<PAGE>   1
                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                    FORM 10-Q

[X]          QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                         SECURITIES EXCHANGE ACT OF 1934

                For the quarterly period ended September 30, 1997

                                       OR

[ ]         TRANSACTION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                         SECURITIES EXCHANGE ACT OF 1934

                         Commission file number 0-28330

                              LEGACY SOFTWARE, INC.
             (Exact name of registrant as specified in its charter)

           Delaware                                     95-456-1156
(State or other jurisdiction of             (I.R.S. Employer Identification No.)
 information or organization)

        5340 Alla Road
        Los Angeles, California                           90066
        (Address of principal executive offices)          (Zip Code)

                                 (310) 823-2423
               Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.

                                  Yes   X    No
                                      -----     -----

There were 2,655,002 shares outstanding of the registrant's Common Stock, par
value $.001 per share, as of November 11, 1997.



                                       1
<PAGE>   2



                              LEGACY SOFTWARE, INC.

                                      INDEX

<TABLE>
<CAPTION>
                                                                        Page No.
<S>     <C>                                                               <C>
                         PART I - FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited):

        Balance Sheets at September 30, 1997 and
        December 31, 1996

        Statements of Operations for the three months ended
        September 30, 1997 and 1996 and nine months ended
        September 30, 1997 and 1996

        Statements of Cash Flow for the nine
        months ended September 30, 1997 and 1996

        Notes to Condensed Financial Statements

Item 2. Management's Discussion and Analysis of Financial
        Condition and Results of Operations for the three and nine
        months ended September 30, 1997

                           PART II - OTHER INFORMATION

Item 1. Legal Proceedings

Item 2. Changes in Securities

Item 3. Defaults Upon Senior Securities

Item 4. Submission of Matters to a Vote of Security Holders

Item 5. Other Information

Item 6. Exhibits and Reports on Form 8-K

Signatures

Exhibits
         Exhibit 11
         Exhibit 27
</TABLE>



                                       2
<PAGE>   3



                         PART 1 - FINANCIAL INFORMATION

ITEM 1 FINANCIAL STATEMENTS

                              LEGACY SOFTWARE, INC.

                                 BALANCE SHEETS


<TABLE>
<CAPTION>
                                                     SEPTEMBER 30,    DECEMBER 31,
                                                         1997             1996
                                                     -------------    ------------
                        ASSETS                        (Unaudited)
<S>                                                   <C>              <C>
CURRENT ASSETS:
     Cash and cash equivalents                        $   16,657       $1,804,779
     Restricted cash                                          --           55,240
     Accounts receivable, net of allowances for
       doubtful accounts of $0 and $0                    106,475            2,767
     Note Receivable                                      50,000
     Inventory                                            70,600
     Other receivables                                    23,188          125,888
     Other current assets                                 36,987
                                                      ----------       ----------

     Total current assets                                303,907        1,988,674
                                                      ----------       ----------

Product development costs, net                         1,431,731        1,260,478
Property and equipment, net                              330,812          407,632
Other Assets                                              18,994           23,723

                                                      ----------       ----------
Total assets                                          $2,085,444       $3,680,507
                                                      ==========       ==========
</TABLE>

See accompanying notes to condensed financial statements.



                                       3
<PAGE>   4

                              LEGACY SOFTWARE, INC.

                                 BALANCE SHEETS


<TABLE>
<CAPTION>
                                                        SEPTEMBER 30,       DECEMBER 31,
                                                            1997               1996
                                                         -----------        -----------
                                                       (Unaudited)
<S>                                                      <C>                <C>
         LIABILITIES AND SHAREHOLDERS' EQUITY

CURRENT LIABILITIES:
     Line of credit                                      $      0.00        $    35,250
     Accounts payable                                        107,610            167,097
     Accrued expenses                                         55,625             70,489
     Payable to former co-development partner                400,000            400,000
     Deferred Revenues                                        18,760             40,388
     Notes payable and current portion of
       long-term debt                                        135,000            120,433
                                                         -----------        -----------

         Total current liabilities                           716,995            833,657
                                                         -----------        -----------

LONG TERM DEBT PRIMARILY FROM RELATED PARTIES,
     net of current portion                                  339,022            341,369

COMMITMENTS                                                       --

SHAREHOLDERS' EQUITY
     Preferred Stock, par value $.001 per share,
       5,000,000 shares authorized; none issued
       and outstanding

     Common Stock, par value $.001 per share,
       10,000,000 shares authorized: 2,655,002
       and 2,465,885 shares issued and outstanding             2,654              2,522

     Additional paid in capital                            7,044,808          6,858,914
     Acumulated deficit                                   (6,018,035)        (4,355,955)
                                                         -----------        -----------

       Total shareholders' equity                          1,029,427          2,505,481
                                                         -----------        -----------

                                                         $ 2,085,444        $ 3,680,507
                                                         ===========        ===========
</TABLE>


See accompanying notes to condensed financial statements.



                                       4
<PAGE>   5



                              LEGACY SOFTWARE, INC.

                            STATEMENTS OF OPERATIONS

                                   (UNAUDITED)


<TABLE>
<CAPTION>
                                  THREE MONTHS ENDED SEPTEMBER 30,      NINE MONTHS ENDED SEPTEMBER 30,
                                  -------------------------------       ------------------------------
                                     1997               1996               1997               1996
                                  -----------        -----------        -----------        -----------
<S>                               <C>                <C>                <C>                <C>
Revenue
   Royalties                      $    82,096        $    15,085        $   189,029        $    16,295
   Software sales                      33,718              1,974             49,969              7,378
   Consulting                              --             10,000                 --             12,125
                                  -----------        -----------        -----------        -----------

Total revenue                         115,814             27,059            238,998             35,798
                                  -----------        -----------        -----------        -----------

Costs and expenses
   Cost of royalties                   35,148             25,507             35,148             76,507
   Cost of software sales              23,311              1,364             31,379              6,524
   Product development                 10,640            534,951            611,910            811,157
   General & administrative           174,159            565,582            947,060          1,068,989
   Selling                             16,553             42,750            251,697             49,234
                                  -----------        -----------        -----------        -----------

Total costs and expenses              259,811          1,170,154          1,877,194          2,012,411
                                  -----------        -----------        -----------        -----------

Loss from operations                 (143,997)        (1,143,095)        (1,638,196)        (1,976,613)

Interest expense                       12,147             17,719             43,430            443,923
Interest income                           (54)           (45,248)           (19,547)           (73,312)
                                  -----------        -----------        -----------        -----------

Net loss                          $  (156,090)       $(1,115,566)       $(1,662,079)       $(2,347,224)
                                  ===========        ===========        ===========        ===========

Net loss per common share         $     (0.06)       $     (0.46)       $     (0.65)       $     (1.23)

Weighted average common
   stock shares outstanding         2,592,979          2,443,421          2,547,520          1,912,939
</TABLE>


