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

                                  FORM 10-QSB

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

       For the quarterly period ended January 1, 1999


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


       Commission file number 0-16172


                             COMPUTONE CORPORATION
       (Exact name of small business issuer as specified in its charter)


              Delaware                                  23-2472952
    -------------------------------           --------------------------------
    (State or other jurisdiction of           (IRS Employer Identification No.)
     incorporation or organization) 

          1060 Windward Ridge Parkway, Suite 100, Alpharetta, GA 30005
                    (Address of principal executive offices)

         Issuer's telephone number, including area code: (770) 625-0000

                                      N/A
             (Former name, former address and former fiscal year,
                         if changed since last report)

Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter
period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days.
                                  Yes X     No
                                      
               APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY
                  PROCEEDINGS DURING THE PRECEDING FIVE YEARS

Check whether the registrant has filed all documents and reports required to be
filed by Section 12, 13 or 15 (d) of the Exchange Act after the distribution of
securities under a plan confirmed by a court.
                                  Yes      No

                      APPLICABLE ONLY TO CORPORATE ISSUERS

State the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date: 7,734,444 shares of common stock on
February 4, 1999.

Transitional Small Business Disclosure Format (check one):  Yes     No   X
<PAGE>
 
                             COMPUTONE CORPORATION

                                     INDEX

                         PART I - FINANCIAL INFORMATION
                                        
ITEM 1.       Financial Statements:


              Balance Sheets as of January 1, 1999 and April 3, 1998          3

              Statements of Operations for the three months ended
               January 1, 1999 and January 2, 1998                            4

              Statements of Operations for the nine months ended
               January 1, 1999 and January 2, 1998                            5

              Statements of Cash Flows  for the nine months ended
               January 1, 1999 and January 2, 1998                            6


              Notes to Financial Statements                                   7


ITEM 2.       Management's Discussion and Analysis or Plan of Operation
              for the three and nine months ended January 1, 1999
              compared to the three and nine months ended
              January 2, 1998                                                10



                          PART II - OTHER INFORMATION

ITEM 1.       Legal Proceedings                                              13

ITEM 2.       Changes in Securities                                          13

ITEM 3.       Defaults Upon Senior Securities                                13

ITEM 4.       Submission of Matters to a Vote of Security Holders            13

ITEM 5.       Other Information                                              13

ITEM 6.       Exhibits and Reports on Form 8-K                               14


SIGNATURES                                                                   15

                                       2
<PAGE>
 
                        PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

<TABLE> 
<CAPTION> 

                                                       Computone Corporation
                                                          Balance Sheets
                                                          (in thousands)
 
                                                                                January 1, 1999    April 3, 1998
                                                                                ---------------    -------------
                                                                                  (unaudited)
<S>                                                                             <C>                <C> 
ASSETS
Current assets:
    Cash and cash equivalents                                                          $     53         $    146
    Receivables, net of allowance for doubtful accounts
            of $590 at January 1, 1999 and $668 at April 3, 1998                          1,437            2,540
    Inventories, net                                                                      2,050            3,752
    Prepaid expenses and other                                                               80              102
                                                                                       --------         --------
Total current assets                                                                      3,620            6,540
 
Property, equipment and improvements, net                                                   574              594
 
Intangible assets, net                                                                      440              506
 
Advance (See Note 7)                                                                        450               --
 
Other                                                                                        40               27
                                                                                       --------         -------- 
TOTAL ASSETS                                                                           $  5,124         $  7,667
                                                                                       ========         ======== 
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
    Accounts payable, trade                                                            $  2,605         $  2,600
    Accrued liabilities:
         Payroll                                                                             78               97
         Deferred sales                                                                     353              523
         Professional fees                                                                   16              153
         Other                                                                              563              504
   Line of credit                                                                           432            1,252
   Notes payable to stockholders                                                            450              460
   Current maturities of long-term debt                                                      25               76
                                                                                       --------         -------- 
Total current liabilities                                                                 4,522            5,665

Notes payable to stockholders                                                               565               10
 
Long-term debt, less current maturities                                                      --              116
                                                                                       --------         -------- 
Total liabilities                                                                         5,087            5,791
 
