Form of Common Stock Certificate
     10.1(1)  Lease between Harold W. Hill and the Registrant dated April 13,
              1994
     10.2(1)  Addendum of Lease between Harold W. Hill and the Registrant dated
              November 28, 1994
     10.3(1)  Second Addendum of Lease between 1201 Building L.L.C. and the
              Registrant dated June 26, 1995
     10.4(1)  Distribution Agreement between the Registrant and Western
              Washington Beverage dated August 24, 1995
     10.5(1)  Registrant's 1995 Employee Stock Option Plan
     10.6(1)  Registrant's Non-Employee Director Stock Option Plan
     10.7(1)  Form of Non-Qualified Stock Option Agreement
     10.8(1)  Employment Agreement between the Registrant and George Hancock
     10.9(1)  Employment Agreement between the Registrant and Brian Larson
     10.10(1) Commercial Lease between Esther Podlesak, Trustee of the John A.
              and Esther Podlesak 1990 Family Trust and Pyramid Breweries
              California, Inc. dated November 1, 1995
     10.11(1) Assignment, Assumption and Consent Agreement between Esther
              Podlesak, Trustee of the John A. and Esther Podlesak 1990 Family
              Trust, Pyramid Breweries California, Inc. and Pyramid Breweries
              Inc. dated November 17, 1995
     10.12(1) Form of Stockholder Note dated December 1, 1995 between the
              Company and Messrs. Hancock/Bryce/Stoddard/John Morse/Peter Morse
     23.1     Consent of Independent Public Accountants
     27       Financial Data Schedule
</TABLE>
--------
(1) Incorporated by reference to the exhibits filed as part of the
    Registration Statement on Form S-1 of Pyramid Breweries Inc. (File No. 33-
    97834).