See accompanying notes to condensed financial statements



                                       5

<PAGE>   6






                                 LEGACY SOFTWARE, INC.
                             STATEMENT OF CASH FLOWS
                                   (UNAUDITED)


<TABLE>
<CAPTION>
                                                              NINE MONTHS ENDED SEPTEMBER 30,
                                                              ------------------------------
                                                                 1997               1996
                                                              -----------        -----------
<S>                                                           <C>                <C>
Cash flows from operating activities:
   Net loss                                                   $(1,662,079)       $(2,347,224)
   Adjustments to reconcile net loss to net cash
      used in operating activities:
        Amortization of product development costs                      --             76,507
        Amortization of deferred loan fees and original
          issue discount                                               --            355,307
        Depreciation                                               74,776             28,592
        Gain on disposal of property and equipment                   (157)
        Issuance of common stock in exchange for
          services                                                     --             14,400
        Issuance of common stock in acquisition of
           research and development                                                  233,338

Increase (decrease) in cash from changes in:
   Accounts receivable, net                                      (103,708)           (11,764)
   Other receivables                                              102,700
   Inventories                                                    (70,600)
   Other assets                                                   (32,258)           (26,645)
   Accounts payable and accrued expenses                          (74,351)           211,916
   Development expense co-funding billings in
        excess of development expense co-funding
        recognized                                                                   (54,637)
   Deferred revenues                                              (21,628)           667,343
   Accrued interest                                                                  (78,731)

                                                              -----------        -----------
        Net cash provided by (used in)
          operating activities                                 (1,787,305)          (931,598)
                                                              -----------        -----------

Cash flows from investing activities:
   Note receivable                                                (50,000)
   Purchase of property and equipment                              (5,238)          (254,191)
   Proceeds from the disposition of property
       and equipment                                                7,438
   Additions to product development costs                        (171,253)          (773,222)

                                                              -----------        -----------
        Net cash used in investing activities                    (219,053)        (1,027,413)
                                                              -----------        -----------

Cash flows from financing activities
   Payments under line of credit                                  (35,250)
   Note payable                                                    75,000              8,184
   Payments on notes payable and long term debt                   (62,780)          (330,221)
   Net proceeds from initial public offering                           --          5,355,589
   Exercise of Common Stock Warrants                              162,500
   Issuance of stock under the Employee
       Stock Purchase Plan                                         23,526
                                                              -----------        -----------
       Net cash provided by financing activities                  162,996          5,033,552
                                                              -----------        -----------


Increase (decrease) in cash and cash equivalents               (1,843,362)         3,074,541
Cash and cash equivalents, at beginning of period               1,860,019            365,190
                                                              -----------        -----------
Cash and cash equivalents, at end of period                   $    16,657        $ 3,439,731
                                                              ===========        ===========


Supplemental disclosure of cash flow information
   Cash paid during the period for:
         Interest                                             $    43,430        $   176,688
         Income taxes                                         $        --        $        --
                                                              -----------        -----------
</TABLE>

Non-cash investing and financing activity: A convertible note payable in the
amount of $700,000 was converted into 534,351 shares of common stock during the
Company's nine months ended September 30, 1996


See accompanying notes to condensed financial statements



                                       6
<PAGE>   7



                              LEGACY SOFTWARE, INC.

                          NOTES TO FINANCIAL STATEMENTS

(1)   Basis of presentation

      The accompanying unaudited financial statements have been prepared in
accordance with generally accepted accounting principles for interim financial
information and the instructions to Form 10-Q. Accordingly, they do not include
all of the information and footnotes required by generally accepted accounting
principles for complete financial statements. In the opinion of management, all
adjustments (consisting of only normal recurring accruals) considered necessary
for a fair presentation of the Company's financial position at September 30,
1997, the results of operations for the three months and the nine months ended
September 30, 1997 and September 30, 1996, and the cash flows for the nine
months ended September 30, 1997 and September 30, 1996 are included. Operating
results for the three and nine month periods ended September 30, 1997 are not
necessarily indicative of the results that may be expected for the year ending
December 31, 1997.

      The information contained in this Form 10-Q should be read in conjunction
with the Company's Annual Report on Form 10-K.

(2)   Financial Condition and Liquidity

      On May 14, 1996 the Company completed an Initial Public Offering and
generated $5,198,000 of net proceeds. The proceeds have been used to pay off
certain existing debt, to develop new software titles and provide working
capital. For the nine month period ended September 30, 1997 the Company has
expended $1,787,305 in cash in operating activities and $169,053 for software
development costs and acquisition of property and equipment. For the twelve
months ended December 31, 1996 the Company expended $1,968,740 in cash in
operating activities and $1,641,557 in software development costs and
acquisition of property and equipment.

      At September 30, 1997 the Company had working capital of ($413,088)
compared to working capital of $1,155,017 at December 31, 1996. The Company has
incurred net losses since inception and expects to continue to operate at a loss
during 1997. The Company's prospects must be considered in light of the risks,
expenses and difficulties encountered by companies in the early stages of
development, particularly companies in new and rapidly evolving markets. The
Company's ability to maintain operations in the near term and to achieve
positive cash flow in the future depends on a variety of factors. Given the
Company's current working capital deficiency and



                                       7
<PAGE>   8

lack of cash resources, should the Company be unable to obtain additional
funding to supply its near-term cash requirements, there is substantial doubt as
to the Company's ability to continue as a going concern. In addition, the
Company's ability to continue operations and achieve positive cash flow in the
future depends on the timeliness, successful distribution and market acceptance
of its current and future software titles (including without limitation its
District Attorney, The Best of Emergency Room and ER Intern titles and the
Passport2Network internet game service), the cost of developing, producing and
supporting of any such titles, and the Company's ability to obtain or generate
the resources to fund such efforts. Should the Company's future income be less
than anticipated or its software title production and introduction be delayed
significantly or fail to generate sufficient revenues, the Company will require
additional capital in the future. Also, should the Company consummate any
acquisition or business combination, the Company will likely require additional
capital to effect such transaction and/or any related integration and/or
expansion of its business and operations. The Company may seek to satisfy any
such capital needs through additional public or private financings or other
sources, but there can be no assurance that any such additional financing would
be available on favorable terms, it at all. If the Company is unable to generate
or obtain such additional capital, it could have a material adverse effect on
its business, financial condition or results of operations.

      In July, August and September 1997 the Company failed to make a principle
payment on an unsecured note payable to a related party. The monthly payment, in
the amount of $10,000 per month, was due in accordance with the terms of the
original Note dated February 1, 1991 as amended which provides for monthly
payments of principle and interest commencing on July 1, 1997.