Stockholders' Equity
  Convertible redeemable preferred stock, $.01 par value;
      10,000,000 shares authorized; no shares issued                                         --               --
  Common stock, $.01 par value; 25,000,000 shares
      authorized; 7,734,444 and 7,382,622 shares outstanding                                 77               74
  Additional paid-in capital                                                             45,967           45,062
  Accumulated deficit                                                                   (46,007)         (43,260)
                                                                                       --------         --------
Total stockholders' equity                                                                   37            1,876
                                                                                       --------         -------- 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY                                             $  5,124         $  7,667
                                                                                       ========         ========

                            The accompanying notes are an integral part of these financial statements.
</TABLE>

                                       3
<PAGE>
 
                    PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

                              Computone Corporation
                            Statements of Operations
                      (in thousands, except per share data)

<TABLE> 
<CAPTION> 
                                                                                         Three Months Ended
                                                                              ------------------------------------------
                                                                              January 1, 1999            January 2, 1998
                                                                              ---------------            ---------------
                                                                                              (unaudited)
<S>                                                                              <C>                         <C>
Net sales                                                                        $ 1,922                     $  1,863
                                                                                 -------                     --------
Expenses:                                                                                                 
     Cost of products sold                                                         1,212                        1,824
     Selling, general and administrative                                           1,109                        1,338
     Product development                                                             518                          304
                                                                                 -------                      ------- 
                                                                                   2,839                        3,466
                                                                                 -------                      ------- 
Operating loss                                                                     (917)                       (1,603)
Other income (expense):                                                                                
     Other income (expense)                                                          --                           (50)
     Interest expense - affiliates                                                  (23)                          (12)
     Interest expense - other                                                       (37)                          (29)
                                                                                 -------                      ------- 
Loss before income taxes                                                           (977)                       (1,694)
Provision for income taxes                                                           --                            --
                                                                                 -------                      ------- 
Net loss                                                                         $ (977)                      $(1,694)
                                                                                 =======                      ======= 
Loss per common share:                                                                                    
            Basic                                                                $(0.13)                      $ (0.22)
                                                                                 =======                      ======= 
            Diluted                                                              $(0.13)                      $ (0.22)
                                                                                 =======                      =======
</TABLE> 

  The accompanying notes are an integral part of these financial statements.

                                       4

 

<PAGE>
 
 
                    PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

                             Computone Corporation
                           Statements of Operations
                     (in thousands, except per share data)

<TABLE> 
<CAPTION> 
                                                                                      Nine Months Ended
                                                                          ----------------------------------------
                                                                          January 1, 1999          January 2, 1998
                                                                          ---------------          ---------------
                                                                                        (unaudited)
<S>                                                                           <C>                      <C>
Net sales                                                                     $ 7,574                  $ 8,868
                                                                              -------                  -------
Expenses:
     Cost of products sold                                                      5,092                    6,054
     Selling, general and administrative                                        3,635                    3,377
     Product development                                                        1,475                      872
                                                                              -------                  -------
                                                                               10,202                   10,303
                                                                              -------                  -------
Operating loss                                                                 (2,628)                  (1,435)
Other  income (expense):
     Other income                                                                   2                      247
     Interest expense - affiliates                                                (51)                     (36)
     Interest expense - other                                                     (70)                     (79)
                                                                              -------                  -------
Loss before income taxes                                                       (2,747)                  (1,303)
Provision for income taxes                                                         --                       --
                                                                              -------                  -------
Net loss                                                                      $(2,747)                 $(1,303)
                                                                              =======                  =======
Loss per common share:
            Basic                                                             $ (0.36)                 $ (0.18)
                                                                              =======                  =======
            Diluted                                                           $ (0.36)                 $ (0.18)
                                                                              =======                  =======
</TABLE> 
  The accompanying notes are an integral part of these financial statements.