      In the fourth quarter of 1996 the Company and International Business
Machines Corporation ("IBM") mutually agreed to terminate the District Attorney
Development and Licensing Agreement dated November 16, 1995. As consideration
for the termination the Company is obligated to pay to IBM the aggregate sum of
$400,000, the total amount of milestone payments made by IBM to the Company, as
termination cost on or before December 15, 1997; however, the Company does not
expect to be able to make a payment of the principal or any portion of such
obligation to IBM by such date. If such obligation is not paid to IBM by
December 15, 1997 the amount due IBM shall be increased by interest at an annual
rate of ten (10%) percent beginning January 1, 1996 and the Company will pay to
IBM royalties at the rate of forty five (45%) percent on royalty revenue
received from sales of the District Attorney title and ten (10%) percent on
royalty revenue received from sales of derivatives and sequels of the Emergency
Room title until the obligation is paid in full. 

      In May, 1997 IBM notified the Company that it disputed the Company's right
to distribute and/or sell derivatives of the Emergency Room title under the
terms of the Multimedia Rights License Agreement between the Company and IBM, as
amended by Amendment No. 1, Amendment No. 2 and the Amendment and Termination
Agreement pursuant to which the Development and Licensing Agreement with respect
to the District Attorney title was terminated. On October 1, 1997 the Company
and IBM signed Amendment No. 3 in which IBM granted to the Company all rights to
distribute and/or sell derivatives of the Emergency Room title, provided the
Company with registration information on sales of the Emergency Room title by
IBM and agreed not to contest the Company's right to market and retain all
royalties for The Best of Emergency Room title. In exchange, the Company granted
IBM the nonexclusive rights necessary to continue to market, distribute and
support the Emergency Room title and provided IBM with a modification of the
Emergency Room title that permits easier installation in a Windows95 operating
environment.

      In the fourth quarter of 1996, McGraw-Hill Home Interactive 
("McGraw-Hill") without cause effectively terminated a letter of intent entered
into with the Company to co-develop the contemplated Animal Doctor title. A
mutual release was signed in February 1997 at which time the Company received
$75,000 in previously unfunded development costs.

      In conjunction with the termination of the co-development agreements, the
Company accelerated its plans to become a developer/distributor of titles on its
own. To achieve this transition the Company established a sales and marketing
organization in early



                                       8
<PAGE>   9

Spring 1997. The Company modified this distribution strategy in June 1997 and is
proceeding to use a combination of a distributor to market two titles and to
self-distribute two other titles in 1997 and 1998.

      If this transition in distribution methods is not successful the Company
could face short term liquidity requirements that could significantly deplete
current cash resources. At June 30, 1997 the Company implemented programs
designed to improve its liquidity requirements by ceasing all costs associated
with development of new titles, significantly curtailing its Internet gaming
services, significantly reducing staff, implementing other operating cost
reductions and seeking additional funding.

      Additionally, although the Company believes that, together with a
successful effort to obtain additional funding for its near-term cash needs, its
operating plan and efforts to reduce operating expenses, in conjunction with
acquisition of such additional funding, will be adequate to meet its fiscal 1997
working capital needs, there can be no assurance that the Company will be able
to obtain such funding, or that it will not experience liquidity problems caused
by adverse market conditions and other unfavorable events.

(3)   Deferred Revenue

      As of December 31, 1996, the Company had recorded $40,388 in deferred
revenues relating to amounts received from IBM for fourth quarter 1996 sales of
the Emergency Room title co-developed with IBM. In conjunction with the revenue
recognition policy established by the Company, this amount was recognized into
royalty revenue during March of 1997. In June, 1997 the Company received $75,480
for first quarter, 1997 sales of the Emergency Room title. In accordance with
the revenue recognition policy established by the Company, $64,155 was recorded
as revenue and $11,325 was recorded as deferred revenues. In September, 1997 the
Company received $2,509 for second quarter sales of Emergency Room title. During
the third quarter the Company recognized $11,325 representing the deferred
revenue of the second quarter sales and $2,133 for the third quarter sales of
the Emergency Room title and deferred royalty revenue of $12,164 relating to
third quarter sales of the District Attorney and ER Intern titles.

(4)   Earnings Per Share

      Earnings per common share for the three month and nine month periods
ending September 30, 1997 are computed based upon the weighted average number of
common shares actually outstanding during the periods plus the additional shares
that would be outstanding assuming the exercise of dilutive common stock options
and purchase warrants, which are considered common stock equivalents. The number
of shares that



                                       9
<PAGE>   10

would be issued from the exercise of such options and warrants would be reduced
by the number of common shares that could have been purchased from the assumed
use of proceeds at the average market price of the Company's common stock during
the period (treasury stock method). For the three and nine month periods ending
September 30, 1997, all common stock equivalents were excluded from the
calculation of earnings per share as their inclusion would have been
anti-dilutive.

      Statements of Financial Standards No. 128, "Earnings Per Share" (SFAS 128)
is effective for financial statements issued for periods ending after December
15, 1997, including interim periods. Earlier application is not permitted. SFAS
128 requires dual presentation of basic and diluted earnings per share (EPS) on
the face of the income statement. It also requires a reconciliation of the
numerator and denominator of the diluted EPS computation. This statement also
requires restatement of all prior-period EPS data presented. The Company has not
determined the effect on its EPS from the adoption of this statement.

(5)   Termination and Acquisition of Co-Development Partner's Rights Under
      Agreements

      On January 3, 1997, the Company and IBM executed a final termination
agreement with respect to the District Attorney Development and Licensing
Agreement dated November 16, 1995. As consideration for the termination and for
the acquisition of IBM's rights under the agreement, the Company is obligated to
pay to IBM no later than December 15, 1997 the aggregate sum of $400,000,
representing the total amount of milestone payments made by IBM to the Company
under the DA Licensing Agreement however, the Company does not expect to be able
to make a payment of the principal or any portion of such obligation to IBM by
such date. If such obligation is not paid to IBM by December 15, 1997 the amount
due IBM shall be increased by interest at an annual rate of ten (10%) percent
beginning January 1, 1996 and the Company will pay to IBM royalties at the rate
of forty-five (45%) percent on royalty revenue received from sales of the
District Attorney title and ten (10%) percent on royalty revenue received from
sales of derivatives and sequels of the Emergency Room title until the
obligation is paid in full.

      In May, 1997 IBM notified the Company that it disputed the Company's right
to distribute and/or sell derivatives of the Emergency Room title under the
terms of the Multimedia Rights License Agreement between the Company and IBM, as
amended by Amendment No. 1,  Amendment No. 2 and the Amendment and Termination
Agreement pursuant to which the Development and Licensing Agreement with respect
to the District Attorney title was terminated. On October 1, 1997 the Company
and IBM signed Amendment No. 3 in which IBM granted to the Company all rights to
distribute and/or sell derivatives of the Emergency Room title, provided the
Company with registration information on sales of the Emergency Room title by
IBM and agreed not to contest the Company's right to market and retain all
royalties for The Best of Emergency Room title. In exchange, the Company granted
IBM the nonexclusive rights necessary to continue to market, distribute and
support the Emergency Room title and provided IBM with a modification of the
Emergency Room title that permits easier installation in a Windows95 operating
environment.  

      In February of 1997, a release and termination agreement was signed with
McGraw-Hill with respect to the letter of intent for the development and
licensing of the contemplated Animal Doctor title. In association with the
release and termination a payment of $75,000 was received from McGraw Hill in
February of 1997, representing previously unfunded development expenses related
to the contemplated Animal Doctor title. Additionally during the three months
ended March 31, 1997, preliminary conceptual development was halted for a
proposed second McGraw Hill title, Junior Astronaut, for which no agreement or
letter of intent was signed.

(6)   Proposed Acquisitions

      In February of 1997 the Company signed a letter of intent to acquire
certain assets and to assume certain liabilities of Educorp Multimedia, Inc.
("Educorp"), a California based multimedia software publisher, and its wholly
owned subsidiaries Educorp Direct, Inc. and



                                       10
<PAGE>   11

High Text Interactive. The total consideration of $1,800,000 was to be payable
in shares of the Company's common stock with the number of shares calculated
based on the average closing price of the stock for thirty calendar days
following the closing of the transaction, but in no event less than 425,000
shares. On June 30, 1997 the Company and Educorp mutually agreed to terminate
the negotiations.

      On June 27, 1997 the Company signed a non binding letter of intent to
acquire 100 percent of the outstanding stock of Canyon Interactive, LLC.
("Canyon") a California limited liability company. The total proposed
consideration was to be $750,000 in cash and $1,000,000 payable in shares of the
Company's common stock. The actual number of shares was to be determined based
on the average market price of the Company's common stock from June 27, 1997 to
the consummation of the transaction. On September 29, 1997 the Company and
Canyon mutually agreed to terminate negotiations.

(7)   Marketing and Distribution Agreements

      On July 31, 1997 the Company and Alpha Soft Corporation ("Alpha Soft)
entered into a Distribution Agreement for the District Attorney cases 1 through
3 and ER Intern titles. Under the terms of the Agreement Alpha Soft will
produce, market and distribute the titles and the Company will receive a royalty
on each sale.

      On June 5, 1997 the Company entered into an Information Provider
Commission Agreement with AT & T WorldNet Service ("WorldNet") whereby customers
of WorldNet are offered the opportunity to participate in Passport2Network
interactive games. The Passport2Network pays WorldNet a royalty for each
WorldNet customer that becomes a Passport2Network subscriber.

      On October 14, 1997 the Company signed an Information Provider Commission
Agreement with The New York Times Electronic Media Company ("Times On Line")
whereby subscribers of the Times On Line Bridge and Chess columns have the
opportunity to participate in Passport2Network interactive games under terms
including royalty terms similar to the WorldNet agreement.


(8)   Reclassifications

      Certain 1996 expense amounts were reclassified from the "general and
administrative" line item to the "selling" line item to conform with the 1997
presentation.



                                       11
<PAGE>   12




ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL AND RESULTS OF
        OPERATION.

Cautionary Note Regarding Forward-Looking Statements

      Except for historical information contained herein, the statements in this
report (including without limitation, statements indicating that the Company
"expects," "estimates," anticipates," or "believes" and all other statements
concerning future financial results, product offerings, proposed acquisitions or
combinations or other events that have not yet occurred) are forward-looking
statements that are made pursuant to the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995, Section 21E of the Securities Exchange
Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as
amended. Forward-looking statements involve known and unknown factors, risks and
uncertainties which may cause the Company's actual results in future periods to
differ materially from forecasted results. Those factors, risks and
uncertainties include, but are not limited to: the positioning of the Company's
products in the Company's market segments; the Company's ability to effectively
manage its various businesses in a rapidly changing environment; the timing of
new product introductions; retail sell-through of the Company's products; the
continued emergence of the Internet resulting in new competition and changing
consumer demands; the Company's ability to adapt and expand its product
offerings in light of changes to and developments in personal computer platforms
and the Internet environment; growth rates of the Company's market segments;
variations in the cost of, and demand for, customer service and technical
support; price pressures and competitive environment in the consumer software
and edutainment industry; the possibility of programming errors or other "bugs'
in the Company's software games and Internet technology; the Company's ability
to establish itself successfully as a software developer, publisher and
distributor; the emergence of competition from new and existing software and
gaming Internet companies; the timing and consumer acceptance of new product
releases and services (including current users' willingness to upgrade from
older versions of the Company's products); the consummation of possible
acquisitions or combinations; and the Company's ability to integrate acquired or
combined operations with its existing business and otherwise manage growth; and
the Company's ability to generate or obtain additional capital resources to fund
its operations and growth. Additional information on these and other risk
factors are included under the headings "Risk Factors" and elsewhere in this
Form 10-Q.



                                       12
<PAGE>   13


Risk Factors

      Need for Additional Capital; Uncertainty as a Going Concern At September
30, 1997 the Company had working capital of ($413,088) compared to working
capital of $1,155,017 at December 31, 1996. The Company has incurred net losses
since inception and expects to continue to operate at a loss during 1997. The
Company's prospects must be considered in light of the risks, expenses and
difficulties encountered by companies in the early stages of development,
particularly companies in new and rapidly evolving markets. The Company's
ability to maintain operations in the near term and to achieve positive cash
flow in the future depends on a variety of factors. Given the Company's current
working capital deficiency and lack of cash resources, should the Company be
unable to obtain additional funding to supply its near-term cash requirements,
there is substantial doubt as to the Company's ability to continue as a going
concern. On January 3, 1997, the Company and IBM executed a final termination
agreement with respect to the District Attorney Development and Licensing
Agreement dated November 16, 1995. As consideration for the termination and for
the acquisition of IBM's rights under the agreement, the Company is obligated to
pay to IBM no later than December 15, 1997 the aggregate sum of $400,000,
representing the total amount of milestone payments made by IBM to the Company
under the DA Licensing Agreement however, the Company does not expect to be able
to make a payment of the principal or any portion of such obligation to IBM by
such date. If such obligation is not paid to IBM by December 15, 1997 the amount
due IBM shall be increased by interest at an annual rate of ten (10%) percent
beginning January 1, 1996 and the Company will pay to IBM royalties at the rate
of forty five (45%) percent on royalty revenue received from sales of the
District Attorney title and ten (10%) percent on royalty revenue received from
sales of derivatives and sequels of the Emergency Room title until the
obligation is paid in full. In addition, the Company's ability to continue
operations and achieve positive cash flow in the future depends on the
timeliness, successful distribution and market acceptance of its current and
future software titles (including without limitation its District Attorney, The
Best of Emergency Room and ER Intern titles and the Passport2Network internet
game service) the cost of developing, producing and supporting of any such
titles, and the Company's ability to obtain or generate the resources to fund
such efforts. Should the Company's future income be less than anticipated, or
its software title production and introduction be delayed significantly or fail
to generate sufficient revenues, the Company will require additional capital in
the future. Also, should the Company consummate any acquisition or business
combination the Company will likely require additional capital to effect such
transaction and/or any related integration and/or expansion of its business and
operations. The Company may seek to satisfy any such capital needs through
additional public or private financings or other sources, but there can be no
assurance that any such additional financing would be available on favorable
terms, it at all. If the Company is unable to generate or obtain such additional
capital, it could have a material adverse effect on its business, financial
condition or results of operations.