                                       5
<PAGE>
 
                       PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

                             Computone Corporation
                           Statements of Cash Flows
                                (in thousands)
                                  (unaudited)

<TABLE> 
<CAPTION>
                                                                                              Nine Months Ended
                                                                                  -------------------------------------------
                                                                                  January 1, 1999             January 2, 1998
                                                                                  ---------------             ---------------
                                                                                                 (unaudited)
<S>                                                                                  <C>                         <C>
Cash flows from operating activities:
  Net loss from operations                                                           $(2,747)                    $(1,303)
  Adjustments to reconcile loss from operations
     to net cash provided by (used in) operations:
       Depreciation and amortization                                                     336                         389
       Provision for uncollectible accounts                                              110                         154
       Provision for inventory reserve                                                    70                         100   
       Changes in current assets and current liabilities:
          Accounts receivable                                                            993                        (363)
          Inventories                                                                  1,632                         161
          Prepaid expenses and other                                                      22                        (112)
          Accounts payable and accrued liabilities                                      (275)                     (1,035)
                                                                                     -------                     -------
Net cash provided by (used in) operations                                                141                      (2,009)
                                                                                     -------                     -------
Cash flows from investing activities:
   Decrease in other assets                                                               --                          63
   Advance (See Note 7)                                                                 (450)                         --
   Capitalization of software costs                                                     (136)                       (185)
   Capital expenditures                                                                 (114)                        (88)
                                                                                     -------                     -------
Net cash used in investing activities                                                   (700)                       (210)
                                                                                     -------                     -------
Cash flows from financing activities:
  Borrowings from affiliates                                                             545                          35
  Repayment of debt - net                                                               (167)                       (500)
  Net borrowings under term loan                                                          --                         180
  Net (repayments) borrowings under lines of credit                                     (820)                        663
  Exercise of common stock options and warrants                                            3                          25
  Issuance of common stock                                                               905                       1,742
                                                                                     -------                     -------
Net cash provided by financing activities                                                466                       2,145
                                                                                     -------                     -------
Net decrease in cash and cash equivalents                                                (93)                        (74)
Cash and cash equivalents, beginning of period                                           146                          88
                                                                                     -------                     -------
Cash and cash equivalents, end of period                                             $    53                     $    14
                                                                                     =======                     =======
Supplemental  disclosures  of cash flow  information:
  Cash paid during the year for:
    Interest                                                                         $    70                     $   115
</TABLE> 

 The accompanying notes are an integral part of these financial statements.

                                       6



<PAGE>
 
                             COMPUTONE CORPORATION
                         NOTES TO FINANCIAL STATEMENTS
                                  (UNAUDITED)

 
     All statements contained in this Form-10QSB Quarterly Report that are not
historical facts are based on current expectations.  Such statements are
forward-looking (as defined in the Private Securities Litigation Reform Act of
1995) in nature and involve a number of risks and uncertainties.  Actual results
could vary materially.  The factors that could cause actual results to vary
materially include:  the ability of the Company to obtain and maintain adequate
working capital, the Company's need for substantial additional equity capital,
the outcome of certain litigation pending against the Company, including a
Securities and Exchange Commission ("SEC") investigation,  general business and
economic conditions in the market, the Company's ability to maintain its
existing customers and other risks that may be described from time to time in
reports the Company files with the SEC.  Undue reliance should not be placed on
any such forward-looking statements.


1.   BASIS OF PRESENTATION

     The financial statements included in this Form 10-QSB Quarterly Report have
been prepared by the Company, without audit, pursuant to the rules and
regulations of the SEC. Certain information and footnote disclosures, normally
included in financial statements prepared in accordance with generally accepted
accounting principles, have been condensed, or omitted, pursuant to such rules
and regulations.  These financial statements should be read in conjunction with
the financial statements and related notes included in the Company's  Form 10-
KSB Annual Report for its fiscal year ended April 3, 1998.

     The financial statements presented herein as of January 1, 1999 reflect, in
the opinion of management, all adjustments necessary for a fair presentation of
financial position and the results of operations for the periods presented.  The
results of operations for any interim period are not necessarily indicative of
the results for the full year.

2.   REVENUE RECOGNITION

     Product sales are generally recognized, net of an allowance for estimated
sales returns and allowances, when the related products are shipped; however
beginning with the fourth quarter of the fiscal year ended April 3, 1998, the
Company modified the application of its revenue recognition policy to defer
recognition of revenue on sales to customers who are not end users of the
Company's products until such time as the product has been sold through to the
end user.  The modification was implemented in response to management's
determination that the estimated returns and allowances attributable to such
sales cannot be accurately quantified and is considered a change in estimate
under APB Opinion No. 20, "Accounting Changes". The effect of adopting this
modification on  the Company's financial statements for the nine months ended
January 1, 1999 was to increase revenue by approximately $80,000 and decrease
operating loss by approximately $30,000.