      Management of Growth; Uncertainties Relating to Acquisitions, Business
Combinations and New Businesses. The Company has pursued, is currently pursuing
and, in the future may pursue, new technologies and businesses internally and
through acquisitions and combinations which involve significant risks. Any such
acquisition or combination may involve, among other things, the issuance of
equity securities, the payment of cash, the incurrence of contingent liabilities
and the amortization of expenses related to goodwill and other intangible
assets, and transaction costs, which have adversely affected, or may adversely
affect, the Company's business results of operations and financial condition.
The Company's ability to integrate and organize



                                       13
<PAGE>   14

any new businesses and/or products, whether internally developed or obtained by
acquisition or combination, including the Passport2 Internet game and
information service, will likely require significant expansion of the Company's
operations. There is no assurance that the Company will have or be able to
obtain the necessary resources to satisfactorily effect such expansion, and the
failure to do so could have a material adverse effect on the Company's results
of operations, financial condition and business. In addition future acquisitions
and or combinations by the Company involve risks of, among other things,
entering markets or segments in which the Company has no or limited prior
experience, the potential loss of key employees of the acquired company and/or
difficulty, delay or failure in the integration of the operations, management,
personnel and business of any such new business with the Company's business and
operating and financial difficulties of any new or newly combined operations,
any of which could have a materially adverse effect on the Company's business,
financial condition or results of operations. Moreover, there can be no
assurance that the anticipated benefits of any specific acquisition or of any
internally developed new business segment or business combination will be
realized.

      Dependence on IBM and Alpha Soft for Substantially All the Company's
Revenues. For the first nine months of 1997, approximately 46% of the Company's
total revenue was derived from royalty payments made by IBM to the Company on
sales of the Emergency Room title and 33% was derived from Alpha Soft on royalty
revenue generated by the District Attorney and ER Intern titles. The Company
expects royalty revenue from the Emergency Room title, a DOS-based product, to
diminish significantly over the course of 1997, as it will face increased
competition from Windows-based products and the royalty revenue from the
District Attorney and ER Intern titles to increase as these products enter the
market in larger numbers. Although IBM is currently distributing and marketing
the Emergency Room title on behalf of the Company, the Company and IBM have
terminated their co-development relationship with respect to future RealPlay(TM)
titles, including, but not limited to, the District Attorney title. In light of
the Company's dependence on IBM for the distribution and marketing of its
Emergency Room title and Alpha Soft for the distribution and marketing of the
District Attorney and ER Intern titles, if IBM and/or Alpha Soft were to
terminate their distribution and marketing relationships with the Company, if
the Company is unable to develop other CD-ROM titles or other services, if the
Company can not find alternative distribution arrangements for its present or
future titles, or if the Company's other products and services, if any, do not
receive market acceptance, there will be a material adverse effect on the
Company's results of operations, financial condition and business. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" - "General", and "Results of Operations".



                                       14
<PAGE>   15

      Significant Quarterly Fluctuations in Revenue and Operating Results and
Related Factors. The Company's quarterly operating results have fluctuated
significantly in the past, and are likely to fluctuate significantly in the
future based on a number of factors. Such factors include, but are not limited
to, the size and rate of growth of the consumer edutainment and gaming software
market, uncertainties relating to acquisitions and business combinations, market
acceptance of the Company's products and those of its competitors, competition
for shelf space and promotional support, development and promotional expenses
relating to the introduction of new products or enhancements of existing
products, projected and actual changes in computer formats and platforms and the
Internet, the timing and success of product introductions, product returns,
changes in pricing policies by the Company and its competitors, the accuracy of
retailers' forecasts of consumer demand, the timing of orders from major
customers, order cancellations, delays in shipment, delays in royalty revenue
received from IBM, Alpha Soft or other distributors, the effect of personal
computer sales, risks from limited protection of proprietary rights and
significant price reductions in personal computer software, and consignment
shipments of the Company's products. The Company expects to experience
significant fluctuations in its quarterly operating results as a result of
changes in the mix of products with varying profit margins sold by the Company
from quarter to quarter and the timing of product introductions. In response to
competitive pressures, the Company may take certain pricing or marketing actions
that could materially adversely affect the Company's results of operations,
business and financial condition in any quarter. The Company's expense levels
are based, in part, on its expectations regarding future sales. As a result,
operating results would be disproportionately adversely affected by a decrease
in quarterly sales, the failure to meet the Company's sales expectations for any
quarter or costs associated with sales of defective products, higher customer
support costs and product returns.

      Development of New Titles. The Company currently has several titles in the
conceptual, pre-production and production phases of development. The Company
does not currently plan to begin full-scale development of additional titles
until such time as the proposed distribution channels for existing titles are in
place and are operational. There can be no assurance, however, that the Company
will be able to successfully distribute any existing or future titles through
its own efforts or the efforts of distributors, which would impair the Company's
ability to fund the development of future titles, and, as a result, have a
material adverse effect on the Company to generate future operating cash flow.

      Rapidly Changing Technologies and Markets. The markets in which the
Company competes are characterized by ongoing technological



                                       15
<PAGE>   16

developments, frequent new product announcements and introductions, evolving
industry standards, changing customer requirements and new competitors. The
introduction of products and services embodying new technologies and the
emergence of new industry standards and practices, including new platforms,
CD-ROMs and the Internet, can render existing products obsolete and
unmarketable. The Company's future success depends upon its ability to enhance
its existing products and services, develop new products and services that
address the changing requirements of its customers, develop additional products
and services for new or other platforms and environments, such as Windows 95 and
the Internet, and anticipate or respond to technological advances, emerging
industry standards and practices and changes in CD-ROMs, the Internet and other
technologies, in a timely, cost-effective manner. There can be no assurance that
any of such initiatives can be successfully implemented or that they will result
in increased revenue or profits for the Company. Conversely, there can be no
assurance that consumers' use of the Internet, particularly for entertainment
and edutainment, will continue to increase as rapidly as it has during the past
few years, nor can there be any assurance that customers will be willing to pay
for such service in the foreseeable future.

      Competition. Each of the computer software development, Internet
technology and software retail distribution industries is intensely competitive.
The Company's competitors in each industry range from small companies with
limited resources to large, more established companies which have significantly
greater assets and greater financial, technical and personnel resources than
those of the Company. The Company expects competition to continue and increase
in each of these market segments.