     A warranty reserve of less than one percent of sales is accrued at the date
of shipment.  The Company generally provides a warranty of five years on all of
its products sold.

                                       7
<PAGE>
 
                             COMPUTONE CORPORATION
                         NOTES TO FINANCIAL STATEMENTS
                                  (UNAUDITED)

3.   INVENTORIES
 
     Inventories are valued at the lower of cost or market, with cost determined
on the first-in, first-out method.

     Raw materials that have no planned production life or exceed 18 months of
anticipated supply are deemed excess and are fully reserved.  Reserves are also
established, as management deems appropriate, for obsolete, excess and non-
salable inventories, including finished goods inventories.

     Inventories are net of a reserve for obsolete, excess and non-salable items
of $738,000 and $851,000 at January 1, 1999 and April 3, 1998, respectively.

     Inventories, net of a reserve for obsolete, excess and non-salable items,
consisted of the following at January 1, 1999 and April 3, 1998 (in thousands):
<TABLE>
<CAPTION>
                           January 1, 1999   April 3, 1998
<S>                        <C>               <C>
 
     Finished goods                 $  785          $1,375
     Work in progress                  612             533
     Raw materials                     653           1,844
                                    ------          ------
                                    $2,050          $3,752
                                    ======          ======
</TABLE>

4.   LOSS PER SHARE

     In February 1997, the FASB issued SFAS No. 128, "Earnings Per Share." SFAS
No. 128 establishes standards for computing and presenting earnings per share
("EPS").  SFAS No. 128 requires the dual presentation of basic and diluted EPS
on the face of the statement of operations.  Basic EPS excludes dilution and is
computed by dividing income (loss) available to common shareholders by the
weighted average number of common shares outstanding for the period.  Diluted
EPS reflects the potential dilution that could occur if securities or other
contracts to issue common stock were exercised or converted into common stock.
The Company adopted SFAS No. 128 during fiscal 1998 and has restated all prior
period EPS data. For purposes of computing basic and diluted EPS, the net income
(loss) for each period presented (the numerator) is divided by the weighted
average number of common shares outstanding (the denominator) resulting in basic
and diluted EPS of ($0.13) for the three months ended January 1, 1999 and
($0.22) for the three months ended January 2, 1998.  The basic and diluted EPS
for the nine months ended January 1, 1999 is ($0.36) and ($0.18) for the nine
months ended January 2, 1998.  For purposes of computing diluted EPS during the
three and nine month periods ended January 1, 1999, the Company excluded the
effects of outstanding common stock options and warrants because they were anti-
dilutive.

5.   INCOME TAXES

     Income taxes are calculated using the liability method specified by SFAS
109, "Accounting for Income Taxes".  The Company provides a valuation allowance
against its deferred tax assets to the extent that management concludes that it
is more likely than not that the Company will not benefit from the utilization
of such deferred tax assets.

     The Company has available net operating and capital loss carryforwards
amounting to approximately $53 million at April 3, 1998, including operating
loss carryforwards which relate to a predecessor company, which expire in 2013.
As a result of several ownership changes which have occurred since the losses
started to accumulate, statutory provisions will substantially limit the
Company's future use of the loss carryforwards.

                                       8
<PAGE>
 
                             COMPUTONE CORPORATION
                         NOTES TO FINANCIAL STATEMENTS
                                  (UNAUDITED)
                                        
6.    DEBT

      On June 20, 1997, the Company entered into a financing arrangement with a
lender which provided for a term loan in the amount of $254,000 at a rate of
prime plus 1.50%, which was collateralized by the Company's inventory.  In
addition, a line of credit agreement existed with the lender for up to
$2,500,000  and was based on the available borrowing base, at a rate of prime
plus 1.25% which was collateralized by the Company's accounts receivable.

      On September 8, 1998, the Company received notice that the lender had
accelerated all sums due under the financing agreement and made demand for
payment of all outstanding balances due to the Company's violation of the
minimum net worth covenant. The Company and the lender entered into a
forbearance agreement while the Company sought to find another lender.

      On November 17, 1998, the Company and a new lender entered into a
financing arrangement which provides for a line of credit up to $1,800,000
($432,000 outstanding at January 1, 1999) and is based on the available
borrowing base, at rate of prime plus 2.00%.   A portion of the proceeds from
this line of credit was used to retire the debt borrowed under the June 20, 1997
financing agreement.  The line of credit is primarily collateralized by the
Company's accounts receivable and inventory. The financing arrangement contains
various affirmative and negative covenants and, as of January 1, 1999, the
Company was in violation of the minimum consolidated tangible net worth covenant
and the minimum net working capital covenant.   The company has obtained from
the lender a waiver through March 31, 1999 regarding compliance with these two
covenants.

7.    ADVANCE
 
      On June 5, 1998, the Company entered into an Agreement and Plan of
Reorganization (the "Agreement") with Ladia Communications Technologies, Inc., a
newly formed subsidiary of the Company ("LCTI"), New Computone Corporation, a
newly formed subsidiary of the Company ("Newco"), Ladia, L.L.C., a Massachusetts
limited liability company ("Ladia") and the members of Ladia.  A copy of the
Agreement was included as Exhibit 1 to the Company's Form 8-K Report dated
August 3, 1998 and reference is made to such exhibit for a full statement of the
terms and conditions of the transactions contemplated by the Agreement.  In
summary, the Agreement provides that the current holders of the Company's Common
Stock and the current members of  Ladia will become shareholders of LCTI and the
Company and Ladia will become subsidiaries of LCTI.  The Agreement provides that
the current members of Ladia and the holders of approximately $250,000 of debt
owed by Ladia would initially receive approximately 430,000 shares of LCTI
Common Stock and, subject to the satisfaction of certain specified criteria
relating to Ladia financial performance through April 30, 1999, could receive up
to 8.1 million shares of LCTI Common Stock.  A copy of the Company's June 9,
1998 press release relating to the execution of the Agreement is included as
Exhibit 2 to the Company's Form 8-K Report.

      The Company and Ladia have agreed in principle on a renegotiation of
certain terms of the Agreement.  Under the terms negotiated, members of Ladia
would receive approximately 40% of the ownership interests of LCTI.  The Company
cannot currently predict when a revised definitive Agreement will be executed or
when the transactions contemplated by the Agreement as renegotiated in principle
will be consummated.

      Under the renegotiated terms, it is contemplated that  would use
commercially reasonable efforts to raise additional equity financing of up to $4
million for Ladia.  During the nine months period ending January 1, 1999, the
Company made available to Ladia $450,000 in proceeds from the private placement
of Common Stock by the Company, and has made an additional $250,000 available
subsequent to January 1, 1999.  The unwritten understanding between the Company
and Ladia is that the funds advanced to Ladia by the Company would be converted
in Common Stock of LCTI upon the consummation of the transactions contemplated
by the Agreement and, if those transactions are not consummated, the amount of
advances would constitute unsecured indebtedness of Ladia to the Company.

                                       9
<PAGE>
 
ITEM 2.   MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS FOR THE
          THREE AND NINE MONTHS ENDED JANUARY 1, 1999 COMPARED TO THE THREE AND
          NINE MONTHS ENDED JANUARY 2, 1998.

RESULTS OF OPERATIONS

FOR THE THREE MONTHS ENDED JANUARY 1, 1999 COMPARED TO THE THREE MONTHS ENDED
JANUARY 2, 1998

     The Company reported a loss from operations for the quarter ended January
1, 1999 of $917,000 compared to a loss of $1,603,000 for the comparable quarter
of the prior fiscal year. The Company's operating results for the three months
ended January 1, 1999 were favorably affected by increased net sales,  increased
gross margins on sales and decreased general and administrative expenses

     Product sales revenue for the quarter ended January 1, 1999 totaled
approximately $1,922,000 compared to $1,863,000 for the comparable quarter of
the prior fiscal year, a increase of $59,000, or 3%.  This increase in net
product sales revenue is attributable to lower number of returns from the
Company's distribution channel. As a result of a reorganization of the Company's
sales force, sales to major accounts and North American distributors increased
and sales to OEM's, VAR's and international customers decreased.