      Increased competition in the software development market, resulting from,
among other things, the timing of competitive product releases and the
similarity of such products to those of the Company, may result in significant
price competition, reduced profit margins, loss of shelf space or a reduction in
sell-through of the Company's products at retail stores, any of which could have
a material adverse effect on the Company's results of operations, business or
financial condition. In addition, the Company believes that large software
companies, media companies and film studios are increasing their focus on the
interactive entertainment and edutainment sectors of the software market and, as
a result of their greater resources, name recognition, customer base and
licensed rights, are significant competitors in the software industry. Current
and future competitors with greater resources than the Company may be able to,
among other things, carry larger inventories, undertake more extensive marketing
campaigns and distribution efforts, adopt more aggressive pricing policies and
make higher offers or guarantees to software developers and co-development
partners than the Company. New hardware formats and electronic delivery systems
may be introduced into the software market



                                       16
<PAGE>   17

and potential new competitors may enter the software development and
distribution market, resulting in greater competition for the Company. There can
be no assurance that the Company will have the resources required to respond
effectively, or at all, to market or technological changes, or to compete
successfully with current or future competitors, or that competitive pressures
faced by the Company will not materially and adversely affect the Company's
business, operating results or financial condition.

      Consolidation among software companies significantly increased in l996 and
has shown signs of continuing. For example, CUC, Inc. has purchased Davidson
Software, Sierra and Knowledge Adventure; Softkey, Inc. has purchased The
Learning Company and MECC; IBM has purchased Edmark, and GT Interactive, Inc.
has purchased Humungous Entertainment, Inc. This consolidation process makes it
more difficult for small publishers, such as the Company, to obtain broad retail
distribution without "affiliating" with larger distributors in certain channels.

      In the past, the Company focused primarily on the edutainment product
category. Through the acquisition of On The Toes Of Giants in 1996, the Company
has moved into the area of Internet edutainment products and games. The Internet
category is dominated by a number of very large competitors and is subject to
rapid change in consumer preference. Should the Company increase its presence in
the Internet industry segment, it will experience these additional risks and
competitive pressures.

      Products in the market compete primarily on the basis of subjective
factors, such as entertainment value, and objective factors, such as price,
graphics and sound quality. Large diversified entertainment, cable and
telecommunications companies, in addition to large software companies such as
Microsoft Corporation, are increasing their focus on the interactive
entertainment and education software market, which will result in even greater
competition for the Company. Many of these companies have substantially greater
financial, marketing and technical resources than the Company. As competition
increases, significant price competition and reduced profit margins may result.
In response to increased competition for shelf space, the Company may need to
increase marketing expenditures and/or implement reduced pricing policies. In
addition, competition from new technologies (such as new hardware platforms and
the Internet) may reduce demand in current markets. The Company may have to
commit capital, marketing expenditures and management talent to establish itself
in new markets entered by way of acquisition of, combination with or internal
development of new businesses. There can be no assurance that the Company will
have sufficient resources to make such commitments, or that the Company will be
able to compete successfully in any new market even if such resources are
available.



                                       17
<PAGE>   18

      Seasonality. Typically, revenues are highest during the fourth fiscal
quarter, decline in the first fiscal quarter and are lowest in the second and
third fiscal quarters. This seasonal pattern is due primarily to the increased
demand for the Company's products during the calendar year-end holiday selling
season. There can be no assurance that the Company will achieve profitability
and, even if achieved, that such profitability will be consistent on a quarterly
or annual basis.









                                       18
<PAGE>   19

General.

      The Company completed an initial public offering of 1,150,000 shares of
its common stock, par value $.001 per share (the "Common Stock"), on May 14,
1996. The Company was incorporated in California in 1989 and reincorporated in
Delaware in March, 1996. The Company develops edutainment CD-ROM computer
software. An edutainment product combines entertainment and education content
for home and educational use, in which learning is an integral part of playing a
game. The Company is also operates the Passport2Network, an internet gaming
network, with several interactive games currently operational. The Company began
generating revenue from the Passport2 Network during the second quarter of 1997.

      International Business Machines Corporation ("IBM") is currently marketing
the Emergency Room title, the Company's first RealPlay(TM) (formerly Career
Sim(TM)) series title, which the Company co-developed with IBM. Due to the
Company's inability to reasonably estimate returns on the Emergency Room title,
the Company did not recognize royalty revenue on the accrual basis of accounting
until the fourth quarter of 1996 when the amount of returns could be reasonably
estimated in accordance with Statement of Financial Accounting Standards No. 48
("SFAS 48"). Royalty revenue recognized from the Emergency Room title during the
three months ended March 3l, 1997 , the three months ended June 30, 1997 and the
three months ended September 30, 1997 relates to IBM's sales from the fourth
quarter of 1996 and the first two quarters of 1997 respectively. The Company
expects sales of the original DOS based version of Emergency Room distributed
and marketed by IBM to diminish over the next twelve months.

      As of June 30, 1997 the Company completed the first three cases of the
District Attorney title a Windows95 product, The Best of Emergency Room,
consisting of the best 50 cases from Emergency Room and ER Intern comprising 50
new cases under a Windows-enhanced version of Emergency Room.

      On July 31, 1997 the Company and Alpha Soft Corporation ("Alpha Soft")
entered into a Distribution Agreement for the District Attorney cases 1 through
3 and ER Intern titles. Under the terms of the agreement Alpha Soft will
produce, market and distribute the titles and the Company will receive a royalty
on each sale.

      In addition to the Alpha Soft Agreement in June 1997 the Company began
manufacturing, marketing and distributing, through a sales



                                       19
<PAGE>   20

representative organization, the Best of Emergency Room and the District
Attorney titles as individual cases.

      On June 5, 1997 the Company entered into an Information Provider
Commission Agreement with AT & T WorldNet Service ("WorldNet") whereby customers
of WorldNet are offered the opportunity to participate in Passport2Network
interactive games. The Passport2Network pays WorldNet a royalty for each
WorldNet customer that becomes a Passport2Network subscriber.

      On October 14, 1997 the Company signed an Information Provider Commission
Agreement with The New York Times Electronic Media Company ("Times on Line")
whereby subscribers of the Times on Line Bridge and Chess columns have the
opportunity to participate in Passport2Network interactive games under terms,
including royalty terms, similar to the WorldNet agreement.











                                       20
<PAGE>   21


Results of Operations

      For the three months ended September 30, 1997 compared to the three months
ended September 30, 1996.