     Cost of products sold for the quarter ended January 1, 1999 amounted to
$1,212,000, or 63% of product sales revenues versus $1,824,000, or 98%, for the
comparable quarter of the prior year. The decrease in cost of products sold as a
percentage of revenues is attributable to the write-off of previously
capitalized manufacturing overhead costs in the prior fiscal year as well as
increased gross margins on  sales to the Company's domestic customers.

     Selling, general and administrative expenses amounted to $1,109,000, or 58%
of product sales revenue, for the three months ended January 1, 1999 versus
$1,338,000, or 72%, for the comparable three months of the prior fiscal year.
The decrease in selling, general and administrative expenses during the quarter
ended January 1, 1999 versus the same period of the prior fiscal year is
attributable to decreases in compensation costs due to staff reductions which
were partially offset by increased legal costs.

     Product development expenses amounted to $518,000, or 27% of product sales
revenue, for the three months ended January 1, 1999 versus $304,000, or 16%,
for the comparable three month period of the prior fiscal year. This increase in
product development costs is attributable to additional staffing and equipment
rental expenses necessary to complete the Company's new product release dates
for the current fiscal year.


RESULTS OF OPERATIONS

FOR THE NINE MONTHS ENDED JANUARY 1, 1999 COMPARED TO THE NINE MONTHS ENDED
JANUARY 2, 1998

     The Company reported a loss from operations for the nine month period ended
January 1, 1999 of $2,628,000 compared to a loss from operations of $1,435,000
for the comparable period of the prior fiscal year. The Company's operating
results for the nine month period ended January 1, 1999 were unfavorably
affected by depressed sales volume, and increased general and administrative
expenses and product development costs

     Product sales revenue for the nine month period ended January 1, 1999
totaled approximately $7,574,000 compared to $8,868,000 for the comparable
period of the prior fiscal year, a decrease of $1,294,000, or 15%.  This
decrease in product sales revenue is attributable to the continued delay in the
delivery of new products, reorganization of the Company's sales force to utilize
more of the distribution channel and delay in the receipt of product from the
Company's suppliers due to the Company's working capital shortages.

                                       10
<PAGE>
 
ITEM 2.   MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS FOR THE
          THREE AND NINE MONTHS ENDED JANUARY 1, 1999 COMPARED TO THE THREE AND
          NINE MONTHS ENDED JANUARY 2, 1998, CONT.

     Cost of products sold for the nine month period ended January 1, 1999
amounted to $5,092,000, or 67% of product sales revenues versus $6,054,000, or
68% of product sales revenues, for the comparable period of the prior year. The
high dollar volume of  low margin sales to the Company's major customer  and a
reduction in sales volumes were substantially offset by sales at higher gross
margins to the Company's other customers and a reduction in the write-off of
previously capitalized manufacturing overhead costs.

     Selling, general and administrative expenses amounted to $3,635,000, or 48%
of product sales revenue, for the nine month period ended January 1, 1999 versus
$3,377,000, or 38%, for the comparable period of the prior fiscal year.  The
increase in selling, general and administrative expenses is attributable to
increases in  legal costs, trade shows/advertising costs and bad debt expenses,
partially offset by a decrease in compensation costs due to staff reductions.

     Product development expenses amounted to $1,475,000, or 19% of product
sales revenues, for the nine month period ended January 1, 1999 versus $871,000,
or 10%,  for the comparable period of the prior fiscal year. This increase in
product development costs is attributable to additional staffing and equipment
rental expenses necessary to complete the Company's product release dates for
the current fiscal year.


LIQUIDITY

     In order to meet the Company's liquidity needs arising from the operating
losses, the Company has raised and continues to seek additional equity capital
by offering for sale, to accredited investors, shares of the Company's common
stock under Regulation D of the Securities Act of 1993.   Management believes
that sufficient funds can be raised to fund the Company's operations during
fiscal 1999.  However, no assurances can be given that the Company will be
successful in raising additional capital.  Further, there can be no assurance,
assuming the Company successfully raises additional funds, that the Company will
achieve profitability or positive cash flow.