      For the three months ended September 30, 1997, revenues increased from
$27,059 for the three months ended September 30, 1996 to $115,814. This $88,755
increase was due primarily to an increase in royalty revenue, less an estimate
for returns, related to initial sales of the District Attorney and ER Intern
titles by Alpha Soft compared to revenue recognized in 1996 from other Company
titles. Software sales increased from $1,974 in 1996 to $33,718 in 1997
resulting primarily from sales by the Company of The Best of Emergency Room
title and individual cases of the District Attorney title through distributors.

      Total cost of revenue for the three months ended September 30, 1997
increased by $31,588 compared to the three months ended September 30, 1996. This
increase is primarily a result of an increase of $9,641 in cost of royalties
associated with sales of the District Attorney and ER Intern titles and an
increase of $21,947 as a result of the increase in software sales by the Company
through distributors during the three month period ended September 30, 1997.

      Product development expenses, which are net of co-funded development
expenses, decreased from $534,951 for the three months ended September 30, 1996
to $10,640 for the three months ended September 30, 1997. The decrease in
development expense is the result of the completion of the District Attorney, ER
Intern and the Best of Emergency Room titles in July, 1997 and the Company
cessation of future product development at that time.

      General and administrative expenses for the three months ended September
30, 1997 decreased by $391,423 or 69% to $174,159, from $565,582 for the three
months ended September 30, 1996. This decrease is primarily due to the Company
ceasing all costs associated with development of new titles; significantly
curtailing its Internet gaming services; closing one business office;
significantly reducing marketing and public relations efforts; reducing the
total Company staff to four administrative personnel and implementing other
operating cost reductions.

      Selling expenses of $16,553 for the three months ended September 30, 1997
decreased $26,197 or 61% from the $42,750 in the three month period ended
September 30, 1996. This decrease is primarily related to decreases in salaries
and promotional expenses related to the introduction of the District Attorney,
The Best of Emergency Room and ER Intern titles and the Passport2Network.




                                       21
<PAGE>   22

      Interest expense decreased from $17,719 to $12,147 for the three months
ended September 30, 1997 compared to the three months ended September 30, 1996
primarily due to the decrease in notes payable and the line of credit at
September 30, 1997. The Company had interest income of $54 for the three months
ended September 30, 1997 compared to $45,248 for the three months ended
September 30, 1996 primarily as a result of a decrease in funds available for
investment since the Company's initial public offering in May 1996.

      For the nine months ended September 30, 1997 compared to the nine months
ended September 30, 1996.

For the nine months ended September 30, 1997 revenue increased by $203,200 from
$35,798 for the nine months ended September 30, 1996 to $238,998 for the nine
months ended September 30, 1997. This increase was primarily due to an increase
in royalty revenue related to sales of the Emergency Room title by IBM in the
six months ended June 30, 1997, and royalty revenue related to sales of the
District Attorney and ER Intern titles by Alpha Soft during the three months
ended September 30, 1997. During the nine month period ended September 30, 1996,
the Company was unable to recognize royalty revenue because the Company was
unable to estimate returns in accordance with SFAS 48. However, as disclosed in
the Company's Annual Report on Form 10K for 1996, the Company was able to
reasonably estimate the returns and recognize royalty revenue during the fourth
quarter of 1996. The portion of the royalty revenue recognized in the fourth
quarter of 1996, which was attributable to sales during the nine month period
ended September 30, 1996, was $435,208. Software sales increased from $7,378 for
the nine months ended September 30, 1996 to $49,969 for the nine months ended
September 30, 1997 primarily from sales of the Best of Emergency Room title
which began shipping in June, 1997 and individual cases of the District Attorney
title which began shipping in the three months ended September 30, 1997.

For the nine month period ended September 30, 1997 cost of royalties was $35,148
compared to $76,507 for the nine months ended September 30, 1996. The decrease
is the result of amortization of the remaining capitalized product development
costs of the Emergency Room title in 1996 offset by an increase in the
amortization of capitalized product development costs of $35,148 during the
three months ended September 30, 1997 from sales of the District Attorney and ER
Intern titles by Alpha Soft. The cost of software sales increased from $6,524 in
the nine month period ended September 30, 1996 to $31,379 in the nine month
period ended September 30, 1997 as a result of sales of the Best of Emergency
Room and individual cases of the District Attorney titles in the nine months
ended September 30, 1997 compared to sales of older Company software products in
1996, as the Best of Emergency Room was not available in 1996.

      Product development expenses, which are net of co-development expenses,
for the nine months ended September 30, 1997 decreased by $199,247, or 25%, to
$611,910 compared to $811,157 for the nine months



                                       22
<PAGE>   23

ended September 30, 1996. The decrease was primarily due to completion of the
District Attorney, ER Intern and the Best of Emergency Room titles in July 1997
and the Company cessation of development of future products at that time.

      General and administrative expense decreased from $1,068,989 for the nine
months ended September 30, 1996 to $947,060, a decrease of $121,929, or 11%, for
the nine months ended September 30, 1997. Since June 30, 1997 the Company has
implemented cost reduction programs by ceasing all costs associated with
development of new titles; significantly curtailing its Internet gaming
services; closing one business office; significantly reducing marketing and
public relations efforts; reducing the total Company staff to four
administrative personnel and implementing other operating cost reductions.

      Selling expenses for the nine months ended September 30, 1997 increased by
$202,463 to $251,697 from $49,234 for the nine months ended September 30, 1996.
The increase is primarily related to the increases in company public relations
efforts and promotional expenses related to the Passport2Network and promotion
of The Best of Emergency Room, District Attorney and ER Intern titles which were
incurred during the first six months of 1997.

      Interest expense decreased from $443,923 for the nine months ended
September 30, 1996 to $43,430 for the nine months ended September 30, 1997
resulting primarily from that certain convertible note in the original principal
amount of $1,000,000 payable to EBC Trust Corporation that was retired in May of
1996. Interest income decreased to $19,546 for the nine months ended September
30, 1997 compared to $73,312 for the nine months ended September 30, 1996 due to
use of the proceeds of the initial public offering in Company operations during
1997.

Liquidity and Capital Resources

      The Company had $1,787,305 in cash outflows from operating activities for
the nine months ended September 30, 1997 compared to cash outflows of $931,598
for the nine months ended September 30, 1996. The increase in net outflows of
$855,707 between 1997 and 1996 operating cash flows primarily resulted from the
following: a decrease in the net loss from operations after adjustments for
non-cash items of $51,621; a decrease in the change of accounts payable and
accrued expenses of $286,267; a decrease in the change of deferred revenue of
$688,971, and an increase in inventory of $70,600. This has been offset by an
increase of $54,637 in the change of development co-funding billings in excess
of development expense co-funding recognized; a increase in the change of
accounts receivable of $91,944, and a decrease in other receivables of $102,700.
The total net



                                       23
<PAGE>   24

outflows from operating activities are primarily the result of net losses caused
by research and development expenditures associated with the Company's
Passport2Network, increases in general and administrative expense associated
with the increase in the Company's overhead structure and increased selling
costs related to the Company's marketing and distribution activities.