     The Company's primary cash commitments in fiscal 1999 include payments
under non-cancelable operating leases ($308,000), short-term debt ($907,000) and
investments in research and development ($1,475,000 in the first nine months of
fiscal year 1999). Relationships with major vendors are satisfactory although
the Company is on a "Cash On Delivery" status with several raw materials
vendors. Of the $907,000 outstanding as of January 1, 1999, approximately
$475,000 is due to related parties, the maturity of which the Company believes
can be extended as needed.

      On November 17, 1998, the Company and a new lender entered into a
financing arrangement which provides for a line of credit up to $1,800,000
($432,000 outstanding at January 1, 1999) and is based on the available
borrowing base, at rate of prime plus 2.00%. The line of credit is primarily
collateralized by the Company's accounts receivable and inventory. The financing
arrangement contains various affirmative and negative covenants and, as of
January 1, 1999, the Company was in violation of the minimum consolidated
tangible net worth covenant and the minimum net working capital covenant.  The
company has obtained from the lender a waiver through March 31, 1999 regarding
compliance with these two covenants.

     Cash provided by operations amounted to $141,000 for the nine months ended
January 1, 1999 compared to cash used in operations of $2,009,000 for the nine
months ended January 2, 1998.  The increase in cash provided by operations
compared to the prior year fiscal period primarily reflects the decrease in
accounts receivable and inventories.

     Cash used in investing activities amounted to $700,000 for the nine months
ended January 1, 1999 compared with $210,000 used in financing activities for
the nine months ended January 2, 1998.  This increase from the same period of
the prior fiscal year is attributable to funds raised from the private placement
of common stock, a substantial portion of which was used to fund an advance (See
Note 7 for further information).

                                       11
<PAGE>
 
ITEM 2.   MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS FOR THE
          THREE AND NINE MONTHS ENDED JANUARY 1, 1999 COMPARED TO THE THREE
          AND NINE MONTHS ENDED JANUARY 2, 1998, CONT.


     Cash provided by financing activities during the nine months ended January
1, 1999 was $466,000 versus  $2,145,000 for the nine months ended January 2,
1998.  This decrease is partially due to the Company's repayments on the June
20, 1997 financing arrangement during the nine months ended January 1, 1999
versus borrowings under that arrangement during the nine months ended January 2,
1998.  In addition, issuance of common stock was $905,000 in the nine months
ended January 1, 1999 versus $1,742,000 in the nine months ended January 2, 1998
(See Note 7).

     Working capital was a deficit of $902,000 at January 1, 1999 versus
positive working capital of $875,000 at April 3, 1998, a decrease of $1,777,000.
The ratio of current assets to current liabilities at January 1, 1999 was 0.80
to 1.00 compared to 1.15 to 1.00 at April 3, 1998.

YEAR 2000 RISKS

     The year 2000 issue relates to computer programs and systems which
recognize dates using two digit year data rather than four digit year data.  As
a result, such programs and systems may fail or  provide  incorrect information
when using dates after  December 31, 1999.

     The Company has conducted a review of its internal computer programs and
operating systems to assess the impact of the year 2000 issue.  The Company
believes that its internal computer programs and systems are capable of
addressing the year 2000 issue,  and that no material expenditures are required
in this regard.  The Company is in the process of assessing year 2000 compliance
with its key vendors and other companies doing business with it.  Although the
Company is optimistic that it will able to timely address any year 2000 problems
that it identifies, the failure of the Company's or third parties' systems to be
year 2000 compliant could have an material adverse effect on the Company's
business, financial condition or results of operations.

OUTLOOK FOR REMAINDER OF FISCAL YEAR 1999

     Management believes that the release of the Company's TotalAccess DCS-5000,
scheduled for the fourth quarter of fiscal 1999, will significantly enhance the
Company's ability to increase its sales.  The DCS-5000 combines the features of
a high performance Ethernet digital remote access server with up to 12 DSP 24-
channel modem cards.  The DCS-5000 is intended for use by Internet Service
Providers and medium to large companies that require high-density connectivity,
allowing remote users and locations access to the Internet and corporate
Intranets.  The DCS-5000 will reduce the Company's dependence on third party
products and management believes that it can be sold at a considerable margin.
Additionally, during the fourth quarter of fiscal 1999, the Company plans to
introduce two new product families,  the Powergate and the Powerrack RAS-2000.
The Powergate family of products are high performance, cost effective PCI
controller products specifically designed to meet the needs of the remote access
market.  The Powerrack RAS-2000 is a redesign of the Powerrack family of
products and will add additional features such as Ethernet "Plug `n Play"
connectivity.