      Investing activities in the first nine months of 1997 consisted of a note
receivable of $50,000, purchases of computer equipment and construction of
leasehold improvements totaling $5,238 and the capitalization of product
development costs related to the District Attorney and ER Intern titles totaling
$171,253. These outflows were offset by proceeds from the disposition of
property and equipment in the amount of $7,438. In the first nine months of 1996
investing activities consisted of purchases of computer equipment and
construction of leasehold improvements totaling $254,191 and additional product
development costs for the District Attorney title of $773,222.

      The Company has cash inflows of $162,996 from financing activities for the
first nine months of 1997 compared to inflows of $5,033,552 for the first nine
months of 1996. Financing activities for the nine months ended September 30,
1997 included payments of notes payable of $62,780 and payments under a line of
credit of $35,250 which was offset by proceeds of a note payable of $75,000, the
exercise of warrants for common stock of $162,500 and the issuance of stock to
employees of $23,526. Net cash of $5,033,552 for the first nine months of 1996
consisted of receipt of $5,355,589 representing net proceeds of the Company's
initial public offering less $300,000 used to retire the note payable to EBC
Trust Corporation and an increase of $8,184 on the Company's line of credit.

      In July, August and September 1997 the Company failed to make a principle
payment on an unsecured note Payable to a related party. The monthly payment, in
the amount of $10,000, was due in accordance with the terms of the original Note
dated February 1, 1991 as amended which provides for monthly payments of
principle and interest commencing on July 1, 1997.

      On January 3, 1997, the Company and IBM executed a final termination
agreement with respect to the District Attorney Development and Licensing
Agreement dated November 16, 1995. As consideration for the termination and for
the acquisition of IBM's rights under the agreement, the Company is obligated to
pay to IBM no later than December 15, 1997 the aggregate sum of $400,000,
representing the total amount of milestone payments made by IBM to the Company
under the DA Licensing Agreement however, the Company does not expect to be able
to make a payment of the principal or any portion of such obligation to IBM by
such date. If such obligation is not paid to IBM by December 15, 1997 the amount
due IBM shall be increased by interest at an annual rate of ten (10%) percent
beginning January 1, 1996 and the Company will pay to IBM royalties at the rate
of forty five (45%) percent on royalty revenue received from sales of the
District Attorney title and ten (10%) percent on royalty revenue received from
sales of derivatives and sequels of the Emergency Room title until the
obligation is paid in full.

      The Company's ability to achieve positive cash flow over the next twelve
months depends on a variety of factors including the ability to obtain
additional financing, the timeliness, successful distribution of, and market
acceptance of its current and future software titles, most importantly the
District Attorney, The Best of Emergency Room, and ER Intern titles, the costs
of developing, producing and marketing such titles, and various other factors,
some of which may be beyond the Company's control.

      Additionally, in conjunction with the termination of the co-development
agreements, with IBM and McGraw-Hill the Company



                                       24
<PAGE>   25

accelerated its plans to become a developer/distributor of titles on its own. To
achieve this transition the Company established a sales and marketing
organization in early Spring 1997. The Company modified this distribution
strategy in June 1997 and is proceeding to use a combination of a distributor to
market two titles and to self-distribute two other titles in 1997 and 1998.

      If this transition in distribution methods is not successful the Company
could face short term liquidity requirements that could significantly deplete
current cash resources. At June 30, 1997 the Company implemented programs
designed to improve its liquidity requirements by: ceasing all costs associated
with development of new titles; significantly curtailing its Internet gaming
services; closing one business office; significantly reducing marketing and
public relations efforts; reducing the total Company staff to four
administrative personnel; implementing other operating cost reductions and
seeking additional funding.

      Additionally, although the Company believes that, together with a
successful effort to obtain additional financing to fulfill near-term cash
requirements, its operating plan and efforts to reduce operating expenses, in
conjunction with the acquisition of additional funding, will be adequate to meet
its fiscal 1997 working capital needs, there can be no assurance that the
Company will be able to obtain the necessary financing or that it will not
experience liquidity problems caused by adverse market conditions and other
unfavorable events.

      Should the Company's future income be less than anticipated or its
software title production and introduction be delayed significantly or not
generate sufficient future revenues, the Company will require further additional
capital. The Company may seek to satisfy such capital needs through additional
public or private financings or other sources. However, there can be no
assurance that the Company would be able to obtain such financings on favorable
terms, or at all, and the failure to do so would have a material adverse effect
on the Company's business, financial condition, and results of operations. The
Company's prospects must be considered in light of the risks, expenses and
difficulties encountered by companies in the early stages of development,
particularly companies in new and rapidly evolving markets. The Company has
incurred net losses since inception and expects to continue to operate at a loss
during 1997. Similarly, the Company's future capital requirements will be
affected by, among other things, the timing and cost of producing new titles,
promotional and advertising expenses required to launch new titles, future
titles, debt service requirements including long term notes payable and amounts
due to a former co-development partner, operating leases, and investments in
technological and production process research.



                                       25
<PAGE>   26



PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

      On March 26, 1997 a complaint was filed against the Company in California
Superior Court for the West District of Los Angeles County by The Brief Exchange
Legal Network, Inc. ("Brief Exchange") and Comp-Pro Seminars, Inc. (together the
"Plaintiffs"). The complaint claimed breach by the Company of an alleged oral
contract with Plaintiffs respecting marketing and distribution of the Company's
"District Attorney - Pursuit of Justice" CD-ROM title. The Plaintiffs jointly
alleged damages from lost earnings in the amount of $1,500,000, and Brief
Exchange alleges additional damages from harm to its reputation of $1,000,000.
The parties have reached an agreement to settle the case, documentation of which
is currently being prepared. The settlement contemplates a future business
relationship between the parties and does not involve any monetary payments by
the Company.

      Other than described above, the Company is neither currently a party to
nor is any of its property the subject of any legal proceedings which would be
material to the business or financial condition of the Company.

ITEM 2. CHANGES IN SECURITIES.

      Not Applicable.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES.

      Not Applicable.

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

      Not Applicable.

ITEM 5. OTHER INFORMATION.

      Not Applicable.






                                       26
<PAGE>   27



ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.

      (A)   The following exhibits are included herewith:
          
            Exhibit 11 - Weighted Average of Common Stock Shares
                         Outstanding
            Exhibit 27 - Financial Data Schedule

      (B)   The Company filed no reports on Form 8-K during the quarter for
            which this form is filed.









                                       27
<PAGE>   28



                                   SIGNATURES

      Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

Date:  November 11, 1997             LEGACY SOFTWARE, INC.


                                     /s/ WILLIAM E. SLINEY
                                     ------------------------------------------
                                     William E. Sliney
                                     Vice President and Chief Financial Officer
                                     (Duly Authorized Officer and Principal
                                     Financial and Accounting Officer)







                                       28