     The Company's backlog was approximately $403,000 and $995,000 at January 1,
1999 and January 31, 1999, respectively.  The Company anticipates that
substantially all of its backlog will be shipped during the fourth quarter of
the 1999 fiscal year.

     During January 1999, the Company received proceeds from the sale of common
stock under Regulation D of the Securities Act of 1933 in the amount of
$710,000.

                                       12
<PAGE>
 
                          PART II - OTHER INFORMATION


ITEM 1.   LEGAL PROCEEDINGS

          During the third quarter of fiscal 1999, the Company reached a
          settlement with Edward T. Lack, Jr. in the matter  described in Item 3
          to the Company's Annual Report on Form 10-KSB for the year ended April
          3, 1998.  The settlement calls for the Company to issue Mr. Lack
          50,000 shares of the Company's Common Stock.  Such shares will be
          issued during the fourth quarter of 1999.  In exchange, Mr. Lack will
          release all claims against the Company.

          During the third quarter of fiscal 1999, the Company reached a
          settlement with Capella Worldwide and Comerica Bank in the matter
          described in Item 3 to the Company's Annual Report on Form 10-KSB for
          the year ended April 3, 1998.  The settlement calls for the Company to
          pay both parties an aggregate amount of $150,000.   The Company had
          adequate amounts accrued to cover the cost of this settlement.  In
          exchange, both parties will release all  claims in against the
          Company.

          During February 1999, the Company reached an agreement in principle
          with Marshall Industries to settle the matter described in Item 3 to
          the Company's Annual Report of Form-10KSB for the year ended April 3,
          1998.  This agreement will not have a material adverse affect on the
          Company.

ITEM 2.   CHANGES IN SECURITIES

          In December 1998, the Company sold 36,000 shares of Common Stock at a
          price of $2.10 per share to one accredited investor in a private
          placement. The private placement is pursuant to Regulation D under the
          Securities Act of 1933. No underwriters were utilized in connection
          with such sales, nor were any underwriting discounts or commissions
          paid. The aggregate proceeds from such sales of Common Stock of
          $75,600 were used for working capital items and to partially fund the
          Company's loss from operations of $917,000 during the fiscal quarter
          ended January 1, 1999.

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

          On December 2, 1998, the Company's Common Stock was delisted from the
          Nasdaq SmallCap Market for failure to satisfy the Nasdaq requirement
          that the Company maintain net tangible assets of not less that $3
          million. The Company's Common Stock is now being traded on the OTC
          Bulletin Board. On December 3, 1998, the Company issued a press
          release reporting the delisting, a copy of which is included as
          Exhibit 99.1 to this Form 10-QSB Quarterly Report.

                                       13
<PAGE>
 
                    PART II - OTHER INFORMATION, continued.



ITEM 6.   EXHIBITS AND REPORTS ON FORM 8-K

<TABLE> 
<CAPTION> 

          (a) Exhibits

          Exhibit No.               Description of Exhibit              Reference
<S>                          <C>                                     <C>  
              1               December 3, 1998 press release of       Filed Herewith
                              the Company relating to Nasdaq
                              delisting.
 
</TABLE> 

          (b) Reports on 8-K:

              Current report on Form 8-K Report dated November 17, 1998
              reporting the Company's new financing agreement.

                                       14
<PAGE>
 
                                   SIGNATURES


     In accordance with the requirements of the Exchange Act, the registrant
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.



                             COMPUTONE CORPORATION


Date: February 11, 1999      By:   /s/ Perry J. Pickerign
                                   -------------------------------------------
                                   Perry J. Pickerign
                                   President and Chief Executive Officer
                                   (Principal Executive Officer)


                             By:   /s/ Keith H. Daniel
                                   --------------------------------------------
                                   Keith H. Daniel
                                   Chief Financial Officer
                                   (Principal Financial and Accounting Officer)
 

                                       15
<PAGE>
 
                                 EXHIBIT INDEX


Exhibit Number                 Description                     Reference

     1               December 3, 1998 press release of      Filed Herewith
                     the Company relating to Nasdaq
                     Delisting

                                       16